Introduction

Marginal costing is not a distinct method: Marginal costing is not a distinct method of costing like job costing, process costing, operating costing, etc., but a special technique used for management decision making. Marginal costing is used to provide a basis for the interpretation of cost data to measure the profitability of different products/ Processes and costs centres in the course of decision making. It can therefore be used in conjunction with the different methods of costing such as standard costing or budgetary control.

Cost Ascertainment as on the basis of nature of cost: In marginal costing, cost ascertainment is made on the basis os the nature of control. It gives consideration to behavior of costs. In other words, the technique has developed from a particular conception and

expression of the nature and behavior cost and their effect upon the profitability of an undertaking.

Marginal costing facilitates decision making:

In the orthodox or total cost method, as

opposed to marginal costing method, the classification of costs is based on functional basis. Under this method the total cost is the sum of the cost direct material, direct labour. Direct expense, manufacturing overheads, administrating overheads, selling and distribution

overheads. In this system other things being equal, the total cost per unit will remain constant only when the level of output or mixture is the same from period to period. Since these factors are continually fluctuating, the actual total cost will vary from one period to another. Thus it is possible for the costing department to say one day that an item cost Rs 20 and the next day it costs Rs 18.This situation arises because of changes in volume of output and the peculiar behavior of fixed expense included in the total cost. Such fluctuating manufacturing activity and consequently the variations in the total cost from period to period or even from day to day, poses a serious problem to the management in taking sound decisions. Hence the application of marginal costing has been wide recognition in the field of decision making.

Basic Characteristics of Marginal Costing

The technique of marginal costing is based on the distinction between product costs and period costs. Only the variables costs are regarded as the costs of the product while the fixed costs are treated as period costs which will be incurred during the period regardless of the volume of output. The main characteristics of marginal costing are as follows:

1. All elements of costs are classified into fixed and variable components. Semi-variable costs are also analyzed into fixed and the variable elements.

2.

The marginal or variable costs (as direct material, direct labour, direct expenses) are treated as the cost of product.

3. Under marginal costing, the value of finished goods and work-in-progress is also comprised only of marginal costs. Variable selling and distribution are excluded for valuing these inventories. Fixed costs are not considered for valuation of closing stock or finished goods and closing WIP.

4. Fixed cost are treated as period costs and is charged to profit and loss account for the period for which they are incurred.

5. Prices are determined with reference to marginal costs and contribution margin.

6. Profitability of departments and products is determined with reference to their contribution margin.

Definitions
In order to appreciate the concept of marginal costing, It is necessary to study the definition of marginal costing and certain other items associated with this technique. The important terms have been defined as follows:

1. Marginal Costing: The ascertainment of marginal cost and the effect on profit of changes in volume of type of output by differentiating between fixed costs and variable costs. 2. Marginal Cost: The amount at any given volume of output by which aggregate variable costs are changed if the volume of output is increased by one unit. In practice this is sum of prime cost and variable overhead. 3. Direct Costing: direct costing is the practice of changing all direct cost to operations, Processes of products, Leaving all indirect costs to be written of against profits on the period in which they arise. Under firect costing the stocks are valued at direct costs, ie., costs whether fixed or variable which can be directly attributable to the cost units. Differential Cost: It may be defined as the increase or decrease in total cost or the change in specific elements of cost that result from any variation in operations. It represents an increase or decrease in total cost resulting out of:

4.

(a) Producing or distributing a few more or few less of the products. (b) A change in the method of production or of distribution. (c) An addition or deletion of a product or a territory and (d) Selection of additional sales channel.

5. Incremental Cost: It is defined as the additional costs of a change in the level or nature of activity. As such for all practical purposes there is no difference between incremental cost and differential cost. However, from a conceptual point of view, differential cost refers to both incremental as well as decremental cost. One aspect which is worthy to note is that incremental cost is not the same at all levels. Incremental cost between 50% an 60% level of output may be different from that which is arrived at between 80% and 90% level of output.

Ascertainment of Marginal Cost

Under marginal costing, fixed expenses are treated as period costs and are therefore charged to profit and loss account. In order to ascertain the marginal cost, we classify the expenses as under:

1. Variable Expenses: Apart from prime costs which are variable, the overhead expenses that change in proportion to the change in the level of activity are also variable expenses. Thus when expense go up or come down in proportion to a change in volume of output, such that, with every increase of 20% in output, expenses fluctuate in total with fluctuations in the level of output tend to remain constant per unit of output. Examples os such expenses are raw material, power, commission paid to salesmen as a percentage of sales etc.

2. Fixed Expenses: Fixed expenses or constant expenses are those which do not vary in total with the change in volume of output for a given period of time. Fixed cost per unit of output will, however, Fluctuate with changes in the level of production. Examples of such levels of fixed costs at different levels of output. As for example, where after certain level of output extra expenditure may be needed, in the case of introduction of additional shift working, fixed expenses will be incurred, say, for the appointment of additional supervisors. Fixed expenses are treated as period costs and are therefore charged to profit and loss account.

3. Semi-Variable Expenses: these expense (also known as semi-fixed expenses) do not change eithin the limits of a small range of activity but may change when the output reaches a new level in the same direction in which the output changes. Such increases or decreases in expenses are not in proportion to output. An example of such an expense is delivery van expense. Semi-variable expenses may remain constant at 50% to 60% level of activity and may increase in total from 60% to 70% level of activity. These expenses can be segregated into fixed and variable by using any one of the method, as given under next heading. Depreciation of plant and machinery depends partly on efflux of time and partly on wear and tear. The former is fixed ant the latter is variable. The total cost is arrived at by merging these three types of expenses.

Separating Fixed and Variable Costs

Uses of segregation of cost

Segregation of all expenses into fixed and variable elements is the essence of marginal costing. The primary objective of the classification of expenses into fixed and variable elements is not to find out the marginal cost for various types of managerial decesions. A number of such decesions will be discussed later in the chapter. The other uses of it are below:

(a) Control of Expenses: the classification of expenses helps in controlling expenses. Fixed expenses are said to be sunk costs as these are incurred irrespective of the level of production activity and they are regarded as un controllable expenses. Since variable

expenses vary with the production they are said to be controllable. By this classification therefore, responsibility for incurring varialble expenses is determined in relation to activity and hence the management is acle to control these expenses. The departmental heads always try to keep these expenses within limits set by the management.

(b) Preparation of Budget Estimates: This distinction between fixed and variable cost also helps the management to estimate precisely, the budgeted expenses to gauge the actual efficiency of the business bu comparing the actual with budgets.

Advantages and Limitations of Marginal Costing

Advantages of Marginal Costing

1. Simplified pricing policy:

The marginal cost remains constant per unit of output

whereas the fixed cost remains constant in total. Since marginal cost per unit is constant from period to period within a short span of time, firm decesions on pricing policy can be taken. If fixed cost is included, the unit cost will change from day to day depending upon the volume of output. This will make decision making task difficult.

2. Proper recovery of Overheads: Overheads are recovered in costing on the basis of predetermined rates. If fixed overheads are included on the basis of pre determined rates, there will be under recovery of overheads if production is more than the budget or actual expenses are less than the estimate. This creates the problem of treatment of such under or over recovery of overheads. Marginal Costing avoids such under or over recovery of overheads.

3.

Shows Realistic Profit: Advocates of marginal costing argues that under the marginal costing technique, the stock of finished goods and work-in-progress are carried on marginal cost basis and the fixed expenses are written off to profit and loss account as period cost. This shows the true profit for the period.

4. How much to produce: marginal costing helps in the preparation of break-even analysis which shows the effect of increasing or decreasing production activity on the profitability of the company.

5. More control over expenditure: segregation or expenses as fixed and variable helps the management to exercise control over expenditure. The management can compare the

actual variable expenses with the budgeted variable expenses and take corrective action through analysis of variances.

6. Helpa in Decision Making: Marginal costing helps the management in taking a number of business decesions like make or buy, discontinuance or a particular product, replacement of machines, etc.

Limitations of Marginal Costing

1. Difficulty in Classifying fixed and variable elements: It is difficult ot classify exactly the expenses into fixed and variable category. Most of the expenses are neither totally variable nor wholly fixed. For example, various amenities provided to workers may have no relation either to volume of production or time factor.

2. Scope for Low Profitability: Sales staff may mistake marginal cost for total cost and sell at a price; which will result in loss or low profits. Hence, sales staff should be cautioned while giving marginal cost.

3. Faulty valuation: Overheads of fixed nature cannot altogether be excluded particularly in large contracts. While valuing the work-in-progress. In order to show the correct position fixed overheads have to be included in work-in-progress.

4. Unpredictable nature of cost: Some of the assumptions regarding the behavior of the various costs are not necessary true in a realistic situation. For example, the assumption that fixed cost will remain static throughout is not correct. Fixed cost may change from one period to another. For example salaries bill may go up because of annual increment or due to change in pay rate etc. The variable costs do not remain constant per unit of output. There may be changes in the prices of the raw materials, wage rate, etc. after a certain level of output has been reached due to shortage of material, shortage of skilled labour, concessions of bulk purchases etc. 5. Marginal costing ignores time factor and investment: the marginal cost of two jobs may be the same nut the time taken for their completion and the cost of machines used may differ. The true cost of a job which takes longer time and uses costlier machine would be higher. The fact is not disclosed by marginal costing.

6. Contribution of a product itself is not a guide for optimum profitability unless it is linked with the key factor.

MARGINAL COSTING AS A MANAGEMENT ACCOUNTING TOOL

1. Marginal Costing is clearly the core aspect of traditional management accounting. Some of the classical applications of management accounting, however, have begun to lose their significance. The question thus arises: What is the current role of Marginal Costing in modern management accounting?

2. Businesses today frequently voice their disapproval of the traditional cost accounting approaches. At the beginning of the 1990s, these criticisms were taken up by researchers involved with the applications of cost accounting concepts.

The main thrust of the dissatisfaction with conventional cost accounting methods is that they are too highly developed and too complex, and furthermore are no longer needed in their current form since other tools are now available. Calls for increased use of cost management tools, investment analyses, and value-based tool concepts are frequently associated with criticism of the functionality of current cost accounting approaches as management tools. This line of criticism sees little relevance in traditional cost accounting tasks such as monitoring the economic production process or assigning the costs of internal activities. At their current level of detail, such tasks are neither necessary nor does their perceived pseudo accuracy further the goals of management.

The viewpoint of the present author is that cost accounting has by no means lost its right to exist, for it is an easily overlooked fact that the data structure required by the new tools is already present in traditional cost accounting.

3. To assess the present- day value of Marginal Costing, the changes occurring in the business world must be analyzed more closely. We need first to look at how the purposes of cost accounting are shifting before we can determine its significance.

(i)

cost planning takes precedence over cost control. The effort involved in planning and monitoring costs is increasingly being seen as excessive. The charge levied against traditional cost accounting--that its complex cost allocations merely generate a kind of pseudo precision--lends further credence to this assessment.

An alternative increasingly being called for is to control costs through direct activity/process information (quantities, times, quality) for cost management at local, decentralized levels instead of relying on delayed and distorted cost data. In particular, empirical U.S. research on appropriate variables for performance measurement, in the context of continuous improvement and modern managerial concepts, is based on this view. The need for exact cost planning for profitability management is thus touched on ex ante.

(ii) cost accounting must be employed as a tool for cost control at an early stage. The relative significance of traditional cost accounting as a management accounting tool will decline as it is applied mainly to fields where costs cannot be heavily influenced. More significant than influencing the current costs of production with cost center controlling and authorized-actual comparisons of the cost of goods manufactured is timely and market-based authorized cost management. The greatest scope for influencing costs is at the early product development phase and when setting up the production processes. At the same time, this is the stage where cost information is most urgently needed since the time and quantity standards as defined by Bills of Materials (BOMs) and production routings are still lacking. This requires different methods of cost planning than those normally provided by Marginal Costing. (iii) the behavioural effect of cost information is starting to be recognized. There is a strong current of accounting research in the U.S. that takes human psychological factors into consideration. This is resulting in an extension of cost theory beyond its pure microeconomic basis. Results of theoretical and empirical research based, for example, on the principal-agent theory indicate that knowledge of the "relevant" costs does not always lead to the optimization of overall enterprise profitability. Hence, the perspective that formed the basis for the absorption costing issue has changed. Theories according to which cost allocations can contain information and increase the efficiency of the use of available capacity, or where future allocations can influence ex-ante decisions, require empirical research. 4. The shift in the purposes of cost accounting is being accompanied by a shift in the main applications of standard costing. Costing solutions for market-oriented profitability management and life-cycle-based planning and monitoring should be developed further. They should be implemented both in indirect areas and at the corporate level. In addition, cost accounting must be integrated into performance measurement.

10

Competitive dynamics are giving rise to an increasing differentiation of market-based profitability controlling. This applies to the management of the profitability of products and product lines, as well as distribution channels and increasingly customers, customer groups, and markets. The information required for this purpose can only be supplied by multilevel and multidimensional marketing segment accounting based on contribution margin accounting.

Long-term cost planning based on the idea of lifecycle costing is gaining in prominence compared with short- term standard costing. Product decisions are increasingly based on more than just the cost of goods manufactured and sales costs and now tend to include pre-production costs (such as development costs) and phasing-out costs (such as disposal costs). Product decisions are viewed strategically.

Whether or not a product is successful is determined by the amortization of its overall cost. Furthermore, the cost and revenue trend forecasts should be more dynamic to support the lifecycle pricing policy. This shift in cost and revenue planning is moving cost and revenue accounting in the direction of investment-related calculations.

As management accounting is increasingly applied to the growing share of the costs of indirect areas, the tool requirements increase. After J. G. Miller's and T. E. Vollmann's discovery of the "hidden factory" as an area whose costs are neglected by conventional production costing in the U.S., it was only a small step to the identification of the lost relevance of conventional cost accounting by H. T. Johnson and R. S. Kaplan and their call to develop accounting systems separated into "process control, product costing, and financial reporting," which eventually led to activity-based costing. Improving the cost transparency of indirect activity areas through Marginal Costing requires a thorough understanding of the output processes. Analysis frequently shows that even many support activities have a wide range of repetitive processes for which planning and cost allocation using drivers is worthwhile, providing the cost-volume is large enough. For this purpose, the different operations in the cost centers must be identified, for which resource consumption is then planned and tracked. The number of these operations is used as the driver. This process of costing operations using proportional costs competes with the attempt to achieve better cost transparency in indirect areas with process costing tools to also improve the planning and control of costs that were previously budgeted only as a lump sum.

11

Industrial production and marketing are increasingly being handled by groups of affiliated companies. To plan and monitor the costs of these activities calls for the establishment of independent group cost accounting. This necessity results mainly from the requirements of inventory valuation, the costing basis of transfer prices, and to further the consistency of corporate cost accounting. Group cost accounting leads to the definition of independent group cost categories. Marginal Costing and its tools have been developed for individual companies and are the suitable platform for this expansion.

Performance measures are gaining increasing prominence in decentralized management accounting. Standard U.S. management books devote a great deal of space to performance measurement in the broad sense of the word. The concept is broad for the reason that performance measurement is accompanied by the provision of decision - support information, the management of business units, and the use of incentive systems. Using modelling and empirical research, the exponents of this area are developing the idea that monetary factors are not the only possible components of performance measurement. Since the 1980s there has been a growing consciousness of the significance of continuously improving the performance capabilities of the company, resulting in the increased importance of nonmonetary indicators. The recent literature on performance measurement has focused on problems in the following areas:

* The usability of performance information for managers, * The assessment of teamwork, * The motivational effects of performance measurement, * The strategic dimension.

The tenor of the recent investigations into performance measurement reflects the general criticism of management accounting voiced by Johnson and Kaplan in Relevance Lost. It was recognized that short-term accounting information is insufficient to evaluate and control company activities effectively. In particular, it was acknowledged that the use of standard costs does not adequately take performance improvements into consideration. Moreover, the conventional allocation approach based on the operating rate encourages high utilization of capacity at any cost, underestimates the problem of increasing numbers of variants, uses the wrong overhead allocation base, and fails to appreciate interdepartmental interrelationships.

12

While top management benefits most from financial success indicators that it examines in monthly or longer intervals and that can consist of multidimensional aggregate figures, lower management must necessarily be concerned mainly with nonfinancial, operational, and very short-term data at the day or shift level. In concrete terms, measures in the categories of time, quantity, and quality-such as equipment downtime, lead time, response time, degree of utilization (ratio of actual output quantity to planned output quantity), sales orders, and error rate-- are becoming increasingly significant for controlling business processes.

In the strategic dimension, the Balanced Scorecard developed by Kaplan and Norton--which links financial and nonfinancial indicators from different strategically relevant perspectives including cause-effect chains--is the main proposal under consideration for performance measurement. The Balanced Scorecard links strategic contingencies to financial measures, incorporates success factors of the future, and explicitly includes monetary and nonmonetary parameters. The Balanced Scorecard therefore provides a framework for systematic mapping and control of the critical success factors for an enterprise.

A Balanced Scorecard is a system that defines objectives, measures, targets, and initiatives for each of the four perspectives of financial, customer, internal business process, and learning and growth. Further analyses and experience in measuring performance can enable identification and assessment of cause-effect relationships within the four perspectives (such as the effect of delivery time on customer satisfaction) and between the perspectives (such as the effect of customer satisfaction on profitability). The knowledge so gained may eventually lead to a reformulation of strategy.

In the context of comprehensive performance measurement, even short- term costs and financial results can serve as control instruments for strategic enterprise management, such as a lower authorized cost of goods manufactured as a benchmark. Concrete planned costs and planned results must be rigorously derived from higher-level target factors so that specific requirements can be derived in turn when they are broken down into smaller organizational units for the time and quantity standards.

13

Information for decision making The need for a decision arises in business because a manager is faced with a problem and alternative courses of action are available. In deciding which option to choose he will need all the information which is relevant to his decision; and he must have some criterion on the basis of which he can choose the best alternative. Some of the factors affecting the decision may not be expressed in monetary value. Hence, the manager will have to make 'qualitative' judgements, e.g. in deciding which of two personnel should be promoted to a managerial position. A 'quantitative' decision, on the other hand, is possible when the various factors, and relationships between them, are measurable. This chapter will concentrate on quantitative decisions based on data expressed in monetary value and relating to costs and revenues as measured by the management accountant.

Elements of a decision A quantitative decision problem involves six parts:

a) An objective that can be quantified Sometimes referred to as 'choice criterion' or 'objective function', e.g. maximisation of profit or minimisation of total costs.

b) Constraints Many decision problems have one or more constraints, e.g. limited raw materials, labour, etc. It is therefore common to find an objective that will maximise profits subject to defined constraints.

c) A range of alternative courses of action under consideration. For example, in order to minimise costs of a manufacturing operation, the available alternatives may be:

i) to continue manufacturing as at present ii) to change the manufacturing method iii) to sub-contract the work to a third party.

d) Forecasting of the incremental costs and benefits of each alternative course of action.

e) Application of the decision criteria or objective function, e.g. the calculation of expected profit or contribution, and the ranking of alternatives.

f) Choice of preferred alternatives.

14

Relevant costs for decision making

The costs which should be used for decision making are often referred to as "relevant costs". CIMA defines relevant costs as 'costs appropriate to aiding the making of specific management decisions'.

To affect a decision a cost must be:

a) Future: Past costs are irrelevant, as we cannot affect them by current decisions and they are common to all alternatives that we may choose. b) Incremental: ' Meaning, expenditure which will be incurred or avoided as a result of making a decision. Any costs which would be incurred whether or not the decision is made are not said to be incremental to the decision. c) Cash flow: Expenses such as depreciation are not cash flows and are therefore not relevant. Similarly, the book value of existing equipment is irrelevant, but the disposal value is relevant. Other terms: d) Common costs: Costs which will be identical for all alternatives are irrelevant, e.g. rent or rates on a factory would be incurred whatever products are produced. e) Sunk costs: Another name for past costs, which are always irrelevant, e.g. dedicated fixed assets, development costs already incurred. f) Committed costs: A future cash outflow that will be incurred anyway, whatever decision is taken now, e.g. contracts already entered into which cannot be altered.

Opportunity cost Relevant costs may also be expressed as opportunity costs. An opportunity cost is the benefit foregone by choosing one opportunity instead of the next best alternative. Example A company is considering publishing a limited edition book bound in a special leather. It has in stock the leather bought some years ago for $1,000. To buy an equivalent quantity now would cost $2,000. The company has no plans to use the leather for other purposes, although it has considered the possibilities:

a) of using it to cover desk furnishings, in replacement for other material which could cost $900 b) of selling it if a buyer could be found (the proceeds are unlikely to exceed $800).

15

In calculating the likely profit from the proposed book before deciding to go ahead with the project, the leather would not be costed at $1,000. The cost was incurred in the past for some reason which is no longer relevant. The leather exists and could be used on the book without incurring any specific cost in doing so. In using the leather on the book, however, the company will lose the opportunities of either disposing of it for $800 or of using it to save an outlay of $900 on desk furnishings.

The better of these alternatives, from the point of view of benefiting from the leather, is the latter. "Lost opportunity" cost of $900 will therefore be included in the cost of the book for decision making purposes. The relevant costs for decision purposes will be the sum of: i) 'avoidable outlay costs', i.e. those costs which will be incurred only if the book project is approved, and will be avoided if it is not ii) the opportunity cost of the leather (not represented by any outlay cost in connection to the project). This total is a true representation of 'economic cost'. Now attempt exercise 5.1. The assumptions in relevant costing Some of the assumptions made in relevant costing are as follows: a) Cost behaviour patterns are known, e.g. if a department closes down, the attributable fixed cost savings would be known. b) The amount of fixed costs, unit variable costs, sales price and sales demand are known with certainty. c) The objective of decision making in the short run is to maximise 'satisfaction', which is often known as 'short-term profit'. d) The information on which a decision is based is complete and reliable.

16

Cost-Volume-Profit Analysis
It is a managerial tool showing the relationship between various ingredients of profit planning viz, cost, selling price and volume of activity.

As the name suggests, cost volume profit (CVP) analysis is the analysis of three variables cost, volume and profit. Such an analysis explores the relationship between costs, revenue, activity levels and the resulting profit. It aims at measuring variations in cost an volume.

CVP analysis is based on the following assumptions:

1. Changes in the levels of revenues and cost arise only because of changes in the number of product (or service) units produced and sold- for example, the number of television sets produced and sold by sony corporation or the number of packages delivered by overnight express. The number of output unit is the only revenue driver and the only cost driver. Just as a cost driver is any factor that affects costs, a revenue driver is variable, such as volume, that casually affects revenues.

2. Total costs can be separated into two components: a fixed component that does not vary with output level and a variable component that changes with respect to output level. Furthermore, variable cost include both direct cariable cost and indirect variable cost of a product. Similarly fixed cost include both direct fixed cost and indirect fixed cost of a product.

3. When represented graphically, the behaviours of total revenues and total cost are linear (meaning they can be represented as a straight line) in relation to output level within a relevant range (and time period).

4. Selling price, variable cost per unit, and total fixed costs (within a relevant range an time period) are known and constant.

5. The analysis either covers a single product or assumes that the proportion of different products when multiple products are sold will remain constant as the level of total units sold changes.
17

6. All revenues and costs can be added, subtracted and compared without taking into account the time value of money.

USES OF CVP ANALYSIS: a) Budget planning. The volume of sales required to make a profit (breakeven point) and the 'safety margin' for profits in the budget can be measured.

b) Pricing and sales volume decisions.

c) Sales mix decisions, to determine in what proportions each product should be sold.

d) Decisions that will affect the cost structure and production capacity of the company.

18

Importance of CVP analysis

It provides the information about the folloeing matters:

1. The behavior of cost in relation to volume.

2. Volume of production or sales, where the business will be break even.

3. Sensitivity of profits due to variation in output

4. Amount of profit for a projected sales volume.

5. Quantity of production and sales for a target profit level.

An understanding of CVP analysis is extremely useful to management in budgeting and profit planning. It elucidates the impact of the following on the net profit:

(i) (ii) (iii) (iv)

Changes in selling prices Changes in volume of sales Changes in variable cost Changes in fixed cost

19

Break Even Analysis

Break even analysis is a generally used method to study the cvp analysis. This technique can be explained in two ways: 1. In narrow sense it is concerned with computing the break-even point. At this point of production level and sales there will be no profit and loss i.e. total cost is equal to total sales revenue. 2. In broad sense this technique is based to determine the possible profit/loss at any given level production or sales. Methods of Break-Even Analysis Break even analysis may be conducted by the following two methods: 1. Algebraic Computation 2. Graphic Presentation

20

Marginal Cost Equation

The contribution theory explains the relationship between the variable cost and selling price. It tells us that selling price minus variable cost of the units sold is the contribution towards fixed expenses and profit. If the contribution is equal to fixed expense, there will be no profit no loss and it is less than fixed expenses, loss is incurred. Since the variable cost varies in direct proportion to output, therefore if the firm does not produce any unit, the loss will be there to the extend of fixed expense. These points can be described with the help of the following marginal cost equation: S-V=C-F+P

Where, S= Selling price per unit V= Variable cost per unit C= Contribution F= Fixed cost P= Profit/Loss

21

Principles of Marginal Costing

Period fixed costs are the same, for any volume of sales and production (provided that the level of activity is within the relevant tange). Therefore by selling an extra item of product or service of the following will happen:

1. Revenue will increase by the sales value of the item sold,

2. Cost will increase by the variable cost per unit,

3. Profit will increase by the amount of contribution earned from the extra item.

Similarly, If the volume of sales falls by one item, the profit will fall by the amount of contribution earned from the item.

Profit measurement should therefore be based on an analysis of total contribution. Since fixed costs relate to a period of time, and do not change with increase or decrease in sales volume, it is misleading to charge units of sale with a share of fixed costs from total contribution for the period to derive a profit figure.

When a unit of product is made, the extra costs incurred in its manufacture are the variable production costs. Fixed costs are unaffected, and no extra fixed costs are incurred when output is increased. It is therefore argued that the valuation of closing stock should be variable production cost (direct material, direct labour, direct expenses and variable production overhead) because there are the only costs properly attributable to the product.

22

Margin Of Safety
Margin of safety represents the strength of the business. It enables a business to know that what is the exact amount he/ she has gained or loss over or below break even point). Margin of safety = (( sales - break-even sales) / sales) x 100% If P/V ratio is given then sales/pv ratio

In unit sales If the product can be sold in a larger quantity that occurs at the breakeven point, then the firm will make a profit; below this point, a loss. Break-even quantity is calculated by:

Total fixed costs / (selling price - average variable costs). Explanation - in the denominator, "price minus average variable cost" is the variable profit per unit, or contribution margin of each unit that is sold. This relationship is derived from the profit equation: Profit = Revenues - Costs where Revenues = (selling price * quantity of product) and Costs = (average variable costs * quantity) + total fixed costs. Therefore, Profit = (selling price * quantity) - (average variable costs * quantity + total fixed costs). Solving for Quantity of product at the breakeven point when Profit equals zero, the quantity of product at breakeven is Total fixed costs / (selling price - average variable costs).

Firms may still decide not to sell low-profit products, for example those not fitting well into their sales mix. Firms may also sell products that lose money - as a loss leader, to offer a complete line of products, etc. But if a product does not break even, or a potential product looks like it clearly will not sell better than the breakeven point, then the firm will not sell, or will stop selling, that product.

23

An example: Assume we are selling a product for $2 each. Assume that the variable cost associated with producing and selling the product is 60 cents. Assume that the fixed cost related to the product (the basic costs that are incurred in operating the business even if no product is produced) is $1000. In this example, the firm would have to sell (1000 / (2.00 - 0.60) = 715) 715 units to break even. in that case the margin of safety value of NIL and the value of BEP is not profitable or not gaining loss. Break Even = FC / (SP VC) where FC is Fixed Cost, SP is selling Price and VC is Variable Cost.

Significance: Up to the BEP, the contribution is earned is sufficient only to recover the fixed costs. However the beyond the BEP, the contribution is called the profit. Profit is nothing but the contribution earned out of margin of safety of sales. The size of the margin of safety shows the strength of the business. A low margin of safety indicates the firm has a large fixed expenses and is moir vulnerable to changes. A high margin of safety implies that a slight fall in sales may not the business very much.

Improvements in margin of safety:

The possible steps for improve the margin of safety.

Increase in selling price, provided the demand is inelastic so as to absorb the increased prices. Reduction in fixed expenses Reduction in variable expenses Increasing the sales volume provided capacity is available. Substitution or introduction of a product mix such that more profitable lines are introduced.

24

Distinction between Marginal and Absorption Costing

Absorption Costing Approach

Direct Material Direct labour Variable Factory overheads fixed factory overheads Charged to cost of goods purchased Charged as expense when goods are sold

All Selling and Administrative overheads

Charged as expenses when incurred

25

Marginal Costing Approach

Direct Material Direct Labour Direct Factory overheads Charged to cost of goods purchased Charged as Expenses when goods are sold

Fixed Factory Overheads And All Selling and distribution Overheads Charged as Expenses when Incurred

Marginal Costing Approach

26

Marginal Costing

Absorption Costing

1.

Only variable costs are considered for product costing and inventory valuation.

Both fixed and variable costs are considered for product costing and inventory valuation.

2.

Fixed costs are regarded as period costs. The profitability different products is judged by the P/V ratio.

Fixed costs are charged to the of cost of production. Each product bears a reasonable share of fixed cost and thus the profitability of a product is influenced by the apportionment of fixed costs.

3.

Cost data highlight the total contribution of each product.

Cost data are presented in conventional pattern. Net profit of each product is determined after subtracting fixed cost along with their variable cost.

4.

The difference in the magnitude of opening stock and closing stock does not affect the unit cost of production.

The difference in the magnitude of opening stock and closing stock affects the unit cost of production due to the impact of related fixed cost. In case of absorption costing the cost per unit reduces, as the production increases as it is fixed cost which reduces, whereas, the variable cost remains the same per unit.

5.

In case of marginal costing the cost per unit remains the same, irrespective of the production as it is valued at variable cost.

27

PROFIT AND LOSS FORECAST

A Profit and Loss Account is designed to show the financial performance of a business over a given period (usually Monthly or Annually) and to indicate whether it is (or, in the case of a P & L Forecast, if it will) make or lose money. Without Profit there eventually will be no business

Profit and Loss is also essential in providing information for Inland Revenue for Taxation purposes.

Understanding how a Profit and Loss Account works will help you to choose the right time to buy items that you need for the business, reduce your tax liability (Tax Bill) and work out how much Tax you will have to pay.

PROFIT AND PLANNING

Profit planning is essential when you want your business to focus on enhancing its profitmaking capabilities. Effective profit planning happens when you determine in advance a set of clear and realistic goals that your business or organization needs to fulfil. Those goals must be based upon objective existing and expected business conditions. Anticipating the changes in your business environment is also central to profit planning.

Given the central role profit planning can play in the future prospects of an organization, it might come as a surprise to learn that a large number of businesses do not usually have or develop a financial plan. What is even more amazing is that many of the businesses which do plan for their financial future often just repeat the same procedure over and over every year. They do not take the time to look at how the plan works, or if it is really working.

A very small number of businesses currently knows how to practice and benefit from proficient profit planning. However, research indicates that profit planning might be a central reason behind the increased sales and profits enjoyed by these few businesses. Appropriate profit planning can help your company enjoy those benefits too.

28

Effective profit planning can have a deep impact in the life of your organization. The professionals at FRS Consultants believe that profit planning is a key element which has led to the success of big and small businesses alike. That said, it could truly ensure continuous prosperity for your own business, as well. FRS Consultants is a trustworthy firm of honest and experienced professionals that can lead you to make the best out of profit planning. Many goldbricks in the field are more eager to charge you premiums for their time than to deliver what you are paying for. At FRS Consultants we do not shirk our work. We will strive to deliver on time and prove the value of our service. Other consulting firms may seem less expensive than us, but that is not the case. To learn more or to request a free consultation please complete our online form.

29

Difference in Profit under Marginal and Absorption Costing

The above two approaches will compute the different profit because of the difference in the stock valuation. This difference is explained as follows in different circumstances.

1. No opening and closing stock: In this case, Profit/loss under absorption and marginal will be equal.

2. When opening stock is equal to closing stock: In this case, Profit/loss under two approaches will be equal provided the fixed cost element in both the stock is same amount.

3. When closing stock is more than opening stock: In other words when production during a period is more than sales, then profit as per absorption approach will be more than by marginal approach. The reason behind this difference is that a part of fixed overhead included in closing stock value is carried forward to next accounting period.

4. When opening stock is more than the closing stock: In other words when production is less than the sales, profit shown by marginal costing will be more than that shown by absorption costing. This is because a part of fixed cost from the preceding period is added to the current years cost of goods sold in the form of opening stock.

30

Problem 1

From the under mentioned figures calculate: (i) P/V ratio and the total fixed expense;

(ii) Profit or loss arising from the sales of Rs. 12,000; (iii) Sales required to earn a profit of Rs. 2,000; (iv) Sales required to break-even.

Sales Rs. First period Second period 14,433 18,203

profit Rs. 385 1,139

Solution (i) P/V ratio and total fixed expenses First Period Rs. Sales Less: profit Total costs 14,433 ___385 14,048 Second period Rs. 18,203 _1,139 17,064 increase Rs. 3,770 __754 3,016

Assuming the variable unit cost per unit and fixed expenses to be the same and that the prices are stable in both the period, the increase in total cost of Rs. 3,016 consists of variable costs only. For an increase in the sales of Rs. 3,770 the variable cost is Rs. 3,016. Hence P/v ratio is
Rs.3,770 Rs.3,016 x100 = 20% Rs.3,770

31

Taking the figures relating to period 1. Rs. Gross margin (Rs. 14,43320%) Less: Profit for period 1 Fixed expenses 2,887 __385 2,502

(ii)

Profit or loss on sales of Rs. 12,000 Rs. Gross margin on this sale (Rs. 12,00020%) Less: Fixed expenses Loss 2,400 2,502 __102

(iii)

Sales required to earn a profit of Rs. 2,000. Contribution required = fixed expenses + profit = Rs. 2,502 + Rs. 2,000 = Rs. 4,502 The sales, should produce a gross margin of Rs. 4,502

Hence, sales value

Rs.4,502 x100 20

= Rs. 22,510 (iv) Sales required to break-even: At BEP gross margin is equal to fixed expenses So, gross margin required = Rs. 2,502
Rs. 2,502 P/V ratio

Sales required = ----------------------- =

Rs.2,502 x100 20

32

Problem 2 Paramount Food products is a new entrant in the market for chocolates. It has introduced a new product Sweetee. This is a small rectangular chocolate bar. The bars are wrapped in aluminum foil and packed in attractive cartons containing 50 bars. A carton is, therefore, considered the basic sales unit. Although management had made detailed estimates of costs and volumes prior to undertaking this venture, new projects based on actual cost experience are now required. Income statements for the last two quarters are each thought to be representative of the costs and productive efficiency we can expect in the next few quarters. There were virtually no inventories on hand at the end of each quarter. statements reveal the following: The income

First Quarter Sales 50,000 Rs. 24 70,000 Rs. 24 cost of Goods sold Gross Margin Selling and Administration Net income (loss) before taxes Tax (negative) Net income (Loss) Rs. 12,00,000 ___7,00,000 5,00,000 __6,50,000 (1,50,000) ___(60,000) __(90,000)

Second Quarter Rs. 16,80,000 __8,80,000 8,00,000 __6,90,000 1,10,000 ___44,000 __66,000

The firms overall marginal and average income tax rate is 40%. This 40% figures has been used to estimate the tax liability arising from the chocolate operations.

33

Required: (a)Management would like to know the break even point in terms of quarterly carton sales for the chocolates. (b)Management estimates that there is an investment of Rs. 30,00,000 in this product line. What quarterly carton sales and total revenue are required in each quarter to earn an after tax return of 20% per annum on investment? (c)The firms marketing people predict that if the selling price is reduced by Rs. 1.50 per carton (Re. 0.03 off per chocolate bar) and a Rs. 1,50,000 advertising campaign among school children is mounted, sales will increase by 20% over the second quarter sales. Solution Basic calculations (a)Variance Mfg. Cost per carton = Change in cost/ change in output =
8,80 ,000 7,00 ,000 70 ,000 50 ,000

= 1,80,000 20,000 = Rs. 9 per carton (b)Fixed Mfg. Cost = Fixed manufacturing cost + Variable manufacturing cost cost of goods sold = Rs. 7,00,000 Rs. 4,50,000 = Rs. 2,50,000 (c)Variable selling & Admn. Cost per carton = Change in cost/ change in output =
6,90 ,000 6,50 ,000 70 ,000 50 ,000

= Rs. 40,000 /Rs. 20,000 = Rs. 2 per carton (d)Fixed selling and Admn. cost (e)Total Fixed costs = 6,50,000 1,00,000 = Rs. 5,50,000 =Rs.2,50,000+Rs.5,50,000 = Rs. 8,00,000

34

(f)Quarterly Break even point (in cartons) = Fixed costs/ contribution per carton = 8,00,000 /13 = 61,539 cartons (b)Desired annual return after tax (ii)Desired quarterly return after tax (iii)Desired quarterly return before tax (Tax rate 40%) Quarterly sales for Desired return
Fixed Costs + Desired Return

= Rs. 6,00,000 = 6,00,000 /4 = Rs. 1,50,000

Rs.1,50,000x100 Rs.2,50,000 60

In cartons

= ----------------------------------------Contribution per carton

= Quarterly sales revenue

8,00,000 2,50,000 80,769cartons 13

= 80,769 Rs. 24 = Rs. 19,38,456

(c)New selling price per carton New contribution per unit

= Rs. 24 Rs. 1.50 = Rs. 22.50 = Rs. 22.50 Rs. 13 = Rs. 11.50

New sales: 70,000 + 14,000 = 84,000 cartons Total new contribution = 84,000 Rs. 11.50= Rs. 9,66,000 Less: Fixed costs (8,00,000 + 1,50,000) Rs. 9,50,000 Rs. 16,0000 Less: Tax (40%) Net income after tax ____6,400 ____9,600

35

The firm made a net income after tax of Rs. 66,000 at a selling price of Rs. 24. The reduction in selling price increases in sales volume but decreases the net income after tax to Rs. 9,600. Hence, the plant to reduce the selling price should not be implemented by the management.

36

Bibliography:

1. www.wikipedia.org 2. www.google.com 3. www.managementparadise.com 4. www.scribd.com 5. Also assisted by Kiran Kale Article Assistant at Haskins & Sells. 6. www.businessdictionary.com

37