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Process of marginal costing:

Under marginal costing, calculation of the difference between sales & marginal cost of sales is done.
This difference is known as contribution, which provides for fixed cost & profit. Excess of contribution over
the fixed cost is known as net margin or profit. Here on the increasing total contribution emphasis remains.
Variable Cost:
Variable is that part of total cost which in proportion with volume changes directly. With change in
volume of output, total variable cost changes. Increase in total variable cost results from increase in output &
reduction in total variable cost results from decrease in output. However, irrespective of increase or decrease
in volume of production, there will be no change in variable cost per unit of output. Cost of direct material,
direct labour, direct expenses etc. are included in variable cost. By dividing total variable cost by units
produced, variable cost per unit is arrived at. Variable cost per unit is also referred as variable cost ratio. By
dividing change in cost by change in activity, variable cost can be arrived at.
Variable costs are very sensitive in nature & variety of factors can influence the same. Helping
management in controlling variable cost is the main aim of marginal costing because this is the area of cost
which itself needs control by management.
Fixed Cost:
Cost which is incurred for a period & which tends to remain unaffected by fluctuations in the level of
activity, output or turnover, within certain output & turnover limits. Examples are rent, rates, salaries of
executive & insurance etc.
Break-Even Point (B/E Point):
The break-even point is the level of activity or sales at which a company makes neither profit nor loss.
Sales revenue exactly equals total costs at this level. Thus, the sales volume at which operations break-even
is indicated by the break-even point. In terms of number of units sold or in terms of sales value, it can be
expressed.
Sales Variable cost = Fixed cost + Profit
Since at break-even point, profit is nil, it follows that:
Sales at break-even point Variable cost = Fixed cost
Thus, at break-even point, contribution is just enough to provide for fixed cost. Thus, enough
contribution is necessary to be earned to cover fixed costs before any profit can be earned. If level of actual
sales is above break-even point, profit will be earned by the company. On the other hand, if actual sales are
below break-even point, loss will be incurred by the company.
By any of the following formula, the by the break-even point (B/E) can be calculated:
(a)

(b)

B/E

B/E

(in
terms
Contribution per unit
(in

terms

of
sales
Contribution

of

units)

value)

Or, Fixed

= Fixed

= Fixed

Cost

Cost

Sales

Cost

P/V ratio

the

When graphical presentation of cost-volume-profit relationship is made, the break-even point will be
point
at
which
total
cost
line
&
total
sales
line
intersect
each
other.

The break-even point is important to the management because the lowest level to which activity can
be dropped without putting the continued life of the firm in jeopardy is indicated by the break-even point.
Occasionally, operating below the break-even point may not be necessarily being fatal for a concern, but it
must operate above this level in the long run.
Contribution:
On the idea of contribution, analysis of marginal costing depends a lot. In this technique, for increasing
total contribution only, efforts are directed. Contribution is a term which defines the surplus that remains
after variable cost of sales is deducted from sales revenue as indicated below:
Contribution = Sales revenue Variable cost of sales
A product whose selling price exceeds its variable cost is said to have:
(a)

Covering

its

(b)

variable

Making
(i)

towards

the

firms

cost

a
fixed

cost

&

after

&
contribution,

these

have

been

covered;

(ii) towards the firms profit.


Alternatively, contribution is equivalent to fixed cost plus profit. Thus, this relationship may be
expressed as under:
Sales Variable cost = Contribution
Fixed cost + Profit = Contribution
Thereby, Sales Variable cost = Fixed cost + Profit
It becomes easy to determine the missing one if any three of these four items is known to us. In breakeven analysis, some of the specific uses of contribution are:
a.

Break-even point determination;

b.

Profitability of products assessment;

c.

Different departments selling price determination;

d.

The optimum sales mix determination.

Key factor or Limiting factor:


There are always factors which, for the purpose of managerial control, do not lend themselves. For
example, if at a particular point of time, on the import of a material, which is the principal element of
companys product, there is a restriction of Government, then the production cannot be undertaken by the
company, as it wishes. Production has to be planned after taking into consideration this limiting factor.
However, towards the maximum utilization of available sources, its efforts will be directed. Thus, limiting
factor is a factor, by which, at a given point of time, the volume of output of an organization gets influenced.
Key factor is the factor whose influence, for the purpose of ensuring the maximum utilization of
resources, must be ascertained first. Profit can be maximized by gearing the process of production in the
light of influences of key factors. Managerial action is constrained & output of company is limited by key
factor. Any of the following factors can be a limiting factor, although usually sale is the limiting factor but:

(a) Material (b) Labour (c) Power (d) Capacity of plant (e) Action of government.
When, in operation, there is a key factor & regarding relative profitability of different products, a decision has
to be taken, then for selecting the most profitable alternative, contribution for each product is divided by key
factor.
With the products or projects, the choice of management rests with, thereby showing more contribution
per unit of key factor. Thus, if the key factor is sales, then consideration should be given to contribution to
sales ratio. If labour shortage is faced by the management, then consideration should be given to
contribution per labour hour. Suppose sales of product X & Y are $ 200 & $ 220 & variable cost of sales are $
60 & $ 46. The labour hours (key factor) required for these products are 4 hours & 6 hours respectively. The
contribution will be: Product X, $200 - $60 = $ 140 per unit or $ 35 per hour; Product Y, $220 - $46 = $174
per unit or $29 per hour. In this case, P/V ratio of product Y (79%) is better than P/V ratio of product X (70%)
& producing product Y will be the normal conclusion. Here, the key factor is time. Contribution per hour is
better in product X than in product Y. Thereby, product X is more profitable than product Y, during labour
shortage.
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Key Factors or Limiting Factor


The marginal costing technique provides that the product with highest contribution per unit
is preferred. This inference holds true so long as it is possible to sell as much as it can
produce. But sometimes an organisation can sell all it produces but production Is limited
due to scarcity of raw material, labour, electricity, plant capacity or capital.
These are called key factors or limiting facto$ A key factor or limiting factor puts a limit on
production and profit of the firm. In such situation, management has to take a decision
whose production is to be increased, decreased or stopped. In such cases, selection of the
product is done on the basis of contribution per unit of scarce factor of production. The key
factor or scarce factor should be utilized in such a manner that contribution per unit of
scarce resource is the maximum.
Mathematically,
Contribution
Profitability =
Key Factor

It is a costing technique based on the segregation of cost into fixed and variable. In this technique, only variable
manufacturing costs are considered while determining the cost of goods sold and also for valuation of inventories.
Fixed expenses are written off against the contribution for that period. Contribution is the difference between the
sales value and variable cost. If the company is producing more than one product, the contribution from each product
is combined as a pool from which the total fixed cost is deducted to obtain the profit.
Applications (merits) of marginal costing
1. Cost control
Concentrating on the variable costs will be more advantageous and practical for cost control purposes. Marginal
costing technique helps in this task by segregating the costs between variable and fixed.
2. profit planning
The marginal costing technique helps to generate data required for profit planning and decision-making. For example,
computation of profit if there is a change in the product mix, impact on profit if there is a change in the selling price,
change in profit if one of the product is discontinued or if there is a introduction of new product, decision regarding the
change in the sales mix are some of the areas of profit planning in which necessary information can be generated by
marginal costing for decision making. The segregation of costs between fixed and variable is thus extremely useful in
profit planning.
3. Key Factor Analysis
The management has to prepare a plan after taking into consideration the constraints, if any, on the various
resources. These constraints are also known as limiting factors or principal budget factors. These key factors may be
availability of raw material, availability of skilled labour, machine hour availability, or the market demand of the
product. Marginal costing helps the management to decide the best production plan by using the scarce resources in
the most beneficial manner and thus optimize the profits.
4. Decision making
The segregation of costs between fixed and variable helps the management in predicting the cost behavior in various
alternatives. Thus it becomes easy to take decisions such as:

Make or buy decisions.

Accepting or rejecting an export offer.

Variation in selling price.

Variation in product mix.

Variation in sales mix.

Closing down/continuation of a division.

Capital expenditure decisions etc..

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