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Amount (Rs.)
Sales
(S)
Less: Variable Costs (V)
Contribution
(C)
Less: Fixed Costs
(F)
Profit (P)
Advantages
1. Marginal costing is simple to understand.
2. By not charging fixed overhead to cost of production, the effect of varying charges per
unit is avoided.
3. The effects of alternative sales or production policies can be more readily available and
assessed, and decisions taken would yield the maximum return to business.
4. Practical cost control is greatly facilitated. It is useful to various levels of management.
5. It helps in short-term profit planning by breakeven and profitability analysis, both in
terms of quantity and graphs.
6. Comparative profitability and performance between two or more products and
divisions can easily be assessed and brought to the notice of management for decision
making.
Disadvantages
1. The separation of costs into fixed and variable is difficult and sometimes gives
misleading results.
2. Under marginal costing, stocks and work in progress are understated. The exclusion of
fixed costs from inventories affect profit, and true and fair view of financial affairs of
an organization may not be clearly transparent.
3. Application of fixed overhead depends on estimates and not on the actual and as such
there may be under or over absorption of the same.
4. In order to know the net profit, we should not be satisfied with contribution and hence,
fixed overhead is also a valuable item.
5. A system which ignores fixed costs is less effective since a major portion of fixed cost
is not taken care of under marginal costing.
6. In practice, sales price, fixed cost and variable cost per unit may vary.
Thus, the assumptions underlying the theory of marginal costing sometimes becomes
unrealistic. For long term profit planning, absorption costing is the only answer.
Amount (Rs.)
Sales
Opening Stock
Add: Cost of Production
Fixed overheads
+ Variable overheads
Less: Closing Stock
Cost of Sales
Profit (Sales Cost of sales)
Amount (Rs.)
---
-----------
-----
Marginal Costing
Under marginal costing,
costs are classified as either
Fixed or Variable.
Absorption Costing
Under adsorption costing, costs are
classified on functional basis i.e.
Production, Administration, Selling &
Distribution etc.
Fixed costs are treated as product
costs.
2. Product v/s
Period Costs
3. Stock Valuation
4. Profit
Manipulation
5. Over / Under
Absorption
6. Application
Rs.
Rs.
Rs.
48,000
22,000
13,000
2,000
Rs. 20,000
8,000
Rs. 1, 25,000
Amount (Rs.)
Amount (Rs.)
1,25,000
48,000
22,000
13,000
2,000
85,000
40,000
Contribution
(C) = S-V
Less: Fixed Costs
(F)
- Factory
- Adm. & selling
Profit (P)
20,000
8,000
28,000
12,000
Amount (Rs.)
48,000
22,000
Direct materials
Direct wages
Prime Cost
Factory Overhead
- Fixed
- Variable
Cost of Production
Adm. & selling overhead
- Fixed
- Variable
Cost of Sales / Total Cost
Profit
Sales
Amount (Rs.)
70,000
20,000
13,000
33,000
1,03,000
(F)
8,000
2,000
10,000
1,13,000
12,000
1,25,000
Comments: Profit under absorption costing & marginal costing is the same. This is because
there are no opening & closing stocks. However, when there are opening and / or
closing stocks, profit/loss under two systems may be different.
Problem 2: XYZ Ltd. supplies you the following data for the year ending 31st Dec. 2005.
Production 1,100 units & Sales 1,000 units
There was no opening stock
Direct Material
Rs. 3
Direct Wages
Rs. 2
Variable manufacturing cost per unit
Rs. 7
Fixed manufacturing overhead (total)
Rs. 2,200
Variable selling & administration overhead
Rs. 0.50 per unit
Fixed selling & administration overhead
Rs. 400
Selling Price per unit
Rs. 20
Prepare:
(a) Income statement under marginal costing
(b) Income statement under absorption costing
(c) Explain the difference in profit under marginal & absorption costing, if any
Solution:
(a) INCOME STATEMENT (Marginal Costing)
For the year ended 31st Dec., 2005
Particulars
(a) Sales
(S)
Variable Manufacturing Costs :
Direct materials (3 1,100 units)
Direct wages (2 1,100 units)
Variable overheads:
- Factory / Manufacturing (7 1,100 units)
Add: Opening Stock
Cost of goods produced (for 1,100 units)
Less: Closing Stock
(100 units Rs.12 p.u.)*
Cost of goods sold
(1,000 units)
Add : Variable adm. & selling overheads (1,000 @ Re. 0.50 p.u.)
(b) Total Variable costs (V)
(c) Contribution
(C) = S - V
Less: Fixed Costs
(F)
- Manufacturing
- Adm. & selling
Profit
(P)
6
Amount (Rs.)
3,300
2,200
7,700
13,200
--13,200
1,200
12,000
500
12,500
2,200
400
Amount (Rs.)
20,000
12,500
7,500
2,600
4,900
Note: * Closing stock is valued at total variable manufacturing cost p.u. i.e. 3+2+7 = Rs.12 p.u.
Amount (Rs.)
3,300
2,200
Prime Cost
Manufacturing / Factory Overhead
- Fixed
- Variable (7 1,100 units)
Cost of Production (for 1,100 units)
Add: Opening stock
Less: Closing Stock (100 units) * i.e.
15,400 100
1,100
Cost of Goods sold (1,000 units)
Adm. & selling overhead
- Fixed
- Variable (1,000 @ Re. 0.50 p.u.)
Cost of Sales / Total Cost
Profit
Sales
Amount (Rs.)
5,500
2,200
7,700
9,900
15,400
----1,400
( -1,400)
14,000
400
500
900
14,900
5,100
20,000
Note: * Closing stock is valued at cost of production i.e. for 1,100 units = Rs.15, 400
So, for 100 units = 15,400 100 = Rs. 1,400
1,100
(c) Profit under Marginal costing is Rs. 4,900 & under Absorption costing Rs. 5,100. The
difference of Rs. 200 in profit is due to over valuation of closing stock in absorption
costing by Rs. 200 (i.e. Rs 1,400 Rs. 1,200) .
Profit
Cost-Volume-Profit Analysis
Cost-Volume-Profit analysis is analysis of three variables i.e.
(a) Cost of production,
(b) Volume of production and
(c) Profit.
These three factors are inter-connected in such a way that they act and react on one another
because of cause and effect relationship amongst them. The cost of a product determines its
selling price & the selling price determines the level of profit. The selling price also affects the
volume of sales which directly affects the volume of production in turn influences cost.
Acc. to CIMA London , CVP analysis is the study of the effects on future profits of changes in
fixed cost, variable cost, sales price, quantity & mix.
It aims at measuring variations of profits and costs with volume, which is significant for business
profit planning.
CVP analysis makes use of principles of marginal costing. It is an important tool of planning for
making short term decisions.
The following are the basic decision making indicators in Marginal Costing:
(a) Profit Volume Ratio (PV Ratio) / Contribution Margin ratio
(b) Break Even Point (BEP)
(c) Margin of Safety (MOS)
(d) Indifference Point or Cost Break Even Point
(e) Shut-down Point
8
(i)
Profit Volume Ratio (PV Ratio)
The Profit Volume Ratio (PV Ratio) is the relationship between Contribution and Sales Value. It
is also termed as Contribution to Sales Ratio.
P/V ratio =
Contribution (C)
100
Sales(S)
Change Profit
100
Change Sales
The Break Even Point is that level of production & sales where there is no profit & no loss. At
this point total cost is equal to total sales revenue. In other words, at this point, the total
contribution equals fixed costs.
In narrow sense, Break even analysis is concerned with determining break even point. And in
broad sense, break-even analysis is used to determine probable profit/loss at any given level of
production / sales.
Assumptions underlying break even analysis
1. Total costs can be easily classified into Fixed and Variable categories.
2. Selling Price per unit remains constant, irrespective of quantity sold.
3. Variable Costs per unit remain constant. However total variable costs increase as output
increases.
4. Fixed Costs for the period remains same irrespective of output.
5. Productivity of the factors of production will remain the same.
6. The state of technology process of production and quality of output will remain unchanged.
7. There will be no significant change in the level of opening and closing inventory.
8. The company manufactures a single product. In the case of a multi-product company,
the sales-mix remains unchanged.
9. Both revenue and cost functions are linear over the range of activity under
considerations.
F
C per unit
F
P /V ratio
Break-even chart:
The break-even chart is a graphical representation of cost-volume profit relationship.
Margin of Safety
Margin of Safety (MOS) represents the difference between the actual total sales and sales at
break-even point. It can be expressed as a percentage of total sales, or in value, or in terms of
quantity.
MOS = Actual sales Breakeven point
P
P /V ratio
Or MOS =
MOS RATIO =
MOS SALES
ACTUAL SALES
OTHER FORMULAS:
1) C = S V
or
C=F+P
OR S V = C
&
CF=P
(C = Contribution , S = Sales)
(V = variable cost, F = Fixed Cost & P = Profit)
F+ P
C per unit
F +P
P /V ratio
P/V ratio =
Contribution (C)
100
Sales(S)
P/V ratio =
3
100
12
= 25%
(b)
F +P
P /V ratio
12,000+15,000
25
= Rs. 1, 08,000
Sales
Rs. 1,20,000
Rs 1,40,000
Year 2004
Year 2005
Find out
(i)
(ii)
(iii)
(iv)
(v)
P/V ratio
B.E.P.
Profit when sales are Rs. 1,80,000
Sales required to earn a profit of Rs. 12,000
Margin of safety in year 2005
Solution:
Sales
Profit
11
Profit
Rs 8,000
Rs. 13,000
Year 2004
Year 2005
Difference
(i)
P/V ratio =
Rs. 1,20,000
Rs. 1,40,000
Rs. 20,000
Rs 8,000
Rs. 13,000
Rs. 5,000
Change Profit
100
Change Sales
5,000
= 20,000 100
= 25%
B.E.P. =
=
(iii)
F
P /V ratio
22,000
25
= Rs. 88,000
(iv)
(v)
Rs. 45,000
Rs. 22,000
Rs. 23,000
22,000+ 12,000
25
12
= Rs. 1, 36,000