Chapter 1: Marginal Costing & Profit

Planning

Chapter 2:Decisions Involving Alternative

Choices:
 MARGINAL COSTING AND PROFIT PLANNING:
• Definition: According to the Institute of Cost and
Management accountants , London marginal cost is,
the amount of any given volume of output by which
aggregate costs are changed if the volume of output
is changed by one unit.
• Marginal costing is a costing technique that
considers only those costs which vary directly with
volume- direct materials, direct labor and variable
factory overheads and ignores fixed costs.
 Advantages of marginal costing:
1. How much to produce.
Ascertainment of the most profitable relationship
between costs, price and volume of the business
shall assist management in fixing best selling
prices.
2. What to produce:
The manufacture of which product should be
undertaken can be decided upon after comparing
the profitability results of different products.
3.Whether to produce.
The decision whether a particular product should be
manufactured in the factory or brought from
outside will depend on comparing the price at
which it can be had from outside and the marginal
cost of producing it in the factory.
4. How to produce:
Method of manufacture: when a particular product
is manufactured by two or more methods, the
ascertainment of marginal cost of manufacturing
the product is helpful in making a decision.
Hand or machine labor. The problem of employing
machine or to produce entirely by hand labor can
be solved with the help of marginal costing
technique.

5. When to produce.
6. At what cost to produce?

• Efficiency and economy of plants

• Lease or ownership of plant
• No profit no loss points
• Cost control
• Inventory valuation
 Limitations of marginal costing:
• Classification into fixed and variable elements is a
difficult task. Certain costs may be partly fixed and
partly variable and the division of such cost into
fixed and variable parts is based on the
assumptions not f acts.
• Faulty decisions: if a fixed overhead is not taken
into consideration, the management’s decision
regarding price fixing, manufacturing the product
etc may prove to be faulty and deceptive.
• Difficult application: the application of marginal
costing technique is difficult in most of the
concerns. It cannot be easily applied in job costing.
• Under or over recovery of overheads. Variable
overheads are estimated and therefore its
application not being based on actual may result in
over recovery of overheads.
• Better technique available: the systems of
budgetary control and standard costing are better
than marginal costing.
 Features of marginal costing:
• Separation of costs into fixed and variable
elements: under marginal costing all types of
operating costs (factory, selling and administrative)
are separated into fixed and variable components
are recorded separately.
• Method of recording and reporting: Marginal
costing is the method of recording as well as
reporting costs. Variable costing requires a unique
method of rerecording cost transactions as they
originally taken place.
• Variable costs charged to product: all the variable
costs are considered and handled as product costs
i.e., they are charged to the duct at the appropriate
movements.
• Fixed costs written off as period costs: All the fixed
costs including fixed factory overheads as treated as
period costs, they are written off as expenses in the
period in which they are incurred.
Basis Marginal costing Absorption costing
Recover In marginal costing In absorption costing the
y of the product is fixed costs are not affected
overhea changed only with by volume changes are also
ds those costs that are charged to the cost of
directly affected by production..
changes in volume.
Valuatio The stocks of work Stocks of WIP and FG are
n of in progress and valued at works cost
stocks finished goods are (including fixed works
valued at marginal overheads) and total cost of
cost under marginal production (including fixed
costing system. works overheads and office
overheads) respectively
Absorpti In marginal costing In absorption costing, the
on of actual fixed over or under recovery of
overhea overheads are wholly overheads can be transferred
ds transferred to costing to costing profit and loss
profit and loss account.
account.
Treatme Marginal costing lays Under absorption costing all
nt of emphasis on the costs are first charged to
cost and contribution. Any products and then total costs
profit increase in are deducted from sales to
contribution means arrive at the profit
increase in profit,
since fixed cost
remains constant.
 Marginal Cost Equation
• Marginal cost= = total variable cost
• Or =total cost – fixed cost
• Or
=directmaterial+directlabour+directexpenses(variable)+v
ariable overheads
• Contribution =selling price/sales-variable cost
• Profit =contribution-fixed cost
• =sales-variable cost-fixed cost
•
• Fixed cost =contribution-profit
• Contribution =fixed cost + profit
• P/V ratio (profit volume ratio) = contribution per unit
• Selling price per unit
 KEY FACTOR:
• Key factor is that factor which is the most important
one for taking decisions about profitability of a
product.
• The extent of its influence must be assessed to
maximize the profits.
• It is the limiting factor or the governing factor or
principal budget factor.
• If sales cannot exceed a given quantity, sales are
regarded as the key factor.
• Generally on the basis of contribution, the decisions
regarding product mix is taken.
• If production capacity is limited, contribution; per unit
i.e., in terms of output has to be compared.
 Break Even Point, CVP Analysis
• Break-even analysis is a technique widely used by
production management and management
accountants.
• Total variable and fixed costs are compared with
sales revenue in order to determine the level of
sales volume, sales value or production at which
the business makes neither a profit nor a loss (the
"break-even point").
Break-even point:

Break-even point (of output) = fixed cost

Contribution per unit
Break-even point of sales
= fixed cost x selling price per unit
Contribution per unit

Or =break even output x selling price per unit

Or = fixed costs x total sales
Total contribution
Or =fixed costs
P/V ratio
• Output (units) for a desired profit = fixed cost
+ desired profit
• Contribution per unit
•
• Sales for a desired profit = fixed cost +
desired profit
• P/V ratio
 MARGIN OF SAFETY:

• Margin of safety= total sales – break even sales

(sales at break even point)
• As a percentage= margin of safety x 100
Total sales
• If the margin of safety is large, it is a sign of
soundness of the business .
• if the margin is small, reduction in sales even to
small tune may affect the profit position very
adversely.
• Thus margin of safety serves as a guide to the
strength of the business.
 Angle of incidence:
• The angle by the sales line and the total cost line at
the break-even point is known as angle of
incidence.
• A high rate of profit indicated by a large angle of
incidence and a low rate of profit indicated by a
small angle of incidence.
UNIT IV-CHAPTER 2: DECISION INVOLVING ALTERNATIVE CHOICES:
Concepts of relevant costs:
• Decision making is the process of selecting a
particular course of action from among a number
of alternatives.
• At the time of decision making it is necessary to
consider only those costs that are affected by the
decision. Such costs are termed as relevant costs.
• If fixed costs remain same, it will be treated as
irrelevant costs.
• Relevant costs are expected future costs that will
differ between the alternatives being considered in
the decision situation.
Any cost that is avoidable is relevant for decision
making.
So relevant costs are
– Expected future costs
– They are avoidable costs
– They differ between alternatives.
 STEPS IN DECISION MAKING:

• Defining the problem.

The problem must be defined in exact terms. If there
would be ambiguity about defining the problem
and it would result manifold interpretations, the
analysis can’t proceed further.
• Spelling out the alternatives: different alternatives
are clearly identified, so that there is no confusion
as to what the problem really is.
• Determining evaluation criterion: the criterion
should be laid down first and the evaluation process
is preceded based on the criterion.
• Evaluating alternatives and selecting the best
alternative:
On the basis of the evaluation criterion, different
alternatives are to be evaluated. Information might
have to be collected regarding Quantitative factors
and Qualitative factors
• Mid term appraisal: The decision should be tested
during the period of its implementation. The
decision should not be a static one and there should
be an inbuilt flexibility in the decision making
system.
• Decisions regarding determination of sales mix:
• To continue or shut down a product /department.
• Exploring new markets:
• Make or buy decisions.
• Equipment / asset replacement decision:
• Discontinuance of a product line:
• Expand or not to expand or contract
• Change versus status quo
 Decisions regarding determination of
sales mix:
• The decision regarding the sales mix is taken on the
basis of the contribution per unit of each product
pursuing that fixed costs will remain constant.
• The product which gives higher contribution is
preferred over the product which gives lower
contribution.
• The product with the lowest contribution is given
the least priority.
 To continue or shut down a product /department.
• In order to decide whether to continue operations
or close down or give up the project, comparison
should be made between revenues from
continuing operations and revenues from closing
down and sale of the plant.
• In case the revenue from closing down exceeds
the revenues from continuing operations.
 Exploring new markets:
• Decision regarding selling goods in the new market
(whether Indian or foreign) should be taken after
considering the following factors.
• Whether the firm has surplus capacity to meet the
new demand?
• What price is being offered in the new market?
• Whether the sale of goods in the new market will
affect the present market for the goods?
 Make or buy decisions.
• There are certain non cost factors are also taken
into consideration.
• The part to be bought should be available every
time needed and at the same price at which the
company is considering to buy it at present.
• If there is difference in quality, specification etc of
the component to be bought, it must be workable.
• If production is not carried out, labor problems
should not crop up.
 Equipment / asset replacement decision:
• To replace an equipment or fixed asset is a capital
investment decision rather is a part of long term
capital decision. While deciding about the
replacement of capital equipment or asset, the
firm should taken into consideration the resultant
savings in operating costs and the incremental
investment in the new equipment.
 Discontinuance of a product line:
The following factors should be considered before
taking a decision about the discontinuance of a
product line:
• The contribution given by the product.
• The capacity utilization
 Expand or not to expand or contract
• In case the profit is likely to increase, the expansion
may be undertaken.
• The business may likely to contract if there is a
permanent tendency of customers to shift to
products manufactured by other producers.
• It may also be due to managerial handicap, lost
production capacity etc.
 Change versus status quo
• The forward looking and enlightened management
will ever like to manipulate production, selling
prices etc to increase the overall profitability of the
business.
• Maintenance of status quo leads business to static
conditions and makes management and its team
lethargic.