UNIT V

MARGINAL COSTING AND BREAK-EVEN ANALYSIS

Costing Techniques
Costing techniques are the approaches or principles used to appropriately present cost data and statement
to the management for evaluation and/or decision making. The three common costing techniques are;
1. Absorption costing
2. Marginal costing
3. Budgetary control costing
4. Standard costing

Absorption Costing
Definition; it is a practice/procedure of combining all the costs associated to a particular product during
production process. The technique considers charging all types of costs, be it direct materials, direct
labour, direct expenses and overheads on a particular product.
The procedure is that the direct costs is charged to the particular product and if there is any overhead, it is
first charged to the cost Centre and then later absorbed to the cost unit.
The outlay with absorption costing approach appears as follows;

Therefore, the cost accountant presents the cost/ profit statement to the management in this structure for
decision-making purposes.
Marginal Costing
Definition; it is a practice/procedure of ascertaining variable costs only which is affiliated to specific
product or unit during production process. The technique considers charging all types of variable costs, be
it direct materials, direct labour, direct expenses and overheads on a particular product as long as it is
variable in nature.
The procedure is that the marginal costs is charged to the particular product and if there is any fixed
overhead pertaining certain period of time, it is written off against the contribution of that period.
It is normally assumed that fixed costs remain constant and such costs does not affect the decisions of the
management pertaining the production of alternative product.
The outlay with marginal costing approach appears as follows;

Budgetary Control
Definition; it is a technique of presenting costs and statement to the management in a manner that
comparison is possible between departments or organizations. Hence, the technique entails presentation of
both estimated and actual results of a department, a company or an organization. The resultant outcome is
a deviation, which may favourable or unfavourable or a zero deviation. In all those circumstances, the
management make well-informed decisions.
Standard Costing
Definition; Standard costing is a technique that involves presentation of cost data at predetermined value
for each product which is compared with actual cost of the product to evaluate the performance of the
firm. If the actual cost is less than the predetermined cost, it is a case of unfavourable results. Whereas, if
the predetermined cost is more than the actual cost, it is a case of favourable results
Definitions of Marginal cost and Marginal costing
According to the Terminology of Cost Accountancy of the Institute of Cost and Management
Accountants, London, Marginal Cost represents "the amount of any given volume of output
by which aggregate costs are changed if the volume of output is increased by one unit.
Marginal cost may also be defined as "the aggregate of variable costs" or "prime cost-plus
variable overheads".
Thus, if for the production of 1,000 units of a product the manufacturer has to incur Rs.
75,000 for materials, Rs. 50,000 for direct wages, Rs. 25,000 for variable overheads and Rs.
50,000 fixed overheads, the marginal cost can be ascertained as follows:
Total (1,000 units) Rs. Per unit
Rs.
Direct materials 75,000 75
Direct Wages 50,000 50
Prime Cost 1,25,000 125
Variable Overheads 25,000 25
Marginal Cost 1,50,000 150
MARGINAL COSTING
The Institute of Cost and Management Accountants, London, has defined
Marginal Costing as "the ascertainment of marginal costs and of the effect on profit of
changes in volume or type of output by differentiating between fixed costs and variable
costs.
BASIC CHARACTERISTICS OF MARGINAL COSTING
1. The stocks of finished goods and work-in-process are valued at marginal costs only.
2. It is a technique of analysis and presentation of costs which help management in
taking many managerial decisions; and is not an independent system of costing
such as process costing or job costing.
3. The variable costs (marginal costs) are regarded as the costs of the products.
4. All elements of cost production, administration and selling and distribution are
classified into variable and fixed component.
5. Fixed costs are treated as period costs.

ASSUMPTIONS OF MARGINAL COSTING

1. The volume of production or output is the only factor which influences the costs.
2. All elements of cost production, administration and selling and distribution— can
be segregated into fixed and variable components.
3. The selling price per unit remains unchanged or constant at all levels of activity.
4. Variable cost remains constant per unit of output irrespective of the level of
output and thus fluctuates directly in proportion to changes in the volume of
output.
5. Fixed costs remain unchanged or constant for the entire volume of production.
MARGINAL COSTING Vs DIRECT/DIFFERENTIAL /VARIABLE COSTING
The term marginal costing is also referred to as 'variable costing', 'direct costing',
'differential costing' or incremental costing.
MARGINAL COSTING Vs ABSORPTION COSTING OR FULL COSTING
1. Absorption costing is the total cost technique. Under absorption costing all costs
whether variable or fixed are treated as product costs. In marginal costing
technique only, variable costs are treated as product costs.
2. In absorption costing arbitrary apportionment of fixed costs, over the products,
results in under or over-absorption of such costs. While marginal costing
excludes fixed costs and the question of under or over absorption of fixed costs
does not arise.
3. Absorption costing differs from marginal costing from the point of view of
inventory valuation also. In absorption costing, the stock of finished goods and
work-in-process is valued at total cost which includes both variable and fixed
cost. In marginal costing, such stocks are valued at marginal cost.
4. In absorption costing, managerial decision-making is based upon 'profit' which is
the excess of sales value over total cost. While in marginal costing, the
managerial decisions are guided by 'contribution' which is the excess of sales
value over variable cost.

CONTRIBUTION:
Contribution is the difference between sales and variable cost or marginal cost
of sales. It may also be defined as the excess of selling price over variable cost per unit.
Contribution is also known as Contribution Margin or Gross Margin. Contribution being
the excess of sales over variable cost is the amount that is contributed towards fixed
expenses and profit
If the selling price of a product is Rs. 20/- per unit and its variable cost is Rs.15/-
per unit contribution per unit is Rs. 5/- (i.e., Rs. 20-15.
Contribution = Sales - Variable (Marginal) Cost
Or Contribution per unit = Selling Price-Variable (or marginal) cost per unit or
Contribution = Fixed Costs + Profit (—Loss)
Advantages of contribution:

 It helps the management in deciding whether to purchase or manufacture a

product or a component
 It helps the management in the fixation of selling prices. It assists in
determining the break-even point
 It helps in taking a decision as regards to adding a new product in the market.
 It helps management in the selection of a suitable product mix for profit maximization.
 It helps in choosing from among alternative methods of production; the method
which gives highest contribution per limiting factor is adopted.
Marginal Cost Equation:
Sales - Variable cost=Contribution or, Sales = Variable cost + Contribution or,
Sales = Variable cost + Fixed Cost ± Profit/Loss or, Sales-Variable
cost=Fixed cost ± Profit/Loss or, S-V = F±P

Where 'S' stands

for Sales V‘stands for
Variable cost F‘stands
for Fixed cost
P‘stands for Profit/Loss

Determine the amount of variable cost from the following particulars:

Sales 150000
Fixed Cost 30000.
Profit 40000

Solution:
Sales -Variable cost = Fixed Cost ±
Profit / Loss or 150000 - V.C. = 30,000
+ 40,000 or
Variable cost= 1, 50,000-70,000 = Rs.80, 000.

Illustration: From the following information find out the amount of profit earned
during the year using the marginal costing technique:
Fixed Cost Rs. 250000
Variable cost Rs. 10 per unit
Selling price Rs. 15 per unit
Output level 75000 units

Solution:
S-V =F + P
Sales = Rs. 75,000 x 15 = Rs. 11, 25,000
Variable Cost = 75,000 x 10 = Rs. 7, 50,000

Fixed Cost =Rs.

2, 50,000 Profit
(P)

=?
 11, 25,000-7, 50,000= 2, 50,000+ P
3, 75,000 = 2, 50,000+ P P
= 3, 75,000-2, 50.000
Profit =Rs. 1, 25,000.
Profit/Volume Ratio (P/V ratio or C/S Ratio
The Profit/volume ratio, which is also called the 'contribution ratio' or 'marginal ratio',
expresses the relation of contribution to sales and can be expressed as under:
P/V Ratio= Contribution / Sales
P/V Ratio = Sales-Variable cost / Sales i.e.

S-V \ S or, P/V Ratio = Fixed cost + Profit /

Sales or,
P/V Ratio = Change in profit or Contribute /
Change in Sales P/V Ratio = 20 – 15 / 20 xl00 = 5
/ 20 xl00 = 25%
The PA/ ratio, which establishes the relationship between contribution and sales is of
vital importance for studying the profitability of operations of a business. It reveals the
effect on profit of changes in the volume.
The formula for the sales volumes required to earn a given profit is:
P/V Ratio = Contribution / Sales
or, P/V Ratio = Fixed Cost + Profit / Sales
or, Sales = Fixed cost + Profit / P/V Ratio = F+P / P/V Ratio

Illustration:
Sales Rs.100000
Profit Rs. 10000
Variable cost 70%
Find out (i) PA/ ratio, (ii) Fixed Cost (iii) Sales Volume to earn a Profit of
Rs. 40000 Sales = Rs.100000
Variable cost = 70% = 70 / 100 x 100000 =
Rs. 70000 P/V Ratio = sales – variable cost /
sales x 100
= 100000 – 70000 / 100000 x 100 = 30%
Contribution = Fixed cost +
profit 30000 = fixed cost +
10000 = Rs. 20000
Fixed cost = 30000 - 10000
Sales = Fixed cost + profit / P/V Ratio
= 20000 + 40000 / 30%
= 60000 x 100 / 30 =Rs. 200000

Illustration:
The sales turnover and profit during two years were as follows:
Year Sales Rs. Profit Rs.
2015 140000 15000
2016 160000 20000

You are required to calculate:

a) P/V ratio
b) Sales required to earn a profit of Rs. 40,000,
c) Profit when sales are Rs. 1, 20,000.
 Solution:
a) P/V Ratio = Change Profit / Change in Sales x100
= 5000 / 20000 = 100 = 25%
b) Sales required to earn a profit of
Rs. 40,000 P/V Ratio = Fixed cost
+ profit / Sales or
25 / 100 = F+15,000 / 1, 40,000 or
140000 x 25 / 100 = F + 15000 = 35000 – 15000 = F or
Fixed cost = Rs. 20000 or Fixed Cost =Rs.
20,000 Desired Sales = F+P / P/V Ratio
= 20000+ 40000 / 25/ 100 = 60000 x 100 / 25 = Rs.240000
c) Profit when sales are Rs.
1,20,000 S = F + P / P/V
Ratio
S x P/V ratio =F + P
1, 20,000 x 25 /100 = 20,000+ P
30,000 = 20,000+ P
Profit = 30,000-20,000 = Rs. 10,000
COST-VOLUME & PROFIT ANALYSIS
Cost-Volume-Profit Analysis a technique for studying the relationship between
cost, volume and profit. Profits of an undertaking depend upon a large number of factors.
The CVP relationship is an important tool used for the profit planning of a business. In
cost-volume- profit analysis an attempt is made to analyses the relationship between
variations in cost with variations in volume.
The cost-volume-profit relationship is of immense utility to management as it
assists in profit planning, cost control and decision making. Cost-volume-profit analysis
can be used to answer questions such as:
1. How much sales should be made to avoid losses?
2. How much should be the sales to earn a desired profit?
3. What will be the effect of change in prices, costs and volume on profits?
4. Which product or product mix is most profitable?
5. Should we manufacture or buy some product or component? And so on.
BREAK-EVEN ANALYSIS
The study of cost-volume profit analysis is often referred to as ‗break-even
analyses. The term "break-even analysis" is used in two senses. In its broad sense, break-
even analysis refers to the study of relationship between costs, volume and profit at
different levels of sales or production. In its narrow sense, it refers to a technique of
determining that level of operations where total revenues equal total expenses, i.e., the
point of no profit, no loss.
ASSUMPTIONS OF BREAK-EVEN ANALYSIS
1. The break-even analysis is based upon the following assumptions:
2. All elements of cost, i.e., production, administration and selling and distribution
can be segregated into fixed and variable components.
3. Selling price per unit remains unchanged or constant at all levels of output.
4. There is only one product or in case of multi-products, the sales mix remains unchanged.
5. Variable cost remains constant per unit of output irrespective of the level of
output and thus fluctuates directly in proportion to changes in the volume of
output.
6. There will be no change in the general price-level.
7. Fixed cost remains constant at all volumes of output.
 8. Volume of production is the only factor that influences cost.
9. There is synchronization between production and sales.

BREAK EVEN POINT

The break-even point may be defined as that point of sales volume at which total revenue is
equal to total cost it is a point of no profit no loss. A business is said to break-even when its total
sales are equal to its total costs. At this point contribution, i.e., sales minus marginal cost equals the
fixed costs and hence this point is often called as Critical Point or Equilibrium Point or Balancing
Point or no profit no loss. If production/sales are increased beyond this level, there shall be
profit to the organization and if it is decrease from this level, there shall be loss to the
organization.
Break-even point can be stated in the form of an equation:

Sales revenue at break-even point = Fixed Costs + Variable Costs.

ALGEBRAIC FORMULA METHOD FOR COMPUTING THE BREAKEVEN POINT

The break-even point can be computed in terms of:
a. Units of sales volume.
b. Budget total or in terms of money value.
c. As a percentage of estimated capacity.
(a) Break-Even Point in Units:
As the break-even point is the point of no profit no loss, it is that level of
output at which the total contribution equals the total fixed costs, it can be calculated
with the help of following formula:
Break Even Point = Fixed Cost / Selling Price per unit- Variable Cost per unit
= Fixed Cost / Contribution per unit

(b) Break-Even Point in terms of budget-total or money value:

At break-even point:
Total Sales = Total Fixed Cost + Total Variable Cost
or
Break-Even Sales = Fixed Cost / Sales-Variable Cost x Sales
= Fixed Cost /Contribution x Sales
With the use of P/V Ratio, B.E.P = Fixed cost /
P/V Ratio (As, contribution / sales = P/V Ratio)
MARGIN OF SAFETY
The excess of actual or budgeted sales over the break-even sales is known as the
margin of safety. It is the difference between actual sales minus the sales at break-even
point.
Margin of Safety=Total Sales - Sales at Break -
Even Point Margin of Safety (M/S) = Profit /
P/V Ratio
ANGLE OF INCIDENCE
The angle of incidence is the angle between the sales line and the total cost line
formed at the breakeven point where the sales line and the total cost line intersect each
other. The angle of incidence indicates the profit earning capacity of a business. A large
angle of incidence indicates a high rate of profit and, on the other hand, a small angle of
incidence indicates a low rate of profit.

MANAGERIAL APPLICATIONS OF MARGINAL COSTING

(Decisions Involving Alternative Choices)
Marginal costing technique is a valuable aid to management in taking" many
managerial decisions. It is a useful tool for making policy decisions, profit planning
and cost control. The
following are some of the important managerial problems where marginal costing
technique can be applied.
1. Pricing Decisions.
2. Profit Planning and Maintaining a Desired Level of Profit.
3. Make or Buy Decisions.
4. Problems of Key or Limiting Factor.
5. Selection of a Suitable or Profitable Sales Mix.
6. Effect of Changes in Sales Price.
7. Alternative Methods of Production.
8. Determination of Optimum Level of Activity.
9. Evaluation of Performance.
10. Capital Investment Decisions.

PRICING DECISIONS
Fixing of selling prices is one of the most important functions of management.
Although prices are generally determined by market conditions and other economic
factors yet marginal costing technique assists the management in the fixation of selling
prices under various circumstances as:
a) Pricing under normal conditions
b) During stiff competition
c) During trade depression.
Profit Planning and Maintaining a Desired Level of Profit
Marginal costing techniques can be applied for profit planning as well. Profit
planning involves the planning of future operations to achieve maximum profits or to
maintain a desired level of profits.
Make or Buy Decisions:
Sometimes a concern has to decide whether a certain product or a component
should be made in the factory itself (having unused production facilities) or bought
from outside from a firm which specializes in it. In taking such a 'make or buy' decision,
the technique of marginal costing is of immense help.
Materi
als
Direct
labour
Other Variable Expenses
Depreciation and other Fixed Expenses Solution:
Since fixed costs are to be incurred whether we manufacture this component or
not the decision depends upon the marginal cost of making the component which is
calculated as follows:

Marginal Cost of Component 0.51 (per unit) Rs.

Materials 3.00
Direct Labour 2.00
Other Variable Expenses -

It is advisable to make the component itself if the marginal cost of making the
component is lower than the purchase price because every component produced will
give some contribution to the company. But in case the marginal cost is higher than the
purchase price, it is better to buy the component from outside than to make it
In the above example, if the purchase price is Rs. 6.50, it is not advisable to buy
the component from outside. We should rather make the component of our own because
every component manufactured will give a contribution of 50 paise. But the company
should not manufacture the component if it is available at Rs. 5.50 from outside. In that
case it is better to buy than to make.

Problem of Key or Limiting Factor:

A limiting factor is a factor which limits or restricts production or sales and thus
prevents a concern from making unlimited profits. Limiting factor is also known as key
factor. The limiting factor may be any factor of production such as availability of raw
material, labour, capital, plant capacity and even sales.
Effect of Changes in Sales Price:
Management is generally confronted with a problem of analyzing the effect of
changes in sales price upon the profitability of the concern. It may be required to reduce
the prices on account of competition, depression.
Alternative Methods of Production:
Sometimes the management has to choose from among alternative methods of
production, e.g., machine work or hand work. The same product may be produced either
by employing machine No. 1 or Machine No. 2, and the management may be confronted
with the problem of choosing one among them. In such circumstances, technique of
marginal costing can be applied and the method which gives the highest contribution can
be adopted keeping in view, of course, the limiting factor.
Evaluation of Performance:
Evaluation of performance efficiency of various departments, product lines or
markets can also be made with the use of the technique of managerial costing.
Capital Investment Decisions:
The technique of marginal costing also helps the management in taking capital
investment decisions.
ADVANTAGES OF MARGINAL COSTING:
 The technique of marginal costing is very simple to operate and easy to understand.
 It does away with the need for allocation, apportionment and absorption of fixed
overheads and hence removes the complexities of under absorption of overheads.
 Marginal cost remains the same per unit of output irrespective of the level of
activity. It is constant in nature and helps the management in production
planning.
 There is no possibility of factitious profits by over-valuing stocks.
 It facilitates the calculation of various important factors.
 It is a valuable aid to management for decision-making and fixation of
selling prices, selection of a profitable product/sales mix.
 It facilitates the study of relative profitability of different product lines, departments.
 It is complimentary to standard costing and budgetary control.
 Help in cost control
 It helps the management in profit planning.
 It is very useful in management reporting

LIMITATIONS OR DISADVANTAGES OF MARGINAL COSTING

 The technique of marginal posting is based upon a number of assumptions
which may not hold good under all circumstances.
 All costs are not divisible into fixed and variable.
 Variable costs do not always remain constant.
  Selling prices do not remain constant.
 Fixed costs do not remain constant after a certain level of activity
 The exclusion of fixed costs from the stocks of finished goods and working-
progress is illogical.
 Although the technique of marginal costing overcomes the problem of under or
over- absorption of fixed overheads, the problem still exists in regard to under or
over- absorption of variable overheads.
 Marginal costing completely ignores the time factor.
 The technique of marginal costing cannot be applied in contract or
shipbuilding industry.
 Cost control can be better be achieved with the help of other techniques, viz.,
standard costing and budgetary control than by marginal costing technique.
 Fixation of selling prices in the long run cannot be done without considering
fixed costs. Thus, pricing decisions cannot be based on marginal cost alone.
 Managerial decisions based upon only the marginal cost ignoring equally
important element of fixed cost may not be correct.

Basis for
Marginal Costing Absorption Costing
Comparison

Marginal costing is a technique that Absorption costing is a technique that

1. Meaning assumes only variable costs as assumes both fixed costs and variable
product costs. costs as product costs.

Variable cost is considered as

2. What it’s all Both fixed cost and variable costs are
product cost, and fixed cost is
about? considered in product cost.
assumed as a cost for the period.

Overheads, in the case of absorption

3. Nature of costing, are quite different –
Fixed costs and variable costs;
overheads production, distribution, and selling &
administration.

4. How is the By using the profit volume ratio

Fixed costs are considered in product
profit calculated? (P/V ratio)
costs; that’s why profit reduces.

5. Determines The cost of the next unit; The cost of each unit.

Since the emphasis is on the next

Since the emphasis is on each unit,
6. Opening & unit, change in opening/closing
change in opening/closing stocks
Closing stocks stocks doesn’t affect the cost per
affects the cost per unit.
unit.

7. Most
Contribution per unit. Net profit per unit.
important aspect
 To show forth the emphasis of To show forth the accuracy and fair
8. Purpose
contribution to the product cost. treatment of product cost.

9. How is it Most conveniently for financial and

By outlining the total contribution;
presented? tax reporting;