Module 10 - Financial Management

Marginal Costing
Some Important Definition:

❖ Marginal Cost: Marginal Cost is the additional cost incurred for increase in
one additional unit of output. Marginal cost is nothing but the variable cost.
❖ Marginal Costing: Marginal Costing is the method of ascertaining marginal
cost and it evaluates the effect of fixed and variables costs on profit due to
change in volume of production.
❖ Distinguish features of Marginal Costing are:
(a) Only variable costs are charged to the cost unit. Fixed costs are recovered
from contribution;
(b) All costs including semi variable costs are divided into two parts, fixed and
variable;
(c) Closing inventories are valued at variable cost only;
(d) Break-even Analysis and Cost-volume-profit Analysis are integral parts of
this costing technique.
❖ Marginal Costing technique is having many advantages, such as:
(a) It provides useful data for managerial decision- making;
(b) It is a very effective tool of profit planning;
(c) Its facilities control over variable costs by avoidance of arbitrary
apportionment or allocation of fixed costs;
(d) Problems on computation of accurate fixed factory overhead rate can be
avoided as fixed overheads are charged against contribution;
 (e) It provides the management with many useful techniques for decision –
making like Break – even Analysis, etc.
❖ Limitations of Marginal Costing are:
(a) It assumes the semi- variables costs can be segregated into two parts, fixed
and variable elements. In practice, however, such segregation of semi-
variable costs is very difficult;
(b) It excludes fixed cost for decision – making, which sometimes may lead to
wrong conclusion;
(c) It fails to reflect the impact of increased fixed costs due to development of
technology on production costs;
(d) Variable cost technique cannot be successfully applied in “Cost plus
contract”.
❖ Cost-volume-profit (CVP) Analysis examines the relationship of costs and
profit to the volume of production to maximize profit of the firm. The method
of studying the relationship between the cost, volume of production, sales and
their impact on profit is called as ‘Cost-volume-profit Analysis’. CVP
Analysis is a logical extension of marginal costing and is used as a very
powerful tool by the management in the process of budgeting and profit
planning.
❖ Objectives of CVP Analysis are:
(a) It helps to forecast profit fairly and accurately;
(b) It acts as an effective tool of profit planning to the management;
(c) It helps in ascertaining break-even point of the product produced and sold.
(d) It is very much useful in setting up flexible budget;
(e) It assists the management in the process of performance evaluation for the
purpose of control;
 (f) It helps in formulating price policies by projecting the effect of different
price structures on costs and profits.
❖ Underlying assumption of CVP Analysis are:
(a) Total cost consists of two components – fixed cost and variable cost;
(b) Selling price per unit remains constant at different volume of sales;
(c) Only one product is sold by the concern or if it sells multiple product, the
sales mix remains constant at different volume of sales;
(d) Volume of production is equal to the sales volume.
❖ In CVP Analysis, costs are classified in two parts – fixed cost and variable
cost. Semi – variable cost is not separately recognized in CVP Analysis. Fixed
portion of semi – variable cost is clubbed with the fixed cost and its variable
portion is clubbed with the variable cost.
❖ Elements of CVP Analysis are:
✓ Marginal Cost Equation;
✓ Contribution;
✓ Profit – Volume Ratio;
✓ Break-even Point;
✓ Margin of Safety
❖ Marginal Cost Equation exhibits the relationship between the contribution,
fixed cost and profit. It explains that the excess of sales over variable cost is
the contribution towards fixed cost and profit, i.e. S – V = F + P.
❖ Contribution is the excess of sales over variable cost, i.e. C = S – V. This
contribution is available towards fixed cost and profit, i.e. C = F + P.
❖ Profit – Volume Ratio (P/V Ratio) is the ratio of contribution and sales. It is
generally expressed in percentage. It exhibits % of contribution included in
sales, i.e. P/V Ratio = C/S x 100. It indicates the effect on profit for a given
change in sales.
❖ Break - even Point (BEP) is that level of sales where there is no profit or no
loss. At break – even point, total sales revenue is equal to total cost. Any sales
above this BEP, a concern earns profit, whereas any sales below this BEP, the
concern suffers loss. At BEP, total fixed cost and variable cost up to that level
of sales have been recovered from sales. Generally, at any other point of sales,
contribution from sales is available towards fixed cost and profit. But as there
is no profit or loss at BEP, Contribution from sales at BEP is available towards
fixed cost only, i.e. at BEP, C = F.
❖ Margin of Safety (MS) is the level of sales made above the break – even
point. In other words, Margin of Safety is the excess of actual sales over BEP
sales. Generally, at any point of sales, contribution from sales is available
towards fixed cost and profit. But as the total fixed cost has already been
recovered at break – even point, contribution from sales at margin of safety is
available towards profit only, i.e. at MS, C = P.
❖ CVP Analysis is popularly known as Break – even Analysis, although there
exists a narrow difference between these two terms. CVP Analysis refers to
the study of the effect on profit due to changes in cost and volume of output,
whereas BE Analysis refers to the study of determination of that level of
activity where total sales is equal to the total cost and also the study of
determination of profit at any level of activity. However, the technique of BE
Analysis is so popular for studying CVP Analysis that these two terms are
generally used synonymously.
❖ Break – even Chart (BE Chart) is the graphical presentation of Break – even
Analysis. It depicts the relationship between costs, sales and profits. BE Chart
graphically shows the profit or loss at various levels of activity and also shows
the level of activity where there is no profit no loss (i.e. total cost equals total
sales)
 ❖ Angle of Incidence is the angle formed by intersection of sales line and total
cost line at break – even point in the break – even chart. This angle exhibits
the rate at which profits are being earned by a concern after reaching the break
– even point. It shows the profit earning capacity of a concern. Wider angle
of incidence exhibits higher profit earning capacity of the concern or vice –
versa.

Income Statement under Marginal Costing:

Rs.

Sales xxxx

Less: Variable Cost xxx

Contribution xxxxx

Less: Fixed Cost (Operating) xxx

Profit (EBIT) xxxxx

Formula:

1. Contribution (C) = Sales – Variable Cost = Fixed Cost + Profit

2. Profit – Volume Ratio (P/V Ratio) = Contribution / Sales * 100
= {(Change in profit) / (Change in sales)} * 100
3. BEP Sales (in value) = Fixed Cost / (P/V Ratio)

BEP Sales (in units) = Fixed Cost / Contribution per unit

4. Margin of Safety (MOS) = Actual Sales – BEP sales

= Profit / (P/V ratio)
5. Required Sales (in value) = (Fixed Cost + Profit) / Contribution per unit
Required Sales (in units) = (Fixed Cost + Profit) / (P/V Ratio).
 Marginal Costing

Marginal costing can helps the management in respect of following points :

1. Make or buy :
Make or buy decisions are best taken with full knowledge of the marginal
cost of making rather than being a product buy. It is also helpful to know though marginal
costing what contribution to fixed cost will result from a ‘make decision’.
This decision will be taken with the help of marginal costing technique under
the following situations;
a. When the company is working at full capacity :
The contribution per unit earned by different components, assemblies or products will be arrived
and the contribution, Thus earned will be lost by not manufacturing the component, this
contribution lost will be consider whether the manufacture a component or buy it from outside.
b. When the company is not working at full capacity :
The lost of contribution approach is irrelevant & should manufacture if it
earns contribution over variable cost incurred on it. If variable cost in production is more than
the purchase price from out side market then only the company will prefer to procure from
outside suppliers.
Though make or buy analysis as outlined above, will ensure that all the
capacity, capability, differential cost & opportunity cost factors will have been taken fully into
consideration before the choice is made.
Thus, marginal costing can also helps to management in decision taking to
various conditions & situations.
2. Price fixation :
This technique is most useful in fixation of price under the following situation:
a. Where supply is in excess to the existing demand.
b. Pricing of new product.
c. Make or buy decision.
d. Where the installed capacity is more than operating level of production.
e. Public utility services.
f. When cut - throat competition is prevailing in the market.
g. Pricing for export products.
h. Pricing decision relating to special orders.
The selling price fixations is also done under different circumstances :
a. fixing selling price.
b. reducing selling price.
c. selling at or below marginal cost.
Product pricing is a very important function of management. One of the

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purpose of cost, for fixation of selling price. Marginal cost of product represent the minimum
price for that product and any sale below the marginal cost would until a loss of cash. There are
cyclic periods in business i.e. boom depression, recession etc. in these situations price fixation is
very important.

3. Operate or shut down : Marginal costing is also helpful in respect of closure

of a department or discontinuing a product. Marginal costing technique shows the contribution of
each product to fixed cost profit. If department or a product contributes the least amount, then
the department can be closed or its production can be discontinued. It means the product which
gives a higher amount of contribution may be chosen & the rest should be discontinued.

4. Profit planning : Profit planning is a plan for future operations or planning budget to
attained the given objective or to attained the maximum profit, the volume of sale required to
maintain a desired profit can be known from the formula –

Desired Profit = __fixed cost+desired profit

p/v ratio

5. Decision to accept a bulk order or foreign market order :

Large scale purchases may demand products at less than the market
price. A decision has to be taken now whether to accept the order to or reject it. By reducing the
normal price, the volume of output & the sales can be increased. If the price is below the total
cost, rejection of the order is suggested at in marginal costing. The offer may accepted, if the
quoted price is above marginal cost, because of the reason that existing business contribution can
recover the fixed costs & the margin of profits.
In such case, the contribution made by foreign market or bulk orders
will be an addition to the profit but the price should not be less than the marginal cost. However,
it should be affect the normal market price. Thus the marginal costing can also help to
management in taking decision.

Explain circumstances in which the technique of marginal costing

will help the management in taking decisions :
Marginal costing is a very useful technique of decision-making for the
management. Any decision which involves consideration of variable cost & revenue requires
application /use of marginal costing. Some of the important decision taken with the help of
marginal costing techniques pointed are :
1.Fixation of selling price : The marginal costing technique help in determining the
selling price in normal & special circumstances. In normal circumstances, every firm would
like to sale its products at a price which covers the total cost & yields reasonable
profit.
There can be situation when a firm may framed it beneficial to sale
below total cost, at marginal cost or even below marginal cost. The determination of selling price
in various circumstances have been explained below

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 1. If the raw materials are perishable or when the raw materials are
perishable or when the raw material prices have fallen considerably, a firm may sell the
finished product at marginal cost or at a price which is less than the marginal cost to
avoid or to reduce total losses.
2. A firm may also do so to meet actual competition,
3. To introduce a new product,
4. To avoid shut-down costs,
5. To push up the sale of another highly profitability product,
6. To retain future market, or to capture foreign market.
Selling at marginal cost or below marginal cost can be for a limited period only, that too
keeping in view the long-term interest.

a. Selling price in normal circumstances :

In normal circumstances, to determine the selling price of a
product, a firm has first to ascertain the variable cost & desired p/v ratio. Thereafter, the selling
price of the product can be determined by dividing the variable cost by . (100 % =p/v ratio)

b. Selling price for special market ( export market ) OR for a special

customer :
If a company has some idle capacity, it may develop special
markets to utilize the idle capacity by selling goods at a price which covers the marginal cost, but
not the total cost. Thus, a firm has surplus capacity; it may offer a confessional price to a group
of customers.
Since a price of additional goods will be higher than the
marginal cost, the firm will be able to increase its total profits because there will not be
additional fixed expenses for the extra output.
A firm may export goods at a price less than the total cost or it
may sell to a special class of customers at a confessional price by doing this differential selling
price. For doing this differential selling two precautions are necessary,

Firstly : price for normal sales should not be adversely affected by the confessional price.
Secondly : Extra sales should be limited only up to the idle capacity. Otherwise the fixed
overheads will rise & reduce the profit instead of increasing it.
2 . Selling price during recession :
During a recession or a depression, a concern may decide to
continue to product & sell at a price which is below the total cost, in such a case, the principle
followed should be that as long as the price is above the marginal cost, production & sale would
continue, it is obvious that selling in such a situation would give at least some margin to meet the
fixed costs & hence the losses of the firm would be lower than had production been stopped
altogether. However, in this case, one should not sell below the marginal cost because that will
only increase the losses.
3. selling price at marginal cost or below marginal cost :
A firm may sell at marginal cost or even below marginal cost merely to keep the
machines in running condition or to retain highly skilled work

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4. Decision relating to the most profitable product mix :
Normally, a product which yields the maximum
contribution is considered to be the most profitable, however, when a factor of production is
short supply, generally called key factor or limiting factor. A product that yields the highest
contribution per unit of key factor is considered the most profitable.

5.Decision relating to make or buy :

A decision whether a component should be produced in
the factory or bought from outside is taken by comparing the marginal cost of production with
the cost of buying the concerned part.
In the make or buy decision, only marginal (variable)
cost of manufacturing or special additional cost, if any are relevant. Fixed cost which have
already been incurred are sunk cost & irrelevant for the decision as they cannot be avoided
(saved) if it is decided to buy the concerned part. However the decision will be influenced by the
fact whether or not be capacity released by the non manufacture of the part can be used
profitably somewhere else. If yes the contribution from the use of released capacity will also be
considered as opportunity cost in taking a make or buy decision.

6. Shout down or continued or determination of out put level in periods of

recession or depressions :
A firm can continued working till the sales revenue is
sufficient to cover the variable cost plus a part of the fixed overheads i.e. excess of fixed cost
over shut down cost. Shut down cost are those cost which a frame is bound to incur even if the
plant is closed down. Any part of such fixed cost recovered will reduce the losses of the firm
which it is otherwise bound to suffer.
The shut down point can be determined with the help of
the following formula:
Shut down point {in sale value} = fixed cost-shut down cost
p/v ratio
Shut down point {in sales unit}= fixed cost - shut down cost

 Marginal costing can also help in taking decisions with regard to :

1. To diversify or not to diversify.
2. To sell in the home market or in the export market.
3. To drop out a product line.
4. To substitute one factor of production with another.
5. To rise or not to raise the production level.
6. To retain or replace a machine.
7. To expand or not to be expand. Etc.

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 So long as fixed costs remain unchanged irrespective of change
in volume of production, the marginal cost & differential cost are the same.

Short Notes :
1. Make or Buy Decision :
Make or buy decision are best taken with full knowledge of
marginal or variable cost of making rather than buying a product but it is also helpful to know
though marginal costing what contribution to fixed cost will result from a make decision.
If the product has a component part it is necessary to decide whether it is
to be made in the factory to utilize the idle capacity or purchase it from outsider, if the price
demanded by the outside suppliers is more than the marginal cost, the components should be
manufacture in the factory & if it is less than marginal cost it should purchased from the outside
supplier. Suppose the marginal cost of a unit is Rs.10 & the expenses or Rs. 5. The suppliers is
prepared a supply it at Rs. 12 as the total cost of manufacture is Rs 15, but fixed expenses are
required to be incurred even though the component is purchase from outsider & as such the total
cost will be Rs. 17 the real cost of making the component is Rs. 12 i.e. its variable cost or
marginal cost & as such it is not justified to purchase the component at Rs. 15. which price is
more than its marginal cost.
However, in arriving at a final decision, other factors like regularity of
supply, use of idle capacity for some other alternative use etc. must be considered.
2. Opportunity costs :
Opportunity cost is the value of a benefit sacrificed in favor of an
alternative course of action. Opportunity cost represents income foregone by rejecting
alternative. This cost can be defined as the revenue foregone by not making the best alternative
use. The concept of opportunity cost is more important & useful to the management in decision
making. For ex. If a firm receives an export order when its capacity is not fully utilized, capacity
of the plant for export production would be nil or zero since the unutilized capacity of the plant
has no alternative uses.
An opportunity cost is an imputed cost which represents the greatest
benefit foregone or sacrifice made as a result of using particular resources or choosing an
alternative course of action. If e.g. A choice lies between alternative A, B, & C then
opportunity cost of choosing alternative A is more profitable of alternative B & C which has
been foregone although opportunity cost are not collected within the accounting system as future
commitments, they can be affected by decision & are therefore relevant.
Thus, opportunity costs represents the benefits forgone by not choosing
the best alternative in favors of alternative accepted.
3. Incremental cost :
Incremental cost is also known as differential cost, is the difference in
total cost that will arise from the selection of one alternative to the other.
Differential costs are defined as the difference in total costs between any
two acceptable alternative. The term ‘differential cost’ covers both incremental & decremented
costs, incremental costs is the increase in cost from one alternative to another. Detrimental cost
is decrease in the cost due to acceptance of alternative.
The differential cost is the result of an alternative course of action; it is
the most important concept of cost in decision- making process.

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 Naturally, the difference in cost is arrived at by subtracting cost of one
alternative from the cost of another alternative.
ex. The total cost at 60% level of activity is RS. 50,000/- & that at 80% capacity RS. 60,000/- the
differential cost is RS. 10,000/- .
Differential cost can be use both under absorption costing & marginal
costing. It can be used for all short, medium & long term decision depending on the nature of
problem. It is only uses the accounting information & it can be part of accounting system,
incremental cost may include certain fixed costs. It tabulated & presented to the management to
enable them to take certain decisions.
So long as incremental revenue exceeds the differential cost, it is
profitable to increase the production but when differential cost is equal to or more than
incremental revenue, the volume of production should not be in creased thereafter.
4. Operate or shut down :
Marginal costing is also helpful about taking decisions in the form of
business activity the business is running various situation time to time taking decision is most
important to management business is which time shut down or continue or is most important
question of marginal costing.
Shut down or continue : temporary shut down :-Differential cost
analysis helps to take decision whether to continue operation or temporary or permanently shut
down the plant if operation are continued instead of being temporary shut down, the revenue
from the sales of the products may not be sufficient to cover fixed costs. Some fixed costs may
be reduced due to temporarily closing down of the plant, but the others will continue.
The decision would depend upon a comparison of direct economic
consequence of shutting down & continue business operations. If the fixed costs not recovered
from sales effected exceeds the cost of shut down, it would be worthwhile to shut down
temporary units the operations can be conducted at an economic advantage. It is in the interest of
the company to continue the operations as long as differential costs or any amount above that can
be obtained.
In case of decision to permanently closing down plant a comparison
should be made between the revenue from continued operations & revenue from complete
closing down & sale of plant if the latter amount is more than the first, the business should be
closed down.

5. Retain or Replacement Decision:

Management is required many times to decided whether to retain
the old equipment or to replace it be new one. Replacement of equipment or machinery, it a
question of capital investment & as such it is a long- term decision requiring use of discounted
cash flow technique.
However, here discussion is confined to short term problems. As
such we have to decide how to deal with written down value of an old equipment. Replacement
may involve the questions of additional fixed costs that will be required to be incurred.
While deciding about replacement of a capital equipment the
management should taken into consideration the resultant saving in operating costs & the
incremental investment in the new equipment if the saving is more than the cost of raising
additional funds for the new equipment, the proposal for replacement may be accepted. Besides

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