COST & MANAGEMENT ACCOUNTING

Unit 2

(a) MARGINAL COSTING

2.1 Introduction

Absorption costing and marginal costing are two different techniques of cost accounting.
Absorption costing is widely used for cost control purpose whereas marginal costing is
used for managerial decision-making and control.

Marginal Costing is not a method of costing like job, batch or contract costing. It is a technique
of costing in which only variable manufacturing costs are considered while determining the cost
of goods sold and also for valuation of inventories.

2.1.1 Definitions of Marginal Costing

According to economists, marginal cost of production refers to the cost of producing one
additional unit of output. For example, if the total number of units produced are 800 and the total
cost of production is Rs.12, 000, if one unit is additionally produced the total cost of production
may become Rs.12,010 and if the production quantity is decreased by one unit, the total cost may
come down to Rs.11, 990. Thus the change in the total cost is by Rs.10 and hence the marginal
cost is Rs.10. The increase or decrease in the total cost is by the same amount because the
variable cost always remains constant on per unit basis.

According to an accountant’s concept, marginal cost is variable cost only.

Acc. To ICMA, “Marginal cost is the amount at any given volume of output by which aggregate
costs are changes if the volume of output is increased or decreased by one unit.”

Hence it is clear that marginal cost is nothing but variable cost. It can be calculated as follows:
(i) Marginal cost = Prime cost + variable overheads
(ii) Marginal cost = Direct Material + D. Labour + D. Expenses + Variable overheads

Marginal Costing is a technique of decision making, which involves:

(a) Ascertainment of total costs
(b) Classification of costs into (1) Fixed and (2) Variable
(c) Use of such information for analysis and decision making.

Thus, Marginal costing is defined as the ascertainment of marginal cost and of the ‘effect of
changes in volume or type of output by differentiating between fixed costs and variable costs.

Marginal costing is mainly concerned with providing information to management to assist in

decision making and to exercise control.

Marginal costing is also known as ‘variable costing’ or ‘out of pocket costing’. And under his
method of costing only variable costs are charged to operations, processes or products.
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Income Statement under Marginal Costing

XYZ LTD. Product P

Particulars Amount (Rs.)

Sales (S)
Less: Variable Costs (V)
Contribution (C)
Less: Fixed Costs (F)
Profit (P)

2.1.2 Features of Marginal Costing

1) Technique of analysis & presentation of Costs: It is a technique of analysis &

presentation of costs which helps management to take the decisions.
2) Segregation of Costs into Fixed & Variable costs: In marginal costing, all costs are
classified into fixed & variable.
3) Marginal Costs as Product Costs: Only marginal (variable) costs are charged to products.
4) Fixed cost as Period Costs: Fixed costs are treated as period cost & are charged for the
period in which they are incurred.
5) Valuation of Inventory: The work-in-progress & finished goods are valued at marginal
cost.

2.1.3 Advantages and Disadvantages of Marginal Costing Technique

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.

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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.

2.2 ABSORPTION COSTING

Absorption costing is a costing system which treats all costs of production as product costs,
regardless weather they are variable or fixed. The cost of a unit of product under absorption
costing method consists of direct materials, direct labor and both variable and fixed overhead.
Absorption costing allocates a portion of fixed manufacturing overhead cost to each unit of
product, along with the variable manufacturing cost. Because absorption costing includes all
costs of production as product costs, it is frequently referred to as full costing method.

Income Statement under Absorption Costing

XYZ LTD. Product Q

Particulars Amount (Rs.) Amount (Rs.)

Sales ---
Opening Stock ---
Add: Cost of Production
Fixed overheads ---
+ Variable overheads ---
Less: Closing Stock ---
Cost of Sales --- ---
Profit (Sales – Cost of sales) ---

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2.5 Difference between Marginal Costing and Absorption Costing

Basis of Difference Marginal Costing Absorption Costing

1. Cost Under marginal costing, Under adsorption costing, costs are
classification costs are classified as either classified on functional basis i.e.
Fixed or Variable. Production, Administration, Selling &
Distribution etc.
2. Product v/s Fixed costs are treated as period Fixed costs are treated as product
Period Costs costs. costs.

3. Stock Valuation The stock valuation includes The valuation of the closing stock
only the variable factory or would include both variable as well as
production cost and not the fixed fixed overheads.
charge.

4. Profit No such manipulation is possible Profit figure can be manipulated by

Manipulation under marginal costing. showing higher stocks under
absorption costing.
5. Over / Under Since all fixed costs are written If the spent amount is different from
Absorption off in the period in which they absorbed amount then, there will be
are incurred there is no over/under absorption under
possibility of over/under absorption costing.
absorption.

6. Application Marginal costing technique is Absorption costing technique is used

used for internal reporting for external reporting purposes. It
purposes. It aids in decision- distorts decision-making.
making.

Problem 1: From the following information prepare an Income statement under:

(a) Marginal Costing (b) Absorption Costing

Zen ltd. Supplies you the following data:

Direct material cost Rs. 48,000
Direct wages Rs. 22,000
Variable overheads - Factory Rs. 13,000
- Adm. & selling Rs. 2,000
Fixed Overhead - Factory Rs. 20,000
- Adm. & selling Rs. 8,000
Sales Rs. 1, 25,000

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(a) INCOME STATEMENT (Marginal Costing)

Zen LTD.

Particulars Amount (Rs.) Amount (Rs.)

Sales (S) 1,25,000
Variable Costs (V):
Direct materials 48,000
Direct wages 22,000
Variable overheads:
- Factory
13,000
- Adm. & selling
2,000 85,000
Contribution (C) = S-V 40,000
Less: Fixed Costs (F)
- Factory 20,000
- Adm. & selling 8,000 28,000
Profit (P) 12,000

(b) INCOME STATEMENT (Absorption Costing)

Zen LTD.

Particulars Amount (Rs.) Amount (Rs.)

Direct materials 48,000
Direct wages 22,000

Prime Cost 70,000

Factory Overhead
- Fixed 20,000
- Variable 13,000 33,000
Cost of Production 1,03,000
Adm. & selling overhead (F)
- Fixed 8,000
- Variable 2,000 10,000
Cost of Sales / Total Cost 1,13,000
Profit 12,000
Sales 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.

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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 Amount (Rs.) Amount (Rs.)

(a) Sales (S) 20,000
Variable Manufacturing Costs :
Direct materials (3 × 1,100 units) 3,300
Direct wages (2 × 1,100 units) 2,200
Variable overheads: 7,700
- Factory / Manufacturing (7 × 1,100 units) 13,200
Add: Opening Stock ---
Cost of goods produced (for 1,100 units) 13,200
Less: Closing Stock (100 units × Rs.12 p.u.)* 1,200
Cost of goods sold (1,000 units) 12,000
Add : Variable adm. & selling overheads (1,000 @ Re. 0.50 p.u.) 500
(b) Total Variable costs (V) 12,500 12,500
(c) Contribution (C) = S - V 7,500
Less: Fixed Costs (F)
- Manufacturing 2,200
- Adm. & selling 400 2,600
Profit (P) 4,900

Note: * Closing stock is valued at total variable manufacturing cost p.u. i.e. 3+2+7 = Rs.12 p.u.

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(b) INCOME STATEMENT (Absorption Costing)

For the year ended 31st Dec., 2005

Particulars Amount (Rs.) Amount (Rs.)

Direct materials (3 × 1,100) 3,300
Direct wages (2 × 1,100) 2,200

Prime Cost 5,500

Manufacturing / Factory Overhead
- Fixed 2,200
- Variable (7 × 1,100 units) 7,700 9,900
Cost of Production (for 1,100 units) 15,400
Add: Opening stock -----
Less: Closing Stock (100 units) * i.e.
15,400 × 100 1,400 ( -1,400)
1,100
Cost of Goods sold (1,000 units) 14,000
Adm. & selling overhead
- Fixed 400
- Variable (1,000 @ Re. 0.50 p.u.) 500 900
Cost of Sales / Total Cost 14,900
Profit 5,100
Sales 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) .

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Marginal Cost Equation:

The Marginal Cost Statement, when written in an equation form, constitutes the
Marginal Cost Equation.

Sales - Variable Cost = Contribution

Fixed Cost 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

(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.

𝐶𝑜𝑛𝑡𝑟𝑖𝑏𝑢𝑡𝑖𝑜𝑛 (𝐶)
P/V ratio = × 100
𝑆𝑎𝑙𝑒𝑠 (𝑆)

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And also we have (i) C = S × P/V ratio

(ii) S = C
P/V ratio
𝐶ℎ𝑎𝑛𝑔𝑒 𝑖𝑛 𝑃𝑟𝑜𝑓𝑖𝑡
P/V ratio can also be calculated as follows: P/V ratio = × 100
𝐶ℎ𝑎𝑛𝑔𝑒 𝑖𝑛 𝑆𝑎𝑙𝑒𝑠

Uses of P/V Ratio:

(a) To compute the variable costs for any volume of sales.
(b) To measure the efficiency or to choose a most profitable line.
(c) To determine break-even point and the level of output required to earn a desired profit.
(d) To decide more profitable sales-mix.

(ii) Break - Even Point (B.E.P.)

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
FORMULA: B.E.P. (in units) =
𝐶 𝑝𝑒𝑟 𝑢𝑛𝑖𝑡

𝐹
B.E.P. (in Rs.) =
𝑃/𝑉 𝑟𝑎𝑡𝑖𝑜

Break-even chart:
The break-even chart is a graphical representation of cost-volume profit relationship.

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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
Or MOS =
𝑃/𝑉 𝑟𝑎𝑡𝑖𝑜

𝑀𝑂𝑆 𝑆𝐴𝐿𝐸𝑆
MOS RATIO =
𝐴𝐶𝑇𝑈𝐴𝐿 𝑆𝐴𝐿𝐸𝑆

OTHER FORMULAS:
1) C = S – V or C=F+P (C = Contribution , S = Sales)

OR S – V = C & C–F=P (V = variable cost, F = Fixed Cost & P = Profit)

2) Calculation of sales to earn a given profit:

𝐹+𝑃
Sales (In units) =
𝐶 𝑝𝑒𝑟 𝑢𝑛𝑖𝑡

𝐹+𝑃
Sales (In Rs.) =
𝑃/𝑉 𝑟𝑎𝑡𝑖𝑜

Problem 1: The following data is given :

Fixed Cost = Rs. 12,000
Selling price = Rs. 12 per unit
Variable cost = Rs 9 per unit
(a) What will be the profit when sales is Rs. 1,00,000 ?
(b) What will be the amount of sales to earn a profit of Rs 15,000?
Solution:
C = Rs 12 – 9 = Rs 3 per unit

𝐶𝑜𝑛𝑡𝑟𝑖𝑏𝑢𝑡𝑖𝑜𝑛 (𝐶)
P/V ratio = × 100
𝑆𝑎𝑙𝑒𝑠 (𝑆)

3
P/V ratio = × 100 = 25%
12

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(a) When sales = Rs 1,00,000

Contribution = Sales × P/V ratio
= 1,00,000 × 25% = Rs 25,000

Contribution – Fixed cost = Profit

So, Profit = 25,000 – 12,000 = Rs 13,000

𝐹+𝑃
(b) Sales for desired profit (In Rs.) =
𝑃/𝑉 𝑟𝑎𝑡𝑖𝑜

12,000 + 15,000
= = Rs. 1, 08,000
25 %

Problem 2: You are given the following data:

Sales Profit
Year 2004 Rs. 1,20,000 Rs 8,000
Year 2005 Rs 1,40,000 Rs. 13,000
Find out –
(i) P/V ratio
(ii) B.E.P.
(iii) Profit when sales are Rs. 1,80,000
(iv) Sales required to earn a profit of Rs. 12,000
(v) Margin of safety in year 2005

Solution:

Sales Profit
Year 2004 Rs. 1,20,000 Rs 8,000
Year 2005 Rs. 1,40,000 Rs. 13,000
Difference Rs. 20,000 Rs. 5,000

𝐶ℎ𝑎𝑛𝑔𝑒 𝑖𝑛 𝑃𝑟𝑜𝑓𝑖𝑡
(i) P/V ratio = × 100
𝐶ℎ𝑎𝑛𝑔𝑒 𝑖𝑛 𝑆𝑎𝑙𝑒𝑠

5,000
= × 100 = 25%
20,000

Contribution in 2004 = Sales ×P/V ratio

= 1, 20,000 × 25% = Rs. 30,000
And, Contribution – Profit = Fixed cost
so, Fixed cost = Rs. 30,000 – 8,000 = Rs. 22,000 (Fixed cost will be same for both years )

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𝐹
(ii) B.E.P. =
𝑃/𝑉 𝑟𝑎𝑡𝑖𝑜

22,000
= = Rs. 88,000
25 %

(iii) Profit when sales are Rs. 1,80,000 :

Contribution (Rs 1, 80,000 × 25%) Rs. 45,000

Less: Fixed Cost Rs. 22,000
Profit Rs. 23,000

(iv) Sales to earn a profit of Rs. 12,000:

𝐹+𝑃 22,000 +12,000

= = Rs. 1, 36,000
𝑃/𝑉 𝑟𝑎𝑡𝑖𝑜 25%

(v) Margin of safety in 2005 –

MOS = Actual sales – B.E.P.

= Rs. 1,40,000 – Rs. 88,000 = Rs. 52,000

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