Marginal Costing and Absorption

Costing
There are mainly two techniques of determining cost
and profit:-
Marginal Costing
Absorption Costing
These are not methods of costing like job costing or
process costing.
Marginal Costing:
CIMA defines marginal costing as the accounting
system in which variable costs are charged to the cost
units and fixed costs of the period are written-off in
full against the aggregate contribution.
ABSORPTION COSTING
Absorption costing is a costing technique, which does
not recognise the difference between fixed costs and
variable costs, all the manufacturing costs are
absorbed in the cost of the products produced.
Absorption costing is a traditional approach and is also
known as Conventional Costing.
Characteristics of Marginal Costing
Segregation of Costs into fixed and variable elements.
Marginal Costs as products costs.
Fixed costs as period costs.
Valuation of inventory(on the basis of variable
manufacturing cost only)
Contribution (sales variable cost ).
Variable Costs
Variable costs are costs such as raw materials, direct
labor, direct expenses and energy, commission on sales
units etc, that vary or change directly with the amount
of product produced and sold.
Differences between Marginal
Costing and Absorption Costing
Marginal costing differs from absorption costing on
the ground of difference in valuation of closing stock.
Marginal costing techniques values closing stock at
marginal cost where as it is valued at total cost of
production in absorption costing techniques.
Uses of Marginal Costing in
Decision making:
Helps in Fixation of selling price
Helps in selecting a suitable produce mix for
maximum profit.
Determining Break Even point.
Choosing from the available alternative method of
production the one which gives highest contribution or
contribution per limiting factor.
Make or buy decision on the basis of higher
contribution
Taking a decision as regard to adding a new product in
the market.

Decisions Based on
Marginal Costing
To plan their operations, manufacturing firms must
decide:
How many units they expect to sell
How many units to produce
How much to spend to produce and sell these units
At what price they must sell the units to make the profit
they want
To make these decisions, firms may calculate the
break-even point.
Break-Even Point
The break-even point is the point at which income
from sales equals the total cost of producing and
selling goods.
It is the point at which the business will neither make a
profit nor suffer a loss.
When sales exceed the break-even point, there is a
profit.
When sales are less than the break-even point, there is
a loss.
Finding the Break-Even Point
To find the break-even point, you need to know three
things:
Fixed costs for manufacturing the product
Variable costs for manufacturing each unit of the
product
Expected selling price of each unit of the product
Break-Even Point in Sales Rs
Break-Even Point in Rs.
= Break-Even Point in Units Sales Price per Unit

or
Fixed cost
P/V ratio

Break Even point in units
Break Even point in units

= Fixed Cost
Contribution per unit
Marginal cost equation

S V = F P
Where S = Sales V = Variable cost
F = Fixed cost P = profit
Break-Even (or cost volume profit)
Analysis

It establishes the relationship of costs, volume and
profit in broader sense break even analysis is one
which determines the profit earned at any point or
level of output. In narrow sense it is to determine the
break even point (no-profit, no-loss) from where
profits accrue.
Contribution and P/V ratio
Contribution
- The amount contributed towards fixed
expenses and profit i.e., sales less variable cost.
Profit / Volume ratio (P/V Ratio)
- Studies the profitability of operations of a
business and establishes the relationship between
contribution and sales.
To improve the P/V

- Reduce variable costs
- Increase the selling price
- Produce products having higher P/V ratio

Margin of Safety

It is the level of sale over and above the break even
point.
MoS = Sales - BEP
Percentage of Margin of Safety
= (Expected Sales BEP sales) x 100
Expected sales
decrease in selling price results in
Reduction in sales volume
Reduction in contribution
Reduction in P/V ratio
Increase in break-even sales volume
Shortening of margin of safety

Sensitivity Analysis
CVP provides structure to answer a variety of what-
if scenarios
What happens to profit if:
Selling price changes
Volume changes
Cost structure changes
Variable cost per unit changes
Fixed cost changes
List of Formulae:

1) Variable expenses per unit
= change in cost
change in output
2) Marginal cost equation
Sales Variable Cost = Fixed cost profit /loss
3) Contribution = Sales variable cost.
4) P/V ratio = contribution ( x 100 for percentage)
sales
Continue
5) Variable Cost = Sales x (1- P/V ratio)
6) Profit = (Sales x P/V ratio) Fixed cost
7) Sales to earn desired profit =
Fixed expenses + Desired profit
Selling price per unit Variable cost per unit
Continue
8) Margin of safety = Actual sales Break Even sales
or profit
P/V ratio
9) % of Margin of safety
= (Expected sales BEP sales) x 100
Expected sales
10) P/V ratio =
change in profit ( x 100 for %)
change in sales
Break Even Chart:

It provides pictorial view of the relationship
between costs, volume & profit, it shows the Break
even points and also indicates the estimated profit
/ loss at various levels of output. Break Even
chart is a point at which the total cost line and the
total sales line intersect.
Profit volume chart:
It represent profit volume relationship, it shows
profit/loss at different volumes of sales
Fixed cost : $2000, variable cost : $120 per unit , selling price per unit ; $200
$10,000
y
$8,000
$6,000
$5,000
$4,000
$2,000
D
o
l
l
a
r
s
10 20 25 30 40 50
x
Units Sold
Operating income
area
Breakeven point
= 25 units
Total
costs
line
Operatin
g loss
area
Operating
income
Variable
cost
Fixed
cost
Ma
rgi
n
of
saf
ety
Margin of safety
The Seattle Contemporary Theater is a newly formed nonprofit enterprise. The theatres
business manager Andrew Lloyd has, made the following projections for the first few
years of operation;

Fixed expenses per month:
Theatre rental $ 10000
employees salaries and fringe benefits 8000
Actors Wages(to be supplemented with local volunteer talent) 15000
Production crews wages 5600
(to be supplemented with local volunteers)
Playwrights royalties for use of plays 5000
Insurance 1000
Utilities fixed portion 1400
Advertising expenses 800
Administrative expenses 1200

Total fixed expenses per month $ 48000
Variable expenses per ticket sold:
Citys charge per ticket for use of theater $ 8
Other miscellaneous expenses (for example, pricing of
playbills and tickets, variable portion of utilities) 2
Total variable cost per ticket sold $ 10

Revenue:
Price per ticket $ 16
Find the break even point in tickets;
Find the break even point in Rs;
Find out the profit or loss if only 6000 tickets are sold;
The board of trustees for Seattle Theater would like to run free workshops and
classes for young actors and aspiring playwrights. This programme would cost $
3600 per month in fixed expenses, no variable expenses would be incurred.
How many theatre tickets must be sold to earn a profit of $ 3600.
What would happen to the break even point if fixed utilities expenses prove to
be $ 2600 instead of $ 1400.
Suppose that various people pledge donations amounting to $ 6000 per month,
what would be the Break Even point ?
What would happen to the Break even point in miscellaneous variable
expenses incur to be $ 3 per ticket instead of $ 2.
What would have the effect on BEP if ticket price is raised to $ 18


Now suppose that the city of Seattle has agreed to refurbish 10 theater
boxes in the historic theatre building. Each box has five seats, which are
more comfortable and affaord a better view of the stage than the
theaters general seating. The board of trustees has decided to charge $
16 per ticket for general seating and $ 20 per ticket for box seats.
Seat type seats in theater seats available
per month(20 performances)
Regular 450 9000
Box 50 1000