Marginal Costing & Its Impact on Profitability Contents• Introduction To Marginal • Decision Making Costing • Pricing Policy• Break Even Point Analysis • Case Studies• Special Situations
Get Familiar With Terms…… Variable Cost: Costs which vary with the output are referred to as Variable Cost. Eg – Material Cost , Labour Cost, etc. Fixed Cost: Fixed Costs are independent of output. They are periodic costs. Eg – Salary, Depreciation on machinery, rent, etc. Sunk Costs: Historical Cost incurred in the past are known as Sunk Costs. They play no role in decision making in the current period. For Eg – In a decision making related to replacement of a machine, the WDV of the existing machine is a sunk cost and therefore not considered. Opportunity Cost: This cost refers to the value of sacrifice made or the benefit of opportunity foregone in accepting an alternative course of action. Eg: A firm financing its expansion plan by withdrawing money from its bank deposits. In such a case , the loss of interest on the bank deposits is the opportunity cost for carrying out the expansion plan. Contribution: Sales Less Variable Costs Marginal Vs Absorption Costing What we do in day to day accounting ? Vs What we should do ? Do not mix accounting and decision making!!!
Lets Illustrate A company manufactures 3 products, A, B and C respectively. The segmental reports show that the production of Product B is loss making and hence the company should discontinue the same.Particulars A B CSales 80,000 50,000 1,00,000Less: Variable Cost (20,000) (30,000) (60,000)Less: Fixed Costs allocated equally (30,000) (30,000) (30,000)Segmental Profit 30,000 (10,000) 10,000Profit (%) 37.5% - 10% Now, Lets Think Like A Cost Accountant…. Recall that Fixed Costs are periodic costs and will be incurred irrespective of production. Hence, Don’t you think we must exclude them while calculating profitability to arrive at a decision of whether or not to produce a product?
Basis Of Decision Making… Particulars Product A Product B Product C Sales 80,000 50,000 1,00,000 Less: Variable Cost (20,000) (30,000) (60,000) Contribution 60,000 20,000 40,000 Contribution (%) 75% 40% 40% In the above computation, we observe that Product B is adding to the Total Contribution by Rs 20,000. Hence, is it right to discontinue the production of B ? WHICH OTHER FACTORS SHOULD MANAGEMENT REVISIT ? What Is Marginal Costing?The principals of Marginal Costing are as follows:a) For any given period of time, the fixed cost will remain the same, for any volume of sales and production. Therefore by selling an extra tem of product or service, the following will happen: Revenues will increase by the sales value of the item sold Costs will increase by the variable cost per unit Profit will increase by the amount of contribution earned from the item.
What Is Marginal Costing?b) Profit measurement should be based on analysis of total contribution. Since fixed cost relate to a period of time, and do not change with increase or decrease in sales volume, it is misleading to charge units of sale with the share of fixed cost.c) When a unit of product is made, the extra cost incurred in its manufacture are the variable production costs. Fixed cost are unaffected and no extra fixed cost are incurred when output is increased. Marginal Costing Pro - Forma Particulars Amount Amount Sales Revenue XXX Less: Marginal Cost of Sales Opening Stock ( Valued at Marginal Cost) XXX Add: Production Cost ( Valued at Marginal Cost) XXX Less: Closing Stock ( Valued at Marginal Cost) (XXX) Add: Selling Admin and Distribution Cost XXX Marginal Cost of Sales (XXX) Contribution XXX Less: Fixed Cost (XXX) Marginal Costing Profit XXX
Break Even Analysis This analysis is also referred to as Break Even Analysis or Contribution Margin Analysis or Cost Volume Profit Analysis and is based on the following 3 presumptions.a) Sales price per unit always remains constantb) The variable cost per unit always remains constantc) The fixed cost for the period always remains constant Break Even Point • It is the level of Sales that gives us the contribution which is exactly equal to the amount of fixed cost. It is a no profit, no loss situation. Break Even Point ( units) = Fixed Cost / Contribution per unit Break Even Point ( Rs) = Fixed Cost / PV Ratio
Other Concepts • PV Ratio : This is the relationship between sales and contribution. PV Ratio = Contribution / Sales x 100 • Margin of Safety : It is the actual difference between Actual Sales and Break Even Sales. The more the amount of Margin of Safety, the more should the company enjoy because, even if the sales fall by the amount of margin of safety, the company still would not make the losses. Margin Of Safety B BEP A Volume of Sales Sales Total Cost Fixed CostAt which point you are safer? A or B? What is your margin of safety?
Example 1 ABC Ltd manufactures a single product which it sells for Rs 20 per unit. Fixed Costs are Rs 60,000 per annum. The contribution to the sales ratio is 40%. Calculate the Break even point. Example 2 ABC Ltd sells a single product for Rs 9 per unit. The variable cost is Rs 6 per unit and the fixed cost total Rs 54,000 per month. In a period when the actual sales were Rs 1,80,000, find the Margin of Safety, in units.
Example 3 Product X generates a contribution to the sales ratio of 30%. Fixed Cost directly attributable to X amounts to Rs 75,000 per month. Calculate the sales revenue required to achieve a monthly profit of Rs 15,000. Decision Making Process When ever decision is to be taken, no matter what is the type of proposal, we always calculate relevant revenues and relevant costs, in respect of the decision and if the net result is a gain, then we take the decision favorably. (a) Relevant Revenue Money to be received Outflow to be avoided (b) Relevant Cost Money to be spent Inflow to be lost Net Gains (loss) a – b
Decision MakingCase Study 1Decision MakingCase Study 2
Shut – Down Decisions Case Study Application To Pricing Decisions• How would you price a new product to be launched in the market if the product is a mass product?• How would you price a new product to be launched in the market if the product is a niche product?• How would you re price an already existing product in the market?• How would you price a product which had to be internally sold from one department to another department?
Application To Pricing Decisions Lets evaluate how various products are priced….. (Refer to the Chart)Application To Pricing Decisions Case Study 1
Application To Pricing Decisions Case Study 2 Special Situations : Determination Of A Profitable Mixa) When there is No Limiting factor Total fixed cost remaining constant, the product which offers more contribution per unit is more profitable since it would maximize the total contribution and therefore the net profit. Particulars Product A Product B Product C SP per unit 1000 800 600 Less: variable Cost per unit (500) (400) (500) Contribution per unit 500 400 100 Priority of Production: A , B , C
Determination Of A Profitable Mixb) When there is a limiting factor Some resources are required for products and are not adequately available. These resources become Limiting Factors. If there are some limiting factors, then the product which offers maximum contribution per unit may not give more amount of total contribution because it may not make more profitable use of the limited resources. Hence, we calculate the contribution per unit of the limiting factor and the production priority is to be decided accordingly.Determination Of A Profitable Mix Continuing the previous example, let us say that labour hours is a limiting factor. Particulars Product A Product B Product C SP per unit 1000 800 600 Less: Variable Cost per unit (500) (400) (500) Contribution 500 400 100 Labour hours required per unit 10 hours 5 hours 1 hours Contribution per unit of labour hour 50 80 100 ( Contribution / Labour hour per unit) Priority of Production: Product C, B and A.
Buy V/S Make Decision• Very often, the management is faced with the problem as to whether a product should be manufactured or purchased from outside market. Under such circumstances, the following factors are to be considereda) Whether surplus capacity is availableb) The Marginal Cost Buy v/s Make Decision Case Study
Treatment Of Semi Variable CostsHow would you treat Semi variableCosts while calculating Break Even Point? Treatment of Semi Variable Cost Case Study
Application of Marginal Costing to Material Procurement• The cost already incurred should be completely ignored.• We compare the resale value with the cost savings and select the higher of the two.• Sometimes, stock has no resale value or other use but we have to incur some disposal cost if the raw material stock is not used. In such cases, by using the stock for the proposal, we do not incur any relevant costs but we avoid the outflow of disposal cost which otherwise would occur and disposal cost to be avoided becomes relevant revenue. Application of Marginal Costing to Material Procurement Case Study