EXECUTIVE SUMMARY:

I begin my project by throwing light on the various concepts of marginal costing including

contribution, profit and breakeven analysis. Marginal costing also helps in understanding the

margin of safety and desired profile.

Marginal cost is the cost management technique for the analysis of cost and revenue

information and for the guidance of management. The presentation of information through

marginal costing statement is easily understood by all mangers, even those who do not have

preliminary knowledge and implications of the subjects of cost and management accounting.

Marginal costing provides this vital information to management and it helps in the discharge

of its functions like cost control, profit planning, performance evaluation and decision

making. Marginal costing plays its key role in decision making.

INTRODUCTIONCost accounting is the process of collecting, processing and presenting financial and

quantitative data within an entity to ascertain the cost of the cost centres and cost units.

Revenue expenditure can be divided into direct costs (eg direct materials) and indirect costs

(eg production overheads) and the information is used to prepare a total cost statement

Product direct costs + Indirect costs = Total cost

One problem with methods of total costing is that the classification of revenue expenditure

into direct costs and indirect costs ignores their different behaviours when production or sales

activity varies. An alternative is to use marginal costing, where the main purpose is to provide

detailed cost information for planning and short-term decisions in a business where activity

levels fluctuate Actual or budgeted/planned figures can be used

The marginal cost of an item is its variable cost. The marginal production cost of an item is

the sum of its direct materials cost, direct labour cost, direct expenses cost (if any) and

variable production overhead cost. So as the volume of production and sales increases total

variable costs rise proportionately.

Fixed costs, in contrast are cost that remain unchanged in a time period, regardless of the

volume of production and sale.

Marginal production cost is the part of the cost of one unit of production service which would

be avoided if that unit were not produced, or which would increase if one extra unit were

produced.

Marginal costing is a method of cost accounting and decision-making used for internal

reporting in which only marginal costs are charged to cost units and fixed costs are treated as

a lump sum. It is also known as direct, variable, and contribution costing.

In marginal costing, only variable costs are used to make decisions. It does not consider

fixed costs, which are assumed to be associated with the time periods in which they were

incurred.

Marginal costs include:

The costs actually consumed when you manufacture a product

The incremental increase in costs when you ramp up production

The costs that disappear when you shut down a production line

The costs that disappear when you shut down an entire subsidiary

In this technique, cost data is presented with variable costs and fixed costs shown separately

for the purpose of managerial decision-making.

Marginal costing is not a method of costing like process costing or job costing. Rather, it is

simply a way to analyze cost data for the guidance of management, usually for the purpose of

understanding the effect of profit changes due to the volume of output.

The direct costing concept is extremely useful for short-term decisions, but can lead to

harmful results if used for long-term decision-making, since it does not include all costs that

may apply to a longer-term decision. Furthermore, marginal costing does not comply with

external reporting standards.

The costs that vary with a decision should only be included in decision analysis. For many

decisions that involve relatively small variations from existing practice and/or are for

relatively limited periods of time, fixed costs are not relevant to the decision. This is because

either fixed costs tend to be impossible to alter in the short term or managers are reluctant to

alter them in the short term.

MEANING OF MARGINAL COSTINGMarginal Costing is ascertainment of the marginal cost which varies directly with the volume

of production by differentiating between fixed costs and variable costs and finally

ascertaining its effect on profit

It is a costing technique where only variable cost or direct cost will be charged to the cost unit

produced.

Marginal costing also shows the effect on profit of changes in volume/type of output by

differentiating between fixed and variable costs.

Salient Points:

Marginal costing involves ascertaining marginal costs. Since marginal costs are direct cost,

this costing technique is also known as direct costing;

In marginal costing, fixed costs are never charged to production. They are treated as period

charge and is written off to the profit and loss account in the period incurred;

Once marginal cost is ascertained contribution can be computed. Contribution is the excess

of revenue over marginal costs.

The marginal cost statement is the basic document/format to capture the marginal costs...

It is the additional cost of producing an additional unit of a product.

Marginal cost= prime cost + total variable overheads

MARGINAL COSTING - DEFINITION Marginal costing distinguishes between fixed costs and variable costs as convention ally

classified.

The marginal cost of a product –“is its variable cost”. This is normally taken to be; direct

labour, direct material, direct expenses and the variable part of overheads.

Marginal costing is formally defined as;

‘the accounting system in which variable costs are charged to cost units and the fixed costs

of the period are written-off in full against the aggregate contribution. Its special value is in

decision making’. Marginal Costing is defined as the amount at any given volume of output by which

aggregate costs can be changed if the volume of output is increased or decreased by one

unit.

J. BATTY: ‘a technique of cost accounting which pays special attention to the behavior

of costs with changes in the volume of output’.

FEATURES OF MARGINAL COSTING The main features of marginal costing are as follows:

1. Cost Classification- The marginal costing technique makes a sharp distinction between

variable costs and fixed costs. It is the variable cost on the basis of which production and sales

policies are designed by a firm following the marginal costing technique.

2. Stock/Inventory Valuation- Under marginal costing, inventory/stock for profit

measurement is valued at marginal cost. It is in sharp contrast to the total unit cost under

absorption costing method.

3. Marginal Contribution- Marginal costing technique makes use of marginal

contribution for marking various decisions. Marginal contribution is the difference between

sales and marginal cost. It forms the basis for judging the profitability of different products or

departments.

It is a method of recording costs and reporting profits;

All operating costs are differentiated into fixed and variable costs;

Variable cost –charged to product and treated as a product cost whilst

Fixed cost treated as period cost and written off to the profit and loss account

It involves ascertaining marginal costs which is the difference of fixed cost and variable cost.

The operating costs are differentiated into fixed costs and variable costs. Semi variable costs are

also divided in the individual components of fixed cost and variable cost.

Fixed costs which remain constant regardless of the volume of production do not find place in the

product cost determination and inventory valuation.

Prices of products are based on variable cost only.

Marginal contribution decides the profitability of the products.

Costs are divided into two categories, i.e., fixed costs and variable costs.

Fixed cost is considered period cost and remains out of consideration for determination of product

cost and value of inventories.

Prices are determined with reference to marginal cost and contribution margin.

Profitability of departments and products is determined with reference to their Contribution

margin.

In presentation of cost data, display of contribution assumes dominant role.

Closing stock is valued on marginal cost

COMMON USE CASES FOR MARGINAL COSTINGMarginal costing can be a useful tool for evaluating some types of decisions. Here are some of

the most common scenarios where marginal costing can provide the most benefit:

Automation investments: Marginal costing is useful to determine how much a firm

stands to gain or lose by automating some function. The key costs to take into consideration

are the incremental labour cost of any employees who will be terminated versus the new costs

incurred from equipment purchase and subsequent maintenance.

Cost reporting: Marginal costing is very useful for controlling variable costs, because you

can create a variance analysis report that compares the actual variable cost to what the

variable cost per unit should have been.

Customer profitability: Marginal costing can help determine which customers are worth

keeping and which are worth eliminating.

Internal inventory reporting : Since a firm must include indirect costs in its inventory

in external reports, and these can take a long time to complete, marginal costing is useful for

internal inventory reporting.

Profit-volume relationship: Marginal costing is useful for plotting changes in profit

levels as sales volumes change. It is relatively simple to create a marginal costing table that

points out the volume levels at which additional marginal costs will be incurred, so that

management can estimate the amount of profit at different levels of corporate activity.

Outsourcing: Marginal costing is useful for deciding whether to manufacture an item in-

house or maintain a capability in-house, or whether to outsource it.

CRITICISM OF MARGINAL COSTING In recent years, there has been a widespread interest in marginal costing. Still very few have

adopted it as method of accounting for cost. Main points of criticism are:

It is not proper to disregard fixed cost for product for product cost determination and

inventory valuation.

Marginal costing is especially useful in short profit planning and decision-making. For

decision of far reaching importance, one is interested in special purpose cost rather than

variability of costs.

Marginal costing technique disregards the use of recovering fixed cost through product

pricing. For long run continuity of business it is not good. Assets have to be recovered of

costs.

Establishing variability of costs is not an easy. I real life situations, variable costs are rarely

completely variable and fixed costs are rarely completely fixed.

Exclusion of fixed cost from inventory valuation does not conform to accept accounting

practice.

The income tax authorities do not recognize the marginal cost for inventory valuation. This

necessitates keeping of separate books for separate purposes.

The basic assumptions made by marginal costing are following:

o Total variable cost is directly proportion to the level of activity. However, variable

cost per unit remains constant at all the levels of activities.

o Per unit selling price remains constant at all levels of activities.

o All the items produced by the organization are sold off.

THE PRINCIPLES OF MARGINAL COSTING

The principles of marginal costing are as follows. For any given period of time, fixed costs will be the same, for any volume of sales and

production (provided that the level of activity is within the ‘relevant range’).

Therefore, by selling an extra item of product or service the following will happen.

Revenue 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 extra item.

Similarly, if the volume of sales falls by one item, the profit will fall by the amount of

contribution earned from the item.

Profit measurement should therefore be based on an analysis of total contribution.

Since fixed costs relate to a period of time, and do not change with increases or

decreases in sales volume, it is misleading to charge units of sale with a share of fixed

costs.

When a unit of product is made, the extra costs incurred in its manufacture are the

variable production costs. Fixed costs are unaffected, and no extra fixed costs are

incurred when output is increased.

ADVANTAGES AND DISADVANTAGES OF MARGINAL COSTING

Advantage:-

Cost control: Marginal costing makes it easier to determine and control costs of production. By avoiding the arbitrary allocation of fixed overhead costs, management can concentrate on achieving and maintaining a uniform and consistent marginal cost.

Simplicity: Marginal costing is simple to understand and operate and it can be combined with other forms of costing (e.g. budgetary costing and standard costing) without much difficulty.

Elimination of cost variance per unit: Since fixed overheads are not charged to the cost of production in marginal costing, units have a standard cost.

Short-term profit planning: Marginal costing can help in short-term profit planning and is easily demonstrated with break-even charts and profit graphs. Comparative profitability can be easily accessed and brought to the notice of the management for decision-making.

Accurate overhead recovery rate: This method of costing eliminates large balances left in overhead control accounts, which makes it easier to ascertain an accurate overhead recovery rate.

Maximum return to the business: With marginal costing, the effects of alternative sales or production policies are more readily appreciated and assessed, ensuring that the decisions taken will yield the maximum return to the business.

It is a relatively simple pricing method - quick to calculate and easy to implement Can help to smooth fluctuations in demand. It can be very useful where the firm has spare capacity and may not be able to put its

resources to other, perhaps more profitable, uses. Can be a useful way to attract other different market segments into the market e.g. low

peak train travellers may be attracted by lower prices and only travel during the day because of low prices - they may not otherwise have travelled.

Can be a good way to remain in business and price-competitive in a time of difficult trading. Prices can then be raised later when the economic situation improves.

Marginal costing is simple to understand. By not charging fixed overhead to cost of production, the effect of varying charges per unit

is avoided. It prevents the illogical carry forward in stock valuation of some proportion of current

years fixed overhead. 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. It eliminates large balances left in overhead control accounts which indicate the difficulty

of ascertaining an accurate overhead recovery rate. It identifies the importance of fixed costs involved in production.

Disadvantages:-

Classifying costs:  It is very difficult to separate all costs into fixed and variable costs clearly, since all costs are variable in the long run. Hence such classification sometimes may give misleading results. Furthermore, in a firm with many different kinds of products, marginal costing can prove less useful.

Accurately representing profits:   Since the closing stock consists only of variable costs and ignores fixed costs (which could be considerable), this gives a distorted picture of profits to shareholders.

Semi-variable costs:  Semi-variable costs are either excluded or incorrectly analyzed, leading to distortions.

Recovery of overheads:   With marginal costing, there is often the problem of under or over-recovery of overheads, since variable costs are apportioned on an estimated basis and not on actual value.

External reporting:  Marginal costing cannot be used in external reports, which must have a complete view of all indirect and overhead costs.

Increasing costs:  Since it is based on historical data, marginal costing can give an inaccurate picture in the presence of increasing costs or increasing production.

The separation of costs into fixed and variable is difficult and sometimes gives

misleading results.

Normal costing systems also apply overhead under normal operating volume and

this shows that no advantage is gained by marginal costing.

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.

Volume variance in standard costing also discloses the effect of fluctuating output

on fixed overhead. Marginal cost data becomes unrealistic in case of highly

fluctuating levels of production, e.g., in case of seasonal factories.

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.

Control affected by means of budgetary control is also accepted by many. In order

to know the net profit, we should not be satisfied with contribution and hence, fixed

overhead is also a valuable item. A system which ignores fixed costs is less

effective since a major portion of fixed cost is not taken care of under marginal

costing.

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

Marginal cost has its limitation since it makes use of historical data while decisions by

management relates to future events;

It ignores fixed costs to products as if they are not important to production;

Stock valuation under this type of costing is not accepted by the Inland Revenue as

its€™s ignore the fixed cost element;

It fails to recognize that in the long run, fixed costs may become variable;

Its oversimplified costs into fixed and variable as if it is so simply to demarcate them;

It’s not a good costing technique in the long run for pricing decision as it ignores fixed

cost. In the long run, management must consider the total costs not only the variable

portion;

Difficulty to classify properly variable and fixed cost perfectly, hence stock valuation

can be distorted if fixed cost is classify as variable

TECHNIQUES OF COSTINGBesides the methods of costing, following are the types of costing techniques which

are used by management only for controlling costs and making some important

managerial decisions. As a matter of fact, they are not independent methods of cost

finding such as job or process costing but are basically costing techniques which can

be used as an advantage with any of the methods discussed above.

1. Marginal CostingMarginal costing is a technique of costing in which allocation of expenditure to

production is restricted to those expenses which arise as a result of production, e.g.,

materials, labour, and direct expenses and variable overheads. Fixed overheads are

excluded in cases where production varies because it may give misleading results. The

technique is useful in manufacturing industries with varying levels of output.

2. Direct CostingThe practice of charging all direct costs to operations, processes or products and

leaving all indirect costs to be written off against profits in the period in which they

arise is termed as direct costing. The technique differs from marginal costing because

some fixed costs can be considered as direct costs in appropriate circumstances.

3. Absorption or Full CostingThe practice of charging all costs both variable and fixed to operations, products or

processes is termed as absorption costing.

4. Uniform CostingA technique where standardized principles and methods of cost accounting are

employed by a number of different companies and firms is termed as uniform costing.

Standardization may extend to the methods of costing, accounting classification

including codes, methods of defining costs and charging depreciation, methods of

allocating or apportioning overheads to cost centres or cost units. The system, thus,

facilitates inter- firm comparisons, establishment of realistic pricing policies, etc.

PROCESS OF MARGINAL COSTINGUnder marginal costing, the difference between sales and marginal cost of sales is

found out. This difference is technically called contribution. Contribution provides for

fixed cost and profit. Excess of contribution over fixed cost is profit emphasis remains

here on increasing total contribution. Variable Cost. Variable cost is that part of total

cost, which changes directly in proportion with volume. Total variable cost changes

with change in volume of output. Variable costs are very sensitive in nature and are

influenced by a variety of factors.

Main aim of ‘marginal costing’ is to help management in controlling variable cost

because this is an area of cost which lends itself to control by management

Fixed Cost. It represents the cost which is incurred for a period, and which,

within certain output and turnover limits tends to be unaffected by fluctuations in

the levels of activity (output or turnover). Examples are rent, rates, insurance and

executive salaries.

Variable Costs Variable costs are those costs which vary directly with the level

of output. They represent payment output-related inputs such as raw materials,

direct labour, fuel and revenue-related costs such as commission. A distinction is

often made between "Direct" variable costs and "Indirect" variable costs.

Direct variable costs are those which can be directly attributable to the production

of a particular product or service and allocated to a particular cost centre. Raw

materials and the wages those working on the production line are good examples.

Indirect variable costs cannot be directly attributable to production but they do

vary with output. These include depreciation (where it is calculated related to

output - e.g. machine hours), maintenance and certain labour costs.

Semi-Variable Costs Whilst the distinction between fixed and variable costs is

a convenient way of categorising business costs, in reality there are some costs

which are fixed in nature but which increase when output reaches certain levels.

These are largely related to the overall "scale" and/or complexity of the business.

For example, when a business has relatively low levels of output or sales, it may

not require costs associated with functions such as human resource management or

a fully-resourced finance department. However, as the scale of the business grows

(e.g. output, number people employed, number and complexity of transactions)

then more resources are required. If production rises suddenly then some short-term

increase in warehousing and/or transport may be required. In these circumstances,

we say that part of the cost is variable and part fixed.

Variable cost = It changes directly in proportion with volume

1. Variable cost Ratio = {Variable cost / Sales} * 100

2. Sales – Variable cost = Fixed cost + Profit

3. Contribution = Sales * P/V Ratio

Break-Even Point. Break-even point is the point of sale at which company

makes neither profit nor loss. The marginal costing technique is based on the idea

that difference of sales and variable cost of sales provides for a fund, which is

referred to as contribution. Contribution provides for fixed cost and profit. At

break-even point, the contribution is just enough to provide for fixed cost. If actual

sales level is above break-even point, the company will make profit if actual sales

are below break-even point the company will incur loss.

BREAK EVEN POINT [BEP]:-

1. Fixed cost / Contribution per unit [in units]

2. Fixed cost / P/V Ratio [in value] (or) Fixed Cost * Sales value per unit

(Sales – Variable cost per unit)

Contribution . - Marginal costing analysis depends a lot on the idea of

contribution. In this technique, efforts are directed to increase total contribution

only. Contribution is the difference between sales and variable cost, i.e., marginal

cost. It can be expressed as follows:

Contribution = Sales - Variable cost of sales.

No

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1.

2.

3.

Contribution

It is a concept used in Marginal costing.

It is before deducting Fixed Costs.

At break- over point, Contribution is equal to

fixed cost.

Profit

It is an accounting concept.

It is after deducting Fixed Costs.

Profit arises only when Sales go beyond

the break- even point.

Profit/Volume Ratio. When the contribution from sales is expressed as a

percentage of sales value, it is known as profit/volume ratio (or P/V ratio). It

expresses relationship between contribution and sales. Better P/V ratio is an index

of sound ‘financial health’ of a company’s product. This ratio reflects change in

profit due to change in volume. Broadly speaking, it shows how large the

contribution will appear, if it is expressed on equal footing with sales. The

statement that P/V ratio is 40% means that contribution is Rs. 40, if size of the sale

is Rs. 100. One important characteristic of P/V ratio is that it remains the same at

all levels of output. P/V ratio is particularly useful when it is considered in

conjunction with margin of safety.

P/V ratio may be expressed as:

P/V ratio = (Sales - Marginal cost of sales)/Sales or = Contribution/Sales or =

Change in contribution/Change in sales or = Change in profit/Change in sales

PROFIT VOLUME RATIO [P/V RATIO]:-

1. {Contribution / Sales} * 100

2. {Contribution per unit / Sales per unit} * 100

3. {Change in profit / Change in sales} * 100

4. {Change in contribution / Change in sales} * 100

Advantages of P/V RatioI. .It helps in determining the break-even point

Ii...It helps in determining profit at various sales levels.

iii. It helps to find out the sales volume to earn a desired quantum of profit.

iv. It helps to determine relative profitability of different products, processes and

departments

Limitations of P/V RatioThere is a growing trend among companies to use the profit -volume-ratio in deciding

the product-worthy additional sale efforts and productive capacity and host of other

managerial exercises. Following are the limitations of the use of P/V Ratio

1 .P/V ratio heavily leans on excess of revenues over variable cost.

2. The P/V ratio fails to take into consideration the capital outlays required by the

additional productive capacity and the additional fixed costs that are added.

3. Inspection of P/V ratio of products can suggest profitable product lines that might

be emphasized and unprofitable lines, which may be re-evaluated or eliminated. Mere

inspection of P/V ratio will not help to take final decision. For this purpose, analysis

has to be broadened to take into consideration different cost of the decision and

opportunity costs, etc. Thus, it indicates only the area to be probed. .

4. The P/V ratios has been referred to as the questionable device for-decision-making

because it only gives an indication of the relative profitability of the products/product

lines that too if other things are equal.

The above points highlight that P/V ratio should not be used inconsiderately.

Margin of Safety. Margin of safety represents the difference between sales at a

given activity and sales at breakeven point. (B.E.P. is the point of sales where

company makes neither profit nor loss). Consequently, it indicates the extent to

which a fall in demand could be absorbed, before company begins to sustain losses.

The margin-of safety is expressed as percentage of sale. The validity of safety

always depends on the accuracy of cost estimates. The wide margin of safety is

advantageous for the company. Margin of safety depends on level of fixed cost,

rate of contribution and level of sales. The relationship of margin of safety with

sales can be expressed as follows: -

Sales - Sales at B.E.P = Margin of safety.

Thus, soundness of a business can be measured by margin of safety. This

knowledge is very useful in taking policy decision like reduction in price to face the

competitors. Margin of safety indicates how many present sales are able to keep

business away from, the crucial point, where business will earn neither profit not

loss. Its relationship with P/V ratio and profit can be expressed as follows:

Basic marginal cost equation is S - V = F + P

MARGIN OF SAFETY [MOP]

1. Actual sales – Break even sales

2. Net profit / P/V Ratio

3. Profit / Contribution per unit [In units]

4. Sales unit at Desired profit = {Fixed cost + Desired profit} / Cont. Per unit

5. Sales value for Desired Profit = {Fixed cost + Desired profit} / P/V Ratio

Cost-Volume-Profit Relationship

IntroductionProfit is, always a matter of primary concern to management. The volume of sale

never remains constant. It fluctuates up and down and. income also goes up and down

with fluctuations in volume. Profit is actually the result of interplay of different factors

like cost, volume and selling price. Effectiveness of a manager depends on his

capability to make right predictions about future profits. This can be done when

correct relationship existing between cost, volume and profit is known. For this

reason, knowledge of relationship among cost, volume and profit is of immense help

to management...

Objectives of Cost-Volume-Profit Analysis In order to forecast profits accurately, it is essential to ascertain the relationship

between cost and profit on one hand and volume on the other.

Cost-volume-profit analysis is helpful in setting up flexible budget which indicates

cost at various levels of activities.

Cost-volume-profit analysis assists in evaluating performance for the purpose of

control.

Such analysis may assist management in formulating pricing policies by projecting

the effect of different price structures on cost and profit.

Use of Cost-Volume-Profit Analysis This relationship enables management to predict profit over a wide range of

volume. This knowledge is very useful in preparing flexible budget.

In a lean business season, company has to determine the price of the products very

carefully. It becomes necessary sometimes to bring down the price to boast the sale

of a product. For all decisions like this, management must determine, by cost-

volume profit analysis, what impact this reduction in price is going to have a profit

position of a company.

Analysis of cost-volume-profit relationship helps in decision-making. There are

situations when management has to decide whether It should add to its capacity or

not. With the knowledge of cost -volume- profit analysis, a manager can easily take

decision showing in its report haw utilization of available capacity will lead to

increase in profit.

Cost-Volume-Profit analysis helps in profit planning. Under profit planning,

company first declares the profit that it wants to make during the ensuing year.

Thereafter, sales level necessary to yield that profit is attempted. Cost-volume-

profit analysis helps in profit planning in the following ways.

It hems in estimating income at a particular sales level.

It helps to determine change in profit due to change in sales volume.

It helps to execute the idea of profit planning. In other words, we

arrive at the sales level to be attempted for a desired profit by the

knowledge of relationship existing between cost, volume and profit.

It helps to find out the sales required to meet proposed expenditure

BREAKEVEN ANALYSIS

Definition

Breakeven analysis is also known as cost-volume profit analysis

Breakeven analysis is the study of the relationship between selling prices, sales volumes,

fixed costs, variable costs and profits at various levels of activity

Application

Breakeven analysis can be used to determine a company’s breakeven point (BEP)

Breakeven point is a level of activity at which the total revenue is equal to the total costs

At this level, the company makes no profit

Assumption of breakeven point analysis

Relevant range

The relevant range is the range of an activity over which the fixed cost will remain

fixed in total and the variable cost per unit will remain constant

Fixed cost

Total fixed cost are assumed to be constant in total

Variable cost

Total variable cost will increase with increasing number of units produced

Sales revenue

The total revenue will increase with the increasing number of units produced

Limitations of breakeven analysis

Breakeven analysis assumes that fixed cost, variable costs and sales revenue behave in linear

manner. However, some overhead costs may be stepped in nature. The straight sales revenue

line and total cost line tent to curve beyond certain level of production

It is assumed that all production is sold. The breakeven chart does not take the changes in

stock level into account

Breakeven analysis can provide information for small and relatively simple companies that

produce same product. It is not useful for the companies producing multiple products

MEANING AND DEFINITION OF ABSORPTION

COSTINGAbsorption costing, also known as full absorption costing can be defined as a

managerial accounting cost method of expensing all costs related to manufacturing of

a specific product. The absorption costing method involves the use of total direct costs

and overhead costs related to the manufacturing of a product as the cost base. Besides,

absorption costing is also required by the Generally Accepted Accounting Principles

(GAAP).

As presented by Investopedia, some of the direct costs related to manufacturing a

product consist of wages for workers involved physically in manufacturing a product,

the raw materials involved in production, as well as the overhead costs, like utility

costs. Moreover, absorption costing counts anything that is a direct cost in production

of goods. Besides, absorption costing is promoted by the advocates for the future

benefits provided.

Absorption costing is, therefore, different from the other costing methods as it takes

into account fixed manufacturing overhead (counting expenses like factory rent,

utilities, amortization). It is, moreover, difficult to factor in the fixed manufacturing

overhead expenses into computing the per unit price of goods, which are not

accounted for by other methods like Variable costing.

Advantages and disadvantages of Absorption Costing

AdvantagesThe key advantages of absorption costing include:

It identifies the importance of fixed costs involved in production.

The absorption costing method is accepted by Inland Revenue as stock is not

undervalued.

The absorption costing method is always used for preparing financial accounts.

The absorption costing method shows less fluctuation in net profits in case of

constant production but fluctuating sales.

Contrasting marginal costing which involves fixed cost changing into variable cost,

it is cost into the stock value thus distorting the stock valuation.

Gives attention to both fixed and variable costs; that is, all production costs are

considered regardless of whether they are variable or fixed. And, this is very

important when it comes to pricing decisions since the manufacturer can have a

clear picture of the profit margin to be made on each sale, as all costs would have

been incorporated into the product cost.

Provides realistic periodic profits if company has a natural business cycle; profits

are realistic in the sense that all production costs are matched to sales volume,

rather than production volume as under Marginal Costing.

It is consistent with external reporting requirements; in fact, International

Accounting Standard Board recommends the use of absorption costing method over

marginal costing, which is considered more useful for internal reporting.

DisadvantagesThe main drawbacks of Absorption Costing include:

Since absorption costing emphasized on total cost that is to say both variables as

well as fixed, it is not useful for management to use to make decision, control, and

planning.

Besides, since the manager emphasizes on the total cost, the cost volume profit

relationship is ignored. The manager, therefore, needs to use his intuition for

decision making.

Absorption costing, a portion of fixed cost is carried over to the subsequent

accounting period as part of closing stock. This is an unsound practice because

costs pertaining to a period should not be allowed to be vitiated by the inclusion of

costs pertaining to the previous period and vice versa.

Further, absorption costing is dependent on the levels of output which may vary

from period to period, and consequently cost per unit changes due to the existence

of fixed overhead. Unless fixed overhead rate is based on normal capacity, such

changed costs are not helpful for the purposes of comparison and control.

The features which distinguish marginal costing from absorption

costing are as follows. In absorption costing, items of stock are costed to include a ‘fair share’ of fixed

production overhead, whereas in marginal costing, stocks are valued at variable

production cost only. The value of closing stock will be higher in absorption costing

than in marginal costing.

As a consequence of carrying forward an element of fixed production overheads in

closing stock values, the cost of sales used to determine profit in absorption costing

will:

i. include some fixed production overhead costs incurred in a previous period but

carried forward into opening stock values of the current period;

ii.Exclude some fixed production overhead costs incurred in the current period by

including them in closing stock values.

In contrast marginal costing charges the actual fixed costs of a period in full into the

profit and loss account of the period. (Marginal costing is therefore sometimes known

as period costing.)

In absorption costing, ‘actual’ fully absorbed unit costs are reduced by producing in

greater quantities, whereas in marginal costing, unit variable costs are unaffected by

the volume of production (that is, provided that variable costs per unit remain

unaltered at the changed level of production activity). Profit per unit in any period can

be affected by the actual volume of production in absorption costing; this is not the

case in marginal costing.

In marginal costing, the identification of variable costs and of contribution enables

management to use cost information more easily for decision-making purposes (such

as in budget decision making). It is easy to decide by how much contribution (and

therefore profit) will be affected by changes in sales volume. (Profit would be

unaffected by changes in production volume).

In absorption costing, however, the effect on profit in a period of changes in both:

I. production volume; and

II. sales volume

Is not easily seen, because behavior is not analyses and incremental costs are not

used in the calculation of actual profit.

MARGINAL COSTING V/S ABSORPTION COSTING

The difference between Marginal costing & absorption costing is as below:

1. Under Marginal costing: for product costing & inventory valuation, only variable cost is

considered whereas, under absorption costing; for product costing & inventory valuation,

both fixed cost & variable cost are considered.

2. Under Marginal costing, there is a different treatment of fixed overhead. Fixed cost is

considered as period cost & by Profit/Volume ratio (P/V ratio); profitability of different

products is judged. On the other hand, under absorption costing system, the fixed cost is

charged to cost of production. A reasonable share of fixed cost is to be borne by each

product & thereby subjective apportionment of fixed overheads influences the profitability

of product.

3. Under Marginal costing, the presentation of data is so oriented that total contribution &

contribution from each product gets highlighted. Under absorption costing, the presentation

of cost data is on conventional pattern. After deducting fixed overhead, the net profit of each

product is determined.

4. Under Marginal costing, the unit cost of production does not get affected by the difference

in the magnitude of opening stock & closing stock. Whereas, under absorption costing, due

to the impact of the related fixed overheads, the unit cost of production get affected by the

difference in the magnitude of opening stock & closing stock.

Effects of opening & closing stock on profit:

When income statements under absorption costing & Marginal costing are compared, the

under mentioned points should be considered:

1. The results under both the methods will be same in situations where sales & production

coincide i.e., there is neither opening stock nor closing stock.

2. Profit under absorption costing will be more than the profit under Marginal costing, when

closing stock is more than the opening stock. The reason behind this is that, under

absorption costing, a portion of fixed overhead, instead of being charged to the current

period, is charged to the closing stock & carried over to the next period.

3. Profit shown under absorption costing will be lower than the profit shown under Marginal

costing, when closing stock is less than the opening stock. The reason behind this is that,

under absorption costing, to the current period, a portion of fixed cost related to previous

year is charged.

Reconciliation of results of absorption costing & Marginal costing:

When comparison of the results of absorption costing & Marginal costing is undertaken,

the adjustments for under- absorbed & / or over absorbed overheads becomes necessary.

Under absorption costing, on the basis of normal level of activity, the fixed overhead rate

is predetermined. A situation of under-absorption &/or over-absorption arises when there is

a difference between actual level of activity & normal level of activity.

(I) Under-absorbed fixed overhead = Excess of normal level of activity over actual level of

activity * Fixed overhead rate per unit.

If there is under-absorption, the profit under absorption costing, before comparison with

profit as per Marginal costing, should be reduced with under-absorbed fixed overheads.

Alternatively, by adding the under-absorbed fixed overhead to the cost of production, the

same objective can be achieved.

(ii) Over absorbed Fixed overhead = Excess of actual level of activity over normal level of

activity * Fixed overhead rate per unit.

 If there is over absorption, then before the comparison of profit as per absorption costing

with the profit as per Marginal costing, with over-absorbed fixed overheads, the profit

under absorption costing should be increased. Alternatively, by reducing the over-absorbed

fixed overhead from the cost of production, the same objective can be achieved

Argument for absorption costing Compliance with the generally accepted accounting principles

Importance of fixed overheads for production

Avoidance of fictitious profit or loss

During the period of high sales, the production is small than the sales, a smaller

number of fixed manufacturing overheads are charged and a higher net profit will

be obtained under marginal costing

Absorption costing is better in avoiding the fluctuation of profit being reported in

marginal costing

Arguments for marginal costing More relevance to decision-making

Avoidance of profit manipulation

Marginal costing can avoid profit manipulation by adjusting the stock level

Consideration given to fixed cost

In fact, marginal costing does not ignore fixed costs in setting the selling price. On

the contrary, it provides useful information for break-even analysis that indicates

whether fixed costs can be converted with the change in sales volume

Amul (Anand Milk Union Limited)

Amulcompany.jpg

Type - Cooperative

Industry - Dairy/FMCG

Founded - 1946

Headquarters -Anand, Gujarat, India

Key people

Chairman, Gujarat Co-operative Milk Marketing Federation Ltd. (GCMMF)

Products - See complete products listing

Revenue - Increase US$3.1 billion (2013–14)

Number of employees

750 employees of Marketing Arm. However, real pool consist of 3 million milk

producer members

Slogan - the Taste of India

Website - www.amul.com

Amul ("priceless" in Sanskrit. The brand name "Amul," from the Sanskrit "Amoolya,"

(meaning precious) formed in 1946, is a dairy cooperative in India. It is a brand name

managed by an apex cooperative organization, Gujarat Co-operative Milk Marketing

Federation Ltd. (GCMMF)

The Gujarat Cooperative Milk Marketing Federation Ltd, Anand (GCMMF) is the largest

food products marketing organization of India.

In 1997, Amul ice creams entered Mumbai followed by Chennai in 1998 and Kolkata and

Delhi in 2002.

The portfolio consisted of impulse products like sticks, cones, cups as well as take home

packs and institutional/catering packs.

It achieved the No 1 position in the country. This position was achieved in 2001 and it has

continued to remain at the top.

Today the market share of Amul ice cream is 38% share against the 9% market share of

HLL (Kwality Walls), thus making it 4 times larger than its closest competitor.

Not only has it grown at a phenomenal rate but has added a vast variety of flavors to its ever

growing range.

In January 2007, Amul introduced SUGAR FREE &ProLifeProbiotic Wellness Ice Cream,

which was a first in India.

Amul’sentry into ice creams is regarded as successful due to the large market share it was

able to capture within a short period of time – due to price differential, quality of products

and of course the brand name.

Amul the co-operative registered on 1 December 1946 as a response to the exploitation of marginal

milk producers by traders or agents of the only existing dairy, the Polson dairy, in the small city

distances to deliver milk, which often went sour in summer, to Polson. The prices of milk were

arbitrarily determined. Moreover, the government had given monopoly rights to Polson to collect

milk from mikka and supply it to Bombay city.

Angered by the unfair trade practices, the farmers of Kaira approached Sardar Vallabhbhai Patel

under the leadership of local farmer leader Tribhuvandas K. Patel. He advised them to form a

cooperative and supply milk directly to the Bombay Milk Scheme instead of Polson (who did the

same but gave them low prices).He sent Morarji Desai to organise the farmers. In 1946, the milk

farmers of the area went on a strike which led to the setting up of the cooperative to collect and

process milk. Milk collection was decentralized, as most producers were marginal farmers who

could deliver, at most, 1–2 litres of milk per day. Cooperatives were formed for each village, too.

The cooperative was further developed and managed by Dr.Verghese Kurien with H.M. Dalaya.

Dalaya's innovation of making skim milk powder from buffalo milk (for the first time in the world)

and a little later, with Kurien's help, making it on a commercial scale, led to the first modern dairy

of the cooperative at Anand, which would compete against established players in the market.

Kurien's brother-in-law K.M. Philip sensitized Kurien to the needs of of attending to the finer points

of marketing, including the creation and popularization of a brand. This led to the search for an

attractive brand name. In a brainstorming session, a chemist who worked in the dairy laboratory

suggested Amul, which came from the Sanskrit word "amulya", which means "priceless" and

"denoted and symbolised the pride of swadeshi production."

The trio's (T. K. Patel, Kurien and Dalaya's) success at the cooperative's dairy soon spread to

Anand's neighbourhood in Gujarat. Within a short span, five unions in other districts – Mehsana,

Banaskantha, Baroda, Sabarkantha and Surat – were set up. To combine forces and expand the

market while saving on advertising and avoid competing against each other, the GCMMF, an apex

marketing body of these district cooperatives, was set up in 1973. The Kaira Union, which had the

brand name Amul with it since 1955, transferred it to GCMMF.

In 1999, it was awarded the "Best of all" Rajiv Gandhi National Quality Award.

Adding to the success, Dr. Madan Mohan Kashyap (faculty Agricultural and Engineering

Department, Punjab Agricultural University Ludhiana), Dr. Bondurant (visiting faculty) and Dr

Feryll (former student of Dr Verghese Kurien), visited the Amul factory in Gujarat as a research

team headed by Dr. Bheemsen. Shivdayal Pathak (ex-director of the Sardar Patel Renewable

Energy Research Institute) in the 1960s. A milk pasteurization system at the Research Centre of

Punjab Agricultural University (PAU) Ludhiana was then formed under the guidance of Kashyap

FACTS

The portfolio consisted of impulse products like sticks, cones, cups as well as take home

packs and institutional/catering packs.

In 1997, Amul ice creams entered Mumbai followed by Chennai in 1998 and Kolkata and

Delhi in 2002. Nationally it was rolled out across the country in 1999.

Has combated competition like Walls, Mother Dairy and achieved the No 1 position in

the country.

Today the market share of Amul ice cream is 38%.

Amul’s entry into ice creams is regarded as successful due to the large market share it

was able to capture within a short period of time.

Ice Cream Industry in India

Industry Snapshot:-

Market Size - 1200 Cores

Ice Cream market is growing at 26%  

Major players:-

Amul - Market Leader with share of 36%

HLL - Kwality Walls - 2nd biggest player

Mother Diary

Arun - Chennai Based Hatsun Agro Product

Few Brands/ Target Consumers

1. Youth Centric - Chillz

2. Kids - Moo

3. Teenagers - Cornetto

4. Health Conscious - Amul Sugarfree& Pro-Life

MARGINAL COST SHEET

SALES 9256250

Variable Cost:

Purchases 3200000

RM Consumed 3384500

CONTRIBUTION 2671750

- Fixed Cost

Factory Expenses 905000

Employee Cost 1000000

Depreciation 100000

Other Expenditure 190000

PROFIT 476750

COST SHEET ANALYSIS

The company is producing 100000 units of ice cream at Rs. 74.05 for which

the total cost incurred is Rs. 7405000 and the total sales is Rs. 9256250

which implies that that the profit being made is Rs. 1851250.

The company is producing a single cup of ice cream at Rs. 92.5625 which

includes the cost of a cup ice cream at Rs. 74.05 which again implies that the

profit of Rs. 18.5125 is earned on a single unit of Amul ice cream

Since the company is earning some percentage of profit above the cost, it

means a slight increase in the cost will not have too much of an effect on the

profit since there is a large margin of safety.

Since the company is earning some amount of profit, the business is capable

to expand and diversify over a period of time.

PVR = C/S = 2671750/9256250 = 28.86%

BEP (in Rs.) = FC/PVR = 2195000/28.86 = Rs.760568.26

BEP (in units) = FC/C = 2195000/2.67175 = 821558.9 = 821559

MOS = Profit/PVR = 476750/28.86 = 16519.404 .

DETERMINATION OF SP

Amul Ice Cream has marked the selling price of their product roughly 20%

above the cost price.

This implies that they are making a profit on each unit of output that is sold.

These profits can be ploughed into the business again to create more output

CONCLUSION

Marginal cost is the cost management technique for the analysis of cost and revenue

information and for the guidance of management. The presentation of information through

marginal costing statement is easily understood by all managers, even those who do not have

preliminary knowledge and implications of the subjects of cost and management accounting.

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.

Amul has shown in all the ways that why it is one of the leading company in the market for

dairy products. Since the company is earning some amount of profit, the business is capable

to expand and diversify over a period of time...Amul Ice Cream has marked the selling price

of their product roughly 20% above the cost price. This implies that they are making a profit

on each unit of output that is sold.

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