Download - Marginal Costing Final
RECIEVED GUIDANCE BY:
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ROYAL COLLEGE OF ARTS, SCIENCE
& COMMERCE (2010-11)
SUBJECT: 4.7 {COST ACCOUNTING}
TOPIC: MARGINAL COSTING & ITS MERITS
AND DEMERITS
S.Y.BANKING & INSURANCE
SEMESTER - 4 SUBMITTED BY
GROUP NO: O2
GROUP MEMBERS:
AZIM SAMNANI (37)
SHIFA SHAIKH {27}
SAMA KHAN {08}
DHAVAL SHAH {38}
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Acknowledgement
We would like to express our profound gratitude to our
project guide
Prof: KAMAL ROHRA, who has so ably guided our research
project with his vast fund of knowledge, advice and
constant encouragement, which made us, think past the
difficulties and lead us to successful completion of the
project.
We have tried to cover all the aspects of the project & every
care has been taken to make the project faultless. We have
tried to write the project in our words as far as possible and
simplified all the concepts by presenting it in a different
form. We’ll be looking forward in future for such type of
project. We are eagerly waiting for fruitful comments &
constructive suggestions.
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SR.NO PARTICULARS PG.NO.
1. INTRODUCTION 05
2. DEFINATION 06
3. THEORY OF MARGINAL COSTING 08
4. THE PRINCIPLES OF MARGINAL
COSTING
10
5. FEATURES OF MARGINAL COSTING 11
6. PRESENTATION OF COST DATA UNDER
MARGINAL COSTING
12
7. CRITICISM AGAINST MARGINAL
COSTING:
15
8. ADVANTAGES AND DISADVANTAGES OF
MARGINAL COSTING
17
9. PRACTICAL APPLICATION OF MARGINAL
COSTING TECHNIQUE
20
10. DISCONTINAUNCE OR DIVERSIFICATION
OF PRODUCT LINE
26
11. CONCLUSION 29
12. WEBLIOGRAPHY & BIBLIOGRAPHY 30
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Marginal costing
Introduction 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.
Marginal costmeans the cost of the marginal or last unit produced. It is
also defined asthe cost of one more or one less unit produced besides
existing level of production. In this
Connection, a unit may mean a single commodity, a dozen, a gross or any
other measureof goods.
For example, if a manufacturing firm produces X unit at a cost of 300
and X+1 units at a cost of 320, the cost of an additional unit will be 20
which is marginal cost.
Similarly if the production of X-1 units comes down to 280, the cost of
marginal unit,
Will be 20 (300–280).
The marginal cost varies directly with the volume of production and
marginal cost perunit remains the same. It consists of prime cost, i.e.
cost of direct materials, direct laborand all variableoverheads. It does
not contain any element of fixed cost which is keptseparate under
marginal cost technique.
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Definition Marginal costing Marginal costing distinguishes between fixed costs and variable costs
as convention allyclassified.
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 fixedcosts of the period are written-off in full against
the aggregate contribution. Its specialvalue is in decision making‟.
(Terminology).
The term „contribution‟ mentioned in the formal definition is the term
given to thedifference between Sales and Marginal cost. Thus
MARGINAL COST = VARIABLE COST
DIRECT LABOUR
+
DIRECT MATERIAL
+
DIRECT EXPENSE
+
VARIABLE OVERHEADS
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The term marginal cost sometimes refers to the marginal cost
per unit and sometimes tothe total marginal costs of a
department or batch or operation. The meaning is usually
Clear from the context.
Alternative names for marginal costing are the contribution approach
and direct costing
In this lesson, we will study marginal costing as a technique quite
distinct fromabsorption costing.
Marginal costing may be defined as the technique of presenting cost
data whereinvariable costs and fixed costs are shown separately for
managerial decision-making. Itshould be clearly understood that
marginal costing is not a method of costing like processcosting or job
costing. Rather it is simply a method or technique of the analysis of
costinformation for the guidance of management which tries to find
out an effect on profitdue to changes in the volume of output.There
are different phrases being used for this technique of costing. In UK,
marginalcosting is a popular phrase whereas in US, it is known as direct
costing and is used inplace of marginal costing. Variable costing is
another name of marginal costing.Marginal costing technique has given
birth to a very useful concept of contribution where
Contribution is given by: Sales revenue less variable cost (marginal
cost)Contribution may be defined as the profit before the recovery of
fixed costs. Thus,contribution goes toward the recovery of fixed cost
and profit, and is equal to fixed cost
Plus profit (C = F + P).
In case a firm neither makes profit nor suffers loss, contribution will
be just equal to fixedcost (C = F). This is known as breakeven point.The
concept of contribution is very useful in marginalcosting. It has a fixed
relation withsales. The proportion of contribution to sales is known as
P/V ratio which remains thesame under given conditions of production
and sales.
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Theory of Marginal Costing The theory of marginal costing as set out in “A report on Marginal
Costing”, London is as follows:
In relation to a given volume of output, additional output can normally
be obtained at lessthan proportionate cost because within limits, the
aggregate of certain items of cost will
Tend to remain fixed and only the aggregate of the remainder will tend
to riseproportionately with an increase in output. Conversely, a
decrease in the volume ofoutput will normally be accompanied by less
than proportionate fall in the aggregate cost.
The theory of marginal costing may, therefore, by understood in
the following two steps:
1. If the volume of output increases, the cost per unit in normal
circumstances reduces. Conversely, if an output reduces, the cost per
unit increases. If a factoryproduces 1000 units at a total cost of
3,000 and if by increasing the output by one unit the cost goes up to
3,002, the marginal cost of additional output will be2.
2. If an increase in output is more than one, the total increase in marginal
cost per unit. If, for example, the output is increased to 1020 units from
1000 units and the total cost to produce these units is 1,045, the average
marginal cost per unit is 2.25. It can be described as follows:
Additional cost =Additional units
1045 = 2.25
20
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The ascertainment of marginal cost is based on the classification and
segregation of costinto fixed and variable cost. In order to understand
the marginal costing technique, it isessential to understand the
meaning of marginal cost.
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The Principles of Marginal Costing The principles of marginal costing are as follows.
a. For any given period of time, fixed costs will be the same, for any
volume of salesand production (provided that the level of activity is
within the „relevant range‟).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 extraitem.
b. Similarly, if the volume of sales falls by one item, the profit will
fall by theamount of contribution earned from the item.
c. 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 ordecreases in sales volume, it is misleading
to charge units of sale with a share offixed costs.
d. When a unit of product is made, the extra costs incurred in its
manufacture are thevariable production costs. Fixed costs are
unaffected, and no extra fixed costs areincurred when output is
increased.
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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 costsand fixed costs. It is the variable cost on the basis of
which production and salespolicies are designed by a firm following the
marginal costing technique.
2. Stock/Inventory Valuation
Under marginal costing, inventory/stock for profit measurement is
valued atmarginal cost. It is in sharp contrast to the total unit cost
under absorption costingmethod.
3. Marginal Contribution
Marginal costing technique makes use of marginal contribution for
markingvarious decisions. Marginal contribution is the difference
between sales andmarginal cost. It forms the basis for judging the
profitability of different productsor departments.
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Presentation of Cost Data under Marginal Costing
Marginal costing is not a method of costing but a technique of
presentation of sales andcost data with a view to guide management in
decision-making.The traditional technique popularly known as total cost
or absorption costing technique does not make any difference between
variable and fixed cost in the calculation ofprofits. But marginal cost
statement very clearly indicates this difference in arriving at thenet
operational results of a firm.
Following presentation of two Performa shows the difference between
the presentation ofinformation according to absorption and marginal
costing techniques:
Marginal Costing Pro-Forma Sales
LESS:-
VARIABLE COST
Direct material
Direct labour
Direct expenses etc.
Variable factory overheads
Selling overheads
Less: Closing stock
Contribution
Less:-
Fixed cost
Net profit
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Argument in favour of Marginal Costing: The supporterof marginal costingtechnique put forth the following
points in support of their argument:
1) Fixed costs are period costs in nature and it should be charged to the
concerned period irrespective of the quantum or level of production or
sale.
2) Marginal costing method is simple in application and is easy for
exercise of cost control. It is more informative and simple to understand.
3) It helps the management with more appropriate information in taking
vital business decisions like make or buy, sub-contracting, export order
pricing, pricing under recession, continue or discontinue a product/
division/ sales territory, selection of suitable product.
4) Inclusion of fixed cost in the product cost distorts the comparability
of products at different volume and disturbs control actions. It highlights
the significance of fixed costs on profits. In a highly competitive
situation, it may be wise to take an order which covers marginal cost and
makes some contribution towards fixed costs, rather lose the order and
the contribution by insisting upon a price above full cost.
5) Profit-volume analysis is facilitated by the use break even charts and
profit-volume graphs, and so on. 6) The analysis of per key factor or
limiting resources is a useful aid in budgeting and production planning.
7) Pricing decisions can be based on the contribution levels of individual
product.
8) The profit and loss statement is not distorted by changes in stock
levels. Stock valuations are not burdened with a share of fixed overhead,
so profits reflect sales volume rather than production volume.
9) Responsibility accounting is more effective when based on marginal
costing because managers can identify their responsibilities more clearly
when fixed overhead is not charged arbitrarily to their departments or
division.
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Criticism against Marginal costing:
1) Difficulty may be experienced in trying to separate fixed and
variable elements of overhead costs. Unless this can be done with
reasonable accuracy, marginal costing cannot be very accurate.
Application of common sense and judgment will be necessary. 2)
The misuse of marginal costing approach may result in setting
selling prices which do not aloe for the full recovery of overhead.
This may be most likely in times of depression or increasing
competitors when prices set to undercut competitors may not allow
for a reasonable contribution margin.
3) The main assumption of marginal costing is that variable cost
per unit will be same at any level of activity. This is partly true
within a limited range of activity. With a major change in activity
there may be considerable change in the rates and prices of men,
material due to shortage of material, shortage of skilled labour,
concessions of bulk purchase, increased transportation costs,
changes in production of men and materials etc. 4) The assumption
that fixed costs remain constant in total regardless of changes in
volume will be correct up to a certain level of output. Some fixed
costs are liable to change from one period to another. For example,
salaries bill may go up because of annual increment or due to
change in the pay rates and due to pay structure. If there is a
substantial drop in activity, management may take immediate
action to cut the fixed costs by retrenchment of staff, renting
office-premises, warehouse taken lease may be given up etc.
5) Exclusion of fixed overheads from costs may lead to erroneous
conclusions. It may create problems in interfirm comparison,
higher demand for salaries and other benefits by employees, higher
demand for tax by Government authorities etc.
6) The exclusion of fixed overhead from inventory cost does not
constitute an accepted accounting procedure and, therefore,
adherence to marginal costing will involve deviation from accepted
accounting practices.
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7) Increased automation and mechanization has resulted the
reduction in labour costs and increased fixed costs like installation,
maintenance and operation costs, depreciation of machinery. The use of
marginal costing creates a tendency to disregard the need to recover cost
through product pricing. For long-run continuity of the business, it is not
good. Assets have to be replaced in the long-run.
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Advantages and Disadvantages of Marginal Costing
Advantages 1. Marginal costing is simple to understand.
2. By not charging fixed overhead to cost of production, the effect of
varyingcharges per unit is avoided.
3. It prevents the illogical carry forward in stock valuation of some
proportion of current years fixed overhead.
4. The effects of alternative sales or production policies can be more
readilyavailable and assessed, and decisions taken would yield the
maximum return tobusiness.
5. It eliminates large balances left in overhead control accounts which
indicate thedifficulty of ascertaining an accurate overhead recovery
rate.
6. Practical cost control is greatly facilitated. By avoiding arbitrary
allocation offixed overhead, efforts can be concentrated on
maintaining a uniform andconsistent marginal cost. It is useful to
various levels of management.
7. It helps in short-term profit planning by breakeven and profitability
analysis, bothin terms of quantity and graphs. Comparative profitability
and performancebetween 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 givesmisleading results.
2. Normal costing systems also apply overhead under normal operating
volume andthis shows that no advantage is gained by marginal costing.
3. Under marginal costing, stocks and work in progress are
understated. The exclusion of fixed costs from inventories affect
profit and true and fair view offinancial affairs of an organization may
not be clearly transparent.
4. Volume variance in standard costing also discloses the effect of
fluctuating outputon fixed overhead. Marginal cost data becomes
unrealistic in case of highlyfluctuating levels of production, e.g., in case
of seasonal factories.
5. Application of fixed overhead depends on estimates and not on the
actual and assuch there may be under or over absorption of the same.
6. Control affected by means of budgetary control is also accepted by
many. In orderto 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 lesseffective since a major portion of
fixed cost is not taken care of under marginalcosting.
7. In practice, sales price, fixed cost and variable cost per unit may
vary. Thus, theassumptions underlying the theory of marginal costing
sometimes becomes unrealistic. For long term profit planning,
absorption costing is the only answer.
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Limitations of Marginal Costing
Marginal costing however, suffers from the following limitations:
1. Marginal costing assumes that all costs can be classified into fixed
and variables. But there may be certain costs which are neither fixed
nor variable.
2. The application of marginal costing in certain industries such as
ship building, construction, etc. may show no profit or loss during
the year work is in progress, but huge profit in the year the work is
completed. This is due to non-inclusion of overheads in the value of
closing work-in-progress.
3. In the long run, true selling price should be based on total cost i.e.,
inclusive of fixed cost also. In the short run or in special situations
when a product is sold below the total cost, customers may insist on
the continuation of reduced prices forever and this may not be
possible in all cases.
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Practical application of Marginal costing
technique
1) Key or limiting factor analysis.
2) Profit planning
3) Optimizing product mix
4) Contribution analysis
5) Make or buy decisions
6) Price fixation
7) Discontinuance or diversification of product line
8) Accept or reject special offer and sub-
contracting
9) Break-even analysis
10) Cost-volume profit analysis
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PRACTICAL APPLICATIONS OF MARGINAL COSTING
TECHNIQUE
1) Key or limiting Factors analysis:
Marginal costing can be used in budgeting to help management to determine what
the profit –maximizing budget. Plan should be made when one or more factors of
production or other business resources are in short supply . Marginal costing really
shows its merit when scarce resources are being considered. Examples of resource
restrictions which may apply are as follows:
a) Limit to the availability of a particular grade of labour.
b) Shortage of raw materials.
c) Limit to machine capacity.
d) Shortage of cash to finance production.
If labour supply , materials availability , machine capacity or cash availability limit
production to less than the volume which could be achieved ,management is faced
with the problem of deciding what to produce and what not to produce , because
there are insufficient resources to make everything. The limiting factor is often
sales demand itself in which the business should produce enough goods or services
to meet the demand in full, provided that sales of the goods earn a positive
contribution towards fixed costs and profits.
However , when the limiting factor is a production resource, the business must
decide which part of sales demand it should meet , and which part must be left
unsatisfied. Marginal costing analysis can be used to indicate the profit-
maximizing.
a) Analysis when only one limiting factor:
If fixed costs are constant , regardless of the level of output and sales within a
relevant range of output , marginal costing principles should lead us to the
conclusion that profits will be maximized if total contribution is maximized.
If there is a shortage of one particular production resource, it is inevitable that all
the available supply of that resource will be used up. For example, if a business has
a chronic shortage of skilled manpower, it will plan to use all the skilled manpower
that it does have available.
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Total contribution will be maximized if the maximum possible contribution is
obtaines per unit of that scarce resource. In other words, a business should get the
best possible value out of the scarce resources that it uses up. In dealing with a
limiting factor problem, the steps to be taken care are as follows:
Identify the possibility that there sre may be a limiting factor other than
sales demand. There may be the maximum availability of one or (more)
resources, so that sales demand cannot be met . this is done quite simple as
follows:
i) Calculate the volume of resources required to produce enough unit to satisfy
sales demand.
ii) Calculate the volume of resources available.
iii) Compare the two totals. If (i) exceeds (ii) there is a limiting factor.
If there is only one such limiting factor, the next step is to calculate the
contribution earned by each product per unit of the scarce resource. The
products with the highest contribution per unit of scarce resource should
receive priority in the allocation of the resource in the production budget.
2) Profit Planning:
The behavioural study of costs in marginal costing technique helps the
management in profit planning exercise. Constant development in science and
technology makes the long run situation more uncertain and highly unpredictable.
Long-run consists of a series of short-runs and one must aim at maximizing
contribution in each short-run which will lead to profit maximization in long-run.
Profit figure is planned and activity level is determined to achieve that planned
profit. It helps in doing sensitivity analysis by observing different cost and revenue
situations and its resultant impact on profit and guides in the determination of
activity level to achieve target profit.
The profit of a business concern can be improved in the following ways:
1. By increasing volume
2. By increasing selling price
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3. By decreasing variable costs, and
4. By decreasing fixed costs.
3) Contribution analysis:
The analysis of the contribution per unit each product makes towards fixed or
current period costs and profit leads to the preparation of statements showing the
total contribution each product class has made towards the recovery of period
costs. These statements may be further refined by deducting any discretionary or
separable period costs (i.e., costs such as annual tooling and product advertising)
which should be avoided if the product line were dropped.
4) Make or buy decisions:
Make or buy decision is simply the choice between making a part or article within
the company or purchasing it from outside. The following considerations apply
when taking a make or buy decision:
The capability of the company to make the item in terms of the capacity
(people, plant and space) available and the ability to achieve required
quality standards.
The availability of outside suppliers who can deliver the item in the
quantities, quality and time required.
The differential cost of making or buying the item. This means that
consideration has to be given to these conditions:
-If items which are currently purchased are manufactured, what additional
or incremental costs will be incurred and how do these compare with the
costs being saved?
- If items are purchased which could be manufactured, what costs will be
avoided and how do these compare with the costs will be incurred?
The opportunity cost of using existing capacity to manufacture alternative
items which would make a greater contribution to profit and fixed costs than
the item under consideration. A make or buy decision is often essentially
about how best to utilize existing facilities.
The impact of a decision to make the item on aggregate volumes, an increase
in which should contribute to overhead recovery and facilitate the balancing
of demand and operations capacity overtime.
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The level of variable overheads which are charged to the part or article.
Procedure:
The procedure for taking a make or buy decision is as follows:
Produce a precise specification of the item and define the quantities
required, the timing of deliveries and the maximum acceptable unit cost.
Analyse existing capacity to find out if the item can be made in
accordance with specifications for quality, quantity and delivery dates.
Analyse tenders made by outside suppliers to find out which ,if any , can
best satisfy requirements for quality, cost limits and delivery.
Calculate the incremental cost of making the item –that is, the full
accounting cost of the labour and direct materials used to make it. The
incremental cost will equal marginal cost if, and only if, factory capacity
is sufficiently under-utilised before the make or buy decision is take to
render all fixed costs irrelevant to the decision.
Calculate the cost to buy, which is the purchase cost invoiced by the
supplier (total cost less any trade discount),plus any delivery and
inspection costs and costs of buying (office-staff time).
Assess the opportunity cost of making the component as measured by the
total contribution that would have been earned by using the resources
required to make the item to manufacture instead of an alternative more
profitable product.
Weigh the results of the various assessments listed above.
A thorough make or buy analysis, as outlined above , will ensure that all
the capacity , capability, differential cost and opportunity cost factors will
have been taken fully into consideration before the choice is made.
5) Price fixation:
Under this method fixed costs are ignored and prices are determined on the basis
of marginal cost. A firm seeks to fix its prices so as to maximize its total
contribution. Marginal cost is the change in total costs that results from production
of additional unit of a product or service. Marginal costing is more effective than
full cost pricing for the following reasons:
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Prevalence of multi-product, multi-process and multi-market
concerns makes the absorption of fixed costs into product costs is
difficult.
Constant development in science and technology makes the long run
situation more uncertain and highly unpredictable. Long-run consists
of a series of short runs and we must aim at maximizing contribution
in each short run which will lead profit maximization in the long-run.
6) Accept or reject new order and sub-contracting:
In times of taking decisions to accept or reject new order or in sub-
contracting, the contribution analysis us made as to whether it is profitable to
accept or reject new order or in sub-contracting.
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DISCONTINAUNCE OR DIVERSIFICATION OF
PRODUCT LINE
The MC technique is used in taking decision regarding discontinuance of a
product. If any product is not impressive, then such should be discontinued only it
there is no contribution margin from that product. In other words, any contribution
from that product will reduce the burden of total fixed cost of the firm and this will
help in better product than if such product is discontinued.
When a firm intend to introduce a new product into the market, the major
consideration in taking such decision is to see whether that particular product is
able to recover at least its variable cost and any contribution in excess of variable
cost from such new product will improve the overall profitability of firm. Here the
important point to remember is that all the present fixed costs of the firm are being
borne by the existing products.
Illustration:
The Skyrock.Ltd produces and sells three types of products P,Q & R. the
management committee has decided to discontinue the production of ‘Q’ since
there is no much profit in it. From the following set of information find out the
profitability of the products and give your short comments on the decision of the
management.
Products Selling
price per
unit
Rs./-
Direct
material
per unit
Rs./-
Direct wages per unit
Dept. A Dept. B Dept. C
P 300 60 20 15 10
Q 275 30 20 20 10
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R 305 70 12 10 20
The absorbtion rates of overheads on direct wages are:
Dept. A Dept. B Dept. C
Variable overhead 150% 12% 200%
Fixed overhead 200% 240% 150%
Profitability statement of Skyrock Ltd.
Particulars P Q R
1. Selling price per unit 300 275 305
2. Direct material 60 30 70
3. Direct wages: Dept. A
Dept. B
Dept. C
20
15
10
20
20
10
12
10
20
4. Prime cost (2+3) 105 80 112
5. Variable overhead
Dept. A (150% of D.
wages)
Dept. B (120% of D.
wages)
Dept. C (200% of D.
wages)
30
18
20
30
24
20
18
12
40
Total 68 74 70
6. Total variable cost 173 154 182
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(4+5)
7. Contribution (1-
6)
127 121 123
8. Fixed cost
Dept. A (200% of D.
wages)
Dept. B (240% of D.
wages)
Dept. C (150% of D.
wages)
40
36
15
40
48
15
24
24
30
Total 91 103 78
9. Profit (7-8) 36 18 45
10. P.V. ratio 42% 44% 40%
Comments:
The management has taken a view to discontinue product Q based on unitary
profit. This is a wrong decision. This decision should be based on P.V. ratio, which
is highest in Product Q. Management should explore the possibility of increasing
the production of product Q, because this step will increase the total profit of the
company owing to better P.V. ratio of Product Q. by discontinuing Product Q its
share of fixed cost will be borne by Product P and R thus profit of company will
reduce.
Accept or reject new order and sub-contracting:
In times of taking decision to accept or reject new order or in sub-contracting, the
contribution analysis is made as to whether it is profitable to accept or reject new
order or in sub-contracting. The following problems demonstrate the use of the
contribution technique.
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In this unit, we have discussed generally the concept of marginal costing. We also looked at the features of contributions. These features make it distinctive with conventional profit. Finally, we tried to identify merits and demerits and also the application area of the marginal costing techniques.
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COST AND MANAGEMENT ACCOUNTING:
AUTHOR: - RAVI M. KISHORE
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