unit-iv marginal costing - msb · marginal costing: marginal costing may be defined as "the...
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Introduction
Unit-IV
Marginal Costing
Marginal Costing is not a method of costing like job, batch or contract costing. It is in fact a technique of
costing in which only variable manufacturing costs are considered while determining the cost of goods sold
and also for valuation of inventories. In fact this technique is based on the fundamental principle that the
total costs can be divided into fixed and variable. While the total fixed costs remain constant at all levels of
production, the variable costs go on changing with the production level. It will increase if the production
increases and will decrease if the production decreases. The technique of marginal costing helps in supplying
the relevant information to the management to enable them to take decisions in several areas. Before we
allocate all manufacturing costs to products regardless of whether they are fixed or variable. This approach
is known as absorption costing/full costing. However, only variable costs are relevant to decision-making.
This is known as marginal costing/variable costing.
Marginal Cost: The term Marginal Cost refers to the amount at any given volume of output by which the
aggregate costs are charged if the volume of output is changed by one unit. Accordingly, it means that the
added or additional cost of an extra unit of output.
Marginal cost may also be defined as the "cost of producing one additional unit of product." Thus, the concept
marginal cost indicates wherever there is a change in the volume of output, certainly there will be some
change in the total cost. It is concerned with the changes in variable costs. Fixed cost is treated as a period
cost and is transferred to Profit and Loss Account.
It is a costing system which treats only the variable manufacturing costs as product costs. The fixed
manufacturing overheads are regarded as period cost.
Simple steps to understand the above theory:
If the volume of output increases, the cost per unit in normal circumstances reduces. Conversely, if an output
reduces, the cost per unit increases.
Example: If a factory produces 1000 units at a total cost of Rs.3, 000 and if by increasing the output by one
unit the cost goes up to Rs.3, 002, the marginal cost of additional output will be Rs.2. (3002-3000)
If an increase in output is more than one, the total increase in cost divided by the total increase in output will
give the average marginal cost per unit.
Example: The output is increased to 1020 units from 1000 units and the total cost to produce these units is
Rs.1,045, the average marginal cost per unit is Rs.2.25. (i.e. Additional cost/Additional units=45/20=Rs.2.25)
Assumptions:
variable cost varies in direct proportion with the level of activity
Per unit selling price remain constant
No variation due to stock
Marginal Costing:
Marginal Costing may be defined as "the ascertainment by differentiating between fixed cost and variable
cost, of marginal cost and of the effect on profit of changes in volume or type of output." With marginal
costing procedure costs are separated into fixed and variable cost.
According to J. Batty, Marginal costing is "a technique of cost accounting pays special attention to the
behaviour of costs with changes in the volume of output." This definition lays emphasis on the ascertainment
of marginal costs and also the effect of changes in volume or type of output on the company's profit.
In other words, Marginal costing may be defined as the technique of presenting cost data wherein variable
costs and fixed costs are shown separately for managerial decision-making. It should be clearly understood
that marginal costing is not a method of costing like process costing or job costing. Rather it is simply a
method or technique of the analysis of cost information for the guidance of management.
Features of Marginal Costing
(1) All elements of costs are classified into fixed and variable costs.
(2) Marginal costing is a technique of cost control and decision making.
(3) Variable costs are charged as the cost of production.
(4) Valuation of stock of work in progress and finished goods is done on the basis of variable costs.
(5) Profit is calculated by deducting the fixed cost from the contribution, i.e., excess of selling price over
marginal cost of sales.
(6) Profitability of various levels of activity is determined by cost volume profit analysis
Absorption Costing
Absorption costing is also termed as Full Costing or Total Costing or Conventional Costing. It is a technique
of cost ascertainment. Under this method both fixed and variable costs are charged to product or process or
operation. Accordingly, the cost of the product is determined after considering both fixed and variable costs.
Trading and Profit and Loss Account
Absorption costing Rs.
Marginal costing Rs.
Sales X Sales X
Less: Cost of goods sold X Less: Variable cost of
Goods sold
X
Gross profit
Less: Expenses
Selling expenses
X
X Product contribution margin
Less: variable non- manufacturing
expenses
X
Admin. Expenses X Variable selling expenses X
Other expenses X X Variable admin. Expenses X
Other variable expenses X
Total contribution expenses
Less: Expenses
Fixed selling expenses
X
X
Fixed admin. Expenses X
Other fixed expenses X
Net Profit X Net Profit X
Example
A company started its business in 2019. The following information was available for January to March 2019
for the company that produced a single product:
Rs.
Selling price per unit 100
Direct materials per unit 20
Direct Labour per unit 10
Fixed factory overhead per month 30000
Variable factory overhead per unit 5
Fixed selling overheads 1000
Variable selling overheads per unit 4
Budgeted activity was expected to be 1000 units each month
Production and sales for each month were as follows:
Jan Feb March
Unit sold 1000 800 1100
Unit produced 1000 1300 900
Prepare absorption and marginal costing statements for the three months.
Absorption costing January
February
March
Rs. Rs. Rs.
Sales 100000 80000 110000
Less: cost of goods sold 65000 52000 71500
Adjustment for Over-/(under)
28000 38500
Absorption of factory overhead 9000 (3000)
Gross profit
Less: Expenses
Fixed selling overheads
35000
1000
37000
1000
35500
1000
Variable selling overheads 4000 3200 4400
Net profit
30000 32800 30100
Marginal costing
January
Rs.
February
Rs.
March
Rs.
Sales 100000 80000 110000
Less: Variable cost of goods
sold (Rs.35) 35000 28000 38500
Product contribution margin 65000 52000 71500
Less: Variable selling overhead 4000 3200 4400
Total contribution margin 61000 48800 67100
Less: Fixed Expenses
Fixed factory overhead 30000 30000 30000
Fixed selling overheads 1000 1000 1000
Net profit 30000 32800 30100
Workings 1:
Standard fixed overhead rate
= Budgeted total fixed factory overheads
Budgeted number of units produced
= Rs. 30000
1000 units
= Rs. 30 units
Workings 2:
Production cost per unit under absorption costing:
Rs.
Direct materials 20
Direct labour 10
Fixed factory overhead absorbed 30
Variable factory overheads 5
65
Workings 3:
(Under-)/Over-absorption of fixed factory overheads:
January February March
Rs. Rs. Rs.
Fixed overhead 30000 39000 27000
(1000 x Rs. 30) (1300 x Rs. 30) (900 x Rs. 30)
Fixed overheads incurred 30000 30000 30000
0 9000 (3000)
Workings 4: No fixed factory overhead
Variable production cost per unit under Marginal Costing:
Rs.
Direct materials 20
Direct labour 10
Variable factory overhead 5
35
Distinction between Absorption Costing and Marginal Costing
The distinction in these two techniques is illustrated by the following diagrams:
Fig. 1 Absorption Costing Approach
Fig. 2 Marginal Costing Approach
All selling and
adm. overhead
Direct Materials
Direct Labour
Variable Factory
Overhead
Fixed Factory
Overhead
Charged to cost
of goods
produced
Charged as
expenses when
goods are sold
Charged as
expenses when
incurred
Direct Materials
Direct Labour
Variable Factory
Overhead
Charged to cost
of goods
produced
Charged as
expenses when
goods are sold
Fixed Factory
Overhead and
all selling and
adm. Overhead
Charged as
expenses when
incurred
The main points of distinction between Marginal Costing and Absorption Costing are as below:
Marginal Costing Absorption Costing
1. Only variable costs are considered for product costing and inventory valuation.
Both fixed and variable costs are considered for product costing and inventory valuation.
2. Fixed costs are regarded as period costs. The
profitability of different products is judged by
their P/V ratio.
Fixed costs are charged to the cost of production.
Each product bears a reasonable share of fixed cost
and thus the profitability of a product is influenced
by the apportionment of fixed costs.
3. Cost data are presented as highlight the total
contribution of each product.
Cost data are presented in conventional pattern. Net
Profit of each product is determined after
subtracting fixed cost along with their variable costs.
4. The difference in the magnitude of opening
stock and closing stock does not affect the unit cost of production.
The difference in the magnitude of opening stock
and closing stock affects the unit cost of production due to the impact of related fixed cost.
5. In case of marginal costing the cost per unit
remains the same, irrespective of the production
as it is valued at variable cost.
In case of absorption costing the cost per unit
reduces, as the production increases as it is fixed
cost which reduces, whereas, the variable cost
remains the same per unit. In case of marginal
costing the cost per unit remains the same,
irrespective of the production as it is valued at
variable cost..
If the production = Sales, AC profit = MC Profit
If Production > Sales, AC profit > MC profit
As some factory overhead will be deferred as product costs under the absorption costing
If Production < Sales, AC profit < MC profit
As the previously deferred factory overhead will be released and charged as cost of goods sold
Applications of Marginal Costing
Marginal costing is a very useful technique of costing and has great potential for management in various
managerial tasks and decision making process. The applications of marginal costing are discussed in the
following paragraphs:
1) Cost Control: One of the important challenges in front of the management is the control of cost. In the
modern competitive environment, increase in the selling price for improving the profit margin can be
dangerous as it may lead to loss of market share. The other way to improve the profit is cost reduction and
cost control. Cost control aims at not allowing the cost to rise beyond the present level. Marginal costing
technique helps in this task by segregating the costs between variable and fixed. While fixed costs remain
unchanged irrespective of the production volume, variable costs vary according to the production volume.
Certain items of fixed costs are not controllable at the middle management or lower management level.
In such situation it will be more advisable to focus on the variable costs for cost control purpose. Since
the segregation of costs between fixed and variable is done in the marginal costing, concentration can be
made on variable costs rather than fixed cost and in this way unnecessary efforts to control fixed costs can
be avoided.
2) Profit Planning: Another important application of marginal costing is the area of profit planning. Profit
planning, generally known as budget or plan of operation may be defined as the planning of future
operations to attain a defined profit goal. The marginal costing technique helps to generate data required
for profit planning and decision-making. For example, computation of profit if there is a change in the
product mix, impact on profit if there is a change in the selling price, change in profit if one of the product
is discontinued or if there is a introduction of new product, decision regarding the change in the sales mix
are some of the areas of profit planning in which necessary information can be generated by marginal
costing for decision making. The segregation of costs between fixed and variable is thus extremely useful
in profit planning.
3) Key Factor Analysis: The management has to prepare a plan after taking into consideration the
constraints, if any, on the various resources. These constraints are also known as limiting factors or
principal budget factors as discussed in the topic of ‘Budgets and Budgetary Control’. These key factors
may be availability of raw material, availability of skilled labour, machine hours availability, or the market
demand of the product. Marginal costing helps the management to decide the best production plan by
using the scarce resources in the most beneficial manner and thus optimize the profits. For example, if
raw material is the key factor and its availability is limited to a particular quantity and the company is
manufacturing three products, A, B and C. In such cases marginal costing technique helps to prepare a
statement, which shows the amount of contribution per kg of material. The product, which yields highest
contribution per kg of raw material, is given the priority and produced to the maximum possible extent.
Then the other products are taken up in the order of priority. Thus the resultant product mix will yield
highest amount of profit in the given situation.
4) Decision Making: Managerial decision-making is a very crucial function in any organization. Decision
– making should be on the basis of the relevant information. Through the marginal costing technique,
information about the cost behaviour is made available in the form of fixed and variable costs. The
segregation of costs between fixed and variable helps the management in predicting the cost behaviour in
various alternatives. Thus it becomes easy to take decisions. Some of the decisions are to be taken on the
basis of comparative cost analysis while in some decisions the resulting income is the deciding factor.
Marginal costing helps in generating both the types of information and thus the decision making becomes
rational and based on facts rather than based on intuition. Some of the crucial areas of decision-making
are mentioned below.
_ Make or buy decisions
_ Accepting or rejecting an export offer
_ Variation in selling price
_ Variation in product mix
_ Variation in sales mix
_ Key factor analysis
_ Evaluation of different alternatives regarding profit improvement
_ Closing down/continuation of a division
Advantages of Marginal Costing
(1) Cost-volume-profit relationship data wanted for profit planning purposes is readily obtained from the
regular accounting statements. Hence management does not have to work with two separate sets of data
to relate one to the other.
(2) The profit for a period is not affected by changes in absorption of fixed expenses resulting from building
or reducing inventory. Other things remaining equal (e.g. selling prices, costs, sales mix), profits move
in the same direction as sales when direct costing is in use.
(3) Manufacturing cost and income statements in the direct cost form follow management‘s thinking more
closely than does the absorption cost form for these statements. For this reason, management finds it
easier to understand and use direct cost reports.
(4) The impact of fixed costs on profits is emphasised because the total amount of such cost for the period
appears in the income statement.
(5) Marginal income figures facilitate relative appraisal of products, territories, classes of customers, and
other segments of the business without having the results obscured by allocation of joint fixed costs.
(6) Marginal costing lies in with such effective plans for cost control as standard costs and flexible budgets.
(7) Marginal costing furnishes a better and more logical basis for the fixation of sales prices as well as
tendering for contracts when business is at low ebb.
(8) Last but not the least, break-even point can be determined only on the basis of marginal costing.
Limitations of Marginal Costing
Marginal costing technique has the following limitations:
(1) In marginal costing, costs are classified into fixed and variable. Segregation of costs into fixed and
variable is rather difficult and cannot be done with precision.
(2) Marginal costing assumes that the behaviour of costs can be represented in straight line. This means that
fixed costs remains completely fixed over a period at different levels and variable costs change in linear
pattern i.e. the change is proportion to the change in volume. In real life, fixed costs are liable to change
at varying levels of production especially when extra plant and equipments are introduced and hence
variable costs may not vary in the same proportion as the volume.
(3) Under marginal costing technique fixed costs are not included in the value of stock of finished goods
and work-in-progress. As fixed costs are incurred, these should also form part of the costs of the product.
Due to this elimination of fixed costs from finished stock and work-in-progress, the stocks are
understated. This affects the results of profit and loss account and the balance sheet. Thus, profit may be
unnecessarily deflated.
(4) In the marginal costing system monthly operating statements will not be as realistic or useful as under
the absorption costing system. This is because under this system, marginal contribution and profits vary
with change in sales value. Where sales are occasional, profits fluctuate from period to period.
(5) Marginal costing fails to give complete information, for example rise in production and sales may be due
to extensive use of existing machinery or by expansion of the resources or by replacement of the labour
force by machines. The marginal contribution of P/V ratio fails to bring out reasons for this.
(6) Under marginal costing system the difficulties involved in the apportionment and computation of under
and over absorption of fixed overheads are done away with but problem still remains as far as the under
absorption or over absorption of variable overheads is concerned.
(7) Although for short term assessment of profitability marginal costs may be useful, long-term profit is
correctly determined on full costs basis only.
(8) Marginal costing does not provide any standard for the evaluation of the performance. Marginal
contribution data do not reveal many effects which are furnished by variance analysis. For example,
efficiency variance reflects the efficient and inefficient use of plant, machinery and labour and this sort
of valuation is lacking in the marginal cost analysis.
(9) Marginal costing analysis assumes that sales price per unit will remain the same on different levels of
production but these may change in real life and give unrealistic results.
(10) In the age of increased automation and technology advancement, impact of fixed costs on product is
much more than that of variable costs. As a result a system that does not account the fixed costs is less
effective because a substantial portion of the cost is not taken into account.
(11) Selling price under the marginal costing technique is fixed on the basis of contribution. This may not be
possible in the case of ‘cost plus contracts’. Thus the above limitations indicate that fixed costs are
equally important in certain cases.
Cost Volume Profit Analysis
Cost Volume Profit Analysis (C V P) is a systematic method of examining the relationship between changes
in the volume of output and changes in total sales revenue, expenses (costs) and net profit. In other words. It
is the analysis of the relationship existing amongst costs, sales revenues, output and the resultant profit. It
provides information about the following matters:
1. The behaviour of cost in relation to volume
2. Volume of production or sales, where the business will break-even
3. Sensitivity of profits due to variation in output
4. Amount of profit for a projected sales volume
5. Quantity of production and sales for a target profit level
Cost-volume-profit analysis may therefore be defined as a managerial tool showing the relationship between
various ingredients of profit planning, viz., cost (both fixed and variable), selling price and volume of
activity, etc. Such an analysis is useful to the Finance Manager in the following respects:
(i) It helps him in forecasting the profit fairly accurately.
(ii) It is helpful in setting up flexible budgets, since on the basis of this relationship, it can ascertain the cost,
sales and profits at different levels of activity.
(iii) It also assists him in performance evaluation for purposes of management control.
(iv) It helps in formulating price policy by projecting the effect which different price structures will have on
cost and profits.
(v) It helps in determining the amount of overhead cost to be charged at various levels of operations, since
overhead rates are generally predetermined on the basis of a selected volume of production.
Thus, cost-volume-profit analysis is an important media through which the management can have an insight
into effects on profit on account of variations in costs (both fixed and variable) and sales (both volume and
value) and take appropriate decisions.
To know the cost, volume and profit relationship, a study of the following is essential:
(1) Marginal Cost Formula
(2) Break-Even Analysis
(3) Profit Volume Ratio (or) PN Ratio
(4) Profit Graph
(5) Key Factors and
(6) Sales Mix
Objectives of Cost Volume Profit Analysis
The following are the important objectives of cost volume profit analysis:
(1) Cost volume is a powerful tool for decision making.
(2) It makes use of the principles of Marginal Costing.
(3) It enables the management to establish what will happen to the financial results if a specified level of
activity or volume fluctuates.
(4) It helps in the determination of break-even point and the level of output required to earn a desired profit.
(5) The P/V ratio serves as a measure of efficiency of each product, factory, sales area etc. and thus helps the
management to choose a most profitable line of business.
(6) It helps us to forecast the level of sales required to maintain a given amount of profit at different levels
of prices.
Basic Equation
Profit = Sales – Total cost
Profit = Sales – (Variable cost + Fixed cost)
Profit = Sales – Variable cost – Fixed cost
Profit + Fixed cost = Sales – Variable cost
Sales – Variable cost = Fixed cost + profit
Sales – Variable cost = Contribution
Contribution =Fixed cost + profit
Contribution – Fixed cost = Profit
Marginal Cost Equation
Contribution is the difference between the sales and marginal cost. Thus, contribution is calculated by the
following formula:
Contribution = Sales – Variable cost
or, C = S - V… ......... (i)
Profit = Contribution – Fixed cost
or, P = C - F,
or, C = F + P ........... (ii)
Therefore, contribution may be said to be equal to Fixed Cost plus Profit (loss). Contribution contributes
towards the recovery of fixed costs and the balance is profit.
Equating equations (i) and (ii), we get,
S - V = F + P ......... (iii)
Sales – Variable cost = Fixed cost + profit
At Break-even point, there is neither profit nor loss (i.e., Total cost = Total Sales) so that P = 0 (zero)
S - V = F + P ......... (iii)
or, S - V = F + 0
or, S = F + V… ....... (iv)
So, Sales = Fixed Cost + Variable Cost (at B.E.P.)
or, Sales = Total Cost (at B.E.P.)
The concept of contribution is extremely helpful in the study of Break-even analysis and managerial decision
making.
Profit Volume Ratio (P/V)
Symbolically, P/V Ratio (or, C/S ratio) is expressed as follows:
P/V Ratio (or, C/S ratio) = Contribution
= C
S𝑎𝑙𝑒𝑠 S
For determining different requirements, different formulae are available:
(a) P/V Ratio = Sales−Variable Cost
=
S𝑎𝑙𝑒𝑠
S−V
S or, 1-
Variable Cost
S𝑎𝑙𝑒𝑠
(b) P/V Ratio =
(c) P/V Ratio =
(d) P/V Ratio =
Fixed Cost+Profit (or loss) =
S𝑎𝑙𝑒𝑠
Change in Contribution
Change in S𝑎𝑙𝑒𝑠
Change in Profit (or Loss)
Change in S𝑎𝑙𝑒𝑠
F+P (or L)
S
P/V Ratio indicates the rate at which profit is being earned. A high P/V Ratio indicates high profitability and
low P/V Ratio indicates low profitability.
Break-even analysis
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.
Break-even analysis is a widely used technique to study cost-volume-profit relationship. The narrower
interpretation of the term break-even analysis refers to a system of determination of that level of activity
where total cost equals total selling price. The broader interpretation refers to that system of analysis which
determines probable profit at any level of activity. It portrays the relationship between cost of production,
volume of production and the sales value.
It may be added here that CVP analysis is also popularly, although not very correctly, designated as ‘Break-
even Analysis’. The difference between the two terms is very narrow. CVP analysis includes the entire gamut
of profit planning, while break-even analysis is one of the techniques used in this process. However, as stated
above, the technique of break-even analysis is so popular for studying CVP Analysis that the two terms are
used as synonymous terms. For the purposes of this study, we have also not made any distinction between
these two terms. In order to understand the concept of break-even analysis, it will be useful to know about
certain basic terms as given below:
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
1. Contribution
This refers to the excess of selling price over the variable cost. It is also known as, ‘gross margin’. The
amount of profit (loss) can be ascertained by deducting the fixed cost from contribution. In other words, fixed
cost plus profit is equivalent to contribution. It can be expressed by the following formula:—
Contribution = Selling Price – Variable Cost
or
Contribution = Fixed Cost + Profit
Profit = Contribution – Fixed Cost
Example
Variable Cost = Rs 50,000
Fixed Cost = Rs 20,000
Selling Price = Rs 80,000
Contribution = Selling Price – Variable Cost
= Rs 80,000 – Rs 50,000
= Rs 30,000
Profit = Contribution – Fixed Cost
= Rs 30,000 – Rs 20,000
= Rs 10,000
Hence, contribution exceeds fixed cost and, therefore, the profit is of the magnitude of Rs 10,000. Suppose
the fixed cost is Rs. 40,000 then the position shall be
Contribution – Fixed cost = Profit
= Rs 30,000 – Rs 40,000 = (–) Rs 10,000
The amount of Rs 10,000 represents the extent of loss since the fixed costs are more than the contribution.
At the level of fixed cost of Rs 30,000, there shall be no profit and no loss. The concept of the break-even
analysis emerges out of this theory.
2. Profit/Volume Ratio (P/V Ratio)
This term is important for studying the profitability of operations of a business, Profit volume ratio
establishes a relationship between the contribution and the sale value. The ratio can be shown in the form of
a percentage also. The formula can be expressed thus:
Contribution C
P/V Ratio (or, C/S ratio) = S𝑎𝑙𝑒𝑠
= S
Or, P/V Ratio =
Sales−Variable Cost =
S𝑎𝑙𝑒𝑠
S−V
S or, 1-
Variable Cost
S𝑎𝑙𝑒𝑠
This ratio can also be called ‘Contribution/Sales’ ratio. This ratio can also be known by comparing the change
in contribution to change in sales or change in profit due to change in sales. Any increase in contribution
would mean increase in profit only because fixed costs are assumed to be constant at all levels of production.
Thus,
P/V Ratio = Change in Contribution
Change in S𝑎𝑙𝑒𝑠 Change in Profit (or Loss)
Or, P/V Ratio =
Change in S𝑎𝑙𝑒𝑠
This ratio would remain constant at different levels of production since variable costs as a proportion to sales
remain constant at various levels.
Example
Sales Rs 2,00,000
Variable Costs 1,20,000
Fixed Costs 40,000 Rs.2,00,000−Rs.1,20,000
P/V Ratio = Rs.2,00,000
= 0.4 or 40%
The ratio is useful for the determination of the desired level of output or profit and for the calculation of
variable costs for any volume of sales. The variable cost can be expressed as under:
VC = S (1 – P/V Ratio)
In the above example if we know the P/V Ratio and sales beforehand, the variable cost can be computed as
follows:
Variable costs = 1 – .04 =.06, i.e., 60% of sales
= Rs 1,20,000 (60% of Rs 2,00,000)
Alternatively, by the formula S−V
Since P/V Ratio = S
Or, S – V = S × P/V ratio
or V = S – S × P/V Ratio
or = S (1 – P/V Ratio)
The following are the special features of P/V Ratio:
(i) It helps the management in ascertaining the total amount of contribution for a given volume of sales.
(ii) It remains constant so long the selling price and the variable cost per unit remain constant or so long they
fluctuate in the same proportion.
(iii) It remains unaffected by any change in the level of activity. In other words, PV ratio for a product will
remain the same whether the volume of activity is 1,000 units or 10,000 units.
(iv) The ratio also remains unaffected by any variation in the fixed cost since the latter are not at all considered
while calculating the PV ratio.
In case of a multi-product organisation, PV ratio is of vital importance for the management to find out which
product is more profitable. Management tries to increase the value of this ratio by reducing the variable costs
or by increasing the selling price.
3. Break-even Point
The point which breaks the total cost and the selling price evenly to show the level of output or sales at which
there shall be neither profit nor loss, is regarded as break-even point. At this point, the income of the business
exactly equals its expenditure. If production is enhanced beyond this level, profit shall accrue to the business,
and if it is decreased from this level, loss shall be suffered by the business.
It will be proper here to understand different concepts regarding marginal cost and break-even point before
proceeding further. This has been explained below:
It is a point of neither profit nor loss. Therefore, at Break-even Point, contribution is equal to Fixed Cost.
Contribution = Fixed cost
Fixed Cost (1) Break-even point (in units) =
Contribution per unit
Fixed Cost (2) Break-even point (in amount) =
Contribution per unit x Selling Price per unit
Fixed Cost Or, =
Total Contribution x Total Sales
Or, = Fixed Cost =
Fixed Cost
Variable Cost per unit Selling price per unit
P/V Ratio
(3) Sales revenue at break-even point = Break-even point x selling price per unit
At break-even point the desired profit is zero. In case the volume of output or sales is to be computed for a
‘desired profit’, or ‘target profit’ the amount of ‘desired profit’ or ‘target profit’ should be added to Fixed
cost in the formulae given above. For example:
Fixed Cost+Desired Profit
(1) No. of units at Desired Profit =
Contribution per unit
(2) Sales for a Desired Profit = Fixed Cost+Desired Profit
P/V Ratio
Illustration A factory manufacturing sewing machines has the capacity to produce 500 machines per annum.
The marginal (variable) cost of each machine is Rs 200 and each machine is sold for Rs 250. Fixed overheads
are Rs 12,000 per annum. Calculate the break-even points for output and sales and show what profit will
result if output is 90% of capacity?
Solution:
Contribution per machine is Rs 250 – Rs. 200 = Rs. 50
Break-even Point for Output
(Output which will give ‘contribution’ equal to fixed costs Rs. 12,000).
Fixed Cost Break-even point (in units) =
Contribution per unit
Rs.12,000
= Rs.50
= 240 machines
Break-even point for sales = Break-even point x selling price per unit
= 240 x Rs. 250 = Rs. 60,000
Break-even point for sales can also be calculated with the help of any of the following formulae:
Fixed Cost (i) BEP =
Contribution per unit x Selling Price per unit
= Rs.12,000
x Rs.250 = Rs. 60,000 Rs.50
Fixed Cost (ii) BEP = Variable Cost per unit
1− Selling price per unit
Rs.12,000 200
250
Rs.12,000 1
5
= Rs. 60,000
(iii) BEP = Fixed Cost
=
P/V Ratio
Rs.12,000 = Rs. 60,000
20%
Contribution Rs.25,000 P/V Ratio =
Sales x 100 =
Rs.1,25,000 x 100 = 20%
Profit at 90% of the capacity has been calculated as follow:
Capacity 500 machines
Output at 90% of capacity 450 machines
Break-even point of output 240 machines
Since fixed overheads will be recovered in full at the break-even point, the entire contribution beyond the
break-even point will be the profit. The profit on 450 units, therefore, will be:
= Rs 50 × (450 – 240) = Rs 10,500.
1−
= 1−
=
Break-even analysis
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
Cost Rs.
Total cost
Variable cost
Fixed cost
Sales (units)
Total Cost/Revenue Rs.
Sales revenue
BEP
Profit
Total cost
Sales (units)
Margin of Safety
Margin of Safety is the difference between the actual sales and the break even sales. As we have discussed,
at the break-even point there is neither any profit nor loss. Hence any firm will always be interested in being
as much above the breakeven level as possible. Margin of safety explains precisely this thing and the higher
the safety margin the better it is. Margin of safety is computed as follows.
Margin of Safety = Actual Sales – Break Even Sales. Margin of safety can also be expressed as a percentage
of sales.
Margin of Safety
Indicates soundness of business
High margin of safety – BEP is much below the actual sales
Margin of safety is a measure of amount by which the sales may decrease before a company suffers a loss.
This can be expressed as a number of units or a percentage of sales
Indicates soundness of business
High margin of safety – BEP is much below the actual sales
Margin of safety is a measure of amount by which the sales may decrease before a company suffers a loss.
This can be expressed as a number of units or a percentage of sales
Margin of safety can be improved by:
(a) Increasing the selling price
(b) Reducing the variable cost
(c) Selecting a product mix of larger PN ratio items
(d) Reducing fixed costs
(e) Increasing the output
Formulae:
Margin of safety = Sales – BEP sales
Margin of safety = Sales – fixed cost/ PV ratio
Margin of safety = Sales x PV ratio – Fixed cost / PV ratio
Margin of safety = Contribution – Fixed cost/ PV ratio
Margin of safety = Profit / PV ratio
Total Cost/Revenue Rs.
Sales revenue
BEP
Profit
Total cost
Sales (units)
Margin of safety
1. Example
The breakeven sales level is at 5000 units. The company sets the target profit at Rs.18000 and the budget
sales level at 7000 units
Required:
Calculate the margin of safety in units and express it as a percentage of the budgeted sales revenue
Solution
Margin of safety
= Budget sales level – breakeven sales level
= 7000 units – 5000 units
= 2000 units
Margin of safety
= Margin of safety
Budget sales level
= 2000
7000
= 28.6%
The margin of safety indicates that the actual sales can fall by 2000 units or 28.6% from the budgeted level
before losses are incurred.
2. Example
Selling price per unit Rs.12
Variable price per unit Rs. 3
Fixed costs Rs.45000
Current profit Rs.18000
If the fixed cost fall by Rs.5000 but the variable costs rise to Rs. 4 per unit, the minimum volume of sales
required to maintain the current profit will be:
𝑨𝒏𝒔
=Fixed Cost + Target Profit
Contribution to Sales ratio
=Rs. 40,000 + Rs. 18,000
Rs. (12 − 4)
= 7250 units
JOB ORDER COSTING
Meaning:
Job order costing is that form of specific order costing which applies where the work
is undertaken as an identifiable unit such as:
i. Manufacture of products to customers’ specific requirements.
ii. Fabrication of certain materials where raw materials are supplied by the customers.
iii. Repairs are done within a factory or at customers’ premises.
iv. Manufacturing goods are not for stock purposes but for immediate delivery once
these are completed in all respects.
v. Internal capital expenditure jobs etc.
Job costing is a method of cost accounting whereby cost is compiled for a specific
quantity of product, equipment, repair or other service that moves through the production
process as a continuously identifiable unit, applicable material, direct labour, direct
expenses and usually a calculated portion of overheads being charged to a job order.
Features of Job Order Costing:
Under this method, costs are collected and accumulated for each job, work order or
project separately. Each job can be separately identified and hence it becomes essential to
analyse the costs according to each job.
The industries, where this method of costing is applied, must possess the following
features:
i. The production is generally against customer’s order but not for stock.
ii. Each job has its own characteristics and needs special treatment.
iii. There is no uniformity in the flow of production from department to department. The
nature of the job determines the departments through which the job has to be
processed. The production is intermittent and not continuous.
iv. Each job is treated as a host unit under this method of costing.
v. Each job is distinctively identified by a production order throughout the production
stage.
vi. The cost of production of every job is ascertained after the completion of the job.
vii. The work-in-progress differs from period to period according to the number of jobs in
hand.
Thus, cost is ascertained for each job separately. This method is applicable to
printers, machine tools manufacturers, foundries, general engineering workshops,
advertising, interior decoration and case making etc.
Objectives of Job Order Costing:
Following are the main objectives of job order costing:
i. It helps to find out the cost of production of every job or order and to know the profit
or loss made on its execution. This ultimately helps the management to judge the
profitability of each job and decide the future course of action.
ii. It helps the management to make more accurate estimates for costs of similar jobs to
be executed in future on the basis of past records. Management can easily and
accurately determine and quote prices of jobs of a similar nature which are in
prospect.
iii. It helps the management to control the operational inefficiency by making a
comparison of actual costs with estimated ones.
iv. It helps the management to provide a valuation of work-in-progress.
The following factors must be considered before adopting a system of job order costing:
a) Each job (or order) should be continuously identifiable from the stage of raw
materials to completion stage.
b) This system should be adopted when it becomes absolutely necessary as it is very
expensive and requires a lot of clerical work in estimating costs, designing and
scheduling of production.
Pre-Requisites for Job Order Costing:
In order to achieve the purposes of job order costing a considerable amount of
clerical work will be involved and to ensure effective and workable system, the following
factors are necessary:
a) A sound system of production control.
b) Comprehensive works documentation, typically this includes: work order and/or
operation tickets, bills of materials and/or materials requisitions, jig and tool
requisitions etc.
c) An appropriate time booking system using either time sheets or piece work tickets.
d) A well organised basis to the costing system with clearly defines cost centres, good
labour analysis, appropriate overhead absorption rates and a relevant issue pricing
system.
Advantages of Job Order Costing:
Following are the advantages of job order costing:
a. It provides a detailed analysis of cost of materials, wages, and overheads classified
by functions, departments and nature of expenses which enable the management to
determine the operating efficiency of the different factors of production, production
centres and the functional units.
b. It records costs more accurately and facilitates cost control by comparing actual with
estimates.
c. It enables the management to ascertain which of the jobs are more profitable than
the others, which are less profitable and which are incurring losses.
d. It provides a basis for estimating the cost of similar jobs taken up in future and thus
helps in future production planning.
e. Determination of predetermined overhead rates in job costing necessitates the
application of a system of budgetary control of overheads with all its advantages.
f. Identification of spoilage and defectives with the respective production orders and
departments may enable the management to take effective steps in reducing these
to the minimum.
g. The detailed cost records of the past years can be used for statistical purposes in the
determination of the trends of cost of the different types of jobs and their relative
efficiencies.
h. It is useful in quoting cost plus contract.
Disadvantages of Job Order Costing:
Following are the disadvantages of job order costing:
i. It involves a great deal of clerical work in recording daily the cost of materials issued,
wages expended and overheads chargeable to each job or work order which adds to
the cost of cost accounting. Thus it is expensive.
ii. The scope of committing mistakes is enough as the cost of one job may be wrongly
posted to the cost of other job.
iii. Cost comparison among different jobs becomes difficult especially when drastic
changes take place.
iv. Determination of overhead rates may involve budgeting of overhead expenses and
the bases of overhead apportionment and absorption but unless such budgeting is
complete i.e., extended to material, labour and expenses, its advantages are
considerably reduced.
v. Job costing is historical costing which ascertains the cost of a job or product after it
has been manufactured. It does not facilitate control of cost unless it is used with
standard or estimated costing.
Procedure of Job Order Cost System:
A cost accounting system should be so designed that it would be able to provide the
necessary information for achieving control of cost and performance. Thus it shows in detail
their cost components of the total cost of executing a job which may take the form of either
a special order or job or a batch of orders.
A job cost sheet is prepared for every job which is undertaken on the basis of
material requisition concerned. Labour cost on the basis of time clocked in respect of the
job with the help of time tickets and factory overheads are added to these cost components
according to some rational methods of overhead absorption.
The total cost of a job as indicated by the job cost sheet consists partly of direct cost
and partly of costs arrived at by assignment, allocation, apportionment and finally by
absorption. Thus it is clear that similar jobs executed during a certain time period are bound
to have different units of production. Unit cost is determined by dividing total cost by the
number of units or a volume of goods produced there under.
The procedure for job order cost system may be summarised as follows:
1. Receiving an Enquiry:
The customer will usually enquire about the price, quality to be maintained, the duration
within which the order is to be executed and other specification of the job before placing
an order.
2. Estimation of the Price of the Job:
The cost accountant estimates the cost of the job keeping in mind the specification of the
customer. While preparing estimate, the cost of execution of similar job in the previous
year and possible changes in the various estimates of cost are taken into consideration. The
prospective customer is informed with the estimate of the job.
3. Receiving of Order:
If the customer is satisfied with the quotation price and other terms of execution, he will
then place the order.
4. Production Order:
If the job is accepted, a Production Order is made by the Planning Department. It is in the
form of instructions issued to the foreman to proceed with the manufacture of the product.
It forms an authority for starting the work.
It contains all the information regarding production. It is prepared with sufficient
copies so that a copy of the same may be given to all the departmental managers or for
man who are required to take any part in the production.
A specimen of production order is given below:
When an order is received, the Production Control Department allots a Production
Order Number to it. Sometimes, the work may be sub-divided and sub-numbers may also
be allotted to various works constituting it in addition to one master number.
5. Recording of Costs:
The costs are collected and recorded for each job under separate Production Order
Number. Generally, Job Cost Sheet (or Card) is maintained for each job. This is a document
which is used to record direct material, direct wages and overheads applicable to respective
jobs.
The bases of collection of costs are:
(a) Materials:
Materials Requisitions, Bill of Materials or Materials Issue Analysis Sheet.
(b) Wages:
Operation Schedule, Job Card or Wages Analysis Sheet.
(c) Overheads:
Standing Order Numbers or Cost Account Numbers.
All the basic documents will contain cross reference to respective production order
numbers for convenience in collection of costs.
A specimen of Job Cost Sheet is as given below:
6. Completion of Job:
On completion of a job, a completion report is sent to costing department. The expenditure
under each element of cost is totalled and the total job cost is ascertained. The actual cost
is compared with the estimated cost so as to reveal efficiency or inefficiency in operation.
7. Profit or Loss on Job:
It is determined by comparing the actual expenditure or cost with the price obtained.
Illustration 1:
The information given below has been taken from the cost records of a factory in respect of
Job No. 707:
Fixed expenses estimated at Rs. 20,000 for 10,000 working hours. Calculate the cost of the
Job No. 707 and the price for the Job to give a profit of 25% on the selling price.
PROCESS COSTING
Introduction:
Process costing is a form of operations costing which is used where standardized
homogeneous goods are produced. This costing method is used in industries like chemicals,
textiles, steel, rubber, sugar, shoes, petrol etc. Process costing is also used in the assembly
type of industries also. It is assumed in process costing that the average cost presents the
cost per unit. Cost of production during a particular period is divided by the number of units
produced during that period to arrive at the cost per unit.
Meaning of Process Costing:
Process costing is a method of costing under which all costs are accumulated for
each stage of production or process, and the cost per unit of product is ascertained at each
stage of production by dividing the cost of each process by the normal output of that
process.
Definition:
CIMA London defines process costing as “that form of operation costing which applies
where standardize goods are produced”.
Features of Process Costing:
a) The production is continuous
b) The product is homogeneous
c) The process is standardized
d) Output of one process become raw material of another process
e) The output of the last process is transferred to finished stock
f) Costs are collected process-wise
g) Both direct and indirect costs are accumulated in each process
h) If there is a stock of semi-finished goods, it is expressed in terms of
equalent units
i) The total cost of each process is divided by the normal output of that process to
find out cost per unit of that process.
Advantages of process costing:
1. Costs are be computed periodically at the end of a particular period
2. It is simple and involves less clerical work that job costing
3. It is easy to allocate the expenses to processes in order to have accurate costs.
4. Use of standard costing systems in very effective in process costing situations.
5. Process costing helps in preparation of tender, quotations
6. Since cost data is available for each process, operation and department, good
managerial control is possible.
Limitations:
1. Cost obtained at each process is only historical cost and are not very useful for
effective control.
2. Process costing is based on average cost method, which is not that suitable for
performance analysis, evaluation and managerial control.
3. Work-in-progress is generally done on estimated basis which leads to inaccuracy
in total cost calculations.
4. The computation of average cost is more difficult in those cases where more
than one type of products is manufactured and a division of the cost element is
necessary.
Where different products arise in the same process and common costs are prorated
to various costs units. Such individual products costs may be taken as only approximation
and hence not reliable.
DISTINCTION BETWEEN JOB COSTING AND PROCESS COSTING
Job order costing and process costing are two different systems. Both the systems
are used for cost calculation and attachment of cost to each unit completed, but both the
systems are suitable in different situations. The basic difference between job costing and
process costing are:
Basis of
Distinction
Job order costing Process costing
1. Specific order Performed against
specific orders
Production
contentious
2. Nature Each job many be
different.
Product is
Homogeneous and
standardized.
3. Cost
determination
Cost is determined
for each job
separately.
Costs are complied
for each process for
department on time
basis i.e. for a given
accounting period.
4. Cost calculations Cost is complied
when a job is
completed.
Cost is calculated at
the end of the cost
period.
5. Control Proper control is
comparatively
difficult as each
product unit is
different and the
production is not
continuous.
Proper control is
comparatively easier
as the production is
standardized and is
more suitable.
6. Transfer There is usually not
transfer from one
job to another
unless there is some
surplus work.
The output of one
process is transferred
to another process as
input.
7. Work-in-Progress There may or may
not be work-in-
progress.
There is always some
work-in-progress
because of
continuous
production.
8. Suitability Suitable to industries
where production is
intermittent
an
d customer orders
can be identified in
the value of
production.
Suitable, where
goods are made for
stock and
productions is
continuous.
COSTING PROCEDURE
For each process an individual process account is prepared. Each process of production is
treated as a distinct cost centre.
Items on the Debit side of Process A/c.
Each process account is debited with –
a) Cost of materials used in that process.
b) Cost of labour incurred in that process.
c) Direct expenses incurred in that process.
d) Overheads charged to that process on some pre determined.
e) Cost of ratification of normal defectives.
f) Cost of abnormal gain (if any arises in that process)
Items on the Credit side:
Each process account is credited with
a) Scrap value of Normal Loss (if any) occurs in that process.
b) Cost of Abnormal Loss (if any occurs in that process)
Cost of Process:
The cost of the output of the process (Total Cost less Sales value of scrap) is
transferred to the next process. The cost of each process is thus made up to cost brought
forward from the previous process and net cost of material, labour and overhead added in
that process after reducing the sales value of scrap. The net cost of the finished process is
transferred to the finished goods account. The net cost is divided by the number of units
produced to determine the average cost per unit in that process.
Specimen of Process Account when there are normal loss and abnormal losses is below:
Dr. Process I A/c. Cr.
Particulars Units Rs. Particulars Units Rs.
To Basic Material xxx xx By Normal Loss xx Xx
To Direct Material xx By Abnormal Loss xx Xx
To Direct Wages xx By Process II A/c. xx Xx
To Direct Expenses xx (output
transferred
to
To
Production
Overheads
xx Next process)
To Cost of
Rectification of
Normal Defects
xx By Process I
Stock A/c.
xx Xx
To Abnormal Gains xx
xx xxx xx Xx
Process Losses:
In many process, some loss is inevitable. Certain production techniques are of such a
nature that some loss is inherent to the production. Wastages of material, evaporation of
material is un avoidable in some process. But sometimes the Losses are also occurring due
to negligence of Labourer, poor quality raw material, poor technology etc. These are
normally called as avoidable losses. Basically process losses are classified into two
categories
(a) Normal Loss (b) Abnormal Loss
1. Normal Loss:
Normal loss is an unavoidable loss which occurs due to the inherent nature of the
materials and production process under normal conditions. It is normally estimated on
the basis of past experience of the industry. It may be in the form of normal wastage,
normal scrap, normal spoilage, and normal defectiveness. It may occur at any time of
the process.
No of units of normal loss= Input x Expected percentage of Normal Loss.
The cost of normal loss is a process. If the normal loss units can be sold as a crap
then the sale value is credited with process account. If some rectification is required before
the sale of the normal loss, then debit that cost in the process account. After adjusting the
normal loss the cost per unit is calculates with the help of the following formula:
𝑪𝒐𝒔𝒕 𝒐𝒇 𝑮𝒐𝒐𝒅 𝑼𝒏𝒊𝒕 =Total cost increased − Sale value of scrap
Input − Normal loss of unit
2. Abnormal Loss:
Any loss caused by unexpected abnormal conditions such as plant breakdown,
substandard material, carelessness, accident etc. such losses are in excess of pre-
determined normal losses. This loss is basically avoidable. Thus abnormal losses arrive
when actual losses are more than expected losses. The units of abnormal losses in
calculated as under:
Abnormal Losses = Actual Loss – Normal Loss
The value of abnormal loss is done with the help of following formula:
Value of Abnormal Loss:
=𝑇𝑜𝑡𝑎𝑙 𝐶𝑜𝑠𝑡 𝐼𝑛𝑐𝑟𝑒𝑎𝑠𝑒𝑑 − 𝑆𝑐𝑟𝑎𝑝 𝑉𝑎𝑙𝑢𝑒 𝑜𝑓 𝑛𝑜𝑟𝑚𝑎𝑙 𝑙𝑜𝑠𝑠
Inputs Unit − Normal loss units× Units of Abnormal loss
Abnormal Process loss should not be allowed to affect the cost of production as it is
caused by abnormal (or) unexpected conditions. Such loss representing the cost of
materials, labour and overhead charges called abnormal loss account. The sales value of
the abnormal loss is credited to Abnormal Loss Account and the balance is written off to
costing P & L A/c.
Dr. Abnormal Loss A/c. Cr.
Particulars Units Rs. Particulars Units Rs.
To Process A/c. Xx xx By Bank xx xx
By Costing P & L
A/c.
xx xx
Xx xxx xx xx
3. Abnormal Gains:
The margin allowed for normal loss is an estimate (i.e. on the basis of expectation
in process industries in normal conditions) and slight differences are bound to occur
between the actual output of a process and that anticipates. This difference may be
positive or negative. If it is negative it is called ad abnormal Loss and if it is positive it is
Abnormal gain i.e. if the actual loss is less than the normal loss then it is called as
abnormal gain. The value of the abnormal gain calculated in the similar manner of
abnormal loss. The formula used for abnormal gain is:
Abnormal Gain
=𝑇𝑜𝑡𝑎𝑙 𝑐𝑜𝑠𝑡 𝑖𝑛𝑐𝑢𝑟𝑟𝑒𝑑 − 𝑆𝑐𝑟𝑎𝑝 𝑣𝑎𝑙𝑢𝑒 𝑜𝑓 𝑛𝑜𝑟𝑚𝑎𝑙 𝑙𝑜𝑠𝑠
Inputs units − Normal loss units× 𝐴𝑏𝑛𝑜𝑟𝑚𝑎𝑙 𝑔𝑎𝑖𝑛 𝑢𝑛𝑖𝑡𝑠
The sales values of abnormal gain units are transferred to Normal Loss Account since
it arrive out of the savings of Normal Loss. The difference is transferred to Costing P & L
A/c. as a Real Gain.
Dr. Abnormal Gain A/c. Cr.
Particulars Units Rs. Particulars Units Rs.
To Normal Loss
A/c.
xx xx By Process A/c. xx Xx
To Costing P & L
A/c.
xx xx
xx xx xx Xx