Notes: UNIT – 2

UNIT - 2

Objective:
To enable the students to analyze and understand cost dynamics with the help of various cost analyses and their implementation in future decision making.

UNIT OVERVIEW

Topics covered: Marginal Costing: Cost, Volume analysis Profit analysis, P/v ratio: analysis and implications, Concept and uses of Contribution, Break-even point and its analysis for the various types of decision-making, Single Product Pricing, Multi Product Pricing, Replacement, sales analysis. Differential costing and Incremental costing: (concepts), Uses and applications of differential costing. Method of calculation of above cost concept and its role in management decision making.

MARGINAL COSTING
INTRODUCTION

Marginal cost means same things as variable cost. Economists define marginal cost as the additional cost of producing one additional unit. This shall include fixed cost and variable cost while for the purpose of accounting Marginal Costing does not include fixed cost. The education of marginal cost is as follows.

Marginal Cost = Prime cost + Total Variable over heads
Marginal Cost = Total cost – Fixed cost

ICWA has defined Marginal Costing as – “The ascertainment by differentiating between fixed cost and variable cost of Marginal Costing and of the effect of the change in the volume type of output.”

According to Batty.

“A technique of cost accounting, Which pays special attention to the behaviour of the cost with the changes in the volume of output.”

COMPARISON BETWEEN MARGINAL COSTING AND
ABSORPTION COSTING / FULL COSTING

Absorption cost is a practice of charging all costs both fixed and variable to the operations process and products while Marginal Costing, only variable cost are charged to the production.
Absorption Costing also known as full costing and includes all type of cost, overheads, setting & distribution charges and other factory burden.
The major difference between Marginal Costing & absorption costing is that absorption costing does not reveal the cost volume profit relationship.
While Marginal Costing shows cost volume profit relationship. which is an important tool for decision – making by managers.

ADVANTAGES OF MARGINAL COSTING

1. To decide how much to produce
With the help of marginal costing we can decide the optimum output for a running concern the organisation can calculate the local of production at which it will achieve its break even and above that output level it will earn profits. The organisation can also decide the level of output for a particular amount of profits. Thus marginal costing can help the organisation to maximize the profits and also to plan the profit for future.

2. To decide what to produce
With the help of marginal costing a company can decide the optimum makes of the product. Any company which is dealing in more than one product can divide the quantity of different products to be manufactured by existing facilities. The relative profitability will be a guiding factor for the organisation to decide what to produce.

3. To decide whether to produce
There decisions are concerned with make or buy decisions by company marginal cost of producing of a product with the out sourcing cost the organisation can take such decision effectively.
4. To decide how to produce
When a product can be manufactured by more than one method, with the help of marginal cost of each method the most effective and efficient method can be decided by the organisation. Such decisions can also be taken for those products which can be manufactured manually or by the help of machines.

5. To decide when to produce
By examining the marginal cost structure at different periods of time the organisation can decide when a product can be manufactured most effectively and efficiently.

6. To decide at what cost to produce
With the help or marginal costing the organisation can decide at what cost the product must be manufactured. This decision is important for those organizations which are dealing in many products with different profitability and manufacturing in more than one plant having different levels of efficiency. The organisation can decide which product should be manufactured in which plant so as to achieve desired level of cost. Other decisions of such nature can be-

(a) How to control the cost against set standards.
(b) How to inventory should be valued.
(c) The plant should be owned by the company or it must be taking on lease.

DISADVANTAGES OF MARGINAL COSTING

1. No Consideration for fixed cost
The Quality decisions can only be taken when all types of cost are considered for valuation of production cost as Marginal costing does not take fixed cost separately for the purpose of analysis. The Quality decision can not be taken with out taken the fixed cost.

2. Classification in to fixed and variable cost is a difficult take
In case of semi-variable and semi-fixed cost it is difficult to deride whether there cost should be taken fixed or variable cost because such cost are partly fixed and partly variable.
COST VOLUME PROFIT ANALYSIS (CVP)
CVP analysis includes three variables namely-

1- Cost, 2- Volume 3- Profit

In this analysis, an attempt is made is to measure the variations of the cost and profit with volume. It helps the management in profit planning. How to maximize the profit is the general concern for the organisation. By defining the relationship between the cost and volume the profit planning for future can be possible and can guide the organisation to achieve its profit maximization objective.
In the profit planning, CVP analysis provides information about the following matters.
1- Behaviour of cost in relation to volume.
2- The volume of production or sales where the business will achieve its break-
even point.
3- Sensitivity of profit due to variations of output.
4- Amount of profit for the projected sales volume.
5- Quantity of production & sales for a target profit level.

To know the CVP relationship the study of the following concepts is necessary-
1. Contribution – Contribution is the difference between sales and marginal cost of sales. It is necessary to know the contribution for the ascertainment or break-even point, PV ratio and margin of safety.
C = Sales – Marginal Cost
C= S –VC
This equation is also known as marginal cost equation and can be used for further analysis.
C= F.C + Profit. (л)



2. Break – Even Analysis – It is a tool of financial analysis where by the impact on profit of the changes in the volume, price, cost and mix can be estimated with accuracy. Break even point is a balancing point of no profit loss. In other words, it is the point where total sales are equal to total cost.
BEP à Sales = F.C + V.C
BEP = Sales x Quantity sold = F.C + V.C x Q
Sales x Q – VC x Q = FC
Q (Sales – VC) = FC
Q x C = FC
BEP =FC
Q x C or contribution per unit













- If the price of the product is reduced in the market then in order to achieve the same BEP? Have to produce more.
- If the market of product is increase in the market then in order to achieve the same BEP. We can reduce our production.

3. Profit volume ratio – PV ration is also knows as contribution sales ratio and expresses the relationship of the contribution to the sales. It is generally expressed as the percentage and indicates the relative profitability of different products.


The management can emphasize upon maximization of profits by the help of PV ratio, which can indicate. What should be done-
1- Whether to increase Sales price.
2- Whether to decrease variable cost.
3- or to produce those products which are having higher PV. ratio.


Margin of safety
Margin of safety is the excess of normal or actual sales over Break even point. The margin of safety refers to the amount by which the sales or revenues can fall before a loss is incurred. High margin of safety indicates the soundness of the business because even with Substantial fall in the sales. Some profit shall be made while small margin of safety is the indicator of weak position of the business and even a small reduction in the sale or production adversely affect the profit position of the business.













APPLICATIONS OF MARGINAL COSTING TECHNIQUES
1-Cost Control
2-Fixation of selling price.
3-Closure of department or discontinuing the product.
4-Selection of a profitable product mix.
5- Profit planning.
6-Decision to make or buy.
7-Decision to accept a bulk order.
8-Introduction of a new product.
9-Choice of a technique.
10-Evaluation of performance.
11-Decision – making.
12-Maintaining a desired level of profit.
13-Level of activity planning.
14-Alternative methods of production.
15-Introduction of product line.

1. Cost Control
It is one of the major concerned for the organisation in this era of competition. There are 2 types of cost variable cost and fixed cost. Fixed cost being the non controllable cost are not considered by marginal costing while variable cost are controllable in nature and controlled by operational level management the main emphasis of cost control in on controlling variable cost because these can be of the organisations.
Here the marginal costing provides a frame work to the operational managers to control the cost by the help of various analysis and controlling techniques.


2. Fixation of selling price

The selling price must be fixed above the total cost of a particulars product any organisation knowin its fixed cost and profits (expected profit) can deside the selling price of its products. (the organisation needs to consider both internal and external factors before desiding the sales price.


3. Closure of Department
Marginal costing techniques can be used to decide about discontinuing of product or closure of a department the above example shows that to deride about discontinuing a product the organisation should evaluate the contribution of each product and total contribution before and after discontinuing a specific product. Fixed cost being uncontrollable in nature will not change even after discontinuing a product. If the organisation discontinue product c. as it is giving 5000 Rs net loss the organisation total profit will decline from 1,000 Rs. Profit to 4,000 Rs loss. If the organisation discontinues product A. its net profit are increasing from Rs. 1,000 to profit to Rs. 2000 profit.

In other words, we can say if the organisation discontinues product c. it earns Rs. 11,000 as total contribution for covering its fixed cost while If organisation discontinues product A. it has 17,000 total contribution to cover its fixed cost and earning reasonable amount of profit (fixed cost is Rs. 15,000 and will not change with discontinuing any product.


4. Selection of a profitable product mix
Sometimes an organisation is involved in manufacturing and distributing more than one product, the management has to deride about the product mix or sales mix which can maximize the profits for the organisation marginal cost can provide a strong basis for such decision by calculating total contribution of each alternative product mix.
The above example shows the organisation should choose 3rd product mix of 2000 of product A and 1000 units of product B. The decision is taking on the basis of total contribution of all available alternatives, which are 15,000 for alternative First Rs. 16500 for alternative Second and Rs. 18000 for alternative three. Thus the alternative with maximum contribution which will result in maximum profit should be chosen as must profitable product mix.
5. Profit Planning
Profit planning is one of the most important decision and should be done Keeping in mind the cost structure of different products of the organisation. If an organisation is knowing the contribution of its product it can planned for the profits from a particular level of sales and similarly it can plan for sales for a particular level of profits.


6. Decision to make or Buy

It may be happened that the organisation is producing a product which is a combination of many parts or sub parts. The organisation can produce all sub components or if possible it can purchase there sub components from other organizations. If it finds cost saving. When it buy the finished sub components Sub decisions are called make or buy component.
Eg. – A radio manufacturing company finds that a component cost Rs. 6.25 when it manufactures it inside the plant where as the same component is available at Rs. 5.50 from outside the company suggest the organisation buy or manufacture the product. If the cost structure of manufacture that product is as follows-
7. Decision to accept a bulk order

Large Scale purchasers may demand the product at lower cost than the market price – a decision has to be taken by the organisation whether to accept lower cost order or not. Such decisions can be taken by compairing the profit situation before and after accepting the large scale order.
Eg. – A company is running at 50% of its capacity and manufacturing 20,000 units of products A the cost structure of the product is as follows –
S.P. -Rs. 7
Material cost -Rs. 2/ unit
Labour -Rs. 1/ unit
Variable over heads -Rs. 3/ unit
F.C. - Rs. 40,000

Suggest the organisation whether it should accept a bulk order of 5000 units at Rs. 6.50/unit
8. Introduction of a new product

It is a crucial decision and must be taken keeping in mind both internal and external factors. As for as internal factors are concerned it includes market demand taste? Preferences of customers and customer response to the product while among the external factor the cost of product is major contributor for deciding which product should be produced.
Among the internal factors the cost of resources manufacturing a particular product is taken in to account for making & effective relation to be launched in the market.
In other words the organisation should choose those products, which gives the maximum contribution towards the fixed cost and Profits to the organisation.

9-Choice of a technique

The main concern of manufacturing organisation is to achieve efficiency in operations and every management wishes to manufactures the product in the most economical way for this marginal costing is a good technique to decide about the most effective and efficient technique to manufacture a particular product for this purpose cost statements are paired for each technique which can be used for production by comparing different techniques, Cost and the contribution in all cases the technique giving the maximum contribution can be selected to maximize the profits of the organisation.

10. Evaluation of performance

Marginal costing help the management in measuring the performance efficiencies of a department or a product. The department or a product which gives highest PV ratio will be most profitable department or product for the organisation.

11. Decision–making

Marginal costing acts as a prize-fixed and high margins will contribute to the fixed cost and profit. Prices can be fixed above the total variable cost keeping in mind the contribution necessary to off-set fixed cost and to earn reasonable amount of profit. If the organisation set its prices according to its variable cost and desired level of profit, there is a loss of fixed cost. Some times the business has to face such problems due to high compitition, perishable nature of the goods, fear or future market. Strategies of competitors the change in the taste & preferences of the customer.

12. Maintaining a desired level of profit

By fluctuating the sales price of its product on account of competition, Government regulation and other compailling reasons the organisation can maintain a particular level of profits. The profits can be maintain either by decreasing the price for increase in sales or by increasing the sales prices to restrict to a particular segment.


13. Level of activity planning

It is concerned with optimum utilization of available resources. Sometime in many organisation some resources are left idle or in other words the organisation is not using its fall capacity it is always important to achieve optimum level of activities in order to maximize the profit of organisation different levels of activities have different rate of return.
Thus an organisation should utilize its capacity up to the point where it gets the positive rate of return.

14. Alternative method of production

Also used in comparing the alternative methods use for manufacturing e.g. Machine work V/S Hand work, which machine should be used instead of other etc. The cost structure may vary from one alternative to another thus the organsation keeping in mind the demand of the market should adopt those alternative which are most efficient in terms of cost.

v Other Numerical Problems.

Reference:

v Management Accounting by M Y Khan and P K Jain.
v Management Accounting by R S N Pillai and Bagavathi.
v Accounting for Managers by O S Gupta and Pankaj Kothari.