Marginal (Variable) Costing and Cost-Volume-Profit Analysis PDF

# Marginal (Variable) Costing and Cost-Volume-Profit Analysis ## Introduction There are mainly two techniques of product costing and income determination: - Absorption costing - Marginal costing. ## Absorption Costing - Absorption costing is a total cost technique where total cost (fixed and v...

# Marginal (Variable) Costing and Cost-Volume-Profit Analysis ## Introduction There are mainly two techniques of product costing and income determination: - Absorption costing - Marginal costing. ## Absorption Costing - Absorption costing is a total cost technique where total cost (fixed and variable) is charged as production cost. - Absorbs all manufacturing costs in the cost of products produced. - Fixed factory overheads are absorbed based on predetermined overhead rates, based on normal capacity. - Under or over absorbed overheads are adjusted before computing profit for a period. - Closing stock is valued at total cost (including direct costs and fixed factory overheads). - Absorption costing is a traditional approach and is also known as Conventional Costing or Full Costing. ## Marginal Costing - An alternative to absorption costing is marginal costing, also known as variable costing or direct costing. - Only variable costs are charged as product costs and included in inventory valuation. - Fixed costs are treated as period costs and are charged to Profit and Loss Account. - Does not consider fixed costs in inventory valuation. - Also known as Variable Costing. **Meaning of Marginal Cost** Marginal cost is the additional cost of producing one more unit of product. - It is the total of variable costs (direct costs and variable overheads). - It represents the cost of one unit that would be avoided if that unit were not produced. - Marginal cost per unit remains unchanged, irrespective of the level of activity. **Characteristics of Marginal Costing** - **Segregation of costs:** All costs are classified as fixed or variable. - **Marginal costs as product costs:** Only variable costs are charged to products. - **Fixed costs as period costs:** Fixed costs are treated as period costs. - **Valuation of inventory:** Work-in-progress and finished stocks are valued at marginal cost. - **Contribution:** Contribution is the difference between sales value and marginal cost of sales. - **Pricing:** Prices are based on marginal cost plus contribution. - **Profit:** Profit is calculated by first determining contribution for each product or department and then deducting total fixed costs. ## Distinction Between Absorption Costing and Marginal Costing - **Treatment of fixed and variable costs:** Marginal costing treats only variable costs as product costs, while absorption costing treats both variable and fixed costs as product costs. - **Valuation of stock:** Marginal costing values stock at marginal cost, absorption costing values stock at total cost. ## Income Determination under Marginal Costing and Absorption Costing The income statement in absorption costing includes fixed costs in the cost of goods sold, while in marginal costing, fixed costs are shown separately. ## Profit Determination under Marginal Costing and Absorption Costing The profit calculated under the two systems may be the same or different. - This difference is due to the different basis of stock valuation. - Absorption costing values stock at total cost while marginal costing values stock at variable cost. ## Measurement of Profitability Marginal costing measures profitability by measuring contribution per unit of product or department. - This approach helps in making management decisions based on contribution. - Absorption costing measures profitability by using profit as a basis. ## Advantages of Marginal Costing - Assists in managerial decisions. - Helps in cost control. - Simple technique. - Avoids under and over absorption of overheads - Constant cost per unit - Realistic valuation of stocks. - Aid to profit planning. - A valuable adjunct to other cost accounting methods. ## Disadvantages of Marginal Costing - Difficult analysis. - Ignores the time factor. - Difficult in application. - Less effective in capital-intensive industries. - Improper basis of pricing. ## Cost-Volume-Profit Analysis - CVP analysis is an extention of marginal costing that studies the interrelationship between cost, the volume of production/sales and profit. - Helps decision making in areas such as selling prices, volume of production, and budgeting. **Assumptions Underlying Break-Even Analysis** - All costs can be classifiedas fixed or variable. - Variable cost per unit remains constant and total variable cost varies directly with production volume. - Selling price per unit is constant. - The sales mix stays the same. - Production is synchronized with sales. - Productivity per worker is constant. - There is no general price level change. ## Break-Even Analysis Break-even analysis is used to determine : - break-even point (where total cost equals total revenue) - Profit or loss at different production/sales levels. **Methods of Break-Even Analysis** - **Algebraic Method:** Total fixed cost is divided by contribution per unit. - **Graphical Method:** Plots total cost and sales revenue line, the point of intersection is the break-even point. ## Contribution and Marginal Cost Equation Contribution is calculated as : - the difference between sales and variable costs - the difference between total fixed costs and profit. ### Uses of P/V Ratio - Calculation of the break-even point - Profit at a given sales volume. - Sales levels required to achieve a desired profit. - Profit when margin of safety is known. - Sales volume needed to maintain the present profit level if the selling price is reduced. ### Improvement in P/V ratio - Increase selling price - Reduce variable cost - Change sales mix ### Methods of Break-Even Analysis - **Algebraic Methods** - **Graphic Presentations** ### Margin of Safety The margin of safety is the difference between actual sales and the break-even point. - Can be expressed in absolute money terms or a percentage of sales. - Shows how much sales can decline before losses occur. ### Cash Break-Even Point - Only considers fixed costs that are payable in cash. - Excludes depreciation and other non-cash expenses. - Useful for short-term analysis. ### Limiting or Key Factor - Limiting factor is a constraint that restricts production output. - Determining the contribution per unit of the limiting factor helps to choose the most profitable course of action. ### Cost Indifference Point - The cost indifference point is the output level where two production methods or machines have the same total cost or profit. - Helps decision making when two or more production methods or machines are available with different fixed and variable costs. ## Summary of Formulae and Abbreviations - Contribution - Contribution/Sales ratio or Profit/Volume Ratio - Break-even point - Cost indifference point - Margin of safety - Break-even sales - Profit - Fixed cost ## Problems and Solutions A variety of problems with solutions related to Marginal Costing and Break-Even Analysis are covered. ## Examination Questions True/False Statements, Fill in the Blanks, Multiple Choice Questions, Practical Questions.