Unit 2: Marginal Costing and CVP Analysis - Subjective Questions

Marginal costing is a costing technique in which only variable costs are charged to products, operations, or processes. Fixed costs are treated as period costs and are written off in full against the contribution earned during the period.

The basic marginal costing equation is:

and:

Main features:

• Costs are classified into fixed costs and variable costs.
• Product cost includes only variable production costs.
• Fixed costs are not included in inventory valuation.
• The difference between sales and variable cost is called contribution.
• Profit is determined after deducting fixed costs from contribution.
• The technique is primarily used for planning, control, and managerial decision making.

Nature of marginal costing:

• It is a costing technique, not an independent method of costing.
• It separates costs according to their behavior into fixed and variable components.
• It focuses on the effect of changes in output or sales on total contribution and profit.
• It treats fixed cost as a period cost because it generally remains unchanged within the relevant range.
• It uses contribution as the main basis for evaluating alternatives.

Importance:

• Helps determine the break-even point and margin of safety.
• Supports profit planning by estimating the sales required for a target profit.
• Assists in make or buy, product mix, special order, and shutdown decisions.
• Helps compare products using contribution and the P/V ratio.
• Supports pricing decisions, particularly when spare capacity exists.
• Enables management to identify the effect of changes in selling price, variable cost, fixed cost, or sales volume.

Marginal costing is especially useful for short-term decisions where fixed costs remain unchanged.

Marginal costing and absorption costing differ in the treatment of fixed production overheads.

When production exceeds sales, absorption costing profit is usually higher because part of the fixed production overhead is carried forward in closing inventory. When sales exceed production, marginal costing profit may be higher because previously deferred fixed overhead is released under absorption costing.

The fundamental marginal costing equation is:

Since contribution first covers fixed cost and the balance represents profit:

Therefore:

Profit can be calculated as:

If contribution per unit is known:

Example: If sales are $500,000, variable cost is $300,000, and fixed cost is $120,000:

Thus, the organization earns a profit of $80,000.

Contribution margin is the excess of sales revenue over variable cost. It represents the amount available to recover fixed costs and generate profit.

It may be calculated as follows:

It can also be expressed as:

Significance of contribution:

• Measures how much each product contributes toward fixed cost and profit.
• Helps calculate the break-even point and target sales.
• Provides a basis for comparing products and selecting a profitable product mix.
• Supports make or buy, special order, and pricing decisions.
• Helps evaluate whether a product should be continued or discontinued.
• Indicates the effect of changes in sales volume on profit.

A product with a higher contribution is generally preferable when no limiting factor exists.

The Profit/Volume Ratio, also called the P/V ratio or contribution-to-sales ratio, expresses contribution as a percentage of sales.

It may also be calculated from changes in profit and sales:

provided fixed cost remains constant.

Interpretation:

• A high P/V ratio indicates a high contribution relative to sales and generally greater profitability.
• A low P/V ratio indicates that a large proportion of sales is consumed by variable costs.
• The ratio helps compare the relative profitability of products, departments, or periods.
• It is used to calculate break-even sales, target sales, and margin of safety.

The P/V ratio can be improved by increasing the selling price, reducing variable cost, or shifting sales toward products with higher contribution ratios.

At the break-even point, total revenue equals total cost and profit is zero.

Let:

• = selling price per unit
• = variable cost per unit
• = units sold
• = total fixed cost

At break-even:

Rearranging:

Since is contribution per unit:

The break-even point in sales value is:

When the P/V ratio is expressed as a percentage:

Managerial significance:

• Identifies the minimum sales required to avoid loss.
• Helps assess business risk and operating feasibility.
• Supports pricing, capacity, and cost-control decisions.
• Provides a benchmark for profit planning.
• Allows management to evaluate the impact of changes in fixed cost, variable cost, or selling price.

The margin of safety is the excess of actual or budgeted sales over break-even sales. It shows how much sales can decline before the organization begins to incur a loss.

The margin of safety ratio is:

It can also be calculated using profit and the P/V ratio:

Importance:

• A high margin of safety indicates lower operating risk.
• A low margin of safety means that even a small fall in sales may result in a loss.
• It helps management assess the stability of current profits.
• It supports decisions relating to cost reduction, pricing, and sales promotion.
• It allows comparison of risk across products, divisions, or periods.

The margin of safety can be improved by increasing sales, improving contribution, reducing fixed costs, or changing the product mix.

The concepts are linked through the marginal costing framework.

First:

Contribution is used to recover fixed cost. Any excess contribution becomes profit:

At the break-even point:

Therefore, profit is zero. Below the break-even point, contribution is less than fixed cost and the organization incurs a loss. Above the break-even point, contribution exceeds fixed cost and profit is earned.

The excess of actual sales over break-even sales is the margin of safety:

Profit earned from this excess sales can be expressed as:

Thus, contribution measures earning capacity, break-even point marks the no-profit-no-loss position, and margin of safety indicates the extent of operating risk.

Major assumptions of CVP analysis:

• Selling price per unit remains constant.
• Variable cost per unit remains constant.
• Total fixed cost remains constant within the relevant range.
• Costs can be accurately divided into fixed and variable components.
• Production volume is the main factor affecting costs and revenue.
• In a multi-product organization, the sales mix remains constant.
• Production is assumed to equal sales, or inventory changes are insignificant.
• Efficiency, productivity, and production methods remain unchanged.

Limitations:

• Cost and revenue relationships may not remain linear in practice.
• Fixed costs may change when capacity levels change.
• Variable costs may change because of discounts, inflation, or efficiency gains.
• A constant sales mix is difficult to maintain.
• Accurate separation of semi-variable costs can be challenging.
• CVP analysis ignores qualitative and strategic factors.
• It is mainly suitable for short-term planning within a relevant activity range.

Therefore, CVP results should be interpreted as estimates rather than exact predictions.

Step 1: Calculate contribution per unit

Step 2: Calculate the break-even point in units

Step 3: Calculate break-even sales value

Step 4: Calculate units required for target profit

Step 5: Calculate required sales value

Therefore, the break-even point is 10,000 units or $800,000, and sales of 15,000 units or $1,200,000 are required to earn the target profit.

Marginal costing evaluates a price change by comparing its effect on unit contribution, sales volume, total contribution, and profit.

If the selling price is reduced:

• Contribution per unit and the P/V ratio generally decrease.
• More units must be sold to cover fixed costs.
• The break-even point increases unless additional volume compensates for the lower contribution.

The revised contribution is:

The sales volume required to maintain existing profit is:

Management should accept a price reduction only when the expected increase in total contribution exceeds any reduction in contribution on existing sales and any additional fixed cost.

The analysis should also consider customer response, competitor reaction, product positioning, capacity, demand elasticity, and the long-term effect on market prices.

A make or buy decision determines whether a component should be manufactured internally or purchased from an external supplier.

Under marginal costing, the relevant cost of making includes:

• Direct materials
• Direct labor, if avoidable
• Variable production overhead
• Avoidable fixed costs
• Opportunity cost of facilities used

The relevant cost of buying includes:

• Supplier's purchase price
• Transportation and inspection costs
• Additional purchasing costs
• Any other incremental costs

Unavoidable fixed costs are excluded because they will continue under either alternative.

The decision rule is:

• Make when the relevant cost of making is lower than the relevant cost of buying.
• Buy when the relevant cost of buying is lower than the relevant cost of making.

Qualitative factors:

• Supplier reliability and financial stability
• Quality of purchased components
• Delivery schedules and supply continuity
• Confidentiality of designs and processes
• Employee relations and possible layoffs
• Dependence on an outside supplier
• Alternative use of released capacity
• Long-term strategic importance of internal capability

The final decision should combine relevant cost analysis with these non-financial considerations.

Allocated fixed cost should not automatically be included in the decision. Only avoidable costs are relevant.

Relevant cost of making per unit:

Relevant cost of buying per unit:

Difference:

The remaining fixed cost of $5 per unit is unavoidable:

It will be incurred whether the company makes or buys the component and is therefore irrelevant to the decision.

The company should continue making the component because making saves $1 per unit. However, if the released capacity from buying can generate an opportunity contribution greater than $1 per component, buying may become preferable. Quality, delivery reliability, and strategic dependence on the supplier should also be considered.

A product mix decision involves determining the combination of products that should be produced and sold to maximize total profit.

When no production resource is scarce, products are normally ranked according to their contribution per unit:

A product with a higher contribution per unit adds more toward fixed cost and profit for every unit sold. Therefore, subject to market demand and production capacity, management should emphasize products with higher contribution.

The decision process is:

• Calculate the contribution per unit of each product.
• Estimate the demand for each product.
• Determine whether adequate capacity exists to satisfy demand.
• Prefer products with higher positive contribution where capacity is freely available.
• Calculate total contribution from the proposed mix.
• Deduct common fixed costs to determine expected profit.

Fixed costs that do not change with the product mix are irrelevant to the short-term ranking. Product-specific avoidable fixed costs, demand constraints, and strategic considerations must nevertheless be considered.

A limiting factor, or key factor, is a scarce resource that restricts production or sales. Examples include machine hours, labor hours, raw materials, floor space, and market demand.

When a limiting factor exists, products should not be ranked merely by contribution per unit. They should be ranked by contribution per unit of the scarce resource:

Procedure:

• Identify the limiting factor.
• Calculate contribution per unit for each product.
• Determine the quantity of the limiting factor required per unit.
• Calculate contribution per unit of the limiting factor.
• Rank products from highest to lowest contribution per scarce resource unit.
• Allocate the scarce resource according to the ranking, subject to maximum demand.
• Compute total contribution and deduct fixed costs to determine profit.

This approach maximizes total contribution from the scarce resource. If several constraints exist simultaneously, a more advanced technique such as linear programming may be required.

Since machine hours are limited, products must be ranked according to contribution per machine hour.

Product A:

Product B:

Although Product A earns a higher contribution per unit, Product B earns a higher contribution from each scarce machine hour.

The ranking is therefore:

1. Product B: $15 per machine hour
2. Product A: $10 per machine hour

Product B should receive priority up to its maximum sales demand. Any remaining machine hours should then be allocated to Product A.

The decision demonstrates why contribution per unit is not a suitable ranking measure when a limiting factor exists. The objective is to maximize total contribution from the scarce resource, not merely contribution from each finished unit.

A special order is usually evaluated by comparing its incremental revenue with its incremental or relevant cost.

If spare capacity exists and normal sales are unaffected, the minimum short-term price is generally the incremental cost of the order. The order is financially acceptable when:

or when:

Relevant costs may include:

• Variable manufacturing cost
• Special packaging or design cost
• Additional delivery and selling expenses
• Additional fixed costs caused by the order

If capacity is fully utilized, accepting the order may displace regular sales. The contribution lost from displaced sales is an opportunity cost and must be included:

Management should also consider whether the special price may affect regular customers, market pricing, product quality, brand position, or future negotiations. Therefore, positive contribution alone does not always justify acceptance.

A shutdown decision considers whether operations should be temporarily suspended when demand or profitability is low.

Operations should generally continue when the contribution earned is greater than the avoidable fixed costs of continuing. The relevant comparison is:

If operations are shut down, some fixed costs may continue, while additional shutdown and restart costs may arise. Therefore:

• Continue when the loss from operating is lower than the loss from shutting down.
• Shut down when the fixed costs saved and losses avoided exceed the contribution sacrificed and shutdown-related costs.

Relevant factors include:

• Fixed costs that can be avoided during shutdown
• Unavoidable fixed costs
• Shutdown and restart costs
• Contribution lost during closure
• Maintenance and security costs
• Loss of skilled employees
• Customer relationships and market share
• Expected duration of adverse conditions

Marginal costing provides the quantitative basis, but long-term commercial consequences must also influence the decision.

Principal applications of marginal costing include:

• Profit planning: Calculates the sales volume required for break-even or target profit.
• Make or buy decisions: Compares relevant internal manufacturing costs with external purchase costs.
• Product mix decisions: Allocates scarce resources to products generating the highest contribution per limiting factor.
• Special order decisions: Determines whether incremental revenue exceeds incremental cost.
• Pricing decisions: Establishes short-term minimum prices and evaluates the effect of price changes.
• Shutdown decisions: Compares the cost of continuing operations with the cost of temporary closure.
• Product discontinuation: Evaluates contribution lost against avoidable fixed costs saved.
• Choice of production method: Compares contribution and relevant costs under alternative methods.
• Sales channel selection: Compares incremental contribution from alternative markets or channels.

Marginal costing should not be used in isolation because it is based mainly on short-term financial information. It may ignore quality, employee morale, supplier reliability, customer relationships, legal obligations, environmental effects, strategic capability, and long-term fixed-cost recovery. Its assumptions regarding constant prices, costs, and sales mix may also be unrealistic. Management should therefore combine marginal costing results with qualitative, strategic, and risk analysis.