Unit 10: Marginal Costing and Profit Planning - Subjective Questions

Marginal Costing is a costing technique in which only variable costs are charged to products or cost units, while fixed costs are treated as period costs and written off against the contribution of the period.

Meaning and key features:

• Marginal cost is the additional cost of producing one extra unit of output. It is essentially the total variable cost per unit.
• Under this technique, costs are segregated into fixed and variable components.
• Only variable costs (direct materials, direct labour, variable overheads) are considered as product costs.
• Fixed costs are treated as period costs and are charged in full against the contribution earned during the period.
• Stock valuation (closing/opening inventory) is done at variable cost only.

Formula:

This technique helps management focus on the relationship between cost, volume and profit for decision-making.

The main objectives of Marginal Costing are:

• Cost control: By separating fixed and variable costs, management can control variable costs more effectively.
• Profit planning: It helps in planning profits at different levels of activity through Cost-Volume-Profit analysis.
• Decision making: It provides useful data for decisions such as make or buy, pricing, product mix, and accepting special orders.
• Determining Break-Even Point: It helps ascertain the level of activity at which there is neither profit nor loss.
• Pricing decisions: Especially useful in fixing prices during trade depression, competitive markets and for export orders.
• Performance evaluation: Contribution helps evaluate the profitability of different products, departments or divisions.
• Simplified stock valuation: Avoids the arbitrary apportionment of fixed overheads to inventory.

Thus, marginal costing serves as an important tool for managerial planning, control and decision-making.

Contribution is the difference between sales revenue and variable (marginal) cost of sales. It represents the amount available to cover fixed costs and provide profit.

Formulae:

Derivation of the Marginal Cost Equation:

We know that:

Since Total Cost = Fixed Cost + Variable Cost:

Rearranging:

Therefore the Marginal Cost Equation is:

Where:

• = Sales
• = Variable Cost
• = Fixed Cost
• = Profit

The left-hand side is the Contribution, which is a central concept in marginal costing.

The Profit-Volume (P/V) Ratio expresses the relationship between contribution and sales. It indicates the rate at which profit is generated with an increase in sales volume.

Formulae:

Significance:

• Measures the profitability of each product or the business.
• Helps in determining the Break-Even Point and margin of safety.
• Useful for comparing profitability of different products or divisions.
• Assists in profit planning and decision-making.

Methods to improve P/V Ratio:

• Increasing selling price per unit.
• Reducing variable costs per unit.
• Changing the sales mix in favour of products with a higher P/V ratio.
• Increasing sales of high-contribution products.

A higher P/V ratio indicates greater profitability.

Cost-Volume-Profit (CVP) Analysis is a technique used to study the relationship between cost, volume of output/sales, and profit. It examines how changes in the level of activity affect costs and profits.

Objectives of CVP Analysis:

• To determine the Break-Even Point.
• To find the level of sales required to achieve a desired profit.
• To study the effect of changes in selling price, cost, and volume on profit.
• To evaluate the profitability of products and choose the best sales mix.

Importance in decision-making:

• Profit planning: Helps in setting sales targets to achieve desired profit.
• Pricing decisions: Assists in fixing selling prices under different market conditions.
• Cost control: Highlights the impact of cost variations on profit.
• Product mix decisions: Aids in selecting the most profitable combination of products.
• Budgeting and forecasting: Provides a base for preparing flexible budgets.

Key relationships analysed:

CVP analysis thus acts as a powerful planning and control tool for management.

Assumptions of CVP Analysis:

• All costs can be clearly segregated into fixed and variable components.
• Fixed costs remain constant over the relevant range of activity.
• Variable cost per unit remains constant; total variable cost varies proportionately with output.
• Selling price per unit remains unchanged at all levels of output.
• Production and sales volumes are equal (no change in inventory levels).
• The product mix remains constant in a multi-product firm.
• Efficiency and productivity remain unchanged.

Limitations of CVP Analysis:

• The segregation of costs into fixed and variable is often difficult and approximate.
• Assumption of constant selling price is unrealistic in competitive markets.
• Fixed costs remain constant only within a limited range (relevant range).
• It assumes a single product or a constant sales mix, which rarely holds true.
• Ignores other factors affecting profit such as technology, market conditions and policies.
• It is essentially a short-term tool and may not be valid for long-term decisions.

Despite these limitations, CVP analysis remains a useful managerial tool when applied within its valid range.

Break-Even Point (BEP) is the level of activity (sales) at which total revenue equals total cost, resulting in neither profit nor loss. At this point, contribution exactly equals fixed cost.

Derivation:

At break-even, Profit = 0, so from the marginal cost equation:

BEP in Units:

Since total contribution = (Number of units) × (Contribution per unit), at break-even:

Therefore:

BEP in Sales Value (₹):

Or equivalently:

At the break-even point, the firm recovers all its costs but earns no profit.

A Break-Even Chart is a graphical representation of the relationship between cost, volume and profit. It shows the break-even point and the profit or loss at various levels of activity.

Construction of a Break-Even Chart:

• The X-axis represents the volume of output/sales (in units or value).
• The Y-axis represents costs and revenues (in ₹).
• Fixed Cost line: drawn parallel to the X-axis (constant at all output levels).
• Total Cost line: starts from the fixed cost point on the Y-axis and rises with output (Fixed Cost + Variable Cost).
• Sales/Total Revenue line: starts from the origin and rises with output.
• The point where the Total Cost line intersects the Sales line is the Break-Even Point.

Information conveyed by the chart:

• The Break-Even Point in units and value.
• The Angle of Incidence (angle between sales and total cost lines) indicating the rate of profit earning.
• The Margin of Safety (distance between BEP and actual sales).
• The profit area (right of BEP) and loss area (left of BEP).
• The impact of changes in cost, volume or price on profit.

The break-even chart is a valuable visual tool for management to understand profitability at a glance.

Margin of Safety (MOS) is the excess of actual (or budgeted) sales over the break-even sales. It represents the amount of sales that can decline before the business reaches the break-even point and starts incurring losses.

Formulae:

Significance / what it indicates:

• A high margin of safety indicates a sound and financially strong business, as sales can fall considerably before a loss occurs.
• A low margin of safety indicates that even a small drop in sales could push the business into a loss.
• It reflects the soundness and risk level of the business.

Ways to improve Margin of Safety:

• Increase sales volume.
• Increase selling price.
• Reduce fixed and variable costs.
• Improve the product mix towards higher P/V ratio products.

A higher margin of safety provides greater cushion against adverse business conditions.

The key differences between Marginal Costing and Absorption Costing are as follows:

Impact on profit:

• When production exceeds sales, absorption costing shows higher profit (fixed cost carried in closing stock).
• When sales exceed production, marginal costing shows higher profit.

Both methods differ mainly in the treatment of fixed manufacturing overheads.

Given data:

• Fixed Cost = ₹1,50,000
• Selling Price per unit = ₹50
• Variable Cost per unit = ₹30
• Contribution per unit = ₹50 − ₹30 = ₹20

(a) P/V Ratio:

(b) Break-Even Point:

In units:

In value:

(c) Sales required to earn profit of ₹90,000:

In units:

The Angle of Incidence is the angle formed at the break-even point by the intersection of the total sales (revenue) line and the total cost line on a break-even chart.

Significance:

• The angle of incidence indicates the rate at which profit is being earned once the break-even point is crossed.
• A large (wide) angle of incidence indicates a high rate of profit after the break-even point, showing that the business is earning profits at a fast rate. It reflects favourable business conditions.
• A small (narrow) angle of incidence indicates a low rate of profit, meaning profits accumulate slowly and the margin between sales and cost is thin.

Combined interpretation with Margin of Safety:

• A large angle of incidence together with a high margin of safety indicates the most favourable and sound business position.
• A narrow angle signals that management should control costs or increase selling prices to improve profitability.

Thus, the angle of incidence is an important indicator of the earning capacity and profitability of a business.

Advantages of Marginal Costing:

• Simplicity: It is simple to understand and easy to operate as there is no arbitrary apportionment of fixed overheads.
• Cost control: Segregation of fixed and variable costs facilitates better cost control.
• Profit planning: Helps in profit planning through CVP analysis and break-even analysis.
• Decision-making: Provides valuable data for decisions such as pricing, make-or-buy, product mix and special orders.
• Avoids over/under absorption: No problem of over or under-absorption of overheads.
• Realistic stock valuation: Inventory is valued at variable cost, avoiding fictitious profits.
• Performance evaluation: Contribution helps assess the profitability of products and divisions.

Disadvantages / Limitations of Marginal Costing:

• Difficulty in segregation: Separating costs into fixed and variable is often difficult and inaccurate.
• Undervaluation of stock: Ignoring fixed costs in stock valuation may understate inventory value.
• Not suitable for long-term pricing: Ignores fixed costs, which are essential for long-run pricing decisions.
• Ignores time factor: Does not consider the time element in cost comparison.
• Not accepted for external reporting: Not recognised for financial statements and tax purposes.
• Fixed costs cannot be ignored: In capital-intensive industries, fixed costs form a major part and should not be overlooked.

Thus, marginal costing is a useful managerial tool but has to be used with an awareness of its limitations.

Given data:

• Selling Price per unit = ₹100
• Variable Cost per unit = ₹60
• Contribution per unit = ₹100 − ₹60 = ₹40
• Fixed Cost = ₹2,00,000
• Actual Sales = 8,000 units

(a) Total Contribution:

(b) Profit:

(c) Margin of Safety:

First, calculate Break-Even Point:

Margin of Safety in units:

Margin of Safety in value:

Margin of Safety (%):

Profit Planning is the process of determining the profit to be earned at various levels of activity and taking steps to achieve target profits. Marginal costing is a vital tool for profit planning because it clearly establishes the relationship between cost, volume and profit.

How Marginal Costing helps in Profit Planning:

• It uses contribution to measure the profitability at different sales levels.
• Helps in fixing sales targets to achieve a desired profit using:
  
• Assesses the effect of changes in selling price, cost, and volume on profit.
• Identifies the break-even point and margin of safety.

Applications of Marginal Costing in decision-making:

• Fixation of selling price: Especially under recession, competition, or for export orders.
• Make or buy decisions: Comparing marginal cost of production with purchase price.
• Product mix decisions: Selecting the most profitable combination of products based on contribution.
• Key factor / limiting factor analysis: Ranking products by contribution per unit of limiting factor.
• Accept or reject special orders: Evaluating additional contribution from extra orders.
• Shutdown or continue decisions: Deciding whether to close operations temporarily.
• Discontinuance of a product line: Based on contribution earned by each product.

By focusing on contribution, marginal costing provides a sound basis for planning profits and making effective managerial decisions.

Given data:

• P/V Ratio = 40% = 0.40
• Fixed Cost = ₹80,000

(a) Break-Even Sales:

(b) Sales required to earn a profit of ₹40,000:

(c) Profit when sales are ₹3,00,000:

Contribution = Sales × P/V Ratio:

Profit = Contribution − Fixed Cost:

This confirms the result of part (b), where sales of ₹3,00,000 yield a profit of ₹40,000.

A Key Factor (also called Limiting Factor or Principal Budget Factor) is a factor that restricts or limits the level of activity or output of a business at a particular time. Examples include shortage of raw materials, labour hours, machine hours, sales demand, or capital.

Role in decision-making:

When there is no limiting factor, decisions are based on contribution per unit. However, when a key factor exists, profitability must be judged by the contribution per unit of the key factor, not merely contribution per unit of product.

Formula:

Application:

• Products are ranked according to their contribution per unit of the limiting factor.
• The product giving the highest contribution per unit of key factor is given priority in the production plan.
• This ensures that scarce resources are used in the most profitable manner.

Example: If machine hours are the limiting factor, the product yielding the maximum contribution per machine hour should be produced first.

Thus, marginal costing, through the key factor concept, ensures optimum utilisation of limited resources to maximise total contribution and profit.

Given data:

Step 1: Calculate P/V Ratio

• Change in Profit = 80,000 − 50,000 = ₹30,000
• Change in Sales = 6,00,000 − 5,00,000 = ₹1,00,000

Step 2: Calculate Fixed Cost

Using 2022 data:

Step 3: Calculate Break-Even Point

Results:

• P/V Ratio = 30%
• Fixed Cost = ₹1,00,000
• Break-Even Point = ₹3,33,333

Distinction between Contribution and Profit:

Why contribution is more useful than profit for decision-making:

• Contribution focuses on the variable cost relationship, which is relevant for short-term decisions.
• Fixed costs are generally unavoidable in the short run, so contribution better reflects the incremental impact of decisions.
• It helps in comparing the profitability of products on a common basis.
• It is the basis for computing P/V ratio, break-even point and margin of safety.
• It aids decisions like product mix, make-or-buy, special orders, and use of limiting factors.

Hence, contribution serves as a more reliable guide than profit for managerial decision-making.

Original situation:

• Selling Price = ₹200; Variable Cost = ₹120
• Contribution per unit = ₹200 − ₹120 = ₹80
• Fixed Cost = ₹4,80,000

Original Break-Even Point:

After 10% reduction in selling price:

• New Selling Price = ₹200 − ₹20 = ₹180
• Variable Cost remains = ₹120
• New Contribution per unit = ₹180 − ₹120 = ₹60

New Break-Even Point:

Analysis and Comment:

• The reduction in selling price lowers the contribution per unit from ₹80 to ₹60.
• Consequently, the Break-Even Point rises from 6,000 units to 8,000 units, an increase of 2,000 units.
• The P/V Ratio falls from 40% to 33.33%, indicating reduced profitability per rupee of sales.
• The company must now sell 2,000 more units just to break even.

Conclusion: The price reduction should be undertaken only if the expected increase in sales volume more than compensates for the higher break-even point and lower contribution per unit. Otherwise, profitability will suffer.