MARGINAL (VARIABLE)

COSTING AND
COST-VOLUME-PROFIT
ANALYSIS
Chapter 17
 PRODUCT COSTING
There are mainly two techniques of product costing and income
determination-
Absorption Costing: This is a total cost technique under which total cost
(i.e., fixed cost as well as variable cost) is charged as production cost. In
other words, in absorption costing, all manufacturing costs are
absorbed in the cost of the products produced.

Marginal Costing: An alternative to absorption costing is marginal

costing, also known as ‘variable costing’ or direct costing. Under this
technique, only variable costs are charged as product costs and
included in inventory valuation. Fixed manufacturing costs are not allotted
to products but are considered as period costs and thus charged directly
to Profit and Loss Account of that year. Fixed costs also do not enter in
stock valuation.
 MARGINAL COSTING
CIMA London as ‘The accounting system in which variable costs are
charged to cost units and fixed costs of the period are written off in
full, against the aggregate contribution. Its special value is in decision
making’.
Characteristics of Marginal
Costing
• In marginal costing all costs are classified into fixed and
Segregation of costs into fixed
variable. Semi-variable costs are also segregated into fixed
and variable elements
and variable elements.

• Only marginal (variable) costs are charged to products

Marginal costs as products costs
produced during the period.

• Fixed costs are treated as period costs and are charged to

Fixed costs as period costs Costing Profit and Loss Account of the period in which they
are incurred.

• The work-in-progress and finished stocks are valued at

Valuation of inventory
marginal cost only.
• Contribution is the difference between sales value and
marginal cost of sales. The relative profitability of products
Contribution
or departments is based on a study of ‘contribution’ made
by each of the products or departments.
• In marginal costing, prices are based on marginal cost plus
Pricing
contribution.
• In this, profit is calculated by a two-stage approach. First
all, contribution is determined for each product or
Marginal costing and profit department which are pooled together called ‘Fund’. Then
from this fund is deducted the total fixed cost to arrive at a
profit or loss.
DISTINCTION BETWEEN ABSORPTION COSTING
AND MARGINAL COSTING
Treatment of •In marginal costing, only variable costs are charged to
products. Fixed costs are treated as period costs and
fixed and charged to Profit and Loss Account of the period. In
absorption costing, all costs (both fixed and variable)
variable costs are charged to the product.

Valuation •In marginal costing, stock of work-in-progress and finished

goods are valued at marginal cost only. In absorption
costing, stocks are valued at total cost which includes both

of stock
fixed and variable costs. Thus stock values in marginal
costs are lower than that in absorption costing.

Measuremen •In marginal costing, relative profitability of products or

departments is based on a study of relative contribution made by

t of
respective products or departments. The managerial decisions are
thus guided by contribution. In absorption costing, relative
profitability is judged by profit figures which is also a guiding
profitability factor for managerial decisions.
FORMAT OF INCOME STATEMENT
(ABSORPTION COSTING)
FORMAT OF INCOME STATEMENT (MARGINAL
COSTING)
 DIFFERENCE IN PROFIT UNDER
MARGINAL AND ABSORPTION COSTING
Profit under the two systems is different because of difference in stock
valuation.
Production is
Production is Production is
more than
equal to sales sales:
less than sales
•(i) When there are no •When production during a •When production during a
period is more than sales, period is less than sales, i.e.,
opening and closing
i.e., when closing stock is when opening stock is more
stock, profit/loss under than closing stock, profit
more than opening stock,
absorption and marginal the profit as per shown by marginal costing
costing systems are equal. absorption costing will be will be more than that shown
•(ii) When opening stock is more than that shown by by absorption costing. This
equal to closing stocks marginal costing. This is is because under absorption
then also profit/loss under because in absorption costing, cost of goods sold
the two systems will be costing a part of fixed is higher because a part of
equal provided the fixed overheads included in fixed cost from the
cost element in opening closing stock value is preceding period is added
carried forward to next to the current year’s cost of
and closing stocks is the
accounting period in the goods sold in the form of
same amount. opening stock.
form of closing stock.
COST-VOLUME-PROFIT ANALYSIS
Cost-volume-profit analysis (CVP analysis) is an extension of the principles
of marginal
costing. It studies the interrelationship of three basic factors of business
operations:
Volume of
Cost of
production/s
production
CIMA London has defined CVP analysis as, ‘the study of the effects on future

ales
profits of changes in fixed cost, variable cost, sales price, quantity and mix.’ An
understanding of CVP analysis is extremely useful to management in
budgeting and profit planning. It explains the impact of the following on the
net profit:

(a) (b)
Changes Changes
in selling in volume

Profit
prices of sales

(c) (d)
Changes Changes
in
variable in fixed
cost cost
 BREAK-EVEN ANALYSIS
Break-even analysis is a widely-used technique to study the CVP
relationship.
In its narrow sense, it is concerned with determining break-even point, i.e.,
that level of production and sales where there is no profit and no loss. At
this point total cost is equal to total sales revenue. When used in broad
sense, break-even analysis is used to determine probable profit/loss at any
given level of production/sales. It is also used to determine the amount of sales
to earn a desired amount of profit.
All costs can be separated into fixed and variable components.
Assumptions underlying Break-even
Variable cost per unit remains constant and total variable cost varies in direct
Analysis
proportion to the volume of production.

Total fixed cost remains constant.

Selling price per unit does not change as volume changes.

There is only one product or in the case of multiple products, sales mix does not
change.
There is synchronization between production and sales. In other words, volume of
production equals volume of sales.

Productivity per worker does not change.

There will be no change in the general price level.

 CONTRIBUTION AND MARGINAL COST
EQUATION
As stated earlier, contribution is the difference between sales and the marginal
(variable) cost of sales. It is also known as contribution margin (Cm) or
gross margin. Thus contribution is calculated by the following formula:
PROFIT-VOLUME RATIO (P/V RATIO)
The profit/volume ratio, better known as contribution/sales ratio
(C/S ratio), expresses the relation of contribution to sales.
METHODS OF BREAK-EVEN ANALYSIS
ALGEBRAIC METHOD (CALCULATIONS IN BREAK-
EVEN ANALYSIS)
Break-even point The break-even point is the volume of output or sales at
which total cost is exactly equal to sales. It is a point of no profit and no loss.
This is the minimum point of production at which total cost is recovered and
after this point profit begins. The fundamental formula to calculate break-even
point is:

Cash Break-even Point: When break-even point is calculated only with

those fixed costs which are payable in cash, such a break-even point is known
as cash break-even point. This means that depreciation and other non-cash
fixed costs are excluded from the fixed costs.
METHODS OF BREAK-EVEN ANALYSI S
GRAPHIC PRESENTATION OF BREAK- EVEN
ANALYSIS
Break-even Chart: Break-even chart is a graphic presentation of break-even
analysis. This chart takes its name from the fact that the point at which the
total cost line and the sales line intersect is the break-even point.
Angle of Incidence: This angle is formed by the intersection of sales line and
total cost line at the break-even point.
CONSTRUCTION
Select a scale on X-axis
OF BREAK-EVEN CHART
• The X-axis is a horizontal base line which is drawn and spaced into equal distances to represent any one or more of the following factors:
• (i) Volume of output (units)
• (ii) Volume of output (in rupee value)
• (iii) Volume of sales (units)
• (iv) Volume of sales (in rupee value)
• (v) Production capacity (in percentage)

Select scale on Y-axis

• The Y-axis is a vertical line at the extreme left of the chart which is spaced into equal distances. On
this Y-axis, it is usual to show cost and sales in rupee value.

Draw the fixed cost line

• This is drawn parallel to X-axis, starting from an appropriate point on Y-axis.

Draw the total cost line

• The variable cost is depicted in the chart by super-imposing it on the fixed cost line. Thus a total cost
line is drawn starting from the point on the Y-axis which represents fixed cost.

Drawn the sales line

• This line starts from the 0 point at the left (the intersection of X-axis and Y-axis, where there is no
production at a nil cost) and extends to the point of maximum or any other sales value.
 PROFIT- VOLUME CHART
The profit-volume chart or profit graph portrays the profit and loss at
different levels of sales and is an alternative presentation of the facts
illustrated in the break-even chart. Such a chart can be constructed from the
same basic data from which a break-even chart can be drawn.

Construction of Profit-Volume Chart

1. •Select a scale on horizontal axis The horizontal axis in the profit-volume graph represents sales. This horizontal line, known as sales line, divides the graph into two parts.

2. •Select a scale on vertical axis The vertical axis shows fixed cost and profit. The fixed costs are market below the sales line on the left hand vertical line and profit is shown above the sales line on the right hand vertical line.

3. •Plot fixed cost and profit Points are plotted for the given fixed cost and profit. These points are connected by a diagonal line which crosses the sales line at break-even point.