Marginal Costing 1

Two Approaches to Compute Profits Conventional income statement Contribution margin income statement 2

Conventional Income Statement Sales – Cost of Goods Sold = Gross Margin – Operating Expenses = Net Income Gross Margin 3

What is Marginal costing? One additional unit of production is known as marginal unit Change in total cost on account of adding/ subtracting one additional unit is known as marginal cost. This one unit may be a product, a batch, a order, a process or even a department 4

Let’s understand it better!! Since fixed cost remains constant for any variation in the volume of production up to total capacity, Marginal cost tends to be equal to the total of all variable expenses. Hence Marginal cost also described as variable cost Marginal cost =Prime cost + all variable overheads 5

Contribution Margin Income Statement Sales – Variable Expenses = Contribution Margin – Fixed Expenses = Net Income Contribution Margin 6

What is BREAK EVEN POINT? The sales volume which equates total revenue with related costs and results in neither profit nor loss is called “BREAK EVEN POINT OR BREAK EVEN VOLUME” At BEP, PROFIT = 0 7

If S= Selling price per unit TC= Total cost V= Variable cost per unit F= Fixed cost Q=units produced Then, TC=VQ+F V=TC-F Q At Break even Point, Profit=0 SQ-VQ=F Q=F/(S-V) 8

What is Contribution? Contribution is excess of sales over variable cost It is quite different from profit It first goes to meet fixed expenses and then contributes to profit. C=S-VC C=F+ Profit Therefore S-VC=F+ profit 9

SOME MORE EQUATIONS  S-VC= Contribution = F+PROFIT  VC=S-C  F=C-PROFIT  PROFIT=C-F In vertical form Sale - variable cost Contribution - Fixed cost Profit 10

Contribution Margin Example Tom and Jerry manufacture a device that allows users to take a closer look at icebergs from a ship. The usual price for the device is Rs.100. Variable costs are Rs.70. They receive a proposal from a company in Vashi to sell 20,000 units at a price of Rs

Contribution Margin Example There is sufficient capacity to produce the order. How do we analyze this situation? Rs.85 – Rs.70 = RS.15 contribution margin. RS.15 × 20,000 units = RS.300,000 (total increase in contribution margin) 12

Assume that fixed expenses amount to RS.90,000. How many devices must be sold at the regular price of Rs.100 to break even? (RS.100 × Units sold) – (Rs.70 × Units sold) – Rs.90,000 = 0 Units sold = Rs.90,000 ÷ Rs.30 = 3,000 13

Per Unit Percent Ratio Sales priceRS Variable expenses Contribution marginRS

Change in Sales Price- Example Suppose that the sales price per device is Rs.106 rather than Rs.100. What is the revised breakeven sales in units? New contribution margin: RS.106 – Rs.70 = Rs.36 Rs.90,000 ÷ Rs.36 = 2,500 units 15

Change in Variable Costs- Example  Suppose that variable expenses per device are Rs.75 instead of Rs.70  Other factors remain unchanged.  What is the revised breakeven sales in units and in Rs.?  Rs.90,000 ÷ Rs.25 = 3,600  Rs.90,000 ÷ 0.25 = RS.360,000 16

Change in Fixed Costs- Example Suppose that rental costs increased by RS.30,000. What are the new fixed costs? RS.90,000 + Rs.30,000 = Rs.120,000 What is the new breakeven point? Rs.120,000 ÷ Rs.30 = 4,000 units Rs.120,000 ÷ 0.30 = Rs.400,000 17

Cost-Volume-Profit Analysis Breakeven point Fixed cost Variable cost Total cost 18

 BEP (units) = Fixed cost / Contribution per unit  BEP( Rs.)= Fixed cost/ P/V Ratio  P/V Ratio= contribution per unit/selling price per unit = s - v /s  Variable cost to Volume ratio (V/V ratio) =1 – P/V ratio  P/V ratio+ V/V ratio =1 or 100 % 19

Important conclusions  If C=0 then loss=F  If C = - ve then loss >F  If C>F, there will be profit = C-F  If C<F, there will be loss = F-C  If C=F, no profit no loss i.e. Break even point 20

Margin of safety The excess of the actual sales revenue over the break even sales revenue is known as the Margin of safety. MOS= ASR-BESR M/S Ratio= (ASR-BESR)/ASR Where ASR= Actual sales revenue BESR= Break even sales revenue Profit= MOS * P/V Ratio Profit = MOS (units) * Contribution margin per unit 21

Margin of safety is the excess of expected sales over breakeven sales. Assume Tom and Jerry’s breakeven point is 3,000 devices. Suppose they expect to sell 4,000 during the period. What is the margin of safety? 22

4,000 – 3,000 = 1,000 units 1,000 × Rs100 = Rs.100,000 1,000 / 4,000 = 25% Rs.100,000 / Rs.400,000 = 25% 23

Compute the sales level needed to earn a target operating income.  Suppose that a business would be content with operating income of Rs.45,000.  Assuming Rs.100 per unit selling price, variable expenses of Rs.70 per unit, and fixed expenses of Rs.90,000, how many units must be sold?  (Rs.90,000 + RS.45,000) ÷ Rs.30 = 4,500 units 24

Assumptions of CVP Analysis 1Expenses can be classified as either variable or fixed. 2CVP relationships are linear over a wide range of production and sales. 3Sales prices, unit variable cost, and total fixed expenses will not vary within the relevant range. 25

4Volume is the only cost driver. 5The relevant range of volume is specified. 6 The sales mix remains unchanged during the period. 26

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