CHAPTER 14

MARGINAL COSTING
LEARNING OUTCOMES

 Explain the meaning and characteristics of Marginal Costing.

 Describe the meaning of CVP Analysis and apply the same in
making short-term managerial decisions.
 Describe the meaning and application of Break-even point,
Margin of safety, Angle of incidence etc. and apply the same
in making computations.
 Calculate and explain the various formulae used in CVP
analysis.
 Apply the concepts of marginal costing and CVP analysis in
short-term decision making.
 Differentiate between Marginal Costing and Absorption
Costing.

© The Institute of Chartered Accountants of India

 14.2 COST AND MANAGEMENT ACCOUNTING

Meaning of Marginal Cost

and Marginal Costing
Break-even Analysis
Marginal Costing

Characteristics of Marginal
Costing
Marginal of Safety
Cost-Volume-Profit (CVP)
Analysis
Angle of Incidence
Short-term Decision
making
Contribution Ratio

14.1 INTRODUCTION
As discussed in the first chapter ‘Introduction to Cost and Management
Accounting’, the cost and management accounting system, by provision of
information, enables management to take various decisions. Marginal Costing is a
technique of cost and management accounting which is used to analyse
relationship between cost, volume and profit.
In order to appreciate the concept of marginal costing, it is necessary to study the
definition of marginal costing and certain other terms associated with this
technique. The important terms have been defined as follows:
1. Marginal Cost: Marginal cost as understood in economics is the incremental
cost of production which arises due to one-unit increase in the production
quantity. As we understood, variable costs have direct relationship with volume of
output and fixed costs remains constant irrespective of volume of production.
Hence, marginal cost is measured by the total variable cost attributable to one unit.
For example, the total cost of producing 10 units and 11 units of a product is
`10,000 and `10,500 respectively. The marginal cost for 11th unit i.e. 1 unit extra
from 10 units is `500.

© The Institute of Chartered Accountants of India

 MARGINAL COSTING 14.3

Marginal cost can precisely be the sum of prime cost and variable overhead.
Example 1: Arnav Ltd. produces 10,000 units of product Z by incurring a total cost
of ` 3,50,000. Break-up of costs are as follows:
(i) Direct Material @ ` 10 per unit, ` 1,00,000,
(ii) Direct employee (labour) cost @ ` 8 per unit, ` 80,000
(iii) Variable overheads @ `2 per unit, ` 20,000
(iv) Fixed overheads ` 1,50,000 (upto a volume of 50,000 units)
In this example, if Arnav Ltd. wants to know marginal cost of producing one extra
unit from the current production i.e. 10,001st unit. The marginal cost would be the
change in the total cost due production of this 10,001st extra unit. The extra cost
would be `20, as calculated below:
10,000 10,001 units Change in
units Cost
(A) (B) (c) = (B) - (A)

(i) Direct Material @ `10 per unit 1,00,000 1,00,010 10

(ii) Direct employee (labour) cost 80,000 80,008 8
@ `8 per unit
(iii)Variable overheads @ `2 per 20,000 20,002 2
unit
(iv) Fixed overheads 1,50,000 1,50,000 0
Total Cost 3,50,000 3,50,020 20

2. Marginal Costing: It is a costing system where products or services and

inventories are valued at variable costs only. It does not take consideration of
fixed costs. This system of costing is also known as direct costing as only direct
costs forms the part of product and inventory cost. Costs are classified on the basis
of behavior of cost (i.e. fixed and variable) rather functions as done in absorption
costing method.
3. Direct Costing: Direct costing and Marginal Costing is used synonymously at
various places. But the relation of costs with respect to activity level must be
understood. Some costs are variable at batch level but fixed for unit level whereas
others are variable at production line level but fixed for batches and units.

© The Institute of Chartered Accountants of India

 14.4 COST AND MANAGEMENT ACCOUNTING

Example 2: Arnav Ltd. produces 10,000 units of product Z by incurring a total cost
of `4,80,000. Break-up of costs are as follows:
(i) Direct Material @ `10 per unit, `1,00,000,
(ii) Direct employee (labour) cost @ `8 per unit, `80,000
(iii) Variable overheads @ `2 per unit, `20,000
(iv) Machine set up cost @ `1,200 for a production run (100 units can be
manufactured in a run)
(v) Depreciation of a machine specifically used for production of Z `10,000
(iv) Apportioned fixed overheads `1,50,000.
Analysis of the costs:
10,000 10,001 Change in Direct Cost
units units Cost
(A) (B) (c) = (B) - (A)
(i) Direct Material 1,00,000 1,00,010 10 Unit level Direct
@ ` 10 per unit Cost.
(ii) Direct employee 80,000 80,008 8 Unit level Direct
(labour) cost @ Cost.
` 8 per unit
(iii) Variable 20,000 20,002 2 Unit level Direct
overheads @ `2 Cost.
per unit
(iv) Machine set up 1,20,000 1,21,200 1,200 Batch level Direct
cost Cost
(v) Depreciation of 10,000 10,000 0 Product level Direct
a machine Cost.
(vi) Apportioned 1,50,000 1,50,000 0 Department level
fixed overheads Direct Cost
Total Cost 4,80,000 4,81,220 1,220
In the example, the direct cost of producing 10,001st unit is 1,220 but it is not the
marginal cost of producing one extra unit rather marginal cost of running one extra
production run (batch).

© The Institute of Chartered Accountants of India

 MARGINAL COSTING 14.5

4. Differential and Incremental Cost: Differential cost is difference between

the costs of two different production levels. It is a relative representation of
costs for two different levels that results in the increase or decrease in cost.
Incremental cost, on the other hand, is the increase in the costs due to change in
the volume or process of production activities. Incremental costs are sometime
compared with marginal cost but in reality, there is a thin line difference between
the two. Marginal cost is the change in the total cost due to production of one
extra unit while incremental cost can be both for increase in one unit or in total
volume. In the Example 2 above, ` 1,220 is the incremental cost of producing one
extra unit but not marginal cost for producing one extra unit.

14.2 CHARACTERISTICS OF MARGINAL COSTING

The technique of marginal costing is based on the distinction between product
costs and period costs. Only the variables costs are treated as the costs of the
products while the fixed costs are treated as period costs which will be incurred
during the period regardless of the volume of output. The main characteristics of
marginal costing are as follows:
1. All elements of cost are classified into fixed and variable components.
Semi-variable costs are also analyzed into fixed and variable elements.
2. The marginal or variable costs (as direct material, direct labour and variable
factory overheads) are treated as the cost of product.
3. Under marginal costing, the value of finished goods and work–in–progress
is also comprised only of marginal costs. Variable selling and distribution
are excluded for valuing these inventories. Fixed costs are not considered for
valuation of closing stock of finished goods and closing WIP.
4. Fixed costs are treated as period costs and are charged to profit and loss
account for the period for which they are incurred.
5. Prices are determined with reference to marginal costs and contribution margin.
6. Profitability of departments and products is determined with reference to
their contribution margin.

14.3 FACTS ABOUT MARGINAL COSTING

Some of the facts about marginal costing are depicted below:
Not a distinct method: Marginal costing is not a distinct method of costing like

© The Institute of Chartered Accountants of India

 14.6 COST AND MANAGEMENT ACCOUNTING

job costing, process costing, operating costing, etc., but a special technique used
for managerial decision making. Marginal costing is used to provide a basis for the
interpretation of cost data to measure the profitability of different products,
processes and cost centres in the course of decision making. It can, therefore, be
used in conjunction with the different methods of costing such as job costing,
process costing, etc., or even with other techniques such as standard costing or
budgetary control.
Cost Ascertainment: In marginal costing, cost ascertainment is made on the basis of
the nature of cost. It gives consideration to behaviour of costs. In other words, the
technique has developed from a particular conception and expression of the nature
and behaviour of costs and their effect upon the profitability of an undertaking.
Decision Making: According to traditional or total cost method, as opposed to
marginal costing, the classification of costs is based on functional basis. Under this
method the total cost is the sum total of the cost of direct material, direct labour,
direct expenses, manufacturing overheads, administration overheads, selling and
distribution overheads. In this system, other things being equal, the total cost per
unit will remain constant only when the level of output or mixture is the same from
period to period. Since these factors are continually fluctuating, the actual total
cost will vary from one period to another. Thus, it is possible for the costing
department to say one day that an item costs ` 20 and the next day it costs ` 18.
This situation arises because of changes in volume of output and the peculiar
behavior of fixed expenses included in the total cost. Such fluctuating
manufacturing activity, and consequently the variations in the total cost from
period to period or even from day to day, poses a serious problem to the
management in taking sound decisions. Hence, the application of marginal costing
has been given wide recognition in the field of decision making.

14.4 DETERMINATION OF COST AND PROFIT

UNDER MARGINAL COSTING
For the determination of cost of a product or service under marginal costing, costs
are classified into variable and fixed. All the variable costs are part of product and
services while fixed costs are charged against contribution margin.

© The Institute of Chartered Accountants of India

 MARGINAL COSTING 14.7

Cost and Profit Statement under Marginal Costing

Amount Amount (`)

(`)
Revenue (A) xxx
Product Cost:
- Direct Materials xxx
- Direct employee (labour) xxx
- Direct expenses xxx
- Variable manufacturing overheads xxx
Product (Inventoriable) Costs: (B) xxx xxx
Product Contribution Margin {A – B} xxx
- Variable Administration overheads xxx
- Variable Selling & Distribution overheads xxx xxx
Contribution Margin: (C) xxx
Period Cost: (D)
Fixed Manufacturing expenses xxx
Fixed non-manufacturing expenses xxx xxx
Profit/ (loss) {C – D} xxx

(i) Product (Inventoriable) Costs: In the case of merchandise inventory, these

are the costs which are associated with the purchase and sale of goods. In the
production scenario, such costs are associated with the acquisition and
conversion of materials and all other manufacturing inputs into finished
product for sale. Hence, under marginal costing, variable manufacturing costs
constitute inventoriable or product costs.
Finished goods are measured at product cost. Work-in-process (WIP) inventories
are also measured at product cost on the basis of percentage of completion (Please
refer Process & Operation costing chapter)
(ii) Contribution: Contribution or contribution margin is the difference between
sales revenue and total variable costs irrespective of manufacturing or non-
manufacturing.

Contribution (C) = Sales Revenue (S) – Total Variable Cost (V)

© The Institute of Chartered Accountants of India

 14.8 COST AND MANAGEMENT ACCOUNTING

It is obtained by subtracting variable costs from sales revenue. It can also be

defined as excess of sales revenue over the variable costs. The contribution concept
is based on the theory that the profit and fixed expenses of a business is a ‘joint
cost’ which cannot be equitably apportioned to different segments of the business.
In view of this difficulty the contribution serves as a measure of efficiency of
operations of various segments of the business. The contribution forms a fund for
fixed expenses and profit as illustrated below:
Example:
Variable Cost = `50,000, Fixed Cost = ` 20,000,
Selling Price = ` 80,000
Contribution = Selling Price – Variable Cost
= ` 80,000 – ` 50,000 = ` 30,000
Profit = Contribution – Fixed Cost
= ` 30,000 – ` 20,000 = `10,000
Since, contribution exceeds fixed cost; the profit is of the magnitude of ` 10,000.
Suppose the fixed cost is ` 40,000 then the position shall be:
Contribution – Fixed cost = Profit or,
= ` 30,000 – ` 40,000 = - ` 10,000
The amount of ` 10,000 represent extent of loss since the fixed costs are more than
the contribution. At the level of fixed cost of ` 30,000, there shall be no profit and
no loss.
(iii) Period Cost: These are the costs, which are not assigned to the products
but are charged as expenses against the revenue of the period in which they
are incurred. All fixed costs either manufacturing or non-manufacturing are
recognised as period costs in marginal costing.

14.5 ABSORPTION COSTING

Absorption Costing is the practice of charging all costs, both variable and
fixed to operations, processes or product.
In absorption costing the classification of expenses is based on functional basis
whereas in marginal costing it is based on the nature of expenses. In absorption
costing, the fixed expenses are distributed over products on absorption costing basis

© The Institute of Chartered Accountants of India

 MARGINAL COSTING 14.9

that is, based on a pre-determined level of output. Since fixed expenses are constant,
such a method of recovery will lead to over or under-recovery of expenses depending
on the actual output being greater or lesser than the estimate used for recovery. This
difficulty will not arise in marginal costing because the contribution is used as a fund
for meeting fixed expenses.
(For understanding the difference between marginal and absorption costing
along with the presentation of information to management under the said two
costing techniques, students are advised to refer Para 14.14)

14.6 ADVANTAGES AND LIMITATIONS OF

MARGINAL COSTING
ADVANTAGES
1. Simplified Pricing Policy: The marginal cost remains constant per unit of
output whereas the fixed cost remains constant in total. Since marginal cost
per unit is constant from period to period within a short span of time, firm
decisions on pricing policy can be taken. If fixed cost is included, the unit
cost will change from day to day depending upon the volume of output. This
will make decision making task difficult.
2. Proper recovery of Overheads: Overheads are recovered in costing on the
basis of pre-determined rates. If fixed overheads are included on the basis
of pre-determined rates, there will be under- recovery of overheads if
production is less or if overheads are more. There will be over- recovery of
overheads if production is more than the budget or actual expenses are less
than the estimate. This creates the problem of treatment of such under or
over-recovery of overheads. Marginal costing avoids such under or over
recovery of overheads.
3. Shows Realistic Profit: Advocates of marginal costing argues that under the
marginal costing technique, the stock of finished goods and work-in-progress
are carried on marginal cost basis and the fixed expenses are written off to
profit and loss account as period cost. This shows the true profit of the period.
4. How much to produce: Marginal costing helps in the preparation of break-
even analysis which shows the effect of increasing or decreasing production
activity on the profitability of the company.
5. More control over expenditure: Segregation of expenses as fixed and
variable helps the management to exercise control over expenditure. The

© The Institute of Chartered Accountants of India

 14.10 COST AND MANAGEMENT ACCOUNTING

management can compare the actual variable expenses with the budgeted
variable expenses and take corrective action through analysis of variances.
6. Helps in Decision Making: Marginal costing helps the management in taking
a number of business decisions like make or buy, discontinuance of a
particular product, replacement of machines, etc.
7. Short term profit planning: It helps in short term profit planning by B.E.P
charts.
LIMITATIONS
1. Difficulty in classifying fixed and variable elements: It is difficult to
classify exactly the expenses into fixed and variable category. Most of the
expenses are neither totally variable nor wholly fixed. For example, various
amenities provided to workers may have no relation either to volume of
production or time factor.
2. Dependence on key factors: Contribution of a product itself is not a guide
for optimum profitability unless it is linked with the key factor.
3. Scope for Low Profitability: Sales staff may mistake marginal cost for total
cost and sell at a price; which will result in loss or low profits. Hence, sales
staff should be cautioned while giving marginal cost.
4. Faulty valuation: Overheads of fixed nature cannot altogether be excluded
particularly in large contracts, while valuing the work-in- progress. In order
to show the correct position fixed overheads have to be included in work-in-
progress.
5. Unpredictable nature of Cost: Some of the assumptions regarding the
behaviour of various costs are not necessarily true in a realistic situation. For
example, the assumption that fixed cost will remain static throughout is not
correct. Fixed cost may change from one period to another. For example,
salaries bill may go up because of annual increments or due to change in pay
rate etc. The variable costs do not remain constant per unit of output. There
may be changes in the prices of raw materials, wage rates etc. after a certain
level of output has been reached due to shortage of material, shortage of
skilled labour, concessions of bulk purchases etc.
6. Marginal costing ignores time factor and investment: The marginal cost
of two jobs may be the same but the time taken for their completion and the
cost of machines used may differ. The true cost of a job which takes longer

© The Institute of Chartered Accountants of India

 MARGINAL COSTING 14.11

time and uses costlier machine would be higher. This fact is not disclosed by
marginal costing.
7. Understating of W-I-P: Under marginal costing stocks and work in progress
are understated.

14.7 COST-VOLUME-PROFIT (CVP) ANALYSIS

Meaning: It is a managerial tool showing the relationship between various ingredients
of profit planning viz., cost, selling price and volume of activity. As the name suggests,
cost volume profit (CVP) analysis is the analysis of three variables cost, volume and
profit. Such an analysis explores the relationship between costs, revenue, activity levels
and the resulting profit. It aims at measuring variations in cost and volume.
Assumptions:
1. Changes in the levels of revenues and costs arise only because of changes
in the number of product (or service) units produced and sold – for
example, the number of television sets produced and sold by Sony
Corporation or the number of packages delivered by Overnight Express. The
number of output units is the only revenue driver and the only cost driver.
Just as a cost driver is any factor that affects costs, a revenue driver is a
variable, such as volume, that causally affects revenues.
2. Total costs can be separated into two components; a fixed component that
does not vary with output level and a variable component that changes with
respect to output level. Furthermore, variable costs include both direct
variable costs and indirect variable costs of a product. Similarly, fixed costs
include both direct fixed costs and indirect fixed costs of a product
3. When represented graphically, the behaviours of total revenues and total
costs are linear (meaning they can be represented as a straight line) in
relation to output level within a relevant range (and time period).
4. Selling price, variable cost per unit, and total fixed costs (within a
relevant range and time period) are known and constant.
5. The analysis either covers a single product or assumes that the proportion
of different products when multiple products are sold will remain
constant as the level of total units sold changes.
6. All revenues and costs can be added, subtracted, and compared without
taking into account the time value of money. (Refer to the FM study
material for a clear understanding of time value of money).

© The Institute of Chartered Accountants of India

 14.12 COST AND MANAGEMENT ACCOUNTING

Importance
It provides the information about the following matters:
1. The behavior of cost in relation to volume.
2. Volume of production or sales, where the business will break-even.
3. Sensitivity of profits due to variation in output.
4. Amount of profit for a projected sales volume.
5. Quantity of production and sales for a target profit level.
Impact of various changes on profit:
An understanding of CVP analysis is extremely useful to management in budgeting
and profit planning. It elucidates the impact of the following on the net profit:
(i) Changes in selling prices,
(ii) Changes in volume of sales,
(iii) Changes in variable cost,
(iv) Changes in fixed cost.
14.7.1 Marginal Cost Equation

The contribution theory explains the relationship between the variable cost and
selling price. It tells us that selling price minus variable cost of the units sold is the
contribution towards fixed expenses and profit. If the contribution is equal to fixed
expenses, there will be no profit or loss and if it is less than fixed expenses, loss is
incurred. Since the variable cost varies in direct proportion to output, therefore if
the firm does not produce any unit, the loss will be there to the extent of fixed
expenses. These points can be described with the help of following marginal cost
equation:

Marginal Cost Equation = S -V = C = F ± P

Where,
S = Selling price per unit, V = Variable cost per unit, C = Contribution,
F = Fixed Cost,
Marginal Cost Statement
(`)

Sales xxxx

© The Institute of Chartered Accountants of India

 MARGINAL COSTING 14.13

Less: Variable Cost xxxx

Contribution xxxx
Less: Fixed Cost xxxx
Profit xxxx

14.7.2 Contribution to Sales Ratio (Profit Volume Ratio or P/V ratio)

This ratio shows the proportion of sales available to cover fixed costs and profit.
Contribution represent the sales revenue after deducting variable costs. This ratio
is usually expressed in percentage.

Contribution Change in contribution / Profit

P / V Ratio = ×100 or, P/V Ratio = ×100
Sales Change in sales

A higher contribution to sales ratio implies that the rate of growth of contribution
is faster than that of sales. This is because, once the breakeven point is reached,
profits shall grow at a faster rate when compared to a product with a lesser
contribution to sales ratio.
By transposition, we have derived the following equations:
(i) C = S × P/V ratio
C
(ii) S=
P / VRatio

14.7.3 Break-Even Analysis

Break-even analysis is a generally used method to study the CVP analysis. This
technique can be explained in two ways:
(i) In narrow sense it is concerned with computing the break-even point. At this
point of production level and sales there will be no profit and loss i.e. total
cost is equal to total sales revenue.
(ii) In broad sense this technique is used to determine the possible profit/loss at
any given level of production or sales.

14.8 METHODS OF BREAK -EVEN ANALYSIS

Break even analysis may be conducted by the following two methods:
(A) Algebraic computations
(B) Graphic presentations

© The Institute of Chartered Accountants of India

 14.14 COST AND MANAGEMENT ACCOUNTING

(A) ALGEBRAIC CALCULATIONS

14.8.1 Breakeven Point
The word contribution has been given its name because of the fact that it literally
contributes towards the recovery of fixed costs and the making of profits. The
contribution grows along with the sales revenue till the time it just covers the fixed cost.
This is the point where neither profits nor losses have been made is known as a break-
even point. This implies that in order to break even the amount of contribution
generated should be exactly equal to the fixed costs incurred. Hence, if we know how
much contribution is generated from each unit sold we shall have sufficient information
for computing the number of units to be sold in order to break even. Mathematically,
Fixed costs
Break-even point in units =
Contributi on per unit

Example 3: ABC Ltd. manufacturing a single product, incurring variable costs of `

300 per unit and fixed costs of ` 2,00,000 per month. If the product sells for
` 500 per unit, the breakeven point shall be calculated as follows;
Fixed costs ` 2,00,000
Break- even point in units = = = 1,000 units
Contribution per unit `200

Total fixed cost

Break- even points (in Value) = × Sales
Contribution
Total fixed cost
Break- even point (in Value) =
P / V Ratio
14.8.2 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
in computing cash break-even point. Its formula is –

Cash fixed costs

Cash break- even point =
Contribution per unit

ILLUSTRATION 1
MNP Ltd sold 2,75,000 units of its product at ` 37.50 per unit. Variable costs are
` 17.50 per unit (manufacturing costs of ` 14 and selling cost ` 3.50 per unit). Fixed

© The Institute of Chartered Accountants of India

 MARGINAL COSTING 14.15

costs are incurred uniformly throughout the year and amounting to ` 35,00,000
(including depreciation of ` 15,00,000). There are no beginning or ending inventories.
Required:
COMPUTE breakeven sales level quantity and cash breakeven sales level quantity.
SOLUTION
Fixed cost ` 35,00,000
Break even Sales Quantity = =
Contribution margin per unit `20

= 1,75,000 units
Cash Fixed Cost ` 20,00,000
Cash Break-even Sales Quantity = =
Contribution margin per unit `20
=1,00,000 units.
14.8.3 Multi- Product Break-even Analysis
In a multi-product environment, where more than one product is manufactured by
using a common fixed cost, the break-even point formula needs some adjustments.
The contribution is calculated by taking weights for the products. The weights
may be of sales mix quantity or sales mix values. The calculation of Multi-Product
Break-even analysis can be understood with the help of the following example.
Example 4: Arnav Ltd. sells two products, J and K. The sales mix is 4 units of J and
3 units of K. The contribution margins per unit are ` 40 for J and ` 20 for K. Fixed
costs are ` 6,16,000 per month.
Sales mix (in quantity) is 4 units of Product- J and 3 units of Product- K
i.e. Sales ratio is 4 : 3
Composite contribution per unit by taking weights for the product sales quantity
4 3
=Product J- ` 40 × + Product K- `20 × = `22.86 + `8.57 = `31.43
7 7
Common Fixed Cost `6,16,000
Composite Break-even point = =
Composite Contribution per unit `31.43
= 19,600 units
4
Break-even units of Product-J = 19,600 × = 11,200 units
7
3
Break-even units of Product- K = 19,600 × = 8,400 units
7

© The Institute of Chartered Accountants of India

 14.16 COST AND MANAGEMENT ACCOUNTING

ILLUSTRATION 2

You are given the following particulars

i. Fixed cost ` 1,50,000
ii. Variable cost ` 15 per unit
iii. Selling price is ` 30 per unit

CALCULATE:
(a) Break-even point
(b) Sales to earn a profit of ` 20,000

SOLUTION
Fixed cost `1,50,000
(a) Break-even point (BEP) = = = 10,000 Units
Contribution per unit * `15

* (Contribution per unit = Sales per unit – Variable cost per unit = ` 30 - `15)

(b) Sales to earn a Profit of ` 20,000:

Fixed cost+Desired profit
= ×Selling price per unit
Contribution per unit

`1,50,000+ `20,000
= ×`30 = ` 3,40,000
`15
Or
Fixed cost+Desired profit `1,70,000 `1,70,000
= = = ` 3, 40,000
P / V Ratio P / V Ratio 50%
Contributi on
PV Ratio = × 100
Sales

ILLUSTRATION 3

A company has a P/V ratio of 40%. COMPUTE by what percentage must sales be
increased to offset: 20% reduction in selling price?

© The Institute of Chartered Accountants of India

 MARGINAL COSTING 14.17

SOLUTION
Desired Contribution 0.40
Revised Sales Value = = = 1.6
Revised P / VRatio * 0.25

This means sales value to be increased by 60% of the existing sales.

Revised Contribution 0.80- 0.60
*Revised P/V Ratio = = = 0.25
Revised Selling Price 0.80

Desired Contribution 0.40

Required Sales Quantity = = =2
Revised P / VRatio *×Revised Selling Price 0.25×0.80

Therefore, Sales value to be increased by 60% and sales quantity to be doubled to

offset the reduction in selling price.
Proof:
Let selling price per unit is `10 and sales quantity is 100 units.
Data before change in selling price:
(`)
Sales (`10 × 100 units) 1,000
Contribution (40% of 1,000) 400
Variable cost (balancing figure) 600
Data after the change in selling price:
Selling price is reduced by 20% that means it became `8 per unit. Since, we have
to maintain the earlier contribution margin i.e. `400 by increasing the sales quantity
only. Therefore, the target contribution will be `400.
The new P/V Ratio will be
(`)
Sales 8.00
Variable cost 6.00
Contribution per unit 2.00
P/V Ratio 25%
DesiredContribution `400
Sales Value = = = `1,600
Revised P / VRatio 0.25
Sales value `1,600
Sales quantity = = = 200 units
Selling price per unit `8

© The Institute of Chartered Accountants of India

 14.18 COST AND MANAGEMENT ACCOUNTING

ILLUSTRATION 4
PQR Ltd. has furnished the following data for the two years:

2019-20 2020-21

Sales ` 8,00,000 ?
Profit/Volume Ratio (P/V ratio) 50% 37.5%
Margin of Safety sales as a % of total sales 40% 21.875%

There has been substantial savings in the fixed cost in the year 2020-21 due to the
restructuring process. The company could maintain its sales quantity level of 2019-
20 in 2020-21 by reducing selling price.
You are required to CALCULATE the following:
(i) Sales for 2020-21 in Value,
(ii) Fixed cost for 2020-21 in Value,
(iii) Break-even sales for 2020-21 in Value.
SOLUTION
In 2019-20, PV ratio = 50%
Variable cost ratio = 100% - 50% = 50%
Variable cost in 2019-20 = ` 8,00,000 × 50% = ` 4,00,000
In 2020-21, sales quantity has not changed. Thus, variable cost in 2020-21 is `
4,00,000.
In 2020-21, P/V ratio = 37.50%
Thus, Variable cost ratio = 100% − 37.5% = 62.5%
4,00,000
(i) Thus, sales in 2020-21 = = `6,40,000
62.5%
In 2020-21, Break-even sales = 100% − 21.875% (Margin of safety) = 78.125%
(ii) Break-even sales = 6,40,000 × 78.125% = ` 5,00,000
(iii) Fixed cost = B.E. sales × P/V ratio
= 5,00,000 × 37.50% = `1,87,500.

© The Institute of Chartered Accountants of India

 MARGINAL COSTING 14.19

(B) GRAPHICAL PRESENTATION OF BREAK EVEN CHART

14.8.4 Break-even Chart
A breakeven chart records costs and revenues on the vertical axis and the level of
activity on the horizontal axis. The making of the breakeven chart would require
you to select appropriate axes. Subsequently, you will need to mark costs/revenues
on the Y axis whereas the level of activity shall be traced on the X axis. Lines
representing (i) Fixed costs (horizontal line at ` 2,00,000 for ABC Ltd), (ii) Total costs
at maximum level of activity (joined to the Y-axis where the Fixed cost of ` 2,00,000
is marked) and (iii) Revenue at maximum level of activity (joined to the origin) shall
be drawn next.
The breakeven point is that point where the sales revenue line intersects the total
cost line. Other measures like the margin of safety and profit can also be measured
from the chart.
The breakeven chart for ABC Ltd (Example-3) is drawn below.

` 000

14.8.5 Contribution Breakeven chart

It is not possible to use a breakeven chart as described above to measure
contribution. This is one of its major limitations especially so because contribution
analysis is literally the backbone of marginal costing. To overcome such a limitation,
accountants frequently resort to the making of a contribution breakeven chart
which is based on the same principles as a conventional breakeven chart except for
that it shows the variable cost line instead of the fixed cost line. Lines for Total cost
and Sales revenue remain the same. The breakeven point and profit can be read off
in the same way as with a conventional chart. However, it is also possible to read
the contribution for any level of activity.

© The Institute of Chartered Accountants of India

 14.20 COST AND MANAGEMENT ACCOUNTING

Using the same example of ABC Ltd as for the conventional chart, the total variable
cost for an output of 1,700 units is 1,700 × `300 = `5,10,000. This point can be
joined to the origin since the variable cost is nil at zero activity.
` 000

The contribution can be read as the difference between the sales revenue line and
the variable cost line.
14.8.6 Profit-volume chart
This is also very similar to a breakeven chart. In this chart the vertical axis represents
profits and losses and the horizontal axis is drawn at zero profit or loss.
In this chart each level of activity is taken into account and profits marked
accordingly. The breakeven point is where this line interacts the horizontal axis. A
profit-volume graph for our example (ABC Ltd) will be as follows,

` 000

Loss

© The Institute of Chartered Accountants of India

 MARGINAL COSTING 14.21

The loss at a nil activity level is equal to ` 2,00,000, i.e. the amount of fixed costs.
The second point used to draw the line could be the calculated breakeven point or
the calculated profit for sales of 1,700 units.
Advantages of the profit-volume chart
1. The biggest advantage of the profit-volume chart is its capability of depicting
clearly the effect on profit and breakeven point of any changes in the variables.
The following example illustrates this characteristic,
Example 5:
A manufacturing company incurs fixed costs of `3,00,000 per annum. It is a single
product company with annual sales budgeted to be 70,000 units at a sales price of
`300 per unit. Variable costs are ` 285 per unit.
(i) Draw a profit volume graph, and use it to determine the breakeven point.
The company is deliberating upon an increase in the selling price of the
product to ` 350 per unit. This shall be required in order to improve the
quality of the product. It is anticipated that despite increase in the selling
price the sales volume shall remain unaffected, however, the fixed costs shall
increase to ` 4,50,000 per annum and the variable costs to ` 330 per unit.
(ii) Draw on the same graph as for part (a) a second profit volume graph and give
your comments.
Solution
Figure showing changes with a profit-volume chart
` 000

© The Institute of Chartered Accountants of India

 14.22 COST AND MANAGEMENT ACCOUNTING

Working notes (i)

The profit for sales of 70,000 units is ` 7,50,000.
(`’000)
Contribution 70,000 × (`300 – `285) 1050
Fixed costs 300
Profit 750

This point is joined to the loss at zero activity, ` 3,00,000 i.e., the fixed costs.
Working notes (ii)
The profit for sales of 70,000 units is ` 9,50,000.
(`’000)
Contribution 70,000 × (`350 – `330) 1400
Fixed costs 450
Profit 950

This point is joined to the loss at zero activity, ` 4,50,000 i.e., the fixed costs.
Comments:
It is clear from the graph that there are larger profits available from option (ii). It
also shows an increase in the break-even point from 20,000 units to 22,500 units,
however, the increase of 2,500 units may not be considered large in view of the
projected sales volume. It is also possible to see that for sales volumes above
30,000 units the profit achieved will be higher with option (ii). For sales volumes
below 30,000 units option (i) will yield higher profits (or lower losses).
ILLUSTRATION 5
You are given the following data for the current financial year of Rio Co. Ltd:

Variable cost 60,000 60%

Fixed cost 30,000 30%
Net profit 10,000 10%
Sales 1,00,000 100%

FIND OUT (a) Break-even point, (b) P/V ratio, and (c) Margin of safety. Also DRAW
a break-even chart showing contribution and profit.

© The Institute of Chartered Accountants of India

 MARGINAL COSTING 14.23

SOLUTION
Sales - Variable Cost 1,00,000 - 60,000
P / V ratio = = = 40%
Sales 1,00,000
Fixed Cost 30,000
Break Even Point = = = ` 75,000
P / V ratio 40%
Margin of safety = Actual Sales – BE point = 1,00,000 – 75,000 = ` 25,000
Break even chart showing contribution is shown below:
Cost and Revenue (` thousands)

Break-even chart

ILLUSTRATION 6
PREPARE a profit graph for products A, B and C and find break-even point from the
following data:

Products A B C Total
Sales (`) 7,500 7,500 3,750 18,750
Variable cost (`) 1,500 5,250 4,500 11,250
Fixed cost (`) --- --- --- 5,000

© The Institute of Chartered Accountants of India

 14.24 COST AND MANAGEMENT ACCOUNTING

SOLUTION
Statement Showing Cumulative Sales & Profit

Sales Cumulative Variable Contributio Cumulative Cumulative

Sales Cost n Contribution Profit
(`) (`) (`) (`) (`) (`)
A 7,500 7,500 1,500 6,000 6,000 1,000
B 7,500 15,000 5,250 2,250 8,250 3,250
C 3,750 18,750 4,500 (750) 7,500 2,500

Profit in `
(+) 5,000
`3,250
(+) 2,500 `2,500
`1,000

0 2,500 5,000 7,500 10,000 12,500 15,000 17,500 20,000

BEP Sales in `
(-) 2,500
Profit Line
(-) 5,000
Loss in `
Break Even Point (BEP) = ` 12,500

14.9 LIMITATIONS OF BREAK-EVEN ANALYSIS

The limitations of the practical applicability of breakeven analysis and
breakeven charts stem mostly from the assumptions underlying CVP which
have been mentioned above. Assumptions like costs behaving in a linear fashion
or sales revenue remain constant at different sales levels or the stocks shall remain
constant period after period are unrealistic. Similarly, the assumption that the only
factor which influences costs is the ‘activity level achieved’ is erroneous because
other factors like inflation also have a bearing on costs.

© The Institute of Chartered Accountants of India

 MARGINAL COSTING 14.25

14.10 MARGIN OF SAFETY

The margin of safety can be defined as the difference between the expected level
of sale and the breakeven sales. The larger the margin of safety, the higher is the
chances of making profits. In the Example-3 if the forecast sale is 1,700 units per
month, the margin of safety can be calculated as follows,
Margin of Safety = Projected sales – Breakeven sales
= 1,700 units – 1,000 units
= 700 units or 41% of sales.
The Margin of Safety can also be calculated by identifying the difference between
the projected sales and breakeven sales in units multiplied by the contribution per
unit. This is possible because, at the breakeven point all the fixed costs are
recovered and any further contribution goes into the making of profits. It also can
be calculated as:
Profit
Margin of Safety =
P / V Ratio

ILLUSTRATION 7
A company earned a profit of ` 30,000 during the year. If the marginal cost and
selling price of the product are ` 8 and ` 10 per unit respectively, FIND OUT the
amount of margin of safety.
SOLUTION
Selling price- Variable cost per unit `10- `8
P/V ratio = = = 20%
Selling price `10

Profit 30,000
Margin of safety = = = ` 1,50,000
P/V ratio 20%

ILLUSTRATION 8
A Ltd. Maintains margin of safety of 37.5% with an overall contribution to sales ratio
of 40%. Its fixed costs amount to ` 5 lakhs.
CALCULATE the following:
i. Break-even sales

ii. Total sales

© The Institute of Chartered Accountants of India

 14.26 COST AND MANAGEMENT ACCOUNTING

iii. Total variable cost

iv. Current profit
v. New ‘margin of safety’ if the sales volume is increased by 7 ½ %.
SOLUTION

(i) We know that: Break- even Sales (BES) × P/V Ratio = Fixed Cost
Break-even Sales (BES) × 40% = ` 5,00,000
Break- even Sales (BES) = ` 12,50,000

(ii) Total Sales (S) = Break Even Sales + Margin of Safety

S = ` 12,50,000 + 0.375S

Or, S – 0.375S = ` 12,50,000

Or, S = ` 20,00,000

(iii) Contribution to Sales Ratio = 40%

Therefore, Variable cost to Sales Ratio = 60%

Variable cost = 60% of sales = 60% of 20,00,000

Variable cost = 12,00,000

(iv) Current Profit = Sales – (Variable Cost + Fixed Cost)

= ` 20,00,000 – (12,00,000 + 5,00,000) = ` 3,00,000

(v) If sales value is increased by 7 ½ %

New Sales value = ` 20,00,000 × 1.075 = ` 21,50,000

New Margin of Safety = New Sales value – BES

= ` 21,50,000 – ` 12,50,000 = ` 9,00,000

© The Institute of Chartered Accountants of India

 MARGINAL COSTING 14.27

14.11 VARIATIONS OF BASIC MARGINAL COST

EQUATION AND OTHER FORMULAE
i. Sales – Variable cost = Fixed cost ± Profit/ Loss
By multiplying and dividing L.H.S. by S
S(S − V)
ii. = F+P
S
 S−V
iii. S × P/V Ratio = F + P or Contribution  P/V Ratio = 
 S 
iv BES × P/V Ratio = F ( at BEP profit is zero)

Fixed Cost
v BES =
P / V Ratio
Fixedcost
vi P/V Ratio =
BES
vii S × P/V Ratio = Contribution (Refer to iii)
Contributi on
viii P/V Ratio =
Sales
ix (BES + MS) × P/V Ratio = Contribution (Total sales = BES + MS)
x (BES × P/V Ratio) + (MS × P/V Ratio) = F + P
By deducting (BES × P/V Ratio) from L.H.S. and F from R.H.S. in (x) above,
we get:
xi M.S. × P/V Ratio = P
Change in profit
xii P/V Ratio =
Change in sales

Change in contribution
xiii P/V Ratio =
Change in sales
Contributi on
xiv Profitability =
Key factor

Profit
xv Margin of Safety = Total Sales – BES or .
P / V ratio

© The Institute of Chartered Accountants of India

 14.28 COST AND MANAGEMENT ACCOUNTING

Xvi BES = Total Sales – MS

Total sales - BES
Margin of Safety Ratio =
Total sales

ILLUSTRATION 9
By noting “P/V will increase or P/V will decrease or P/V will not change”, as the case
may be, STATE how the following independent situations will affect the P/V ratio:
(i) An increase in the physical sales volume;
(ii) An increase in the fixed cost;
(iii) A decrease in the variable cost per unit;
(iv) A decrease in the contribution margin;
(v) An increase in selling price per unit;
(vi) A decrease in the fixed cost;
(vii) A 10% increase in both selling price and variable cost per unit;
(viii) A 10% increase in the selling price per unit and 10% decrease in the physical
sales volume;
(ix) A 50% increase in the variable cost per unit and 50% decrease in the fixed cost.
(x) An increase in the angle of incidence.
SOLUTION

Item no. P/V Ratio Reason

(i) Will not change
(ii) Will not change
(iii) Will increase
(iv) Will decrease
(v) Will increase
(vi) Will not change
(vii) Will not change Reasoning 1
(viii) Will increase Reasoning 2
(ix) Will decrease Reasoning 3
(x) Will increase Reasoning 4

© The Institute of Chartered Accountants of India

 MARGINAL COSTING 14.29

A 10% increase in both selling price and variable cost per unit.
Reasoning 1. Assumptions: a) Variable cost is less than selling price.
b) Selling price `100 variable cost ` 90 per unit.
100 − 90
c) P/V ratio = = 10%
100
10% increase in S.P. = `110
10% increase in variable cost = `99
110 − 99
P/V ratio = = 10% i.e. P/v ratio will not change
10
Reasoning 2. Increase or decrease in physical sales volume will not change P/V
ratio. Hence 10% increase in selling price per unit will increase P/V
ratio.
Reasoning 3. Increase or decrease in fixed cost will not change P/V ratio. Hence
50% increase in the variable cost per unit will decrease P/V ratio.
Reasoning 4. Angle of incidence is the angle at which sales line cuts the total cost
line. If it is large, it indicates that the profits are being made at higher
rate. Hence increase in the angle of incidence will increase the P/V
ratio.

14.12 ANGLE OF INCIDENCE

This angle is formed by the intersection of sales line and total cost line at the break-
even point. This angle shows the rate at which profit is earned once the break-
even point is reached. The wider the angle the greater is the rate of earning
profits. A large angle of incidence with a high margin of safety indicates extremely
favourable position.
The shaded area in the graph given below is representing the angle of incidence.
The angle above and below the break-even point shows the rate of earning
profitability (loss). Wider angle denotes higher rate of earnings and vice-versa.

© The Institute of Chartered Accountants of India

 14.30 COST AND MANAGEMENT ACCOUNTING

280

L ine
les
260
Sa
240

220

200
ea
it Ar
180 of
Pr Line
Cost and Sales (Rs. ‘ 000)

C ost
Margin Angle of Total
Cost and Sales (` '000)

160 of incidence
Safety Break even point
140

120 Variable cost

100

80
ea
Ar
60 oss
L

40 Margin
of Fixed cost
20 Safety

0
2 4 6 8 10 12 14 16 18 20 22 24 26 28

B.E.sales Actual sales

Volume of sales (Unit ‘000)

14.13 APPLICATION OF CVP ANALYSIS IN

DECISION MAKING
As discussed earlier CVP analysis is used as an evaluation tool for managerial decisions.
In this chapter we will discuss the use of CVP Analysis for short term decision making.
Before going into illustration, let us discuss the decision making framework.
14.13.1 Framework for Decision Making

Step 1: Identification of Problem

Step 2: Indentification of Options

Step 3: Evaluation of the Options

Step 4: Selection of the Option

© The Institute of Chartered Accountants of India

 MARGINAL COSTING 14.31

Step-1: Identification of Problem

Every organisation has its own objectives, and goals are set to achieve these
objectives. To reach at the goal, actions are to be taken. For example, if an
organisation wants to be a cost leader in the industry it operates in, it has to achieve
3Es in its all activities. 3Es means economy in inputs, efficiency in process and
operations and effectiveness in output. An entity that exists for profit may identify
few areas (problem areas) which if worked on can add to the profit or wealth
maximisation. For example, Arnav Ltd. a manufacturer of Steel products, has
identified that it can be leader in the industry if it can produce steel products at
lower cost than its rival. Here the goal should be (problem area) low cost
production.
Step- 2: Identification of Options
After identification of problem(s), the next step is identification of options to
achieve the goal (to answer the problem). Every possible options need to be
explored. In the above example, the Arnav Ltd. may have the following options for
low cost production:
(a) Purchase of inputs from specialised market- Local vs Import
(b) Make the input in its own factory- Make or Buy
(c) Bulk purchase to avail discount offer- How much to purchase
(d) Make in-house- Make vs Outsource
(e) Bulk processing- How much to produce
(f) Using efficient machine for manufacturing- Old machine vs New machine
(g) Optimisation of key resources- Product mix decisions etc.
Step- 3: Evaluation of the Options
After identification of options, each option is to be evaluated against the objective
criteria. An entity with objective of making profit may evaluate options on the basis
of financial measures like impact of profit or loss, market share, overall impact on
profitability, return on investment etc. Non-financial factors like customer
satisfaction, impact on existing market/ customer, ethics of decision are also
evaluated.
This step is a very important and may be grouped into two tasks
(i) Identification of Cost and Benefits of each options
(ii) Estimation of amount of each options

© The Institute of Chartered Accountants of India

 14.32 COST AND MANAGEMENT ACCOUNTING

Step-4: Selection of option:

After evaluation of the options, the best option is selected and implemented.
14.13.2 Principles for Identification of Cost and Benefits for
measurement
The cost and benefit of an option is identified for measurement if it passes the
principles of Controllability and Relevance.
(i) Controllability: Those cost and benefits which arise due to choice of an
option. In other words, benefits received and cost incurred are directly related with
the choice of the option. Thus, the costs and benefits which are controllable are
considered for measurement for making decision.
(ii) Relevance: The costs which are controllable need to be relevant for decision
making. This means all controllable costs are not relevant for decision making
unless it differs under the two options. Thus, a cost is treated is relevant only if
(a) it is a future cost and (b) it differs under two options under consideration.
For Example, Arnav Ltd. wants to manufacture 1,000 additional units of Product X.
It is considering either to manufacture in its own factory or to outsource to job
workers. In this example cost of raw materials to manufacture additional 1,000 units
is controllable as it arises due to management’s decision to make additional units.
But it is not relevant for making choice between manufacturing in-house and
outsource to job workers, as under the both options, the raw materials cost would
be same.
Hence, for decision making purpose only those cost and benefits are identified for
measurement which are both Controllable and Relevant.
Below is an analysis of few costs for its relevance:

Cost Relevance Reason

(i) Historical Irrelevant The cost has already been incurred and do
Cost not affect the decision. Example: Book value
of machinery etc.
(ii) Sunk Cost Irrelevant The cost which are already paid either for
goods or services availed or to be availed.
Example: Raw material purchased and held
in store without having replacement cost,
Cost of drawing, blueprint etc.

© The Institute of Chartered Accountants of India

 MARGINAL COSTING 14.33

(iii) Committed Irrelevant The committed costs are the pre-agreed

Cost cost which cannot be revoked under the
normal circumstances. This is also a sunk
cost. Examples: Cost of materials as per rate
agreement, Salary cost to employees etc.
(iv) Opportunity Relevant The opportunity cost is represented by the
Cost forgone potential benefit from the best
rejected course of action. Had the option
under consideration not chosen, the benefit
would come to the organisation.
(v) Notional or Relevant Notional costs are relevant for the decision
Imputed Cost making only if company is actually forgoing
benefits by employing its resources to
alternative course of action. For example,
notional interest on internally generated
fund is treated as relevant notional cost only
if company could earn interest from it.
(vi) Shut-down Relevant When an organization suspends its
Cost manufacturing operations, certain fixed
expenses can be avoided and certain extra
fixed expenses may be incurred depending
upon the nature of the industry. By closing
down the manufacturing, the organization
will save variable cost of production as well
as some discretionary fixed costs. This
particular discretionary cost is known as
shut-down cost.

14.13.3 Principles of Estimation of Costs and Benefits

After identification of the costs and benefits, it is now required to be quantified i.e.,
the cost and benefit should be measured and estimated. The estimation is done by
following the two principles as discusses below:
(i) Variability: Variability means by how much a cost or benefit increased or
decreased due to the choice of the option. Variable costs are the cost which differs
under the different volume or activities. On the other hand, fixed costs remain same
irrespective of volume and activities.

© The Institute of Chartered Accountants of India

 14.34 COST AND MANAGEMENT ACCOUNTING

(ii) Traceability: Traceability of cost means degree of relationship between the

cost and the choice of the option. Direct costs are directly assigned to the option
on the other hand indirect costs needs to be apportioned to the option on some
reasonable basis.
For Example, Arnav Ltd. wants to manufacture 1,000 units of Product X. It is
considering to manufacture the same in its own factory. To manufacture in its own
factory it requires 1,000 hours of employees and a specialised machine. In this
example, employee cost for labour of 1,000 hours is variable cost for in-house
manufacturing and it is directly traceable. Cost of machinery is also direct cost but
so far as traceability of the machinery cost is concerned it is direct cost for 1,000
units as a whole but indirect cost for a unit.
Hence, the cost and benefits of an option is measured at directly traceable and
variable costs.
14.13.4 Short-term Decision-Making using concepts of CVP Analysis
Management uses marginal costing and CVP concepts for making various
decisions. In this chapter, we will learn how the concepts of marginal costing and
CVP is applied for analysis of identified options for short-term decision making.
Generally, short-term decisions are related with temporary gaps between demand
and supply for available resources. The areas of short-term decisions may be
classified into two broad categories:
(i) Decisions related with excess supply, such as:
(a) Processing of Special Order
(b) Determination of price for stimulating demand
(c) Local vs Export sale
(d) Determination of minimum price for price quotations
(e) Shut-down or continue decision etc.
(ii) Decisions related with excess demand, such as:
(a) Make or Buy/ In-house-processing vs Outsourcing
(b) Product mix decision under resource constraints (limiting factors)
(c) Sales mix decisions
(d) Sale or further processing etc.

© The Institute of Chartered Accountants of India

 MARGINAL COSTING 14.35

What is a Limiting Factor? Limiting factor is anything which limits the activity of
an entity. The factor is a key to determine the level of sale and production, thus it
is also known as Key factor. From the supply side the limiting factor may either be
Men (employees), Materials (raw material or supplies), Machine (capacity), or
Money (availability of fund or budget) and from demand side it may be demand
for the product, other factors like nature of product, regulatory and environmental
requirement etc. The management, while making decisions, has objective to
optimise the key resources upto maximum possible extent.

ILLUSTRATION 10
Moon Ltd. produces products 'X', 'Y' and 'Z' and has decided to analyse its production
mix in respect of these three products - 'X', 'Y' and 'Z'.
You have the following information:
X Y Z
Direct Materials ` (per unit) 160 120 80
Variable Overheads ` (per unit) 8 20 12
Direct labour:
Departments: Rate per Hour Hours per unit Hours per Hours per
(` ) unit unit
X Y Z
Department-A 4 6 10 5
Department-B 8 6 15 11

From the current budget, further details are as below :

X Y Z
Annual Production at present (in units) 10,000 12,000 20,000
Estimated Selling Price per unit (` ) 312 400 240
Sales departments estimate of possible sales in the coming 12,000 16,000 24,000
year (in units)

There is a constraint on supply of labour in Department-A and its manpower cannot

be increased beyond its present level.
Required:
(i) IDENTIFY the best possible product mix of Moon Ltd.
(ii) CALCULATE the total contribution from the best possible product mix.

© The Institute of Chartered Accountants of India

 14.36 COST AND MANAGEMENT ACCOUNTING

SOLUTION
(i) Statement Showing “Calculation of Contribution/ unit”

Particulars X Y Z
(`) (`) (`)
Selling Price (A) 312 400 240
Variable Cost:
Direct Material 160 120 80
Direct Labour
Dept. A (Rate x Hours) 24 40 20
Dept. B (Rate x Hours) 48 120 88
Variable Overheads 8 20 12
Total Variable Cost (B) 240 300 200
Contribution per unit (A - B) 72 100 40
Hours in Dept. A 6 10 5
Contribution per hour 12 10 8
Rank I II III

Existing Hours = 10,000 x 6hrs. + 12,000 x 10 hrs. + 20,000 x 5 hrs. = 2,80,000 hrs.
Best possible product mix (Allocation of Hours on the basis of ranking)
Produce ‘X’ = 12,000 units
Hours Required = 72,000 hrs (12,000 units × 6 hrs.)
Balance Hours Available = 2,08,000 hrs (2,80,000 hrs. – 72,000 hrs.)
Produce ‘Y’ (the Next Best) = 16,000 units
Hours Required = 1,60,000 hrs (16,000 units × 10 hrs.)
Balance Hours Available = 48,000 hrs (2,08,000 hrs. – 1,60,000 hrs.)
Produce ‘Z’ (balance) = 9,600 units (48,000 hrs./ 5 hrs.)
(ii) Statement Showing “Contribution”

Product Units Contribution/ Unit (`) Total Contribution (`)

X 12,000 72 8,64,000

© The Institute of Chartered Accountants of India

 MARGINAL COSTING 14.37

Y 16,000 100 16,00,000

Z 9,600 40 3,84,000
Total 28,48,000

ILLUSTRATION 11
ABC Limited produces and sells two product- X and Y. The product is highly
demanded in the market. Following information relating to both the products are
given as under :
Per Unit (`)
X Y
Direct Materials 140 180
Direct Wages 60 100
Variable Overheads (` 5 per machine hour) 20 40
Selling price 300 450
The company is facing scarcity of machine hours for working. The availability of
machine hours are limited to 60,000 hrs in a month. At present, the monthly demand
of product X and product Y is 8,000 units and 6,000 units respectively. The fixed
expenses of the company are ` 2,25,000 per month.
You are required to:
DETERMINE the product mix that generates maximum profit to the company in the
given situation and also CALCULATE the profit of the company.
SOLUTION
Workings -
Calculation of contribution (per unit)
X (`) Y (`)
Selling price (A) 300 450
Variable cost:
Direct materials 140 180
Direct wages 60 100
Variable overheads 20 40
Total Variable Cost (B) 220 320

© The Institute of Chartered Accountants of India

 14.38 COST AND MANAGEMENT ACCOUNTING

Contribution per unit (A-B) 80 130

Machine hours (MH) 4 8
Contribution per MH 20 16.25
Ranking I II

(i) Product mix to maximise the profit

Produce ‘X’ = 8,000 units
Hours Required = 32,000 hrs (8,000 units × 4 hrs.)
Balance Hours Available = 28,000 hrs (60,000 hrs. – 32,000 hrs.)
Produce ‘Y’ (balance) = 3,500 units (28,000 hrs./ 8 hrs.)
(ii) Profitability of the concern in the best Product mix
X (`) Y (`) Total (`)
Sales (in units) 8,000 units 3,500 units
Contribution per unit 80 130
Contribution 6,40,000 4,55,000 10,95,000
Less: Fixed cost 2,25,000
Profit 8,70,000

Short-term Decisions: Processing of Special Order

When the resources for production are excess in supply, demand for the products
becomes the limiting factor. Any additional demand for the product can earn an
additional contribution to recover fixed costs. Special orders are the orders which
are non-repetitive. Offers for special orders are accepted even if the offered price
covers the marginal cost (incremental cost) as it utilises the resources and can earn
additional profit. Some qualitative factors like the effect of the decision on the
existing customers or market, long term customer relationship, ethical and legal
impact etc. shall also be given due consideration.
ILLUSTRATION 12: Processing of Special Order
PQR Ltd. manufactures medals for winners of athletic events and other contests. Its
manufacturing plant has the capacity to produce 10,000 medals each month. The
company has current production and sales level of 7,500 medals per month. The
current domestic market price of the medal is ` 150.
The cost data for the month of August 2021 is as under:

© The Institute of Chartered Accountants of India

 MARGINAL COSTING 14.39

(` )

Variable costs:
- Direct materials 2,62,500
- Direct labour cost 3,00,000
- Overhead 75,000
Fixed manufacturing costs 2,75,000
Fixed marketing costs 1,75,000
10,87,500

PQR Ltd. has received a special one-time only order for 2,500 medals at ` 120 per
medal.
Required:
(i) Should PQR Ltd. accept the special order? Why? EXPLAIN briefly.
(ii) Suppose the plant capacity was 9,000 medals instead of 10,000 medals each
month. The special order must be taken either in full or rejected totally.
ANALYSE whether PQR Ltd. should accept the special order or not.
SOLUTION
In this question, the existing demand for the medals is 7,500 units per month
against the 10,000 units capacity. There is an idle capacity for 2,500 medals in a
month. Since, the capacity of the plant (supply) is more than the demand, any
additional order could increase the existing profit provided the offered price is
more than the marginal cost.
The existing cost and profit structure is as under:

Particulars Amount (`) Amount (`)

A. Selling price per unit 150.00
B. Variable Cost per unit:
- Direct material (` 2,62,500 ÷ 7,500 units) 35.00
- Direct labour (` 3,00,000 ÷ 7,500 units) 40.00
- Overhead (` 75,000 ÷ 7,500 units) 10.00 85.00
C. Contribution per unit (A-B) 65.00
D. Total Contribution (` 85 × 7,500 units) 4,87,500

© The Institute of Chartered Accountants of India

 14.40 COST AND MANAGEMENT ACCOUNTING

E. Fixed Costs:
- Fixed manufacturing costs 2,75,000
- Fixed marketing costs 1,75,000 4,50,000
F. Profit (D-E) 37,500
(i) The offered price for the additional demand of 2,500 medals is more than the
variable cost per unit. Any additional demand will contribute towards fixed
costs and profit.

Particulars Amount Amount

(`) (`)
A. Sales Value {(` 150 × 7,500) + (` 120 × 2,500)} 14,25,000
B. Variable Cost (` 85 × 10,000) 8,50,000
C. Contribution (A-B) 5,75,000
D. Fixed Costs:
- Fixed manufacturing costs 2,75,000
- Fixed marketing costs 1,75,000 4,50,000
E. Profit (C-D) 1,25,000
The offer for 2,500 unit be accepted as it increases the profit by ` 87,500
(` 1,25,000 – ` 37,500).
(ii) In this instant case, the capacity to produce medals is decreased by 1,000 unit
per month and the existing demand for the medals is 7,500. The spare
capacity is for 1,500 medals only but the special demand is for 2,500 medals.
By accepting the offer, the company has to lose contribution on 1,000 medals
from existing customers. The offer will only be acceptable if the gain from the
new offer supersedes the loss from the existing customers.

Particulars Amount Amount

(`) (`)
A. Sales Value {(` 150 × 6,500) + (` 120 × 2,500)} 12,75,000
B. Variable Cost (` 85 × 9,000) 7,65,000
C. Contribution (A-B) 5,10,000
D. Fixed Costs:
- Fixed manufacturing costs 2,75,000
- Fixed marketing costs 1,75,000 4,50,000
E. Profit (C-D) 60,000

© The Institute of Chartered Accountants of India

 MARGINAL COSTING 14.41

By accepting the special order at ` 120 per unit, the total profit of the company is
increased by ` 22,500 (` 60,000 – ` 37,500) hence the order may be accepted,
however, other qualitative factors may also be taken care-off.
Short-term Decisions: Make or Buy
Make or Buy is a situation of decision making where it is to be decided whether the
product should be made using the own production facility or to be produced
outside by outsourcing or to buy from the market instead of making. This type of
situation arises when Demand for the product is more than the supply of resources
(material, men, machine etc.). The resource is limiting or key factor and decision is
made keeping optimum utilization of the key resource and the maximization of
profitability into consideration. However, as discussed earlier the qualitative factors
shall also be kept into consideration.
ILLUSTRATION 13: Make or Buy Decision
NN Ltd. manufactures automobiles accessories and parts. The following are the total
cost of processing 2,00,000 units:
Direct materials cost ` 375 per unit
Direct labour cost ` 80 per unit
Variable factory overhead ` 16 per unit
Fixed factory overhead ` 500 lakhs
The purchase price of the component is ` 485. The fixed overhead would continue to
be incurred even when the component is bought from outside.
REQUIRED:
(a) Should the part be made or bought from outside considering that the present
facility when released following a buying decision would remain idle?
(b) In case the released capacity can be rented out to another manufacturer for
` 32,00,000 having good demand. What should be the decision?
SOLUTION
The present cost structure is as follows:
Variable cost per unit is:

Direct materials cost ` 375

Direct labour cost ` 80

© The Institute of Chartered Accountants of India

 14.42 COST AND MANAGEMENT ACCOUNTING

Variable factory overhead ` 16

Total variable cost per unit ` 471
The fixed cost of ` 500 lakhs is irrelevant for decision making as it would incur in
either case.
(a) The decision shall be made comparing the marginal cost of making and
buying the component.
Here the variable cost of making the component is ` 471 as compared to
buying cost of ` 485. The component shall be made by using own production
facility as it would save the company ` 14 per unit.
(b) If by releasing the production facility the company can earn a rental income
of ` 32,00,000, then the additional cost of buying from outside and the rental
income from releasing the capacity shall be compared for making decision.

(i) Rental income ` 32,00,000

(ii) Additional cost of buying (` 14 × 2,00,000 units) ` 28,00,000
Additional Income {(i)-(ii)} ` 4,00,000
The component should be bought from outside as it would save the company
` 4,00,000 in fixed cost.
ILLUSTRATION 14
A company can make any one of the 3 products X, Y or Z in a year. It can exercise its
option only at the beginning of each year.
Relevant information about the products for the next year is given below.
X Y Z
Selling Price (` / unit) 10 12 12
Variable Costs (` / unit) 6 9 7
Market Demand (unit) 3,000 2,000 1,000
Production Capacity (unit) 2,000 3,000 900
Fixed Costs (`) 30,000

Required
COMPUTE the opportunity costs for each of the products.

© The Institute of Chartered Accountants of India

 MARGINAL COSTING 14.43

SOLUTION

X Y Z

I. Contribution per unit (`) 4 3 5

II. Units (Lower of Production / Market Demand) 2,000 2,000 900
III. Possible Contribution (`) [ I × II ] 8,000 6,000 4,500
IV. Opportunity Cost* (`) 6,000 8,000 8,000

(*) Opportunity cost is the maximum possible contribution forgone by not producing
alternative product i.e. if Product X is produced then opportunity cost will be maximum of
(` 6,000 from Y, ` 4,500 from Z).

ILLUSTRATION 15
M.K. Ltd. manufactures and sells a single product X whose selling price is ` 40 per
unit and the variable cost is ` 16 per unit.
(i) If the Fixed Costs for this year are ` 4,80,000 and the annual sales are at 60%
margin of safety, CALCULATE the rate of net return on sales, assuming an
income tax level of 40%
(ii) For the next year, it is proposed to add another product line Y whose selling
price would be ` 50 per unit and the variable cost ` 10 per unit. The total fixed
costs are estimated at ` 6,66,600. The sales mix values of X : Y would be 7 : 3.
DETERMINE at what level of sales next year, would M.K. Ltd. break even? Give
separately for both X and Y the break-even sales in rupee and quantities.
SOLUTION
(i) Contribution per unit = Selling price – Variable cost
= `40 – `16 = `24
` 4,80,000
Break-even Point = = 20,000 units
`24
Actual Sales – Break - even Sales
Percentage Margin of Safety =
Actual Sales

Actual Sales – 20,000units

Or, 60% =
Actual Sales

∴ Actual Sales = 50,000 units

© The Institute of Chartered Accountants of India

 14.44 COST AND MANAGEMENT ACCOUNTING

(`)
Sales Value (50,000 units × `40) 20,00,000
Less: Variable Cost (50,000 units × `16) 8,00,000
Contribution 12,00,000
Less: Fixed Cost 4,80,000
Profit 7,20,000
Less: Income Tax @ 40% 2,88,000
Net Return 4,32,000
 ` 4,32,000 
Rate of Net Return on Sales = 21.6%  ×100 
 `20,00,000 

(ii) Products

X Y
(`) (`)
Selling Price 40 50
Less: Variable Cost 16 10
Contribution per unit 24 40
Sales Ratio 7 3
Contribution in sales Ratio 168 120

Based on Weighted Contribution

24 ×7 + 40 ×3
Weighted Contribution = = ` 28.8 per unit
10
Total Fixed Cost 6,66,600
Total Break-even Point = = = 23,145.80 units
Weighted Cost 28.80

Break-even Point
7
X = ×23,145.80 = 16,202 units
10
or 16,202 × ` 40 = ` 6,48,080
3
Y = ×23,145.80 = 6,944 units or 6,944 × ` 50 =` 3, 47,200
10

© The Institute of Chartered Accountants of India

 MARGINAL COSTING 14.45

Based on distributing fixed cost in the weighted Contribution Ratio

Fixed Cost
168
X = ×6,66,600 = ` 3,88,850
288
120
Y = ×6,66,600 = ` 2,77,750
288
Break-even Point
Fixed Cost 3,88,850
X = = = 16,202 units or ` 6, 48,000
Contribution per unit 24
Fixed Cost 2,77,750
Y = = = 6,944 units or ` 3, 47,200
Contribution per unit 40
ILLUSTRATION 16
X Ltd. supplies spare parts to an air craft company Y Ltd. The production capacity of
X Ltd. facilitates production of any one spare part for a particular period of time. The
following are the cost and other information for the production of the two different
spare parts A and B:
Part A Part B
Per unit
Alloy usage 1.6 kgs. 1.6 kgs.
Machine Time: Machine P 0.6 hrs 0.25 hrs.
Machine Time: Machine Q 0.5 hrs. 0.55 hrs.
Target Price (`) 145 115
Total hours available Machine P 4,000 hours
Machine Q 4,500 hours

Alloy available is 13,000 kgs. @ ` 12.50 per kg.

Variable overheads per machine hours Machine P: ` 80
Machine Q: ` 100
Required
(i) IDENTIFY the spare part which will optimize contribution at the offered price.
(ii) If Y Ltd. reduces target price by 10% and offers ` 60 per hour of unutilized machine
hour, CALCULATE the total contribution from the spare part identified above?

© The Institute of Chartered Accountants of India

 14.46 COST AND MANAGEMENT ACCOUNTING

SOLUTION
(i)

Part A Part B
Machine “P” (4,000 hrs) 6,666 16,000
Machine “Q” (4,500 hrs) 9,000 8,181
Alloy Available (13,000 kg.) 8,125 8,125
Maximum Number of Parts to be manufactured 6,666 8,125
(Minimum of the above three)

(`) (`)
Material (`12.5 × 1.6 kg.) 20.00 20.00
Variable Overhead: Machine “P” 48.00 20.00
Variable Overhead: Machine “Q” 50.00 55.00
Total Variable Cost per unit 118.00 95.00
Price Offered 145.00 115.00
Contribution per unit 27.00 20.00
Total Contribution for units produced …(I) 1,79,982 1,62,500
Spare Part A will optimize the contribution.
(ii)
Part A
Parts to be manufactured numbers 6,666
Machine P : to be used 4,000
Machine Q : to be used 3,333
Underutilized Machine Hours (4,500 hrs. – 3,333 hrs.) 1,167
Compensation for unutilized machine hours (1,167hrs. × `60) (II) 70,020
Reduction in Price by 10%, Causing fall in Contribution of `14.50 96,657
per unit (6,666 units × `14.5) (III)
Total Contribution (I + II – III) 1,53,345

© The Institute of Chartered Accountants of India

 MARGINAL COSTING 14.47

ILLUSTRATION 17
The profit for the year of R.J. Ltd. works out to 12.5% of the capital employed and the
relevant figures are as under:
Sales……………………………………………………………… ` 5,00,000
Direct Materials………………………………………………… ` 2,50,000
Direct Labour…………………………………………………….. ` 1,00,000
Variable Overheads…………………………………………… ` 40,000
Capital Employed……………………………………………… ` 4,00,000
The new Sales Manager who has joined the company recently estimates for next year
a profit of about 23% on capital employed, provided the volume of sales is increased
by 10% and simultaneously there is an increase in Selling Price of 4% and an overall
cost reduction in all the elements of cost by 2%.
Required
FIND OUT by computing in detail the cost and profit for next year, whether the
proposal of Sales Manager can be adopted.
SOLUTION
Statement Showing “Cost and Profit for the Next Year”
Particulars Existing Volume, Costs, Estimated Sale,
Volume, etc. after 10% Cost, Profit,
etc. Increase etc.*
(`) (`) (`)
Sales 5,00,000 5,50,000 5,72,000
Less: Direct Materials 2,50,000 2,75,000 2,69,500
Direct Labour 1,00,000 1,10,000 1,07,800
Variable Overheads 40,000 44,000 43,120
Contribution 1,10,000 1,21,000 1,51,580
Less: Fixed Cost# 60,000 60,000 58,800
Profit 50,000 61,000 92,780
(*) for the next year after increase in selling price @ 4% and overall cost reduction by 2%.
(#) Fixed Cost = Existing Sales – Existing Marginal Cost – 12.5% on `4,00,000
= `5,00,000 – `3,90,000 – `50,000 =
`60,000
 `92,780 
Percentage Profit on Capital Employed equals to 23.19%  x 100 
 ` 4,00,000 
Since the Profit of `92,780 is more than 23% of capital employed, the proposal of
the Sales Manager can be adopted.

© The Institute of Chartered Accountants of India

 14.48 COST AND MANAGEMENT ACCOUNTING

14.14 DISTINCTION BETWEEN MARGINAL AND

ABSORPTION COSTING
The distinctions in these two techniques are illustrated by the following diagrams:

Absorption Costing Approach

Marginal Costing Approach

14.14.1 The main points of distinction between marginal costing and
absorption costing are as below:

Marginal costing Absorption costing

1. Only variable costs are Both fixed and variable costs are
considered for product costing considered for product costing and
and inventory valuation. inventory valuation.
2. Fixed costs are regarded as Fixed costs are charged to the cost of
period costs. The Profitability production. Each product bears a

© The Institute of Chartered Accountants of India

 MARGINAL COSTING 14.49

of different products is judged reasonable share of fixed cost and thus the
by their P/V ratio. profitability of a product is influenced by the
apportionment of fixed costs.
3. Cost data presented highlight Cost data are presented in conventional
the total contribution of each pattern. Net profit of each product is
product. determined after subtracting fixed cost
along with their variable costs.
4. The difference in the magnitude The difference in the magnitude of
of opening stock and closing opening stock and closing stock affects
stock does not affect the unit the unit cost of production due to the
cost of production. impact of related fixed cost.
5. In case of marginal costing the In case of absorption costing the cost per
cost per unit remains the same, unit reduces, as the production increases
irrespective of the production as it is fixed cost which reduces, whereas,
as it is valued at variable cost the variable cost remains the same per
unit.

14.14.2 Difference in profit under Marginal and Absorption costing

The above two approaches will compute the different profit because of the
difference in the stock valuation. This difference is explained as follows in different
circumstances.
1. No opening and closing stock: In this case, profit / loss under absorption
and marginal costing will be equal.
2. When opening stock is equal to closing stock: In this case, profit / loss
under two approaches will be equal provided the fixed cost element in both
the stocks is same amount.
3. When closing stock is more than opening stock: In other words, when
production during a period is more than sales, then profit as per absorption
approach will be more than that by marginal approach. The reason behind
this difference is that a part of fixed overhead included in closing stock value
is carried forward to next accounting period.
4. When opening stock is more than the closing stock: In other words, when
production is less than the sales, profit shown by marginal costing will be
more than that shown by absorption costing. This is because a part of fixed
cost from the preceding period is added to the current year’s cost of goods
sold in the form of opening stock.

© The Institute of Chartered Accountants of India

 14.50 COST AND MANAGEMENT ACCOUNTING

The presentation of information to management under the two costing techniques

is as under:
Income Statement (Absorption costing)

(` )
Sales XXXXX
Production Costs:
Direct material consumed XXXXX
Direct labour cost XXXXX
Variable manufacturing overhead XXXXX
Fixed manufacturing overhead XXXXX
Cost of Production XXXXX
Add: Opening stock of finished goods XXXXX
(Value at cost of previous period’s production)
XXXXX
Less: Closing stock of finished goods XXXXX
(Value at production cost of current period) .
Cost of Goods Sold XXXXX
Add: (or less) Under (or over) absorption of fixed
Manufacturing overhead XXXXX
Add: Administration costs XXXXX
Selling and distribution costs XXXXX XXXXX
Total Cost XXXXX
Profit (Sales – Total cost) XXXXX
Income Statement (Marginal costing)

(` )
Sales XXXXX
Variable manufacturing costs:
– Direct material consumed XXXXX
– Direct labour XXXXX

© The Institute of Chartered Accountants of India

 MARGINAL COSTING 14.51

– Variable manufacturing overhead XXXXX

Cost of Goods Produced XXXXX
Add: Opening stock of finished goods XXXXX
(Value at cost of previous period)
Less: Closing stock of finished goods (Value at current variable
cost)
Cost of Goods Sold XXXXX
Add: Variable administration, selling and dist. overhead XXXXX
Total Variable Cost XXXXX
Add: Selling and distribution costs
Contribution (Sales – Total variable costs) XXXXX
Less: Fixed costs (Production, admin., selling and dist.) XXXXX
Net Profit XXXXX

It is evident from the above that under marginal costing technique the
contributions of various products are pooled together and the fixed overheads are
met out of such total contribution. The total contribution is also known as gross
margin. The contribution minus fixed expenses yields net profit. In absorption
costing technique cost includes fixed overheads as well.
ILLUSTRATION 18
Wonder Ltd. manufactures a single product, ZEST. The following figures relate to ZEST
for a one-year period:

Activity Level 50% 100%

Sales and production (units) 400 800
(`) (`)
Sales 8,00,000 16,00,000
Production costs:
- Variable 3,20,000 6,40,000
- Fixed 1,60,000 1,60,000
Selling and distribution costs:
- Variable 1,60,000 3,20,000
- Fixed 2,40,000 2,40,000

© The Institute of Chartered Accountants of India

 14.52 COST AND MANAGEMENT ACCOUNTING

The normal level of activity for the year is 800 units. Fixed costs are incurred evenly
throughout the year, and actual fixed costs are the same as budgeted. There were no
stocks of ZEST at the beginning of the year.
In the first quarter, 220 units were produced and 160 units were sold.
Required:
(a) COMPUTE the fixed production costs absorbed by ZEST if absorption costing is
used?
(b) CALCULATE the under/over-recovery of overheads during the period?
(c) CALCULATE the profit using absorption costing?
(d) CALCULATE the profit using marginal costing?
SOLUTION
(a) Fixed production costs absorbed: (` )
Budgeted fixed production costs 1,60,000
Budgeted output (normal level of activity 800 units)
Therefore, the absorption rate: 1,60,000/800 = ` 200 per unit
During the first quarter, the fixed production
cost absorbed by ZEST would be (220 units × ` 200) 44,000
(b) Under /over-recovery of overheads during the period: (` )
Actual fixed production overhead 40,000
(1/4 of ` 1,60,000)
Absorbed fixed production overhead 44,000
Over-recovery of overheads 4,000
(c) Profit for the Quarter (Absorption Costing)

(`) (`)
Sales revenue (160 units × ` 2,000): (A) 3,20,000
Less: Production costs:
- Variable cost (220 units × ` 800) 1,76,000
- Fixed overheads absorbed (220 units × ` 200) 44,000 2,20,000
Add: Opening stock --

© The Institute of Chartered Accountants of India

 MARGINAL COSTING 14.53

 `2,20,000  (60,000)
Less: Closing Stock  ×60units 
 220units 
Cost of Goods sold 1,60,000
Less: Adjustment for over-absorption of fixed (4,000)
production overheads
Add: Selling & Distribution Overheads:
- Variable (160 units × `400) 64,000
- Fixed (1/4 of ` 2,40,000)
th
60,000 1,24,000
Cost of Sales (B) 2,80,000
Profit {(A) – (B)} 40,000

(d) Profit for the Quarter (Marginal Costing)

(`) (`)
Sales revenue (160 units × ` 2,000): (A) 3,20,000
Less: Production costs:
- Variable cost (220 units × ` 800) 1,76,000
Add: Opening stock --
 `1,76,000  (48,000)
Less: Closing Stock  ×60units 
 220units 
Variable cost of goods sold 1,28,000
Add: Selling & Distribution Overheads:
- Variable (160 units × `400) 64,000
Cost of Sales (B) 1,92,000
Contribution {(C) = (A) – (B)} 1,28,000
Less: Fixed Costs:
- Production cost (40,000)
- Selling & distribution cost (60,000) (1,00,000)
Profit 28,000

© The Institute of Chartered Accountants of India

 14.54 COST AND MANAGEMENT ACCOUNTING

SUMMARY
♦ Marginal Cost: Marginal cost as understood in economics is the incremental
cost of production which arises due to one-unit increase in the production
quantity. Marginal cost is measured by the total variable cost attributable to
one unit.
♦ Marginal Costing: It is a costing system where products or services and
inventories are valued at variable costs only. It does not take consideration of
fixed costs.
♦ Absorption Costing: A method of costing by which all direct cost and
applicable overheads are charged to products or cost centers for finding out
the total cost of production. Absorbed cost includes production cost as well as
administrative and other cost.
♦ Contribution: Contribution or contribution margin is the difference between
sales revenue and total variable costs irrespective of manufacturing or non-
manufacturing.
♦ Cost-Volume-Profit (CVP) Analysis: It is an analysis of reciprocal effect of
changes in cost, volume and profitability. Such an analysis explores the
relationship between costs, revenue, activity levels and the resulting profit. It
aims at measuring variations in cost and volume.
♦ Contribution to Sales Ratio (Profit Volume Ratio or P/V ratio): This ratio
shows the proportion of sales available to cover fixed costs and profit.
Contribution represent the sales revenue after deducting variable costs.
♦ Break-even Point (BEP): The level of sales where an entity neither earns profit
nor incurs loss. BEP is indicated in both quantity and monetary value terms.
♦ Margin of Safety (MOS): The margin between sales and the break-even sales
is known as margin of safety. It can either be indicated in quantitative or
monetary terms.
♦ Angle of Incidence: This angle is formed by the intersection of sales line and
total cost line at the break-even point. This angle shows the rate at which
profits is earned once the break-even point is reached.
♦ Limiting (Key) factor: Limiting factor is anything which limits the activity of
an entity. The factor is a key to determine the level of sale and production, thus
it is also known as Key factor.

© The Institute of Chartered Accountants of India