Marginal costing and CVP analysis

Meaning of Marginal Costing:

Is the ascertainment of marginal costs and of the effect of changes in volume

or type of output by differentiating between fixed costs and variable costs.

Features:

a. It is a technique of ascertaining marginal costs

b. All costs are classified in to variable costs and fixed costs.

c. Variable costs only charged to production.

d. Selling price=variable costs +contribution.

e. Profit = contribution –fixed costs.

f. Breakeven analysis is one of the integral part of Marginal Costing.

g. Profitability of the product is based on contribution made available by

each product or department.

What is marginal cost?

Is the amount at any given volume of output by which aggregate costs

are changed if the volume of output is increased or decreased by one
unit.

Decision Making:

When the information is provided by the total cost method which is

not sufficient in solving the management problems, the Marginal
costing technique is used in providing assistance to the management
in vital decision making.

The important are areas where managerial problems are simplified by

use of marginal costing.
1. Fixing the selling price: when prices fall during depression and the
product may be sold below the total cost. In case there is a serious
but temporary fall in the demand on account of depression leading
to drastic reduction in selling prices temporarily, then the minimum
selling price should be equal to the marginal cost. If the selling price
is above the marginal cost, then loss on account of fixed can be
reduced. Production should be discontinued if the selling price is
below the marginal cost. There are some exceptions to this concept.

a. When a new product is introduced in the market.

b. When foreign market is to be explored to earn foreign exchange.

c. When the firm has purchased large quantities of materials.

d. When closure of business.

e. When sales of one product at a price below the marginal cost will
push up the sale of other profitable products.

f. When employees cannot be retrenched.

g. When facing sever competition.

h. When goods are perishable in nature.

i. For publicity and advertisement.

j. When weak competitor is to be eliminated from the market.

2. Key or limiting factor: a key factor is that factor which puts a limit
on production and profit of a business. The production is limited due
to the shortage of materials, labour, plant capacity, or capital.
Scarce resources should be utilized in such direction in which
contribution per unit of scarce factor of production is the maximum.

3. Make or Buy decision: a concern may utilize the idle capacity by

making the component parts instead of buying them from market.
In arriving such decisions the price of the suppliers should be
compared with the marginal cost of producing the component
parts. If the marginal cost is less than the purchase price then the
parts should be manufactured, otherwise it should be purchased. Of
 course other technical factors should also be considerd before
making such decision. Other factors are:

a. Quality of goods supplied by the supplier.

b. Uninterrupted supply by the supplier meeting the delivery dates.

c. Any adverse effect to labour relations, if decide to buy outside

instead of making

d. The facility of wider selection in case of buying decision.

e. If secrecy is to be maintained and manufacturing know-how is

not to be passed on to the supplier of the part.

4. Selection of suitable product mix: when a factory produces more

than one product, the selection of a suitable product mix is the
managerial problem. The best product mix is that yields the
maximum contribution. The effect of sales mix can also been by
comparing the P/V ratio and Break-Even Point. The new sales mix
will be favour able if it increases the P/V ratio and reduces the
Break-Even-Point.

5. Cost indifference point: sometimes there are two alternatives one

having low variable costs and high fixed costs and the other having
high variable costs and low fixed costs. The cost indifference point
determine the linking the incremental fixed costs by savings in
variable costs. At indifference point the total costs of two
alternatives will be same. In case of selection to this point will be
helpful in calculating the level of sales at which both machines earn
equal profits and the range of sales at which one is more profitable
than the other.