MARGINAL COSTING AS A COSTING SYSTEM

Marginal Costing is a type of flexible standard costing that separates fixed costs from
proportional costs in relation to the output quantity of the objects. In particular, Marginal
Costing is a comprehensive and sophisticated method of planning and monitoring costs based
on resource drivers. Selecting the resource drivers and separating the costs into fixed and
proportional components ensures that cost fluctuations caused by changes in operating levels,
as defined by marginal analysis, are accurately predicted as changes in authorized costs and
incorporated into variance analysis. This form of internal management accounting has
become widely accepted in business practice over the last 50 years. During this time,
however, the demands placed on costing systems by cost management requirements have
changed radically.
MARGINAL COST
In economics and finance, marginal cost is the change in total cost that arises when
the quantity produced changes by one unit. It is the cost of producing one more unit of a
good.
Mathematically, the marginal cost (MC) function is expressed as the first derivative of
the total cost (TC) function with respect to quantity (Q). Note that the marginal cost may
change with volume, and so at each level of production, the marginal cost is the cost of the
next unit produced.

In general terms, marginal cost at each level of production includes any additional costs
required to produce the next unit. If producing additional vehicles requires, for example,
building a new factory, the marginal cost of those extra vehicles includes the cost of the new
factory. In practice, the analysis is segregated into short and long-run cases, and over the
longest run, all costs are marginal. At each level of production and time period being
considered, marginal costs include all costs which vary with the level of production, and
other costs are considered fixed costs. A number of other factors can affect marginal cost and
its applicability to real world problems. Some of these may be considered market failures.
These may include information asymmetries, the presence of negative or positive
externalities, transaction costs, price discrimination and others.
RELATION BETWEEN MARGINAL COST AND ECONOMIES OFSCALE

Production may be subject to economies(or diseconomies).Increasing returns to scale

are said to exist if additional units can be produced for less than the previous unit, that

is, average cost is falling.

This can only occur if average cost at any given level of production is higher than the

marginal cost.
Conversely, there may be levels of production where marginal cost is higher than
average cost, and average cost will rise for each unit of production after that point.
This type of production function is generally known as diminishing marginal
productivity: at low levels of production, productivity gains are easy and marginal
costs falling, but productivity gains become smaller as production increases;
eventually, marginal costs rise because increasing output (with existing capital, labour
or organization) becomes more expensive. For this generic case, minimum average
cost occurs at the point where average cost and marginal cost are equal (when plotted,
the two curves intersect); this point will not be at the minimum for marginal cost if
fixed costs are greater than zero.

Short and long run marginal costs and economies of scale

The former takes as unchanged, for example, the capital equipment and overhead of
the producer, any change in its production involving only changes in the inputs of labour,
materials and energy.
The latter allows all inputs, including capital items (plant, equipment, buildings) to
vary. A long-run cost function describes the cost of production as a function of output

assuming that all inputs are obtained at current prices, that current technology is employed,
and everything is being built new from scratch. In view of the durability of many capital
items this textbook concept is less useful than one which allows for some scrapping of
existing capital items or the acquisition of new capital items to be used with the existing stock
of capital items acquired in the past. Long-run marginal cost then means the additional cost or
the cost saving per unit of additional or reduced production, including the expenditure on
additional capital goods or any saving from disposing of existing capital goods. Note that
marginal cost upwards and marginal cost downwards may differ, in contrast with marginal
cost according to the less useful text book concept. Economies of scale are said to exist when
marginal cost according to the textbook concept falls as a function of output and is less than
the average cost per unit. This means that the average cost of production from a larger new
built-from-scratch installation falls below that from a smaller new built-from-scratch
installation. Under the more useful concept, with an existing capital stock, it is necessary to
distinguish those costs which vary with output from accounting costs which will also include
the interest and depreciation on that existing capital stock, which may be of a different type
from what can currently be acquired in past years atpast prices. The concept of economies of
scale then does not apply.
Externalities
Externalities are costs (or benefits) that are not borne by the parties to the economic
transaction. A producer may, for example, pollute the environment, and others may bear those
costs. A consumer may consume a good which produces benefits for society, such as
education; because the individual does not receive all of the benefits, he may consume less
than efficiency would suggest. Alternatively, an individual may be a smoker or alcoholic and
impose costs on others. In these cases, production or consumption of the good in question
may differ from the optimum level.

Negative Externalities of Production

Much of the time, private and social costs do not diverge from one another, but at
times social costs may be either greater or less than private costs. When marginal social costs
of production are greater than that of the private cost function, we see the occurrence of a
externality of production. Productive processes that result in pollution are a textbook example
of production that creates negative externalities. Such externalities are a result of firms
externalizing their costs onto a third party in order to reduce their own total cost. As a result
of externalizing such costs we see that members of society will be negatively affected by such
behavior of the firm. In this case, we see that an increased cost of production on society
creates a social cost curve that depicts a greater cost than the private cost curve. In an
equilibrium state we see that markets creating negative externalities of production will
overproduce that good. As a result, the socially optimal production level would be lower than
that observed.

Positive externalities of production

Positive Externalities of Production . When marginal social costs of production are
less than that of the private cost function, we see the occurrence of appositive of production.
Production of goods are a textbook example of production that create positive externalities.

An

example

of

such

public good, which creates a

divergence in social and private costs, includes the production of education. It is often seen
that education is a positive for any whole society, as well as a positive for those directly
involved in the market. Examining the relevant diagram we see that such production creates a
social cost curve that is less than that of the private curve. In an equilibrium state we see that
markets creating positive externalities of production will under produce that good. As a
result, the socially optimal production level would be greater than that observed.
Social costs
Of great importance in the theory of marginal cost is the distinction between the
marginal private and social costs. The marginal private cost shows the cost associated to the
firm in question. It is the marginal private cost that is used by business decision makers in
their profit maximization goals, and by individuals in their purchasing and consumption
choices. Marginal social cost is similar to private cost in that it includes the cost functions of

private enterprise but also that of society as a whole, including parties that have no direct
association with the private costs of production. It incorporates all negative and positive
externalities, of both production and consumption. Hence, when deciding whether or how
much to buy, buyers take account of the cost to society of their actions if private and social
marginal cost coincide. The equality of price with social marginal cost, by aligning the
interest of the buyer with the interest of the community as a whole is a necessary condition
for economically efficient resource allocation.
Other cost definitions in marginal costing

Fixed costs are costs which do not vary with output, for example, rent. In the long run

all costs can be considered variable.

Variable cost also known as, operating costs prime costs on costs and direct costs are
costs which vary directly with the level of output, for example, labour, fuel, power

and cost of raw material.

Social costs of production are costs incurred by society, asa whole, resulting from

private production.
Average total cost is the total cost divided by the quantity of output.
Average fixed cost is the fixed cost divided by the quantity of output.

Average variable cost are variable costs divided by the quantity of output.

What is Marginal Costing?

It is a costing technique where only variable cost or direct cost will be charged to the
cost unit produced. Marginal costing also shows the effect on profit of changes in
volume/type of output by differentiating between fixed and variable costs. Salient Points:

Marginal costing involves ascertaining marginal costs. Since marginal costs are direct

cost, this costing technique is also known as direct costing;

In marginal costing, fixed costs are never charged to production. They are treated as

period charge and is written off to the profit and loss account in the period incurred;
Once marginal cost is ascertained contribution can be computed.Contribution is the

excess of revenue over marginal costs.

The marginal cost statement is the basic document/format tocapture the marginal
costs.

Features of Marginal Costing System:

It is a method of recording costs and reporting profits;

All operating costs are differentiated into fixed and variable costs;
Variable cost charged to product and treated as a product cost whilst
Fixed cost treated as period cost and written off to the profit and loss account

Disadvantages Of Marginal Costing

Marginal cost has its limitation since it makes use of historical data while decisions by

management relates to future events;

It ignores fixed costs to products as if they are not important to production;
Stock valuation under this type of costing is not accepted by the Inland Revenue as

its ignore the fixed cost element;

It fails to recognize that in the long run, fixed costs may become variable;
Its oversimplified costs into fixed and variable as if it is so simply to demarcate them;
Its not a good costing technique in the long run for pricing decision as it ignores
fixed cost. In the long run, management must consider the total costs not only the

variable portion;
Difficulty to classify properly variable and fixed cost perfectly, hence stock valuation
can be distorted if fixed cost is classify as variable.

MARGINAL COSTING AS A MANAGEMENT ACCOUNTINGTOOL

1.

Marginal Costing is clearly the core aspect of traditional management accounting.

Some of the classical applications of management accounting, however, have begun
to lose their significance. The question thus arises: What is the current role of
Marginal Costing in modern management accounting?

2.

Businesses today frequently voice their disapproval of the traditional cost accounting
approaches. At the beginning of the1990s, these criticisms were taken up by
researchers involved with the applications of cost accounting concepts. The main
thrust of the dissatisfaction with conventional cost accounting methods is that they are

too

highly

developed

and

too

complex, and furthermore are no longer needed in their current form since other tools
are now available. Calls for increased use of cost management tools, investment
analyses, and value-based tool concepts are frequently associated with criticism of the
functionality of current cost accounting approaches as management tools. This line of
criticism sees little relevance in traditional cost accounting tasks such as monitoring
the economic production process or assigning the costs of internal activities. At their
current level of detail, such tasks are neither necessary nor does their perceived
pseudo accuracy further the goals of management. The viewpoint of the present
author is that cost accounting has by no means lost its right to exist, for it is an easily
overlooked fact that the data structure required by the new tools is already present in
traditional cost accounting.
3.

To assess the present-day value of Marginal Costing, the changes occurring in the
business world must be analyzed more closely. We need first to look at how the
purposes of cost accounting are shifting before we can determine its significance
.(i)

cost planning takes precedence over cost control. The effort involved in
planning and monitoring costs is increasingly being seen as excessive. The
charge levied against traditional cost accounting--that its complex cost
allocations merely generate a kind of pseudo precision--lends further credence
to this assessment. An alternative increasingly being called for is to control
costs through direct activity/process information (quantities, times, quality) for
cost management at local, decentralized levels instead of relying on delayed
and distorted cost data. In particular, empirical U.S.research on appropriate

variables for performance measurement, in the context of continuous

improvement and modern managerial concepts, is based on this view. The
need for exact cost planning for profitability management is thus touched on
ex ante.
(ii)

cost accounting must be employed as a tool for cost control at an early stage.
The relative significance of traditional cost accounting as a management
accounting tool will decline as it is applied mainly to fields where costs cannot
be heavily influenced. More significant than influencing the current costs of
production with cost centre controlling and authorized-actual comparisons of
the cost of goods manufactured is timely and market-based authorized cost
management. The greatest scope for influencing costs is at the early product
development phase and when setting up the production processes. At the same
time, this is the stage where cost information is most urgently needed since the
time and quantity standards as defined by Bills of Materials (BOMs) and
production routings are still lacking. This requires different methods of cost
planning than those normally provided by Marginal Costing

.(iii)

the behavioural effect of cost information is starting to be recognized. There

is a strong current of accounting research in the U.S. that takes human
psychological factors into consideration. This is resulting in an extension of
cost theory beyond its pure microeconomic basis. Results of theoretical and
empirical research based, for example, on the principal-agent theory indicate
that knowledge of the "relevant" costs does not always lead to the optimization
of overall enterprise profitability. Hence, the perspective that formed the basis
for the absorption costing issue has changed. Theories according to which cost
allocations can contain information and increase the efficiency of the use of

available capacity, or where future allocations can influence ex-ante decisions,

require empirical research.
4.

The shift in the purposes of cost accounting is being accompanied by a shift in the
main applications of standard costing. Costing solutions for market-oriented
profitability management and life-cycle-based planning and monitoring should be
developed further. They should be implemented both in indirect areas and at the
corporate level. In addition, cost accounting must be integrated into performance
measurement. Competitive dynamics are giving rise to an increasing differentiation of
market-based profitability controlling. This applies to the management of the
profitability of products and product lines, as well as distribution channels and
increasingly customers, customer groups, and markets. The information required for
this purpose can only be supplied by multilevel and multidimensional marketing
segment accounting based on contribution margin accounting. Long-term cost
planning based on the idea of lifecycle costing is gaining in prominence compared
with short-term standard costing. Product decisions are increasingly based on more
than just the cost of goods manufactured and sales costs and now tend to include preproduction costs (such as development costs) and phasing-out costs(such as disposal
costs). Product decisions are viewed strategically.
Whether or not a product is successful is determined by the amortization of its overall

cost. Furthermore, the cost and revenue trend forecasts should be more dynamic to support
the lifecycle pricing policy. This shift in cost and revenue planning is moving cost and
revenue accounting in the direction of investment-related calculations. As management
accounting is increasingly applied to the growing share of the costs of indirect areas, the tool
requirements increase. After J. G. Miller's and T. E. Volkmanns discovery of the "hidden
factory" as an area whose costs are neglected by conventional production costing in the U.S.,

it was only a small step to the identification of the lost relevance of conventional cost
accounting by H. T. Johnson and R. S. Kaplan and their call to develop accounting systems
separated into "process control, product costing, and financial reporting," which eventually
led to activity-based costing. Improving the cost transparency of indirect activity areas
through Marginal Costing requires a thorough understanding of the output processes.
Analysis frequently shows that even many support activities have a wide range of repetitive
processes for which planning and cost allocation using drivers is worthwhile, providing the
cost-volume is large enough. For this purpose, the different operations in the cost centers
must be identified, for which resource consumption is then planned and tracked. The number
of these operations is used as the driver. This process of costing operations using proportional
costs competes with the attempt to achieve better cost transparency in indirect areas with
process costing tools to also improve the planning and control of costs that were previously
budgeted only as a lump sum.
Industrial production and marketing are increasingly being handled by groups of
affiliated companies. To plan and monitor the costs of these activities calls for the
establishment of independent group cost accounting. This necessity results mainly from the
requirements of inventory valuation, the costing basis of transfer prices, and to further the
consistency of corporate cost accounting. Group cost accounting leads to the definition of
independent group cost categories. Marginal Costing and its tools have been developed for
individual companies and are the suitable platform for this expansion .Performance measures
are gaining increasing prominence in decentralized management accounting. Standard U.S.
management books devote a great deal of space to performance measurement in the broad
sense of the word. The concept is broad for the reason that expansion.
Performance measurement is accompanied by the provision of decision-support
information, the management of business units, and the use of incentive systems. Using

modelling and empirical research, the exponents of this area are developing the idea that
monetary factors are not the only possible components of performance measurement. Since
the 1980s there has been a growing consciousness of the significance of continuously
improving the performance capabilities of the company, resulting in the increased importance
of nonmonetary indicators. The recent literature on performance measurement has focused on
problems in the following areas:
* The usability of performance information for managers,
* The assessment of teamwork,
* The motivational effects of performance measurement,
* The strategic dimension.
The tenor of the recent investigations into performance measurement reflects the
general criticism of management accounting voiced by Johnson and Kaplan in Relevance
Lost. It was recognized that short-term accounting information is insufficient to evaluate and
control company activities effectively. In particular, it was acknowledged that the use of
standard costs does not adequately take performance improvements into consideration.
Moreover, the conventional allocation approach based on the operating rate encourages high
utilization of capacity at any cost, underestimates the problem of increasing numbers of
variants, uses the wrong overhead allocation base, and fails to appreciate interdepartmental
interrelationships.

While top management benefits most from financial success indicators that it
examines in monthly or longer intervals and that can consist of multidimensional aggregate
figures, lower management must necessarily be concerned mainly with nonfinancial,

operational, and very short-term data at the day or shift level. In concrete terms, measures in
the categories of time, quantity, and quality--such as equipment downtime, lead time,response
time, degree of utilization (ratio of actual output quantity to planned output quantity), sales
orders, and error rate--are becoming increasingly significant for controlling business
processes.
In the strategic dimension, the Balanced Scorecard developed by Kaplan and Norton-which links financial and nonfinancial indicators from different strategically relevant
perspectives including cause-effect chains--is the main proposal under consideration for
performance measurement. The Balanced Scorecard links strategic contingencies to financial
measures, incorporates success factors of the future, and explicitly includes monetary and
nonmonetary parameters. The Balanced Scorecard therefore provides a framework for
systematic mapping and control of the critical success factors for an enterprise. A Balanced
Scorecard is a system that defines objectives, measures, targets, and initiatives for each of the
four perspectives of financial, customer, internal business process, and learning and growth.
Further analyses and experience in measuring performance can enable identification and
assessment of cause-effect relationships within the four perspectives (such as the effect of
delivery time on customer satisfaction) and between the perspectives (such as the effect of
customer satisfaction unprofitability). The knowledge so gained may eventually lead to are
formulation of strategy.

In the context of comprehensive performance measurement, even short-term costs

and financial results can serve as control instruments for strategic enterprise management,
such as a lower authorized cost of goods manufactured as a benchmark. Concrete planned

costs and planned results must be rigorously derived from higher-level target factors so that
specific requirements can be derived in turn when they are broken down into smaller
organizational units for the time and quantity standards.
Information for decision making The need for a decision arises in business because a
manager is faced with a problem and alternative courses of action are available. In deciding
which option to choose he will need all the information which is relevant to his decision; and
he must have some criterion on the basis of which he can choose the best alternative. Some of
the factors affecting the decision may not be expressed in monetary value. Hence, the
manager will have to make 'qualitative' judgements, e.g. in deciding which of two personnel
should be promoted to a managerial position. A quantitative' decision, on the other hand, is
possible when the various factors, and relationships between them, are measurable. This
chapter will concentrate on quantitative decisions based on data expressed in monetary value
and relating to costs and revenues as measured by the management accountant.
Elements of a decision
A quantitative decision problem involves six parts:
a)

An objective that can be quantified

Sometimes referred to as choice criterion' or 'objective function', e.g. maximization

of profit or minimization of total costs.

b)

Constraints Many decision problems have one or more constraints, e.g. limited raw

materials, labour, etc. It is therefore common to find an objective that will maximize profits
subject to defined constraints.
c)

A range of alternative courses of action under consideration. For example, in order

to minimize costs of a manufacturing operation, the available alternatives may be:

i)

to continue manufacturing as at present

ii)

to change the manufacturing methodiii) to sub-contract the work to a third

party.
d)

Forecasting of the incremental costs and benefits of each alternative course of action.

e)

Application of the decision criteria or objective function, e.g. the calculation of

expected profit or contribution, and the ranking of alternatives.

f)

Choice of preferred alternatives.

Relevant costs for decision making

The costs which should be used for decision making are often referred to as "relevant
costs". CIMA defines relevant costs as 'costs appropriate to aiding the making of specific
management decisions'. To affect a decision a cost must be:
a) Future:
Past costs are irrelevant, as we cannot affect them by current decisions and they are
common to all alternatives that we may choose.

b) Incremental:
' Meaning, expenditure which will be incurred or avoided as a result of making a
decision. Any costs which would be incurred whether or not the decision is made are
not said to be incremental to the decision.

c)

Cash flow:
Expenses such as depreciation are not cash flows and are therefore not relevant.

Similarly, the book value of existing equipment is irrelevant, but the disposal value is
relevant. Other terms:
d) Common costs:
Costs which will be identical for all alternatives are irrelevant, e.g. rent or rates on a
factory would be incurred whatever products are produced.
e) Sunk costs:
Another name for past costs, which are always irrelevant, e.g. dedicated fixed assets,
development costs already incurred.
f)

Committed costs:
A future cash outflow that will be incurred anyway, whatever decision is taken now,

e.g. contracts already entered into which cannot be altered.

Opportunity cost
Relevant costs may also be expressed as opportunity costs. An opportunity cost is the
benefit foregone by choosing one opportunity instead of the next best alternative.

Example

A company is considering publishing a limited edition book bound in a special leather.

It has in stock the leather bought some years ago for Rs.1,000. To buy an equivalent quantity
now would cost Rs.2,000. The company has no plans to use the leather for other purposes,
although it has considered the possibilities:
a) of using it to cover desk furnishings, in replacement for other material which could
cost Rs.900b) of selling it if a buyer could be found (the proceeds are unlikely to
exceed Rs.800).
In calculating the likely profit from the proposed book before deciding to go ahead
with the project, the leather would not be costed at Rs.1,000. The cost was incurred in the
past for some reason which is no longer relevant. The leather exists and could be used on the
book without incurring any specific cost in doing so. In using the leather on the book,
however, the company will lose the opportunities of either disposing of it for Rs.800 or of
using it to save an outlay of Rs.900 on desk furnishings. The better of these alternatives, from
the point of view of benefiting from the leather, is the latter. "Lost opportunity" cost of
Rs.900

will

therefore be included in the cost of the book for decision

making purposes. The relevant costs for decision purposes will be the sum of:
i)

'avoidable outlay costs', i.e. those costs which will be incurred onlyif the book project
is approved, and will be avoided if it is not

ii)

the opportunity cost of the leather (not represented by any outlay cost in connection to
the project). This total is a true representation of 'economic cost. Now attempt
exercise 5.1.

The assumptions in relevant costing

Some of the assumptions made in relevant costing are as follows:
a)

Cost behavior patterns are known, e.g. if a department closedown, the attributable

fixed cost savings would be known.

b)

The amount of fixed costs, unit variable costs, sales price and sales demand are

known with certainty.

c)

The objective of decision making in the short run is to maximize 'satisfaction', which

is often known as 'short-term profit'.

d)

The information on which a decision is based is complete and reliable.

THE BASIC DECISION MAKING INDICATORS INMARGINAL COSTING

PROFIT VOLUME RATIO

BREAK- EVEN POINT
CASH VOLUME PROFIT ANALYSIS
MARGIN OF SAFETY
INDIFFERENCE POINT
SHUT DOWN POINT

PROFIT VOLUME RATIO (P/ V RATIO)

The profit volume ratio is the relationship between the Contribution and Sales value. It is
also termed as Contribution to Sales Ratio Formula:
P /V Ratio =

Contribution X 100 /Sales

Significance of P/V Ratio

It is considered to be the basic indicator of profitability of business.

 The higher the PV Ratio, the better it is for the business. In the case of the firm
enjoying steady business conditions over aperiod of years, the PV Ratio will also
remain stable and steady.
If PV Ratio is improved, it will result in better profits.
Improvement of PV Ratio
By reducing the variable costs.
By increasing the selling price
By increasing the share of products with higher PV Ratio in the overall sales mix.
(where a firm produces a number of products)
Use of PV Ratio
To compute the variable costs for any volume of sales
To measure the efficiency or to choose a most profitable line. The overall profitability
of

the

firm

can

be

improved

by

increasing the sales/output of product giving a higher P/V Ratio.

To determine the Break Even Point and the level of output required to earn a desired
profit.
To decide the most profitable sales mix.
BREAK EVEN ANALYSIS

Break-Even Analysis is a mathematical technique for analyzing the relationship

between sales and fixed and variable costs. Break-even analysis is also a profit-planning tool
for calculating the point at which sales will equal total costs.

The break-even point is the intersection of the total sales and the total cost lines. This

point determines the number of units produced to achieve breakeven.

The analysis generally assumes linearity (100% variable or100% fixed) of costs. If a

firms costs were all variable, the firm could be profitable from the start. If the firm is to
avoid losses, its sales must cover all costs that vary directly with production and all costs that
do not change with production levels.

Fixed costs are those expenses associated with the project that you would have to pay

whether you sold one unit or10,000 units. Examples include general office expenses, rent,
depreciation, interest, salaries, research and development, and utilities. Variable costs vary
directly with the number of units that you sell. Examples include materials, direct labour,
postage, packaging, and advertising. Some costs are difficult to classify. As a general
guideline, if there is a direct relationship between cost and number of units sold, consider the
cost variable. If there is no relationship, then consider the cost fixed.

A break-even chart is constructed with a horizontal axis representing units produced

and a vertical axis representing sales and costs. Represent fixed costs by a horizontal line
since they do not change with the number of units produced. Represent variable costs and
sales by upward sloping lines since they vary with the number of units produced and sold.
The break-even point is the intersection of the total sales and the total cost lines. Above that
point, the firm begins to make a profit, but below that point, it suffers a loss. Here is a sample
break-even chart:

The algebraic equation for break-even analysis consists of four factors. If you know any three
of the four, you can solve for the fourth factor. You calculate the break-even amount with the

following equation: Sales Price per Unit * Quantity Sold = Fixed Costs + [Variable Costs per
Unit * Quantity Sold]For example, assume you have total fixed monthly costs of Rs.1200 and
total variable costs of Rs.6 per unit. If you could sell the units for Rs.10 each, the equation
indicates that you need to sell 300 units to break even. If you knew you could sell 400units,
the equation would indicate that the sales price would need to be Rs.9 per unit to break even.

When managing inventory, you should aim for the Economic Order Quantity

(EOQ). This is the level of inventory that balances two kinds of inventory costs: holding (or
carrying)costs, which increase with the amount of inventory ordered, and order costs, which
decrease with the amount ordered.

The largest components of holding costs for most companies are the cost of space to

store the inventory and the cost of tying up capital in inventory. Other components include
the labour costs associated with inventory maintenance and insurance costs. Also include
deterioration, spoilage, and obsolescence costs. The costs of more frequent orders include lost
discounts for larger quantity purchases and labour and supply costs of writing the orders.
Additional costs include paying the bills and processing the paperwork, associated telephone
and mail costs, and the labour costs of processing and inspecting incoming inventory.

EOQ is the size of order that minimizes the total of holding and ordering costs. The

algebraic expression of EOQ is as follows:

EOQ = square root of [2*U*O divided by H] where U is the number of units used
annually, O is the order cost per order, and H is the holding cost per unit.
For example, assume you use 40,000 units annually, it costsRs.50 to place an order,
and it costs Rs.20 to hold the raw materials for one unit. The equation yields an amount of
447,which is the number of units you need to order at one time to minimize total costs.
The reorder point, or Economic Order Point (EOP), tells you when to place an order.
Calculating the reorder point requires you to know the lead time from placing to receiving an
order. You compute it as follows: EOP = Lead time * Average usage per unit of time.
For example, assume you need 6400 units evenly throughout the year, there is a lead
time of one week, and there are 50 working weeks in the year. You calculate the reorder point
to be 128 units as follows.
1 week * [6400 units / 50 weeks] = 128 units
You might also consider Just In Time inventory management, if available and
appropriate. Just In Time allows you to keep minimal inventory in stock. You only order
when you make a sale. Carefully analyze the time lag. You must be able to satisfy the
customer as well as keep your inventory investment minimized.
Use of BEP Analysis In capital budgeting
Break even analysis is a special application of sensitivity analysis. It aims at finding
the value of individual variables which the projects NPV is zero. In common with sensitivity
analysis, variables selected for the break even analysis can be tested only one at a time. The

break even analysis results can be used to decide abandon of the project if forecasts show that
below breakeven values are likely to occur. In using break even analysis, it is important to
remember the problem associated with sensitivity analysis as well as some extension specific
to the method:
Variables are often interdependent, which makes examining them each individually
unrealistic.
Often the assumptions upon which the analysis is based are made by using past
experience / data which may not hold in the future.
Variables have been adjusted one by one; however it is unlikely that in the life of the
project only one variable will change until reaching the breakeven point. Management
decisions made by observing the behavior of only one variable are most likely to be
invalid.
Break even analysis is a pessimistic approach by essence. The figures shall be used
only as a line of defense in the project analysis.
Limitations Of BEP Analysis
Break-even analysis is only a supply side (i.e. costs only) analysis, as it tells you
nothing about what sales are actually likely to be for the product at these various
prices.
It assumes that fixed costs (FC) are constant
It assumes average variable costs are constant per unit of output, at least in the range
of likely quantities of sales. (i.e. linearity)
It assumes that the quantity of goods produced is equal to the quantity of goods sold
(i.e., there is no change in the quantity of goods held in inventory at the beginning of
the period and the quantity of goods held in inventory at the end of the period).
In multi-product companies, it assumes that the relative proportions of each product
sold and produced are constant (i.e., the sales mix is constant).
COST VOLUME PROFIT ANALYSIS

 Analysis that deals with how profits and costs change with a change in volume. More
specifically, it looks at the effects on profits of changes in such factors as variable
costs, fixed costs, selling prices, volume, and mix of products sold.
CVP analysis involves the analysis of how total costs, total revenues and total profits
are related to sales volume, and is therefore concerned with predicting the effects of
changes

in
costs and sales

volume on profit. It is also known as breakeven analysis'.

By studying the relationships of costs, sales, and net income, management is better
able to cope with many planning decisions. For example, CVP analysis attempts to
answer the following questions:
(1) What sales volume is required to break even?
(2) What sales volume is necessary in order to earn a desired (target) profit?
(3) What profit can be expected on a given sales volume?
(4) How would changes in selling price, variable costs, fixed costs, and output affect
profits?
(5) How would a change in the mix of products sold affect the break-even and target
volume and profit potential?
Cost-volume-profit analysis (CVP), or break-even analysis, issued to compute the
volume level at which total revenues are equal to total costs. When total costs and
total revenues are equal, the business organization is said to be "breaking even." The
analysis is based on a set of linear equations for a straight-line and the separation of
variable and fixed costs.
Total variable costs are considered to be those costs that vary as the production
volume changes. In a factory, production volume is considered to be the number of
units produced, but in a governmental organization with no assembly process, the
units produced might refer, for example, to the number of welfare cases processed.
There are a number of costs that vary or change, but if the variation is not due to
volume changes, it is not considered to be a variable cost. Examples of variable costs
are direct materials and direct labour. Total fixed costs do not vary as volume levels

change within the relevant range. Examples of fixed costs are straight-line
depreciation and annual insurance charges.
All the lines in the chart are straight lines: Linearity is an underlying assumption of
CVP analysis. Although no one can be certain that costs are linear over the entire
range of output or production, this is an assumption of CVP.
To help alleviate the limitations of this assumption, it is also assumed that the linear
relationships hold only within the relevant range of production. The relevant range is
represented by the high and low output points that have been previously reached with
past production. CVP analysis is best viewed within the relevant range, that is, within
our previous actual experience. Outside of that range, costs may vary in a nonlinear
manner. The straight-line equation for total cost is: Total cost = total fixed cost + total
variable cost Total variable cost is calculated by multiplying the cost of a unit, which
remains constant on a per-unit basis, by the number of units produced. Therefore the
total cost equation could be expanded as: Total cost = total fixed cost + (variable cost
per unit number of units) Total fixed costs do not change. A final version of the
equation is:
Y = a + bx
Where a is the fixed cost, b is the variable cost per unit, x is the level of activity, and
Y is the total cost. Assume that the fixed costs are Rs.5,000, the volume of units produced is
1, 000, and the per-unit variable cost is Rs.2. In that case the total cost would be computed as
follows:
Y = Rs.5,000 + (Rs.2 1,000)Y = Rs.7,000
It can be seen that it is important to separate variable and fixed costs. Another reason
it is important to separate these costs is because variable costs are used to determine the
contribution margin, and the contribution margin is used to determine the break-even point.

The contribution margin is the difference between the per-unit variable cost and the selling
price per unit. For example, if the per-unit variable costs Rs.15 and selling price per unit is
Rs.20, then the contribution margin is equal to Rs.5. The contribution margin may provide a
Rs. 5 Contribution toward the reduction of
fixed costs or a Rs. 5contribution to profits. If the business is operating at a volume above the
break-even point volume (above point F), then theRs.5 is a contribution (on a per-unit basis)
to additional profits. If the business is operating at a volume below the break-even point
(below point F), then the Rs.5 provides for a reduction in fixed costs and continues to do so
until the break-even point is passed.
Once the contribution margin is determined, it can be used to calculate the break-even
point in volume of units or in total sales dollars. When a per-unit contribution margin
occurs below a firm's break-even point, it is a contribution to the reduction of fixed
costs. Therefore, it is logical to divide fixed costs by the contribution margin to
determine how many units must be produced to reach the break-even point:
The financial information required for CVP analysis is for internal use and is usually
available only to managers inside the firm; information about variable and fixed costs
is not available to the general public. CVP analysis is good as general guide for one
product within the relevant range. If the company has more than one product, then the
contribution margins from all products must be averaged together. But, any costaveraging process reduces the level of accuracy as compared to working with cost
data from a single product. Furthermore, some organizations, such as nonprofits
organizations, do not incur a significant level of variable costs. In these cases,
standard CVP assumptions can lead to misleading results and decisions.

USES OF CVP ANALYSIS

a)

Budget planning
The volume of sales required to make a profit(breakeven point) and the 'safety

margin' for profits in the budget can be measured.

b)

Pricing and sales volume decisions

c)

Sales mix decisions, to determine in what proportions each product should be sold.

d)

Decisions that will affect the cost structure and production capacity of the

company.

THE BASIC PRINCIPLES OF CVP ANALYSIS

CVP analysis is based on the assumption of a linear total cost function (constant unit
variable cost and constant fixed costs) and so is an application of marginal costing principles.
The principles of marginal costing can be summarized as follows:
a)

Period fixed costs are a constant amount, therefore if one extra unit of product
is made and sold, total costs will only rise by the variable cost (the marginal
cost ) of production and sales for that unit.

b)

Also, total costs will fall by the variable cost per unit for each reduction by
one unit in the level of activity.

c)

The additional profit earned by making and selling one extra unit is the extra
revenue from its sales minus its variable costs, i.e. the contribution per unit.

d)

As the volume of activity increases, there will be an increase in total profits

(or a reduction in losses) equal to the total revenue minus the total extra
variable costs. This is the extra contribution from the extra output and sales.

e)

The total profit in a period is the total revenue minus the total variable cost of
goods sold, minus the fixed costs of the period.

MARGIN OF SAFETY
Margin of safety represents the strength of the business. It enables a business to know
that what is the exact amount he/ she has gained or loss over or below break even
point).Margin of safety = (( sales - break-even sales) / sales) x 100% If P/V ratio is given then
sales/p v ratio
In unit sales
If the product can be sold in a larger quantity that occurs at the breakeven point, then
the firm will make a profit; below this point, a loss. Break-even quantity is calculated by:
Total fixed costs / (selling price - average variable costs).Explanation - in the denominator,
"price minus average variable cost" is the variable profit per unit, or contribution

margin of each unit that is sold.

This relationship is derived from the profit equation: Profit =Revenues - Costs where
Revenues = (selling price * quantity of product) and Costs = (average variable costs *
quantity) +total fixed costs.

Therefore, Profit = (selling price * quantity) - (average variable costs * quantity +

total fixed costs).Solving for Quantity of product at the breakeven point when Profit equals
zero, the quantity of product at breakeven is Total fixed costs / (selling price - average
variable costs).
Firms may still decide not to sell low-profit products, for example those not fitting
well into their sales mix. Firms may also sell products that lose money - as a loss leader, to
offer a complete line of products, etc. But if a product does not break even, or a potential
product looks like it clearly will not sell better than the breakeven point, then the firm will not
sell, or will stop selling, that product. An example:
Assume we are selling a product for Rs.2 each.
Assume that the variable cost associated with producing and selling the product is 60
cents.
Assume that the fixed cost related to the product (the basic costs that are incurred in
operating the business even if no product is produced) is Rs.1000.
In this example, the firm would have to sell (1000 / (2.00 -0.60) = 715) 715 units to
break even. In that case the margin of safety value of NIL and the value of BEP is not
profitable or not gaining loss.
Break Even =FC/ (SPVC)
Where FC is Fixed Cost, SP is selling Price and VC is Variable Cost
Significance:
Up to the BEP, the contribution is earned is sufficient only to recover the fixed costs.
However the beyond the BEP, the contribution is called the profit
Profit is nothing but the contribution earned out of margin of safety of sales.
The size of the margin of safety shows the strength of the business.
A low margin of safety indicates the firm has large fixed expenses and is moir
vulnerable to changes.

 A high margin of safety implies that a slight fall in sales may not the business very
much.

Improvements in margin of safety:

The possible steps for improve the margin of safety.
Increase in selling price, provided the demand is inelastic so as to absorb the

increased prices.
Reduction in fixed expenses
Reduction in variable expenses
Increasing the sales volume provided capacity is available.
Substitution or introduction of a product mixes such that more profitable lines are
introduced.

SHUT DOWN PROBLEMS

Shut down point indicates the level of operation (sales), below which it is not justifiable to
pursue production. For this purpose fixed expenses of a business are classified as
(i)
(ii)

avoidable or discretionary fixed costs

Unavoidable or committed fixed costs.

The focus of shut down point calculation is to recover the avoidable fixed costs in the first
place. By suspending the operations, the firm may save as also incur some additional
expenditure. The decision is based on whether contribution is more than the difference
between the fixed expenses incurred in normal operation and the fixed expense incurred
when the plant is shut down. A firm has to close down if its contribution is insufficient to
recover even the avoidable fixed costs. Shutdown problems involve the following types of
decisions:

a)

Whether or not to close down a factory, department, product line or other activity,
either

b)

because it is making losses or because it is too expensive to run.

If the decision is to shut down, whether the closure should be permanent or

temporary. Shutdown decisions often involve long-term considerations, and capital
expenditures and revenues.

c)

A shutdown should result in savings in annual operating costs for a number of years in
the future.

d)

Closure results in release of some fixed assets for sale. Some assets might have a
small scrap value, but others, e.g. property, might have a substantial sale value.

e)

Employees affected by the closure must be made redundant or relocated, perhaps

even offered early retirement. There will be lump sums payments involved which
must be taken into consideration. For example, suppose closure of a regional office
results in annual savings of Rs.100,000, fixed assets sold off for Rs.2 million, but
redundancy payments would be Rs.3 million. The shutdown decision would involve
an assessment of the net capital cost of closure (Rs.1million) against the annual
benefits (Rs.100,000 per annum).It is possible for shutdown problems to be simplified
into short run decisions, by making one of the following assumptions
a)

Fixed asset sales and redundancy costs would be negligible.

b)

Income from fixed asset sales would match redundancy costs and
these items would be self-cancelling. In these circumstances the

financial aspects of shutdown decisions would be based on short run

relevant costs.
CASH POSITION AND FORECAST
1. The Cash position and forecast enquiry is usually used by the Treasurer or whoever is
responsible for ensuring that the company has adequate funds for expected outgoings.
2. The Cash Position input data is the known balances:
3. Postings in cash and bank accounts (any account relevant to cash management),the
unreconciled entries in the bank clearing accounts (uncashed cheques etc), and
4. any memo records which may have been manually entered(planning advices) as
relevant to a cash position
5. cash flows from transactions managed in Treasury Management Examples are:
6. -bank balances
7. outgoing checks posted to the bank clearing account
8. -outgoing transfers posted to the bank clearing account
9. -maturing deposits and loans
10. -notified incoming payments posted to the bank account
11. -incoming payments with a value date
GUIDELINES FOR RUNNING THE CASHPOSITION OR FORECAST ENQUIRY
1. Understanding the Business Requirements
Describes the information that you should gather about your companys operations in
this area to adequately configure it.
2. Dates and the Cash Forecast
The Cash position and forecast is all about amounts and dates. The section explains
how the dates are determined for the various inputs.
3. Cash Forecast Terminology
Explains the key terms that are encountered in the configuration. Must be read before
embarking on the configuration section.

4. Cash Forecast Configuration

Guidelines on configuring the Cash Position and Forecast - presented in two sections essential and then advanced configuration.
5. Related Configuration / Processing areas
Describes some of the related configuration and processing areas that impact or feed
data to the cash forecast.
6. Preparing test data
Presents some hints on preparing test data directly without having to run the feeder
programs.

PROFIT AND LOSS FORECAST

A Profit and Loss Account is designed to show the financial performance of a
business over a given period (usually Monthly or Annually) and to indicate whether it is (or,
in the case of a P & L Forecast, if it will) make or lose money.
Without Profit there eventually will be no business.
Profit and Loss is also essential in providing information for In land Revenue for
Taxation purposes.
Understanding how a Profit and Loss Account works will help you to choose the right
time to buy items that you need for the business, reduce your tax liability (Tax Bill) and work
out how much Tax you will have to pay.
PROFIT AND PLANNING

Profit planning is essential when you want your business to focus on enhancing its
profit-making capabilities. Effective profit planning happens when you determine in advance
a set of clear and realistic goals that your business or organization needs to fulfil. Those goals
must be based upon objective existing and expected business conditions. Anticipating the
changes in your business environment is also central to profit planning.
Given the central role profit planning can play in the future prospects of an
organization, it might come as a surprise to learn that a large number of businesses do not
usually have or develop a financial plan. What is even more amazing is that many of the
businesses which do plan for their financial future often just repeat the same procedure over
and over every year. They do not take the time to look at how the plan works, or if it is really
working.
A very small number of businesses currently knows how to practice and benefit from
proficient profit planning. However, research indicates that profit planning might be a central
reason behind the increased sales and profits enjoyed by these few businesses. Appropriate
profit planning can help your company enjoy those benefits too.
Effective profit planning can have a deep impact in the life of your organization. The
professionals at FRS Consultants believe that profit planning is a key element which has led
to the success of big and small businesses alike. That said, it could truly ensure continuous
prosperity for your own business, as well. FRS Consultants is a trustworthy firm of honest
and experienced professionals that can lead you to make the best out of profit planning. Many
goldbricks in the field are more eager to charge you premiums for their time than to deliver
what you are paying for. At FRS Consultants we do not shirk our work. We will strive to
deliver on time and prove the value of our service. Other consulting firms may seem less

expensive than us, but that is not the case. To learn more or to request a free consultation
please completes our online form.

You are supplied with the information relating to sales and costs of sales of a manufacturing
company. You are required to find out
1)
b)
c)
d)
e)
2)

A) P. V. Ratio
Break even point
Margin of safety in 2002
Profit when sales are Rs. 120000
Sales required to earn a profit of Rs.75000
Calculate the revised P.V. ratio, break even point in each of the following cases:
a) Decrease of 10% in selling price
b) Increase of 10% in variable costs
c) Increase of sales volume to 4000 units and increase in fixed costs by Rs. 40000
d) Increase of Rs. 18000 in fixed costs.
e) Increase of 20% in selling price and increase of Rs. 8000 in fixed costs.
3) The sales and costs of sales during the two years were as follows:
Year
2001
2002

Sales (Rs.)
600000
750000

Cost of sales (Rs)

560000
680000

Units
2400
3000

SOLUTION :
1) A) P.V. Ratio
= Change in profit /change in sales x 100
=70000 40000 / 750000 600000 x 100 = 20 %
B) BEP = Fixed cost
P. V. Ratio
= 80000
20%
= Rs 400000
2001 profit = (sales x P.V. Ratio) fixed costs
40000 = (600000 x 0.2) fixed costs
Fixed costs = Rs. 80000
C) Margin of safety in 2002 = 750000 400000 = Rs.350000
D) Profit
= (sales x P.V.Ratio) fixed cost
= (120000 x 0.2) 80000
Loss
= Rs 56000
E) profit
= (sales x P.V. Ratio) fixed costs
75000
= (sales x 0.2) 80000
155000
= 0.2 sales
Sales
= Rs 775000
(2)

P. V. Ratio =

a)

10
90

b)
c)

12
100
20

C
S

x 100

x 100 = 11.11%
x 100
x 100

= 12%
= 20%

B.E.P. =

FC
P. V. Ratio

80,000
11.11%

= 7,20,072

80,000
12%

= 6,66,667

1,20,000 = 6,00,000

100

20%

c) 20%

98,000

= 4,90,000

20%
d) 40
120

x 100

= 33.33%

88,000

= 2,64,000