# Elements Of Marginal Costing

Process of marginal costing:

Under marginal costing, calculation of the difference between sales & marginal cost of sales is done. This difference is known as contribution, which provides for fixed cost & profit. Excess of contribution over the fixed cost is known as net margin or profit. Here on the increasing total contribution emphasis remains.

Variable Cost:

Variable is that part of total cost which in proportion with volume changes directly. With change in volume of output, total variable cost changes. Increase in total variable cost results from increase in output & reduction in total variable cost results from decrease in output. However, irrespective of increase or decrease in volume of production, there will be no change in variable cost per unit of output. Cost of direct material, direct labour, direct expenses etc. are included in variable cost. By dividing total variable cost by units produced, variable cost per unit is arrived at. Variable cost per unit is also referred as variable cost ratio. By dividing change in cost by change in activity, variable cost can be arrived at.

Variable costs are very sensitive in nature & variety of factors can influence the same. Helping management in controlling variable cost is the main aim of ‘marginal costing’ because this is the area of cost which itself needs control by management.

Fixed Cost:

Cost which is incurred for a period & which tends to remain unaffected by fluctuations in the level of activity, output or turnover, within certain output & turnover limits. Examples are rent, rates, salaries of executive & insurance etc.

Break-Even Point (B/E Point):

The break-even point is the level of activity or sales at which a company makes neither profit nor loss. Sales revenue exactly equals total costs at this level. Thus, the sales volume at which operations break-even is indicated by the break-even point. In terms of number of units sold or in terms of sales value, it can be expressed.

Sales – Variable cost = Fixed cost + Profit

Since at break-even point, profit is nil, it follows that:

Sales at break-even point – Variable cost = Fixed cost

Thus, at break-even point, contribution is just enough to provide for fixed cost. Thus, enough contribution is necessary to be earned to cover fixed costs before any profit can be earned.  If level of actual sales is above break-even point, profit will be earned by the company. On the other hand, if actual sales are below break-even point, loss will be incurred by the company.

By any of the following formula, the by the break-even point (B/E) can be calculated:

(a) B/E (in terms of units) = Fixed Cost
Contribution per unit

(b) B/E (in terms of sales value) = Fixed Cost * Sales
Contribution

Or, Fixed Cost
P/V ratio

When graphical presentation of cost-volume-profit relationship is made, the break-even point will be the point at which total cost line & total sales line intersect each other.

The break-even point is important to the management because the lowest level to which activity can be dropped without putting the continued life of the firm in jeopardy is indicated by the break-even point. Occasionally, operating below the break-even point may not be necessarily being fatal for a concern, but it must operate above this level in the long run.

Contribution:

On the idea of contribution, analysis of marginal costing depends a lot. In this technique, for increasing total contribution only, efforts are directed. Contribution is a term which defines the surplus that remains after variable cost of sales is deducted from sales revenue as indicated below:

Contribution = Sales revenue – Variable cost of sales

A product whose selling price exceeds its variable cost is said to have:

(a) Covering its variable cost &

(b) Making a contribution,

(i) towards the firm’s fixed cost & after these have been covered;

(ii) towards the firm’s profit.

Alternatively, contribution is equivalent to fixed cost plus profit. Thus, this relationship may be expressed as under:

Sales – Variable cost = Contribution

Fixed cost + Profit = Contribution

Thereby, Sales Variable cost = Fixed cost + Profit

It becomes easy to determine the missing one if any three of these four items is known to us. In break-even analysis, some of the specific uses of contribution are:

1. Break-even point determination;
2. Profitability of products assessment;
3. Different department’s selling price determination;
4. The optimum sales mix determination.

Key factor or Limiting factor:

There are always factors which, for the purpose of managerial control, do not lend themselves. For example, if at a particular point of time, on the import of a material, which is the principal element of company’s product, there is a restriction of Government, then the production cannot be undertaken by the company, as it wishes. Production has to be planned after taking into consideration this limiting factor. However, towards the maximum utilization of available sources, its efforts will be directed. Thus, limiting factor is a factor, by which, at a given point of time, the volume of output of an organization gets influenced.

Key factor is the factor whose influence, for the purpose of ensuring the maximum utilization of resources, must be ascertained first. Profit can be maximized by gearing the process of production in the light of influences of key factors. Managerial action is constrained & output of company is limited by key factor. Any of the following factors can be a limiting factor, although usually sale is the limiting factor but:

(a) Material (b) Labour (c) Power (d) Capacity of plant (e) Action of government.
When, in operation, there is a key factor & regarding relative profitability of different products, a decision has to be taken, then for selecting the most profitable alternative, contribution for each product is divided by key factor.

With the products or projects, the choice of management rests with, thereby showing more contribution per unit of key factor. Thus, if the key factor is sales, then consideration should be given to contribution to sales ratio. If labour shortage is faced by the management, then consideration should be given to contribution per labour hour. Suppose sales of product X & Y are \$ 200 & \$ 220 & variable cost of sales are \$ 60 & \$ 46. The labour hours (key factor) required for these products are 4 hours & 6 hours respectively. The contribution will be: Product X, \$200 - \$60 = \$ 140 per unit or \$ 35 per hour; Product Y, \$220 - \$46 = \$174 per unit or \$29 per hour. In this case, P/V ratio of product Y (79%) is better than P/V ratio of product X (70%) & producing product Y will be the normal conclusion. Here, the key factor is time. Contribution per hour is better in product X than in product Y. Thereby, product X is more profitable than product Y, during labour shortage.

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