International financial and management accounting lesson 08

8 INTRODUCTION TO MARGINAL COSTING CONTENTS 8.0 Aims and Objectives 8.1 Introduction 8.2 Variable Costs 8.3 Fixed Costs 8.4 Mixed Costs/Semi-variable Costs 8.4.1 High-Low Method 8.4.2 Sc

UNIT III

8

INTRODUCTION TO MARGINAL COSTING

CONTENTS

8.0 Aims and Objectives

8.1 Introduction

8.2 Variable Costs

8.3 Fixed Costs

8.4 Mixed Costs/Semi-variable Costs

8.4.1 High-Low Method

8.4.2 Scattergraph Method

8.4.3 The Method of Least Squares

8.4.4 Uses of Segregation of Cost

8.5 Meaning of Marginal Costing

8.6 Importance of Marginal Costing

8.6.1 Method of Difference

8.6.2 Method of Coverages

8.7 Problem of Decision Making

8.7.1 Incremental Analysis Approach

8.7.2 How Incremental Analysis Works

8.7.3 Types of Incremental Analysis

8.8 Let us Sum up

8.9 Lesson End Activity

8.10 Keywords

8.11 Questions for Discussion

8.12 Suggested Readings

8.0 AIMS AND OBJECTIVES

After studying this lesson, you will be able to:

 Define marginal costing

 Distinguish between fixed and variable costs

 Understand marginal cost analysis and its role in decision making

8.1 INTRODUCTION

To manage a business, it is essential to understand how costs respond to changes in sales volume and the effect of costs and revenues on profit i.e., CVP relationships It is therefore essential to know how costs behave

1 Cost behaviour analysis is the study of how specific costs respond to changes in the level of business activity As you might expect, some costs change, and others remain the same

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2 A knowledge of cost behaviour helps management plan operations and decide between alternative courses of action Cost behaviour analysis applies to all types

of entities

3 For an activity level to be useful in cost behaviour analysis, changes in the level or volume of activity should be correlated with changed in costs The activity level selected is referred to as the activity (or volume) index The activity index identifies the activity that causes changes in the behaviour; in other words, by correlating costs with an appropriate activity index, it is possible to classify the behaviour of costs in response to changes in activity levels into three categories: variable, fixed,

or mixed

8.2 VARIABLE COSTS

Variable costs are costs that vary in total directly and proportionately with changes in the activity level

It is for this reason, if the level of activity increases by 25 percent, total variable costs will increase by 25 percent If the level of activity decreases by 25 percent, variable costs will decrease by 25 percent In the same way if there is no change in the activity level, total variable costs will also remain unchanged

Example of variable costs include direct materials and direct labour for a manufacturer; consumption of petrol and diesel in transport companies; sales commissions for a merchandiser etc Generally it is observed that those companies which are labour intensive have high proportion of variable cost as compared to companies which are capital intensive

It is important to note, although the variable cost in total will vary proportionately, yet at the same time it remains the same per unit at every level of activity

y

x

Vc

0

Units of Production

Figure 8.1: Variable Costs

8.3 FIXED COSTS

Fixed Costs are costs that remain the same in total regardless of changes in the activity level

Examples include insurance, rent, supervisory salaries, and depreciation on buildings and equipment

Since total fixed costs remain constant irrespective of activity changes, it follows that fixed costs per unit vary inversely with activity: As volume increases, per unit fixed cost declines, and vice versa

Note: With the rise in use of automation in most manufacturing companies, the proportion

of fixed costs has risen considerably by way of increase in the value of depreciation cost and other expenses like lease rent charges

147 Introduction to Marginal Costing y

x

Fc

0

Units of Production

Figure 8.2: Fixed Costs

In most business situations, a straight-line relationship does not exist for fixed costs

throughout the entire range of possible activity At abnormally low levels of activity, it

may be impossible to be cost efficient

Total fixed costs also do not have a straight-line relationship over the entire range of

activity Some fixed costs will not change But it is possible for management to change

other fixed costs

8.4 MIXED COSTS/SEMI-VARIABLE COSTS

Mixed costs are costs that contain both a variable element and a fixed element They

are also referred to as semi-variable costs

Mixed costs change in total but not proportionately with changes in the activity level

Example of mixed costs are telephone cost or electricity cost which includes a fixed

rental charge and the rest of the billed amount would depend on the units of consumption

For purposes of CVP analysis the costs are bifurcated into either fixed or variable costs

It is therefore necessary to segregate fixed and variable elements in mixed costs

In order to segregate the costs, the management must analyse the fixed and the variable

element each time the cost is incurred This method of segregation is not a practical

approach because of time and cost constraints

Another way is to determine the total mixed costs for the period, and then, by using its

past experience on the behaviour pattern of the mixed costs, segregate the fixed and the

variable elements For this the following methods can be used:

8.4.1 High-Low Method

STEP-1 Calculate the total costs incurred at the high and low levels of activity during

a period of time

STEP-2 Find out the difference between the costs of these two levels

STEP-3 The result of the above step is the total variable cost, since only the variable

element of the cost will change due to change in the activity level

STEP-4 Variable cost per unit =

(Change in total costs) ÷ (High-Low activity level)

Example:

The maintenance cost of Carriers Ltd for a quarter was found to be Rs 9000 for 7000

Kms during the peak period Similarly the lowest cost was Rs 8200 while running for

5400 Kms

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The fixed and variable element in the maintenance cost is found as follows:

Maintenance Cost (Rs.) Kms.run

Highest 9000 7000 Lowest 8200 5400 Difference 800 1600 Variable cost per km = Highest Cost = Lowest Cost

Highest kms = Lowest kms

Unit = Unit 800/1600 = Rs 0.50/km

Substituting the value of the variable cost to find out the fixed cost in any of the cost data

of a period given in the question, we use it in the peak period cost data, thus:

Variable costs at the peak level = 7000 km X 0.50 = Rs 3500

Fixed cost = Total cost – variable cost

Rs.9000 – Rs.3500 = Rs 5500

To check let us substitute the valued in the lowest period cost

Variable costs at the lowest level = 5400 km X 0.50 = Rs.2700

Fixed cost = Total cost – variable cost

Rs.8200 – Rs.2700 = Rs 5500

Hence verified

Drawback of this Method

 It assumes variable element of cost for an item per unit is constant but this does not always holds true as increase or decrease of cost may not be proportionate to the change in the activity level

 The high-low method does not produce a precise measurement of the fixed and variable elements in a mixed cost because other activity levels are ignored in the computation

8.4.2 Scattergraph Method

 This method is also known as regression line or the line of best fit Here again we take the past data but unlike the high-low method, we use all the data pertaining to the year or a period

 On the horizontal axis (X-axis), we take the hours or outputs or sales as the case may be On the vertical axis (Y-axis), we take the values of expenses

 Plot the given data on a graph After plotting all the points, a straight line is drawn through the points plotted in such a way that equal distance is maintained as far as possible from these points with same number of points on each side

 While drawing the regression line, abnormal costs are excluded The point where the straight line intersects the Y-axis determines the fixed expenses

149 Introduction to Marginal Costing

Example:

The maintenance expenses of Wye Ltd., for six months are as under:

maintenance expenses

(Rs.)

y

x 0

Sem i-Variable

Re gre ssion Line

8.4.3 The Method of Least Squares

This method uses a mathematical approach to determine the components of variable and

fixed expenses It is an accurate method The steps involved in the determination of the

fixed expenses under this method are illustrated by taking the same example as given

under the regression line method

The procedure for determining variable and fixed expenses involves the following steps:

A Monthly average output = x or 1400

S

= 233

B Monthly average expenses = y or 8800

S

= 1467

C Monthly average of square of units =

2

or

S

= 64167

D Monthly average of the product of units and expenses =

xy Rs 2170000 =

S

= 361667

Variable cost (V) per unit = ( )

2

− ×

−

Fixed Cost (F) = B – ( A × V)

Variable Cost = ( )

( )2

361667 233 1467

64167 233

×

−

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= Rs 2.0101 (say Rs 2 p.u.) Fixed cost = Rs 1467 – (233 × 2)

= Rs 1000 (approx)

8.4.4 Uses of Segregation of Cost

Segregation of all expenses into fixed and variable elements is essential and is used to:

1 Control of expenses: Since fixed expenses remain same and do not vary with the level of production they are regarded as sunk cost, and are uncontrollable expenses Variable expenses are said to be controllable because they vary with the production level With full details of the fixed and variable expenses, management can try to keep them within the limits set

2 Preparation of Budget Estimates: The distinction between fixed and variable cost helps the management to make precise estimates which helps to prepare budgets

8.5 MEANING OF MARGINAL COSTING

According to ICMA, London “Marginal cost is the amount at any given volume of output,

by which aggregate costs are charged, if the volume of output is increased or decreased

by one unit.”

Marginal cost is the cost nothing but a change occurred in the total cost due to changes taken place on the level of production i.e either an increase / decrease by one unit of product

The firm XYZ Ltd incurs Rs 1000 for the production of 100 units at one level of operation

By increasing only one unit of product i.e 101 units, the firm’s total cost of production amounted Rs1010

Total cost of production at first instance (C’) = Rs.1000 Total cost of production at second instance (C”) = Rs.1010 Total number of units during the first instance (U’) = 100 Total number of units during the second instance (U”) = 101 Increase in the level of production and Cost of production:

Change in the level of production in units= U”-U’ = DU

Change in the total cost of production = C”-C’ = DC

MarginalCost = Change (Increase) in the total cost of production ÄC Rs.10

= = = Rs.10 Change (Increase) in the level of production ÄU 1

If the same firm reduces the total volume from 100 units to 99 units, the total cost of production Rs

990/-Decrease in the level of production and Cost of production:

Marginal Cost = Change (Increase) in the total cost of production C Rs.10

∆

∆ Rs.10

=

Why Marginal cost is called as incremental cost?

151 Introduction to Marginal Costing

From the above example, it is obviously understood that marginal cost is nothing but a

cost which incorporates the incremental changes in the cost of production due to either

an increase or decrease in the level of production by one unit, meant as incremental

cost

Why Marginal cost is called in other words as variable cost?

From the following classifications of cost, the inter twined relationship in between the

variable cost and marginal cost is explained as below:

Table 8.1: Statement of Fixed, Variable and Total Costs and Per Unit

Sl.No Units Fixed

Cost

Rs

Fixed Cost per unit Rs

Variable Cost

Rs

Variable Cost per unit Rs

Marginal Cost Rs

ΔC/ΔU

Total Cost

Rs

Fixed Cost: It is a cost remains constant or fixed irrespective level of production.

E.g: Rent Rs 5,00/ is to be paid irrespective level of production It remains constant/

fixed irrespective of changes taken place on the level of production

Y’

Fixed Cost per unit Line X’

X’- Units

Y’- Cost in Rupees

Variable cost: It is a cost, which varies with level of production.

Variable Cost

Variable Cost per unit

X’- Units

Y’- Cost in Rupees

The following are the various components of variable cost

 Direct Materials: Materials cost consumed for the production of goods.

 Direct Labour: Wages paid to the labourers who directly involved in the

production of goods

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 Direct Expenses: Other expenses directly involved in the production stream.

 Variable portion of Overheads: Generally the overheads can be classified

into two categories viz Variable overheads and Fixed overheads.

The variable overheads is the cost involved in the procurement of Indirect materials, Indirect labour and Indirect expenses

Indirect Material- cost of fuel, oil and soon Indirect Labour- Wages paid to workers for maintenance of the firm

From the Table 8.1 the marginal cost is equivalent to the variable cost per unit of the various levels of production The fixed cost of Rs.500 is the cost remains the same at not only irrespective levels of production but also already absorbed at the initial level of production The initial absorption of fixed overhead led the marginal cost to become as variable cost

Semi-Variable cost: Another major classification is semi variable/fixed cost which is a

cost partly fixed /variable to the certain level of production or consumption e.g Electricity charges, telephone charges and so on

It jointly discards the importance of the fixed cost and the semi- variable cost for analysis while ascertaining the marginal cost

Marginal Costing is defined as “ the ascertainment of marginal cost and of the effect on profit of changes in volume or type of output by differentiating between fixed and variable costs.”

In marginal costing, the change in the level of cost of operation is equivalent to variable cost due to fixed cost component which is fixed irrespective level of outputs

8.6 IMPORTANCE OF MARGINAL COSTING

 The costs are classified into two categories viz fixed and variable cost

 Variable cost per unit is considered as marginal cost of the product

 Fixed costs are charged against contribution of the transaction

 Selling price of the product = marginal cost + contribution

Contribution

Method of Difference Sales - Variable Cost

Method of Meeting Fixed cost + Profit

Marginal costing profitability statement as follows:

Sales xxxx Variable Cost xxxx Contribution xxxx Fixed Cost xxxx Profit xxxx Sales Rs.100,000, variable cost Rs.25,000/- and fixed cost Rs.20,000 find out the contribution and profit

153 Introduction to Marginal Costing

Rs

Sales 1,00,000 Variable Cost 50,000 Contribution 50,000 Fixed Cost 20,000 Profit 30,000

8.6.1 Method of Difference

Under this method, the contribution can be computed through finding the differences in

between Sales and Variable Cost i.e Contribution = Sales – Variable Cost =

Rs.1,00,000-50,000= Rs.50,000

8.6.2 Method of Coverages

In this method, the contribution is equated with the summation of Fixed cost and Profit

i.e Contribution=Fixed Cost + Profit =Rs.20000+30000=Rs.50,000

Marginal Costing(MC)

Cost Volume Profit (CVP) Analysis

Break Even Point (BEP) Analysis

8.7 PROBLEM OF DECISION MAKING

Decision-making is an important managerial function An important purpose of

management accounting is to provide managers with relevant information for

decision-making This lesson explains management's decision-making process–and a decision

making approach called incremental analysis

In practical, all the decisions cannot be taken on a uniform pattern This is because

decisions vary significantly in their scope, urgency and importance in accordance with

changing external events Nevertheless, it is still possible to identify certain steps which

are frequently used in the process of decision making This part of the chapter is an

attempt to understand and make use of these steps in various situations in the

decision-making process

Practical business management gives due weightage to both financial and non-financial

information Financial information relates to revenues and costs and their impact on the

company's overall profitability Non-financial information refers to factors like employee

turnover, environment etc These factors impact the overall image and efficiency of the

company This part of the chapter primarily focuses on the financial factors although the

non-financial factors are often as important as the financial factors

8.7.1 Incremental Analysis Approach

In the decision making process financial data - which consists of cost and revenue- will

change depending upon the course of action chosen In some cases only costs will vary

while in others revenues will vary There are certain cases where both costs and revenues