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UNIT-IV
MARGINAL COSTING
Definition
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. In practice, this is measured by the total variable costs attributable to 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.
Features of Marginal Costing
The main features of marginal costing are as follows:
1. CostClassification: The marginal costing technique makes a sharp distinction between variable costs and fixed costs. It is the variable cost on the basis of which production and sales policies are designed by a firm following the marginal costing technique. 2. Stock/InventoryValuation: Under marginal costing, inventory/stock for profit measurement is valued at marginal cost. It is in sharp contrast to the total unit cost under absorption costing method. 3. Marginal Contribution: Marginal costing technique makes use of marginal contribution for marking various decisions. Marginal contribution is the difference between sales and marginal cost. It forms the basis for judging the profitability of different products or departments.
Advantages of Marginal Costing
Cost Control: Practical cost control is greatly facilitated. By avoiding arbitrary allocation of fixed overhead, efforts can be concentrated on maintaining a uniform and consistent marginal cost useful to the various levels of management. Simplicity: Marginal Costing is simple to understand and operate; it can be combined with other forms of costing, such as, budgetary costing, standard costing without much difficulty. Elimination of varying charge per unit: In marginal Costing fixed overheads are not charged to the cost of production due to this the effect of varying charges per unit is avoided. Short-Term Profit Planning: It helps in short-term profit planning by break- even charts and profit graphs. Comparative profitability can be easily assessed and brought to the notice of the management for decision-making. Prevents Illogical Carry forwards: It prevents the illogical carry-forwards in stock-valuation of some proportion of current years fixed overhead. Accurate Overhead Recovery Rate: It eliminates large balances left in overhead control accounts, which indicate the difficulty of ascertaining an accurate overhead recovery rate. Maximum return to the business: The effects of alternative sales or production policies can be more readily appreciated and assessed, and decisions taken will yield the maximum return to the business.
Disadvantages of Marginal Costing
Misleading Results: It is very difficult to segregate all costs into fixed and variable costs very clearly, since all costs are variable in the long run. Hence such segregation sometimes may give misleading results. Distorted Picture of Profits: The closing stock consists of variable cost only and ignores fixed costs. This gives Distorted Picture of Profits. Avoids Semi-Variable Costs: Semi-Variable costs are not considered in the analysis.
Cost-volume-profit analysis is of assistance in performance evaluation for the purpose of control. For reviewing profits achieved and costs incurred, the effects on cost of changes in volume are required to be evaluated. Pricing plays an important part in stabilising and fixing up volume. Analysis of Marginal Costing cost-volume-profit relationship may assist in formulating price policies to suit particular circumstances by projecting the effect which different price structures have on costs and profits. As predetermined overhead rates are related to a selected volume of production, study of cost-volume relationship is necessary in order to know the amount of overhead costs which could be charged to product costs at various levels of operation.
Break even analysis
Break even analysis examines the relationship between the total revenue, total costs and total profits of the firm at various levels of output. It is used to determine the sales volume required for the firm to break even and the total profits and losses at other sales level. Break even analysis is a method, as said by Dominick Salnatore, of revenue and total cost functions of the firm. According to Martz, Curry and Frank, a break even analysis indicates at what level cost and revenue are in equilibrium. In case of break even analysis, the break even point is of particular importance. Break even point is that volume of sales where the firm breaks even i.e., the total costs equal total revenue. It is, therefore, a point where losses cease to occur while profits have not yet begun. That is, it is the point of zero profit. Break even point (In units) = Fixed expenses Selling price per unit−Marginal cost per unit
Advantages of break even analysis
The main advantages of using break even analysis in managerial decision making can be the following:
It helps in determining the optimum level of output below which it would not be profitable for a firm to produce. It helps in determining the target capacity for a firm to get the benefit of minimum unit cost of production. With the help of the break even analysis, the firm can determine minimum cost for a given level of output. It helps the firms in deciding which products are to be produced and which are to be bought by the firm. Plant expansion or contraction decisions are often based on the break even analysis of the perceived situation. Impact of changes in prices and costs on profits of the firm can also be analysed with the help of break even technique. Sometimes a management has to take decisions regarding dropping or adding a product to the product line. The break even analysis comes very handy in such situations. It evaluates the percentage financial yield from a project and thereby helps in the choice between various alternative projects. The break even analysis can be used in finding the selling price which would prove most profitable for the firm. By finding out the break even point, the break even analysis helps in establishing the point wherefrom the firm can start payment of dividend to its shareholders.
Limitations of Break even analysis
Break even analysis is generally used to find out the output level at which the total fixed cost of a company are covered up by the contributions. But due to non availability of separate data for fixed and variable cost for each product
Less: Marginal/variable cost Contribution Less: fixed cost Profit
2. Marginal cost Equation Sales – Variable cost = Fixed cost + Profit (S-V=F+P) Sales – Variable cost = Contribution (S-V=C) Contribution = Fixed cost + Profit (C=F+P) 3. P/V Ratio P/V = Contribution Sales x 100 P/V = Sales−variable cost Sales x 100 P/V = Change in profit Change in Sales x 100 Note : The last formula is used only when profit/loss and sales of two periods are given. 4. Break even Point (B.E.P) (a) Break even volume (units) = Fixed cost Contribution per unit
(or)
Break even sales Selling price per unit (b) Break even sales(in rupees) = Fixed cost P V ratio
(or)
F P/V (or) = Break even volume x selling price per unit 5. Margin of Safety (MOS) Margin of safety = Actual sales – Break even sales
MOS in rupees = Profit P/vratio
P P/v Margin in units = Profit Contribution per unit Margin of safety ratio = Margin of safety Actual sales
x 100
6. Required sales for given profit Required sales in units = Required profit+Fixed cost Contribution per unit Required sales value in Rs. = Required profit+Fixed cost P V ratio 7. Profit from given sales Contribution = Given sales x P/V ratio Profit = Contribution – Fixed cost Note : The above formula can be appropriately used to solve most of the problems of C.V.P or Break even analysis.
BUDGETARY CONTROL
Meaning of Budget Budget is an estimate prepared for definite future period either in terms of financial or non-financial terms. Budget is prepared for any course of action or business or state or Nation, as a whole. The budget is usually expressed in terms of total volume. Definition for Budget According to ICMA, England, a budget is as follows “a financial and or quantitative statements prepared and approved prior to a defined period of time, of the policy to be pursed during the period for the purpose of attaining a given objective”. Budgeting
Objectives of Budgetary control
Budgetary control is inevitable for policy formulation, planning , conrol ad coordination. The essence of budgeting is to plan and control. Following are the main objectives of budgetary control.
1. Planning : Budgeting ensures effective planning by setting up of budgets. 2. Coordination : Budgets are helpful in coordination of business activities. 3. Efficiency and economy : Effective budgetary control results in cost control and cost reduction. 4. Increase in Profitability : Costs are controlled with help of budgets and profits targeted are achieved. 5. Anticipation of future capital expenditure : Estimated increases in sales necessitating higher production capacity provides advance warning for the possible capital expenditure in near future. 6. Control : Controlling function is made to be effective as the control is centralized while budgets are prepared and implemented. 7. Deviations : Ascertainments of deviations is essential to fix responsibility and correct the deviations as far as possible.
Advantages of Budgetary control
1. The use of budgetary control system enables the management of a business concern to conduct its business activities in the efficient manner. 2. It is a powerful instrument used by business houses for the control of their expenditure. It infact provides a yardstick for measuring and evaluating the performance of individuals and their departments.
3. It reveals the deviations to management, from the budgeted figures after making a comparison with actual figures. 4. Effective utilization of various resources like men, material, machinery and money is made possible, as the production is planned after taking them into account. 5. It helps in the review of current trends and framing of future policies. 6. It creates suitable conditions for the implementation of standard costing system in a business organization. 7. It inculcates the feeling of cost consciousness among workers
Disadvantages of Budgetary control
1. Estimates: Budgets may or may not be true, as they are based on estimates. The assumptions about future events may or may not actually happen. 2. Rigidity: Budgets are considered as rigid document. Too much emphasis on budgets may affect day today operations and ignores the dynamic state of organizational functioning. 3. False Sense of Security: Mere budgeting cannot lead to profitability. Budgets cannot be executed automatically. It may create a false sense of security that everything has been taken care of in the budgets. 4. Lack of coordination: Staff cooperation is usually not available during Budgetary Control exercise. 5. Time and Cost: The introduction and implementation of the system may be expensive.
Essential Features Of Budgetary Control
activities which developing a budget. Encouragement should flow from top management. All the members must be involved to make it a workable preposition and a dream driven document. Reporting system: Proper feed back system should be established. Provision should be made for corrective measures whenever comparative measures are proposed. Availability of statistical information: Since budgets are always prepared and expressed in quantitative terms, it is essential that sufficient and accurate relevant data should be made available to each department. Motivation: Since budget acts as a mirror, the entire organization should become smart in its approach. Every employees both executive and nonexecutives should be made part of the overall exercise. Employees should be persuaded than pressurized to appreciate the benefits of the budgets so that the fruits can be shared by all the members of the organization.
Classification of Budgets
The budgets are classified according to their nature. The following are the types of budgets which are commonly used.
A. Classification according to time :
i. Short period budget : These budgets are usually for a period of one year. E.g. Cash budget, Material budget, etc. ii. Long period budget : These budgets are for a longer period say 5 to 10 years. E.g. Capital expenditure budget, research & development budget. iii. Current budget: These budgets are for a very short period, a month or a quarter and are related to current conditions.
B. Classification according to function
A functional budget is a budget which relates to any of the functions of an organization. The following are the commonly used functional budgets.
1. Sales budget : A sales budget is an estimate of expected sales during the budget period. It may be stated in terms of money or quantity or both. It contains information relating to sales, month-wise, product wise and area wise. Sales budget should be carefully prepared as the preparation of other budgets is dependent on it. This budget is prepared by the sales manager. 2. Production budget : The preparation of production budget is dependent on the sales budget. Production budget is an estimate of quantity of goods that must be produced during the budget period. It may be stated in terms of money or quantity or both. Production may be calculated as follows: Units to produced = Budgeted sales + Desired closing stock – Opening stock. 3. Material budget : Materials may be direct or indirect. The materials budget deals with only the direct materials. Indirect materials are included in the factory over head budget. Materials budget can be classified in to two categories. Materials requirement budget and materials purchase budget. Materials requirement budget is an estimate of total quantities of material required for production during the budget period. The material purchase budget is an estimate of quantities of raw materials to be purchased for production during the budget period. 4. Direct labour budget : This indicates detailed requirements of direct labour and its cost to achieve the production target. This budget is classified into two categories namely, labour requirement and labour recruitment budget. The labour requirement budget gives information regarding the different classes of labor required for each department, their rates of pay and the hours to be spent. The labour recruitment budget states the additional direct workers to be recruited. 5. Factory overhead budget: Factory overheads include indirect material, indirect labour and indirect expenses. Factory overhead budget indicates the factory overheads to be incurred in the budget period. The expenses included in the budget are classified
comparison of actual performance with the budget at any level of output. To prepare flexible budget, all costs should be classified into fixed, variable and semi variable.
Difference between Fixed and Flexible budget
Particulars Fixed budget Flexible budget a. Definition b. Rigidity c. Level of Activity d. Effect of variance analysis It is a Budget designed to remain unchanged irrespective of the level of activity actually attained. It does not change with actual volume of activity achieved. Thus it is known as a Rigid or Inflexible budget. It operates on one level of activity and under one set of conditions. It assumes that there will be no change in the prevailing conditions, which is unrealistic. Variance Analysis does not give useful information as all Costs (fixed, variable and semi variable) are related to only one level of activity. If the budgeted and actual activity levels differ significantly, then aspects It is a Budget, which by recognizing the difference between fixed, semi variable and variable costs is designed to change in relation to level of activity attained. It can be recasted on the basis of activity level to be achieved. Thus it is not rigid. It consists of various budgets for different levels of activity Variance Analysis provides
e. Use for Decision making f. Performance Evaluation like cost ascertainment and price fixation do not give a correct picture. Comparison of actual performance with budgeted targets will be meaningless, especially when there is a difference between two activity levels. useful information as each cost is analysed according to its behaviour. If facilitates the ascertainment of cost, fixation of selling price and submission of quotations It provides a meaningful basis of comparison of the actual performance with the budgeted targets.
Steps in Preparation of Budgets
1. Definition of objectives – A budget being a plan for the achievement of certain operational objectives, it is desirable that the same are defined precisely. The objectives should be written out; the areas of control demarcated; and items of revenue and expenditure to be covered by the budget stated. This will give a clear understanding of the plan and its scope to all those who must cooperate to make it a success. 2. Location of the key (or budget) factor – ‘There is usually one factor (sometimes there may be more than one) which sets a limit to the total activity. For instance, in India today sometimes non availability of power does not allow production to increase
