Edited by Harshita Ahuja
What is Marginal Costing?
The ascertainment of marginal cost (Variable Cost) and the effect on profit with changes in the output by differentiating between fixed costs and variable costs.
What is Marginal Cost?
The amount at any given output by which aggregate variable costs are changed if the output is increased by one unit. In practice, this is measured by the total variable cost attributable to one unit. Marginal cost can precisely be the sum of prime cost and variable overhead.
Marginal Cost = Variable Cost = Direct Labour + Direct Material + Direct Expenses + Variable Overheads.
Marginal Cost Sheet
It is a managerial tool showing the relationship between various ingredients of profit planning i.e. cost, selling price and volume. As the name suggests, cost volume profit (CVP) analysis is the analysis of three variables cost, volume and profit.
Impact of various changes on profit
An understanding of CVP analysis is extremely useful to management in budgeting and profit planning. It explains the impact of the following on the net profit:
- Changes in selling prices
- Changes in the volume of sales
- Changes in variable cost
- Changes in fixed cost
Marginal Cost Equation
It tells us that selling price minus the variable cost of the units sold is the contribution towards fixed expenses and profit. If the contribution is equal to fixed expenses, there will be no profit or loss and if it is less than fixed expenses, the loss is incurred.
S -V = C = F ± P
Where, S = Selling price per unit, V = Variable cost per unit,
C =Contribution, F = Fixed Cost, P = Profit/Loss
- Profit Volume Ratio (PV Ratio)
- Breakeven point (BEP)
- Margin of Safety (MOS)
Contribution to Sales Ratio (Profit Volume Ratio or P/V ratio)
A higher contribution to sales ratio implies that the rate of growth of contribution is faster than that of sales. This is because, once the breakeven point is reached, profits shall grow at a faster rate when compared to a product with a lesser contribution to sales ratio.
By transposition, we have derived the following equations:
(i) C = S × P/V ratio
(ii) S = c / (P/v ratio)
Breakeven point (BEP)
This point where neither profits nor losses have been made is known as a break-even point. This implies that in order to break even the amount of contribution generated should be exactly equal to the fixed costs incurred. Hence, if we know how much contribution is generated from each unit sold, we shall have sufficient information for computing the number of units to be sold in order to break even.
The Margin of Safety (MOS)
The margin of safety can be defined as the difference between the expected level of sale and breakeven sales. The larger the margin of safety, the higher is the chances of making profits.
Let’s take an Example to clarify BEP and MOS
BEP Sales is 500 (Situation where you only cover fixed cost)
MOS Sales is 1 (Addition to Fixed Cost)
S.P = 10
V.C = 8
Fixed Cost = 1000