1-1

PREPARATION OF COST
SHEET
1-2
Methods of Costing
The following are the methods of
costing.:
Job Costing
Batch Costing
Process Costing
Operating Costing
Contract Costing

1-3
Methods of Costing: Job
Costing
This costing method is used in firms which work on the
basis of job work. There are some manufacturing units
which undertake job work and are called as job order units.
The main feature of these organizations is that they
produce according to the requirements and specifications of
the consumers. Each job may be different from the other
one.
Production is only on specific order and there is no pre
demand production. Because of this situation, it is
necessary to compute the cost of each job and hence job
costing system is used.
In this system, each job is treated separately and a job cost
sheet is prepared to find out the cost of the job.
The job cost sheet helps to compute the cost of the job in a
phased manner and finally arrives the total cost of
production.
1-4
Methods of Costing: Batch
Costing
This method of costing is used in those firms where
production is made on continuous basis.
Each unit coming out is uniform in all respects and production
is made prior to the demand, i.e. in anticipation of demand.
One batch of production consists of the units produced from
the time machinery is set to the time when it will be shut down
for maintenance.
For example, if production commences on 1st January 2013
and the machine is shut down for maintenance on 1st April
2013, the number of units produced in this period will be the
size of one batch.
The total cost incurred during this period will be divided by the
number of units produced and unit cost will be worked out.
Firms producing consumer goods like television, air-
conditioners, washing machines etc use batch costing.
1-5
Methods of Costing: Process
Costing
Some of the products like sugar, chemicals etc involve
continuous production process and hence process costing
method is used to work out the cost of production.
The meaning of continuous process is that the input
introduced in the process I travels through continuous process
before finished product is produced. The output of process I
becomes input of process II and the output of process II
becomes input of the process III. If there is no additional
process, the output of process III will be the finished product.
In process costing, cost per process is worked out and per
unit cost is worked out by dividing the total cost by the number
of units.
Industries like sugar, edible oil, chemicals are examples of
continuous production process and use process costing.
1-6
Methods of Costing: Operating
Costing
This type of costing method is used in service
sector to work out the cost of services offered
to the consumers.

For example, operating costing method is
used in hospitals, power generating units,
transportation sector etc.

A cost sheet is prepared to compute the total
cost and it is divided by cost units for working
out the per unit cost.
1-7
Methods of Costing: Contract
Costing
This method of costing is used in construction industry to
work out the cost of contract undertaken.
For example, cost of constructing a bridge, commercial
complex, residential complex, highways etc is worked out
by use of this method of costing.
Contract costing is actually similar to job costing, the only
difference being that in contract costing, one construction
job may take several months or even years before they
are complete while in job costing, each job may be of a
short duration.
In contract costing, as each contract may take a long
period for completion, the question of computing of profit
is to be solved with the help of a well defined and
accepted method.
1-8
Cost Sheet
Cost Sheet is a statement of cost
showing the total cost of production
and profit or loss from a particular
product or service.

A Cost Sheet shows the cost in a
systematic manner and element wise.

A typical format of the Cost Sheet is
given below:
1-9
Cost sheet: Sample
1-10
Cost sheet: Sample
1-11
RECONCILIATION OF COST &
FIANCIAL ACCOUNTS
Reconciliation is a process whereby profits
revealed by two sets of books are tallied to
ascertain the reasons for disagreement of
the two profits
RECONCILIATION-NEED
Cost & Financial
Accounting



Integral
Accounting






Cost Accounting
Financial Accounting
Non-integrated
Accounting
System
Separate
Books
1-13
Meaning
In business concern where Non-
integrated Accounting System is
followed. cost and financial accounts are
maintained separately, the difference
between the end result of these two are
required to be reconciled.

Reconciliation is a process whereby profits
revealed by two sets of books are tallied
after ascertaining the reasons for
disagreement of the two profits
1-14
Reasons for Difference
The various reasons which create
difference between cost and financial
profit or loss shown by the two set of
books may be listed under the following
heads :
(1) Items shown only in Financial Accounts
(2) Items shown only in Cost Accounts
(3) Absorption of Overheads
(4) Methods of Stock Valuation
(5) Abnormal Loss and Gains
(6) Methods of Depreciation

1-15
1. Items shown only in Financial
Accounts
Some items of income and expenses which are
included only in financial accounts but are not
shown in cost accounts and vice versa.
The following items are shown in financial accounts
but not in cost accounts:
(A) Items of Incomes:
Profit on sale of fixed assets
Interest received on investment
Dividend received on investment
Rent, brokerage and commission received
Premium on issue of shares
Transfer fees received.


1-16
Contd.
(B) Items of Expenditure:
Loss on sale of fixed assets, e.g., Plant,
Machinery, Building etc.
Interest paid
Discount paid
Dividend paid
Losses due to scrapping of plant and machinery
Penalties and fines
Expenses of shares' transfer fees
Preliminary expenses written off
Damages payable at law
1-17
Contd.
(C) Items of Appropriation of profits:

Dividend & Bonus to Share holders
Transfer to Gen. Reserve, Sinking Fund
Taxes on Income & Profits
Excess Provision against Depreciation
Donations

1-18
2. Items shown only in Cost
Accounts
There are some items which are recorded
only in Cost Accounts but are not included
in financial accounts because the amount is
not actually spent or paid.
These expenses reduced the profit in cost
account while in financial account it may be
the reverse effect, such as:
Notional interest on capital employed
Notional rent of premises owned
Salary to proprietor
Notional Depreciation
1-19
3. Under/Over Absorption of Overheads
In financial accounts actual amount of
expenses paid are recorded while in cost
accounts overheads are charged at
predetermined rates.

If overhead charged are not equal to the
amount of overhead incurred the under or
over absorption of overhead leads to
difference in profits of two accounts.
1-20
4. Methods of Stock Valuation
The term stock refers to opening or closing stock
of raw materials, work in progress and finished
goods.
In financial accounts stocks are valued at cost
price or market price whichever is lower.
In Cost Account; stock of raw materials can be
valued on the basis of FIFO, LIFO and Simple
Average Method etc., and work in progress may
be valued at Prime Cost or Work Cost. Finished
stocks are generally valued on the basis of cost
of production.
Thus, the adaptation of different method of
valuation of stock leads to difference in profits of
two sets of accounts.
1-21
5. Abnormal Losses and Gains
In cost accounts, abnormal losses and gains
are computed and transferred to the Costing
Prot and Loss A/c. No such computation is
made in the nancial accounts. For eample:
Abnormal wastage of material
Abnormal wastage of labour time or abnormal idle
time
Abnormal efficiency

This results in difference between the prots
shown by cost accounts and nancial accounts.
1-22
6. Different Methods of Depreciation
The depreciation charged is, generally,
different in the two sets of books because of
the difference in rates charged under both
the accounts.

In financial accounts depreciation is charged
at the rates prescribed under the Income-tax
Act, whereas in cost accounts depreciation
is charged at the rates based on the extent
of the use of the asset.
1-23
Importance of Reconciliation
Reconciliation of cost and financial account is
necessary for the following reasons :
To ensure arithmetical accuracy of both set of
accounts for effective cost ascertainment and cost
control.
To identify the reasons for different results in two sets
of accounts.
To evaluate the reasons for variations for effective
internal control.
To enable the smooth co-operation and co-ordination
between the activities of cost and financial
accounting departments.
To ensure the standardization of policies relating to
stock valuation, depreciation and absorption of
overheads.
1-24
Methods of Reconciliation
Steps in Reconciliation Process:
The following procedure is adopted for reconciliation:
1. First of all, followings are ascertained:-
Items which affect financial profits only and which
are not given in cost accounts.
Items which affect cost profits only and which are
not given in financial accounts.
Items which affect both financial and cost profits
but with different amounts.
2. Thereafter, profit reconciliation statement is
prepared.
1-25
Preparation of Reconciliation Statement
The following steps are to be taken for preparing this
statement.
The starting point may be either profit shown by cost
accounts or financial accounts.
If the profit as taken in the beginning is reduced due to the
various causes given, these items should be added in the
profits.
If the profit as taken in the beginning is increased due to the
various causes given, these items should be deducted from
the profits.
After completion of these additions and deductions, we will
arrive at the profit as shown by the other system, i.e. if profits
as per cost accounts is taken in the beginning, we will arrive
at the profit as shown by financial accounts and vice versa.
Performa: Reconciliation Statement

Reconciliation Statement
PARTICULARS
Rs
+

Rs _
Profits as per Cost Accounts
Add Incomes not recorded in CA
Expenses only recorded in CA
Overheads over absorbed in CA
Overvaluation of op. stock in CA
Undervaluation of Cl. stock in CA

Less Expenses not recorded in CA
Overheads Under absorbed in CA
Undervaluation of op. stock in CA
Overvaluation of Cl. stock in CA


--- ---
Profit as per Profit & Loss A/c (Balance) -----
Costing Profit
Is less
Increase it
Costing Profit
Is More
Decrease it
1-27
MARGINAL COSTING
&
ABSORPTION COSTING
1-28
Introduction
Before we allocate all manufacturing
costs to products regardless of
whether they are fixed or variable.
This approach is known as absorption
costing/full costing.

However, only variable costs are
relevant to decision-making. This is
known as marginal costing/variable
costing
1-29
Marginal Costing: Definition
The ascertainment of marginal cost and
the effect on profit of changes in volume or
type of output by differentiating between
fixed costs and variable costs.
-------------- ICMA London

Marginal costing is a technique of
determining the amount of change in
aggregate cost due to an increase in one
unit over the existing level of production
------------ D. Joseph
1-30
Introduction contd
Marginal costing is an alternative to
absorption costing.
In Marginal costing, only variable costs
are charged as a cost of sale and a
contribution is calculated.
Closing inventories of work in progress
or finished goods are valued at marginal
(variable) production cost.
Fixed costs are treated as a period cost,
and are charged in full to the profit and
loss account of the accounting period in
which they are incurred.
1-31
Contribution
An important measure in marginal costing
Is the difference between the sales value and
the marginal or variable cost of sales
Contribution may be defined as the profit
before the recovery of fixed costs
Contribution goes toward the recovery of
fixed cost and profit, and is equal to fixed cost
plus profit (C = F + P).
In case a firm neither makes profit nor suffers
loss, contribution will be just equal to fixed
cost (C = F). this is known as break even
point.
1-32
Contribution (contd..)
Thus, contribution may be viewed from two
angles viz., wherefrom contribution
emanates and how is it applied. These two
views can be expressed in equations forms
as under:
a) From the view point where it comes:
Contribution = Sales Variable Cost
C = S - V
b) From the view point of how is it applied:
Contribution = Fixed Cost + Profit
C = F + P
1-33
Contribution Analysis
The above equations give rise to the following
salient points of the Contribution Analysis:
If Contribution is zero, only marginal cost is
covered, the loss is equal to Fixed Cost (period
cost), viz.,
C = zero, there is a loss equal to F

If Contribution is negative, the loss will be more
than Fixed Cost, because Marginal Cost will not be
covered viz.,
C = Negative, Loss > F



1-34
Contribution Analysis (Contd.)
When Contribution is positive and more than Fixed
Cost, there will be profit because Fixed Cost will be
fully recovered and the balance will represent profit,
viz.,
C > F , there will be profit
When Contribution is positive but less than Fixed
Cost, there will be loss but at any rate, it will be less
than Fixed Cost, because some portion of Fixed
Cost will be recovered, viz.,
C < F , there will be loss but less than F
When Contribution is positive but equal to Fixed
Cost, there will be neither profit nor loss (i.e., Break-
even-point), because Contribution will just be
sufficient to absorb Fixed Cost leaving no surplus,
viz.,
C = F , No Profit No Loss or BEP
1-35
The Principles of Marginal
Costing
The principles of marginal costing are as follows:-
(a) For any given period of time, fixed costs will be
the same, for any volume of sales and production
(provided that the level of activity is within the
relevant range). Therefore, by selling an extra
item of product or service the following will
happen.
Revenue will increase by the sales value of the
item sold.
Costs will increase by the variable cost per unit.
Profit will increase by the amount of
contribution earned from the extra item.
1-36
The Principles of Marginal Costing
(Cont..)


(b) Similarly, if the volume of sales falls by one item,
the profit will fall by the amount of contribution
earned from the item.
(c) Profit measurement should therefore be based on
an analysis of total contribution. Since fixed costs
relate to a period of time, and do not change with
increases or decreases in sales volume, it is
misleading to charge units of sale with a share of
fixed costs.
(d) When a unit of product is made, the extra costs
incurred in its manufacture are the variable
production costs. Fixed costs are unaffected, and
no extra fixed costs are incurred when output is
increased.

1-37
Features of Marginal Costing
The main features of marginal costing are as follows:

1. Cost Classification: 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/Inventory Valuation: 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.

1-38
Marginal Costing- Advantages
Easiness
Proper valuation of Closing Stock
Helpful in Profit Planning
Meaningful Managerial Reporting
Profitability appraisal
Useful to Standard and Budgetary Costing
Convenience in computing Fixed
Overheads
Role in Cost Control
Helpful in Managerial Decisions e.g: Make
or Buy, decision of expansion etc..
1-39
Marginal Costing-
Disadvantages
Difficulties in Divisions of Costs
Ignoring time element
Role of fixed expenses with
development of technology
Problem in Valuation of Stock
Not suitable for all concerns
Availability of other better techniques of
cost control
Inappropriate basis of pricing

1-40
Absorption Costing: Definition
A method of costing that, in addition to
direct costs, assigns all, or a
proportion of, production overheads
costs to cost units by means of one or
a number of overhead absorption
rates. .................(CIMA)
Absorption costing calculates the unit
cost of an item taking into account all
costs, fixed and variable, direct and
indirect. Indirect/fixed costs are
allocated to or absorbed by the
products made.

1-41
Absorption Costing: The three As
Allocation: charging to a cost centre those
overheads which result solely from the
existence of that cost centre

Apportionment: the charging to a cost centre
of a fair share of an overhead on the basis of
the benefit received by the cost centre from the
facilities provided by the overhead

Absorption: when all production overheads
have been allocated and apportioned to a
product cost centre, the total has to be charged
to specific units of production
1-42
Absorption Costing-
Advantages
Fixed costs are recovered - fixed costs are
incurred in order to make output so it is only fair
to charge all output with a share of these costs

Ensures that costs are fully recovered

Encourages cost consciousness

It is fair in that it uses appropriate methods for
each overhead

Identifies total costs - this is useful where pricing
is on a cost plus basis

Identifies the profitability of different products and
services

1-43
Absorption Costing-
Disadvantages
All methods are arbitrary - no method of diving up
fixed costs is satisfactory
Absorption cost is true only at the level of activity
at which it was calculated
Danger of under or over absorption of overheads
Complex, time consuming and expensive
Potentially misleading guide to profitability of
products
The capacity levels chosen for overhead
absorption rates are based on historical
information and are open to debate
It does not provide information which aids
decision-making in a rapidly changing market
environment
1-44
Difference between Absorption
and Marginal costing
1-45
Absorption vs Marginal
costing
Rest Bar Total Rest Bar Total
Material cost (food and drink) 1.000 2.000 3.000 1.000 2.000 3.000
Direct labour cost 3.000 4.000 7.000 3.000 4.000 7.000
Total direct/variable cost 4.000 6.000 10.000 4.000 6.000 10.000
Overhead absorbed 4.000 5.000 9.000
Total cost 8.000 11.000 19.000
Revenue (from sales) 10.000 12.000 22.000 10.000 12.000 22.000
Profit 2.000 1.000 3.000
Contribution 6.000 6.000 12.000
Total overhead 9.000
Profit 3.000
Overheads absorbed
Absorption costing
Overheads not absorbed
Marginal costing
1-46
Absorption Costing approach
1-47
Marginal Costing approach
1-48
Absorption costing Marginal costing
Treatment for
fixed
manufacturing
overheads
(Product v/s
Period)
Fixed
manufacturing
overheads are
treated as product
costing. It is
believed that
products cannot be
produced without
the resources
provided by fixed
manufacturing
overheads
Fixed manufacturing
overhead are treated
as period costs. It is
believed that only the
variable costs are
relevant to decision-
making.
Fixed manufacturing
overheads will be
incurred regardless
there is production or
not
Absorption costing Marginal costing
Value of
closing stock
High value of
closing stock will be
obtained as some
factory overheads
are included as
product costs and
carried forward as
closing stock
Lower value of
closing stock that
included the variable
cost only
Basis of
Managerial
Decisions
Based on Profit Based on
Contribution and P/V
Ratio
Absorption costing Marginal costing
Application It is well suited for
determining long-
term cost and long-
term principal
policy
Used for solving
various managerial
decisions, planning
and control
Cost per unit Cost per unit
decreases as the
production increases
Cost per unit remains
the same
Under and
over recovery
of Fixed Cost
It is adjusted in P/L
account
It is not done in this
method
Absorption costing Marginal costing
Reported
profit
If the production = Sales, AC profit = MC
Profit

If Production > Sales, AC profit > MC profit
As some factory overhead will be deferred as
product costs under the absorption costing

If Production < Sales, AC profit < MC profit
As the previously deferred factory overhead
will be released and charged as cost of goods
sold
1-52
Comparison between absorption and marginal
costing
Absorption costing Marginal costing
+
Possible to see the profitability of
the individual businesses
All cost are absorbed somewhere
so the complete cost of a line of
business can be clearly seen
The full cost information can be
used to assess the level of revenue
required to run the line of business
The contribution from each business is shown
Avoids the problem of arbitrary overhead
contribution
Marginal costing has build-in break-even
analysis

-
Method may be inaccurate based
on the criteria chosen, thus might
show unfair results for a line of
business
Not possible to compare profitability of
individual lines of business
1-53
Presentation of costs on
income statement
1-54
Income Statement: Absorption Costing
1-55
Income Statement: Marginal Costing
1-56
Cost-Volume-Profit
Analysis:
A Managerial Planning Tool
1-57
What is CVP ?
CVP is a model used to determine
how profit will be affected by changes
in costs, selling price or business
activity (ie volume of sales).

CVP analysis is a key factor in:
Pricing products
Determining marketing strategies
Assessing viability of a product/event


57
1-58
Assumptions of CVP Analysis
Expenses can be classified as either variable
or fixed.
CVP relationships are linear over a wide range
of production and sales.
Sales prices, unit variable cost, and total fixed
expenses will not vary within the relevant
range.
Volume is the only cost driver.
The relevant range of volume is specified.
Inventory levels will be unchanged.
The sales mix remains unchanged during the
period.
1-59
Strategic role of CVP analysis
Cost leadership firms compete by increasing
volume to achieve low per unit operating cost-
predict effect of volume on profit and risk of
increasing FC
Early stage of cost life cycle- predict the
profitability of the product
Use in target costing profitability of alternative
designs
Later phases of life cycle- mfg. stage- evaluate
most profitable mfg. process
Helps in strategic positioning-
- differentiation- assessing desirability of new
features
- cost leadership- low cost operating means
1-60
Applications of CVP Analysis

Setting prices for products and
services
New product/service introduction
Replacing a machine
Make or buy
What if analysis
1-61
Benefits of CVP
Assists in establishing prices of
products.
Assists in analyzing the impact
that volume has on short-term
profits.
Assists in focusing on the impact
that changes in costs (variable
and fixed) have on profits.
Assists in analyzing how the mix
of products affects profits.
1-62
The Limitations of CVP
Analysis
A number of limitations are commonly mentioned with respect to CVP
analysis:
The analysis assumes a linear revenue function and a linear
cost function.
The analysis assumes that price, total fixed costs, and unit
variable costs can be accurately identified and remain constant
over the relevant range.
The analysis assumes that what is produced is sold.
For multiple-product analysis, the sales mix is assumed to be
known.
The selling prices and costs are assumed to be known with
certainty.
1-63
Cost-Volume-Profit Analysis
1. The Profit Equation
2. Breakeven Point
3. Margin of Safety
4. Contribution Margin
5. Contribution Margin Ratio
6. What-if Analysis
1-64
The Profit Equation
Profit = SP(x) VC(x) TFC

X = Quantity of units produced and sold
SP = Selling price per unit
VC = Variable cost per unit
TFC = Total fixed cost
1-65
Example
Here is the information from the Hero Bikes:
Total Per Unit Percent
Sales (500 bikes) Rs. 250,000 Rs. 500 100%
Less: variable expenses Rs. 150,000 Rs. 300 60%
Contribution margin Rs. 100,000 Rs. 200 40%
Less: fixed expenses Rs. 80,000
Net income Rs. 20,000
1-66
Finding Target Volumes
The formula to find a volume expressed in
units for a target profit is . . .
Target
Volume
(units)
=
Fixed costs + Target profit

Contribution margin per unit
How many bikes must Hero sell to
earn an annual profit of Rs. 1,00,000?
1-67
Break-Even Analysis
The break-even point is the point
where total revenue equals total cost
(Profit = 0).

Usually expressed in units or rupee
sales.

The lower the break-even point the
lower the risk of losing money on the
product or service..

1-68
Break-Even Analysis
The break even point is particularly
useful when a business is considering
entering a new market or selling a new
product.

The estimated level of risk is
compared to the estimated return.

The decision to enter a new market or
develop a new product/service will
depend upon the managers degree of
risk aversion.

1-69
Total Per Unit Percent
Sales (500 bikes) Rs. 250,000 Rs. 500 100%
Less: variable expenses Rs. 150,000 Rs. 300 60%
Contribution margin Rs. 100,000 Rs. 200 40%
Less: fixed expenses Rs. 80,000
Net income Rs. 20,000
Break-Even in Units
Lets use the Hero Bikes information again.
Contribution margin ratio
1-70
Break-Even in Units
Break-Even
Volume
(units)
=
Fixed costs + Target profit

Contribution margin per unit
Put Target Profit = 0

We have:

Break-even Volume in units = 80000 / 200
= 400 units

1-71
Break-Even in Rupees
Break-Even
Volume
(rupees)
=
Fixed costs + Target profit

Contribution margin ratio
Put Target Profit = 0

We have:

Break-even Volume in Rs. = 80000 / .4
= Rs. 2,00,000

1-72
Cost-Volume-Profit Graph
Revenue
Total Revenue
Total Cost
Units sold X
Y
Loss
Profit
X = Break-even point in units
Y = Break-even point in revenue
Break-even Point
1-73
Margin of Safety
The difference between budgeted sales
volume and the break-even sales
volume.



Example
If a company has budgeted sales of 8,000
units and a break even point of 5,000 units
then the margin of safety is 3,000 units or
37.5%.

If sales volume falls by more than 37.5% the
company will begin to make a loss.

Sales Break-even
volume sales volume
= Margin of Safety

1-74
Contribution Margin
SP(u) VC(u) = CM (u)

SP = Selling price per unit
VC = Variable cost per unit
CM = Contribution margin
u = per unit
1-75
Contribution Margin Ratio or P/V Ratio
(SP VC) / SP = CM%

SP = Selling Price per unit
VC = Variable Cost per unit
CM = Contribution Margin
1-76
What If Analysis
WHAT IF?
Change in:
Output level
Selling price
VC per unit
And/or fixed cost of
a product
Behaviour of:
Total revenue
Total cost
Operating income
1-77
MANAGERIAL
APPLICATIONS
OF
MARGINAL COSTING
1-78
Introduction
Marginal Costing is an extremely valuable
technique with the management.
The cost-volume-profit relationship has served
as a key to locked storehouse of solutions to
many situations.
It enables the management to tackle many
problems which are faced in the practical
business.
All the introduction of marginal cost principles
does is to give the management a fresh, and
perhaps a refreshing, insight into the progress
of their business
1-79
Application Areas of Marginal
Costing
The concept of marginal costing is practically applied in the following situations:
Evaluation of Performance : The evaluation of the
performance of various departments or products can be
evaluated with the help of marginal costing which is based on
contribution generating capacity.
Profit Planning : This technique through the calculation of P/V
Ratio helps the management to plan the activities in such a
way that the profit can be maximised.
Cost Control : Marginal Costing is a technique of cost
classification and cost presentation which enable the
management to concentrate on the controllable costs.
Flexible Budget preparation: As the marginal costing
particularly classifies costs as fixed and variable costs which
facilitates the preparation of flexible budgets.
Decision Making Process : Marginal cost analysis helps the
management in decision making process.


1-80
Decision making areas of Marginal
Costing
As mentioned in the introduction section, this
article will mainly focus on the Decision
making processes.

Marginal Costing tool is considered as an
important technique used for Decision
making in management.

The following sections will describe the key
areas in which decision making has been
proven to be required and exercised.
1-81
Application Areas of Marginal
Costing
Marginal Costing helps the management in decision-making in
respect of the following vital areas :
1. Fixation of selling price.
2. In house make or buy decisions
3. Selecting production with Key or limiting factor
4. Effect of change in sales price
5. Maintaining a desired level of profits
6. Selection of a suitable product mix
7. Alternative methods of production
8. Diversification of products
9. Accepting an additional order
10. Closure of Department
11. Alternative course of action
12. Level of activity planning
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1. Fixation of Selling Price
The selling price must be fixed above the total cost of a
particulars product.
Any organization knowing its fixed cost and profits
(expected profit) can decide the selling price of its
products.
To determine the optimum selling price of any product
or service is big challenge for a manager of any
company because company wants to profit of each unit
of any product or service.
In marginal costing technique, fixed cost will not be
changed at any level of production.
Only variable cost is changed for getting optimum
selling price where company can achieve expected
profit.
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2. In house make or buy
decisions
It may be happened that the organization is
producing a product which is a combination
of many parts or sub parts.

The organization can produce all sub
components or if possible it can purchase
there sub components from other
organizations, if it finds cost saving.

When it buy the finished sub components
sub decisions are called make or buy
component.
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3. Selecting production with Key or limiting factor
A key factor is that factor which puts a limit on production
and profit of a business. Usually this limiting factor is
sales.
A company may not be able to sell as much as it can
produce. Sometimes a company can sell all it produces
but production is limited due to the shortage of materials,
labor plant capacity or capital.
A decision has to be taken regarding the choice of the
product whose production is to be increased, reduced or
stopped.
When there is no limiting factor, the choice of the product
will be on the basis of the highest P/V ratio.
When there are scarce or limited resources, selection of
the product will be on the basis of contribution per unit of
scarce factor of production.
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4. Effect of change in sales
price
Management is confronted with the
problem of cut in price of products
from time to time on account of
competition, expansion programs or
government regulations.

The effect of a cut in selling price per
unit will directly reduced the
contribution per unit.
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5. Maintaining a desired level of profits
By fluctuating the sales price of its
product on account of competition,
Government regulation and other
compiling reasons the organization
can maintain a particular level of
profits.

The profits can be maintain either by
decreasing the price for increase in
sales or by increasing the sales prices
to restrict to a particular segment.
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6. Selection of a suitable product
mix
Sometimes an organization is involved in manufacturing
and distributing more than one product, the management
has to deride about the product mix or sales mix which
can maximize the profits for the organization.
Marginal cost can provide a strong basis for such decision
by calculating total contribution of each alternative product
mix.
The best product mix is that which yields the maximum
contribution.
The products which give the maximum contribution are
to be retained and their production should be increased.
The products which give comparatively less contribution
should be reduced or closed down altogether.
The new sales mix will be favorable if it increases the
P/V ratio and reduces the breakeven point.
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7. Alternative methods of
production
Marginal Costing is also used in comparing
the alternative methods use for
manufacturing e.g. Machine work v/s Hand
work, which machine should be used
instead of other etc.

The cost structure may vary from one
alternative to another thus the organszation
keeping in mind the demand of the market
should adopt those alternative which are
most efficient in terms of cost.
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8. Diversification of products
In order to decide about the profitability of the new
product, it is assumed that the manufacture of the
new product will not increase fixed costs of the
concern.
If the price realized from the sale of such product is
more than its variable cost of production it is worth
trying.
If the data is presented under absorption costing
method, the decision will be wrong.
If with the introduction of new product, there is an
increase in the fixed costs, then such specific
increase in fixed costs must be deducted from the
contribution for making any decision.
General fixed costs will be charged to the old
product/products.
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9. Accepting an additional
order
Large scale purchasers may demand
the product at lower cost than the
market price a decision has to be
taken by the organization whether to
accept lower cost order or not.

Such decisions can be taken by
comparing the profit situation before
and after accepting the large scale
order.
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10. Closure of Department
The decision to close down or suspend its activities will
depend whether products are making contribution towards
fixed costs or not. i.e. Whether the contribution is more
than the difference in fixed costs (by working at normal
operations and when the plant or product is closed down
or suspended)
If the business is closed down:
There may be certain fixed costs which could be avoided.
There will be certain expenses which will have to be
incurred at the time of closing the operations like
redundancy payments, necessary maintenance of the
plant or overhauling of plant on reopening training of
personal etc.
Such costs are associated with closing down of business
and must be taken into consideration before taking any
decision.
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Deleting a Product Line: Sports
Store
Golf Tennis Cricket Total
(000's) (000's) (000's) (000's)
Revenue 80 40 60 180
less:
Variable Costs 24 15 46 85
Contribution Margin 56 25 14 95
less Fixed Costs
Rent on Premises 20 10 15 45
Cricket Promotion 5 5
Profit/Loss 36 15 -6 45
1-93
Delete Cricket Line of
Products
Golf Tennis Cricket Total
(000's) (000's) (000's) (000's)
Revenue 80 40 120
less:
Variable Costs 24 15 39
Contribution Margin 56 25 81
less Fixed Costs
Rent on Premises 30 15 45
Cricket Promotion
Profit/Loss 26 10 36
1-94
11. Alternative course of
action
Whatever course of action is adopted,
certain fixed expenses will remain
unaffected.
The criterion is the effect of alternative
course of action upon the marginal
(variable) costs in relation to the revenue
obtained.
The course of action which yields the
greatest contribution is the most
profitable to be followed by the
management.
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12. Level of activity planning
It is concerned with optimum utilization of
available resources.
Sometime in many organization some
resources are left idle or in other words the
organization is not using its full capacity, it is
always important to achieve optimum level of
activities in order to maximize the profit of
organization, as different levels of activities
have different rate of return.
Thus an organization should utilize its capacity
up to the point where it gets the positive rate of
return.