II Jai Sri Gurudev II

Sri Adichunchanagiri Shikshana Trust ®

SJB Institute of Technology
(An Autonomous Institute under Visvesvaraya Technological University, Belagavi)
Approved by AICTE, New Delhi, Recognised by UGC, New Delhi with 2(f) and 12(B).
Accredited by NAAC with ‘A+’ Grade. Accredited by National Board of Accreditation
No.67, BGS Health & Education City, Dr. Vishnuvardhan Road, Kengeri, Bengaluru-560060

Department of Management Studies (MBA)

COURSE
Strategic Cost Management
22MBAFM303 – 3rd SEMESTER
{THEORY & PROBLEMS}
Study Material for the year 2023-24

COMPILED BY
Mr. Vijay Kumar G
Assistant Professor
Department of MBA, SJBIT

Vijay Kumar G, Assistant Professor, Dept. of MBA, SJBIT Page 1 of 11

 MODULE – 03
MARGINAL COSTING

Introduction
Marginal Costing is not a method of costing like job, batch or contract costing. It is in fact a technique
of costing in which only variable manufacturing costs are considered while determining the cost of
goods sold and also for valuation of inventories. In fact this technique is based on the fundamental
principle that the total costs can be divided into fixed and variable. While the total fixed costs remain
constant at all levels of production, the variable costs go on changing with the production level. It will
increase if the production increases and will decrease if the production decreases.

Definition
Marginal Cost is defined as, ‘the change in aggregate costs due to change in the volume of production by
one unit’. For example, if the total number of units produced are 800 and the total cost of production is
Rs.12, 000, if one unit is additionally produced the total cost of production may become Rs.12, 010
and if the production quantity is decreased by one unit, the total cost may come down to Rs.11, 990.
Thus the change in the total cost is by Rs.10 and hence the marginal cost is Rs.10. The increase or
decrease in the total cost is by the same amount because the variable cost always remains constant on
per unit basis.

Features of Marginal Costing:

1) In marginal costing, costs are segregated into fixed and variable. Only variable costs are charged to
the production, i.e. included in the cost of production. Fixed costs are not included in the cost of
production, which means that they are not absorbed in the production.
2) Another important feature of marginal costing is the valuation of inventory is done at variable cost
only. This means, that variable costs only are taken into consideration while valuing the inventory.
Fixed costs are eliminated from the inventory valuation because they are largely period costs and
relate to a particular period or year.
3) Another feature of marginal costing is the preparation of income statement. The income statement
is prepared in a different manner as compared to the statement prepared under traditional
costing, i.e. absorption costing. The income statement is prepared as shown below:

Difference between Traditional Costing and Marginal Costing

Traditional Costing Marginal Costing
Costs are classified into Direct and Indirect Costs. Costs are classified into Fixed and Variable Costs.
The year-end inventory is valued at variable cost
The year-end inventory of finished goods under
only. Fixed costs are not taken into consideration
absorption costing is valued at total cost, i.e. fixed
while valuing inventory, as they are not absorbed
and variable.
in the product units.
The fixed overhead absorption may create some The fixed overheads are charged directly to the
problems like over/under absorption. This Costing Profit and Loss Account and not absorbed
happens because of the overhead absorption rate in the product units. Therefore there is no
which is pre-determined. question of under/over absorption of overheads.
Due to the inventory valuation, which is done at
Fixed costs are not taken into consideration while
the full cost, the costs relating to the current
valuing the inventory and hence there is no
period are carried forward to the subsequent
distortion of profits.
period. This will distort the cost of production

Vijay Kumar G, Assistant Professor, Dept. of MBA, SJBIT Page 2 of 11

The total cost of production is charged to the Only variable costs are charged to the cost of
product without distinguishing between the fixed production and therefore the selling price is also
and variable components. The selling price is thus based on only variable costs. This will result in
fixed on the basis of total costs. fixation of selling price below the total costs.

Applications [Merits] of Marginal Costing:

1) Cost Control
One of the important challenges in front of the management is the control of cost. In the modern
competitive environment, increase in the selling price for improving the profit margin can be
dangerous as it may lead to loss of market share. The other way to improve the profit is cost
reduction and cost control. Cost control aims at not allowing the cost to rise beyond the present
level. Marginal costing technique helps in this task by segregating the costs between variable and
fixed. While fixed costs remain unchanged irrespective of the production volume, variable costs
vary according to the production volume. Certain items of fixed costs are not controllable at the
middle management or lower management level. In such situation it will be more advisable to
focus on the variable costs for cost control purpose. Since the segregation of costs between fixed
and variable is done in the marginal costing, concentration can be made on variable costs rather
than fixed cost and in this way unnecessary efforts to control fixed costs can be avoided.

2) Profit Planning
Another important application of marginal costing is the area of profit planning. Profit Planning,
generally known as budget or plan of operation may be defined as the planning of future
operations to attain a defined profit goal. The marginal costing technique helps to generate data
required for profit planning and decision-making.

3) Key Factor Analysis

The management has to prepare a plan after taking into consideration the constraints, if any, on
the various resources. These constraints are also known as limiting factors or principal budget
factors as discussed in the topic of ‘Budgets and Budgetary Control’. These key factors may be
availability of raw material, availability of skilled labour, machine hour’s availability, or the market
demand of the product. Marginal costing helps the management to decide the best production plan
by using the scarce resources in the most beneficial manner and thus optimize the profits.

4) Decision Making
Managerial decision-making is a very crucial function in any organization. Decision – making
should be on the basis of the relevant information. Through the marginal costing technique,
information about the cost behaviour is made available in the form of fixed and variable costs. The
segregation of costs between fixed and variable helps the management in predicting the cost
behaviour in various alternatives. Thus it becomes easy to take decisions. Some of the decisions
are to be taken on the basis of comparative cost analysis while in some decisions the resulting
income is the deciding factor. Marginal costing helps in generating both the types of information
and thus the decision making becomes rational and based on facts rather than based on intuition.

Vijay Kumar G, Assistant Professor, Dept. of MBA, SJBIT Page 3 of 11

Crucial areas of decision-making
a) Make or buy decisions
b) Accepting or rejecting an export offer
c) Variation in selling price
d) Variation in product mix
e) Variation in sales mix
f) Key factor analysis
g) Evaluation of different alternatives regarding profit improvement
h) Closing down/continuation of a division
i) Capital expenditure decisions.

Break Even Point

The concept of ‘Break Even Point’ is extremely important for decision making in various areas. This
concept is based on the behaviour of costs, i.e. fixed cost and variable costs. As discussed earlier, fixed
costs are those costs that remain constant irrespective of the changes in the volume of production. On
the other hand, variable costs are the costs that vary with the level of production. While fixed cost per
unit is always variable, variable cost per units is always fixed. In addition to these two types of costs,
there are semi variable costs that are partially fixed and partially variable. Semi variable costs thus
have the features of both types of costs. They remain fixed up to a certain level of production and after
crossing that level, they become variable. The Break Even Point is a level of production where the total
costs are equal to the total revenue, i.e. sales. Thus at the break even level, there is neither profit nor
loss. Production level below the break-even-point will result into loss while production above break-
even point will result in profits.

Break Even level can also be worked out with the help of the following formula:
Break Even point [in units] = Fixed Cost / Contribution per Unit
Break Even point [in Rs.] = Fixed Cost / Profit Volume [P/V] Ratio

Break Even point can also be shown on the graph paper as follows:

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Break Even Chart is a graphical relationship between costs, volume and profits. It shows not only the
BEP but also the effects of costs and revenue at varying levels of sales. The break-even chart can,
therefore, be more appropriately called the Cost Volume Profit(CVP) Graph.

Explanation: On horizontal axis, production and sales volume is shown while on the vertical axis, sales
and costs in amount are shown.

Assumptions of Break Even Point: The concept of break even point is based on the following
assumptions.
1) Production and sales are the same, which means that as much as is produced is sold out in the
market. Thus there is no inventory remaining at the end.
2) Fixed cost remains same irrespective of the production volume.
3) Variable cost varies with the production. It changes in the same proportion that of the production.
Hence it has a linear relationship with the production. In other words, variable cost per unit
remains the same.
4) Selling price per unit remains same irrespective of the quantity sold.

Margin of Safety
Margin of Safety is the difference between the actual sales and the break even sales. As we have
discussed, at the break even point there is neither any profit nor loss. Hence any firm will always be
interested in being as much above the break even level as possible. Margin of Safety explains precisely
this thing and the higher the safety margin the better it is. Margin of safety is computed as follows.
Margin of Safety = Actual Sales – Break Even Sales.

Limitations of Break Even Point:

Break Even point is extremely useful in decision- making regarding the production level. It indicates
the level of production where there is neither any profit nor loss. However this is based on the
assumption that the variable cost per unit, sales price per unit and the fixed cost remains the same. If
there is any change in these variables, the break even point will give misleading results.

Income Statement under Marginal Costing

XYZ LTD. Product P
Particulars Amount (₹) Amount (₹)
Sales
Less: Variable Costs
Contribution
Less: Fixed Costs
Profit

Vijay Kumar G, Assistant Professor, Dept. of MBA, SJBIT Page 5 of 11

 Problems on Decision Making (Marginal Costing)

1) A Company budgets for a production of 150000 units. The variable cost per unit is ₹14 and fixed
cost per unit is ₹2 per unit. The company fixes the selling price to fetch a profit of 15% on cost.
You are required to find out:
a) Break Even Point
b) Profit/Volume Ratio
c) If the selling price is reduced by 5%, how does the revised selling price affects the Break Even
Point and the Profit/Volume Ratio?
d) If profit increase of 10% is desired more than the budget, what should be the sales at the
reduced price?

2) From the following figures, find the Break Even Volume.

Selling Price per ton ₹69.50, Variable Cost per ton ₹35.50, Fixed Cost ₹18.02 lakhs. If this volume
represents 40% capacity, what is the additional profit for an added production of 40% capacity,
the selling price of which is 10% lower for 20% production and 15% lower than the existing price,
for the other 20% capacity?

3) A retail dealer in garments is currently selling 24,000 shirts annually. He supplies the following
details for the year ended 31st March 2023.
Selling price per shirt: Rs.800
Variable cost per shirt: Rs.600
Fixed Cost: Staff salaries: Rs.24,00,000
General Office Cost: Rs.8,00,000
Advertising Cost: Rs.8,00,000
As a Cost Accountant, you are required to answer the following each part independently:
a) Calculate Break Even Point and margin of safety in sales revenue and number of shirts sold.
b) Assume that 30,000 shirts were sold during the year, find out the net profit of the firm.
c) Assuming that in the coming year, an additional staff salary of Rs.10,00,000 is anticipated, and
price of shirt is likely to be increased by 15%, what should be the break even point in number
of shirts and sales?

4) The following figures are available from the records of Venus Traders as on 31st March.
Figures: In Lakhs of Rs.
Particulars 2022 2023
Sales 150 200
Profit 30 50
Calculate:
a) Profit/Volume Ratio and Total Fixed Expenses
b) Break Even Sales
c) Sales required to earn a profit of Rs.90 lakhs
d) Profit/Loss that would arise if the sales were Rs.280 lakhs

5) ABC Ltd. maintains a margin of safety of 37.5% with an overall contribution to sales ratio of 40%.
Its fixed costs amount to Rs.5,00,000. Calculate the following:
a) Break Even Sales
b) Total Sales

Vijay Kumar G, Assistant Professor, Dept. of MBA, SJBIT Page 6 of 11

 c) Total Variable Sales
d) Current Profits
e) New ‘Margin of Safety’ if the sales volume is increased by 7.5%

6) A Company has two Plants at Locations I and II, operating at 100% and 75% of their capacities
respectively. The company is considering a proposal to merge the two plants at one location to
optimize available capacity. The following details are available in respect of the two plants,
regarding their present performance/operation.
Particulars Location I Location II
Sales (₹ in lakhs) 200 75
Variable Costs (₹ in lakhs) 140 54
Fixed Costs (₹ in lakhs) 30 14
For decision-making purposes, you are required to work out the following information,
I. The capacity at which the merged plan will break even.
II. The profit of the merged plant working at 80% capacity
III. Sales required if the merged plant is required to earn an overall profit of ₹22,00,000

7) A company sells its products at ₹15 per unit. In a period, if it produces and sells 8,000 units, it
incurs a loss of ₹5 per unit. If the volume is raised to 20,000 units, it earns a profit of ₹4 per unit.
Calculate Break Even Point both in terms of rupees as well as units.

8) A factory engaged in manufacturing plastic buckets is working to 40% capacity and produces
10,000 buckets per annum. The present cost break up for one bucket is as under:
Material ₹10
Labour ₹3
Overheads ₹5 [60% fixed]
The selling price is ₹20 per bucket.
If it is decided to work the factory at 50% capacity, the selling price falls by 3%. At 90% capacity,
the selling price falls by 5% accompanied by a similar fall in the price of material. You are required
to calculate the profit at 50% and 90% capacities and also show break even points for the same
capacity production.

9) You are given the following data. (July/August 2021)

Year Sales Profit
2020 ₹1,20,000 ₹8,000
2021 ₹1,40,000 ₹13,000
Find out:
a) P/V Ratio
b) BEP
c) Profit when sales are ₹1,80,000
d) Sales required to earn a profit of ₹12,000
e) MOS in the year 2021

10) Cost Volume and Profit relationship of a company is described by an equation y = 3,00,000 + 0.7x
in which x represents the sales revenue and y represents the total cost. (Dec 2019 / Jan 2020)
Find out the following:
a) C/S Ratio
Vijay Kumar G, Assistant Professor, Dept. of MBA, SJBIT Page 7 of 11
 b) BEP
c) Sales Volume to earn a profit of ₹1,20,000
d) Sales Volume when there is a loss of ₹40,000

11) Calculate PV Ratio, Fixed Cost from the following: (Dec 2019 / Jan 2020)
Year Sales Profit
2022 ₹20,00,000 ₹2,00,000
2023 ₹30,00,000 ₹4,00,000
Find out profit when the sales is ₹18,00,000.

Vijay Kumar G, Assistant Professor, Dept. of MBA, SJBIT Page 8 of 11

 Process Costing

Process Costing is a method of costing like job or contract costing which is used in those industries
where the production is in continuous process, i.e. the output of one process becomes the input of the
subsequent process and so on. Examples of such industries are paint works, chemical plants, food
manufacturing, oil refining, paper mill, textile mills, sugar factories, fruit canning, dairy and so on. In
such industries, the input is put in the first process and the output of each process becomes the input
of the subsequent process till the final product emerges from the last process. This method is
employed where it is not possible to trace the items of prime cost [which consists of all direct costs] to
a particular order because its identity is lost in the continuous production. Thus it is not possible to
compute the cost of say, 200 liters of oil or 200 kg of sugar produced as thousands of liters of oil or
thousands of kg of sugar is manufactured at the same time. We can get the cost per liter or kg by
dividing the total cost by the total production produced during that period. The features and
intricacies of process costing are discussed in the subsequent paragraphs.

Features of Process Costing

a) The production is in continuous flow and is uniform. All units coming out as finished products are
uniform with each other in all respects.
b) The product is manufactured in a continuous flow and hence individual units lose their identity.
c) The unit cost is obtained by dividing the total cost for a particular period by the total output. This
is the average cost of the product units.
d) Cost per process is ascertained and cost of each process is transferred to the subsequent process
until the finished product emerges.
e) In a particular process normal and abnormal losses emerge. Normal loss is a loss, which is
inevitable in any process and thus cannot be avoided or controlled. Any loss, which, is over and
above, the normal loss is called as abnormal loss and is to be accounted for separately. For
example, if 1000 units are put in Process 1 and it is anticipated that there will be a normal loss of
1% in the process, the output expected is 1,000 – 1% of 1,000 that is 990. If actual production is
980, there is an abnormal loss of 10 units. On the other hand if the production is 995, there is an
abnormal gain of 5 units. Abnormal gain and abnormal loss are to be accounted for in the process
cost accounts.
f) Sometimes each process may be treated as profit center and so while transferring the cost from
one process to another, a percentage of profit is added in the cost of that process. This is known as
inter process profit and needs to be accounted for in the process cost accounts.
g) Though the cost per unit is computed by dividing the total cost by the number of units, there can
be a problem on incomplete units at the end of a particular accounting period. In such cases
equivalent units have to be worked out for computing the cost per unit.

Cost Accumulation in Process Costing

The process cost system accumulates production costs according to departments or processes. Each
department/process constitutes a responsibility centre from the point of view of cost control and
performance evaluation through techniques such as standard costing, responsibility accounting,
budgeting, and so on. It provides unit cost measures that are helpful in establishing selling price
particularly when the firm employs ‘cost plus’ or some type of cost-based product pricing.

Process Costing assumes a sequential flow of costs from one process to another as units of output pass
through a number of specified production processes. That is, the units leave the first process and take
their costs with them to the second process, the unit leave the second process and take their costs
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with them to the third process, and this process continues till the last process, when output is finally
completed. Each process performs part of the total operation and transfers its ‘finished’ output to the
next process, in which it is the input/raw material for further processing. The finished product of the
last process is transferred to the finished goods inventory. Thus, the cost becomes cumulative as
product moves along, the final process determining the total cost.

In Process Costing, a work-in-progress account (Process Accounts) is set up for each production
process which will be discussed below:
Preparing Process Cost Accounts
1) As explained above, the objective of process costing is to work out the cost of each process,
transfer the same to the subsequent process and finally ascertain the total cost of production.
Therefore it is necessary to charge various costs to each process. For this, the factory is divided
into distinct processes or operations and an account is kept of each process to which all the costs
are debited. The following are the various elements of cost, which are shown in the process
accounts.
a) Materials: Raw materials required for each process is drawn from stores against material
requisitions. Proper procedure like preparing and authorizing the requisition, pricing of the
issues, return of materials to the stores, transfer of material from one process to another
should be followed while issuing the materials. Cost of materials consumed should be
computed as per the method employed for pricing of the issues and the cost should be debited
to the process account.
b) Labour: Wages paid to workers and supervisory staff should be charged to the particular
process if they can be identified with it. If workers work on two or more processes, proper
allocation should be made according to some basis like time spent on each process.
c) Direct Expenses: If expenses are identifiable with a particular process, they should be charged
to that process. For example, cost of electricity, depreciation may be charged directly to a
process if they are identifiable with it.
d) Overheads: By nature, overheads are indirect expenses and hence cannot be identified with a
particular process. These expenses can be apportioned on some suitable basis and charged to
the process.

2) Important aspects in Process Accounts: While preparing process cost accounts, some important
aspects are to be taken into consideration. These aspects are given below.
a) Normal Loss: Normal loss is a loss, which is inevitable in any process. Thus if the input is 100,
the output may be 95 if the normal loss is anticipated as 5%. Accounting treatment of normal
loss is explained and illustrated in the subsequent paragraphs.
b) Abnormal Loss/Abnormal Gain: If the actual output is less than the normal output [Normal
output = Input – Normal Loss], the difference between the two is the abnormal loss. On the
other hand if the actual output is more than the normal output, the difference between the two
is abnormal gain. Thus in the example given above, the normal output is 95 which is 100 – 5%
of 100 as the normal loss. If the actual output is 93 units, 2 units will be abnormal loss and if
the actual output is 97 units, 2 units will be abnormal gain. Abnormal loss/gain is to be treated
differently and is illustrated subsequently.
c) Inter Process Profits: Sometimes, while transferring the cost of one process to the subsequent
one, some percentage of profit is added in it. This is called as inter process profits. This is done
when a process is treated as profit center. In such cases, unrealized profit is to be computed
and shown separately. This is also illustrated separately.

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3) Proforma of Process Account [Without normal/abnormal loss/gain] : A simple process account is
prepared in the following manner:

Process I Account
Rate Amount Rate Amount
Particulars Qty. Particulars Qty.
(₹) (₹) (₹) (₹)
To Direct Materials By Output transferred
To Direct Labour to Process II
To Direct Expenses
To Production OHS
Total Total
Note: Process II and subsequent Process Accounts will be prepared in the same fashion. In the final
process, the cost and output will be transferred to the finished goods stock account.

Problems on Process Accounts

1) A product passes through two processes A and B. Prepare the process accounts from the following
details. Also prepare the abnormal wastage/effective account as the case may be with each process
account.

2) A material used for building is produced in three grades. The following information is available.

Management expenses were Rs.17,500 and selling expenses Rs.10,000. 2/3rd of output of process
I and 50% of the output of process II is passed to the next process and remaining is sold. The
entire output of process III is sold. Prepare Process Accounts and Statement of Profit.

3) Prepare necessary accounts from the following details.

There was no opening or closing stock or work in progress The final output from Process II was
17, 000 units.
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