Marginal Costing and Cost-Volume-Profit Analysis

A pump-maker’s costs are mostly the factory itself. Its materials and wages are only a part. Should the factory’s rent be charged to each pump? The answer changes the profit, and the decision.

One product. Coimbatore Pumps sells a pump at ₹50. Each pump costs ₹30 in variable cost, and fixed costs are ₹1,20,000 a year.

Marginal against absorption costing. The factory makes 10,000 pumps and sells 8,000, leaving 2,000 in stock. Absorption costing spreads the fixed cost over all made, ₹12 a pump, so a pump is valued at ₹42. Marginal costing values it at ₹30.

The absorption profit is higher because ₹24,000 of this year’s fixed cost is carried forward in stock to a later year. Over a firm’s life, both methods report the same total profit.

Don’t call contribution profit. Contribution is what is left of sales after variable costs, and is meant to cover fixed costs first. Only the part above fixed costs is profit. Below the break-even point the contribution exists, yet the firm makes a loss.

Where it breaks. Marginal costing is meant for short-term decisions. Over the long run all costs, including the fixed ones, must be recovered by price. Accounting standards for published accounts require stock to be valued at full (absorption) cost, so marginal costing is a management tool, not the basis of the statutory accounts.

For exams. Know the formulas, the difference in stock valuation, and the reason why marginal and absorption profits differ.

Variable costs go in the product; fixed costs wait in the period.

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Production against sales. If production equals sales, both methods give the same profit. If production exceeds sales, absorption profit is higher. If sales exceed production, it is lower. This is why a manager measured on absorption profit may be tempted to build stock at year-end.

A decision. A manager’s bonus depends on reported profit under absorption costing. What could she do in March to raise it without selling anything more, and how would marginal costing remove the temptation?

A printer makes 100 articles for ₹50,000 and 101 for ₹50,450. The 101st article added ₹450 to the bill. That ₹450 is what marginal costing is built on.

Why only variable cost. Within the existing capacity, one more unit raises only variable cost. Fixed costs stay as they are. So the cost of the extra unit is its variable cost, and fixed costs are charged to the period against the contribution.

Several products, one fixed cost. A firm sells three products and has fixed costs of ₹80,000.

Each product adds to the pool that pays the fixed costs. Product C has the thinnest margin per unit, ₹0.50, but its volume makes it worth ₹30,000.

Don’t mix up marginal cost with the average cost of a unit. Average cost spreads fixed costs over all units, and falls as output rises. Marginal cost is only the extra cost of one more, and is constant when variable cost per unit is. A firm that prices on average cost can turn down an order that would have added profit.

Where it breaks. The method assumes variable costs per unit are constant and that there is spare capacity. Near full capacity, the next unit may need new plant, and its cost is far higher than the variable cost. Published accounts must value stock at full cost, so marginal costing is only for internal use.

For exams. Know the definitions and the three alternative names, the features, and the advantages and limitations, and be ready to prepare a statement for more than one product.

Extra unit, extra variable cost; fixed cost waits for the contribution.

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Why the 101st unit matters. Marginal cost is a rule for the next decision: should we make one more, or take one more order? It does not tell us whether the whole business pays. For that, contribution must exceed fixed costs.

A decision. A firm’s product C has a contribution of only ₹0.50 a unit. Should it drop C to save effort? What would happen to profit if it did?

Before opening a second shop, a trader asks: how many sales do I need just to cover my costs? Cost-volume-profit analysis answers that, and tells how a rise or fall in sales moves the profit.

At 8,000 pumps, sales are ₹4,00,000 and the margin of safety is ₹1,00,000, or 2,000 pumps. Sales could fall by 25% before the firm made a loss.

The assumptions. Selling price and variable cost per unit stay constant. Fixed costs stay constant within the range considered. All production is sold, with no closing stock. The product mix does not change.

Don’t use the unit formula when the question gives sales in rupees. Both formulas give the same result: ₹3,00,000 is 6,000 pumps at ₹50. The P/V ratio form works in rupees, which is useful when a firm sells many products at different prices.

Where it breaks. Real costs are not straight lines. A price cut to win volume changes the contribution. Fixed costs rise in steps. Competition and inflation move prices and costs. The analysis is a simplification, best for short-term what-if questions and less suited to long-term planning.

For exams. Write the formulas in both units and rupees, and state the assumptions and limitations.

Break-even is where contribution equals fixed cost.

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Operating leverage. A firm with high fixed costs and low variable costs has a large contribution per unit. Its profit rises sharply once above break-even, and falls just as sharply below it. That is why a small drop in sales hurts such a firm, and why the margin of safety matters.

A decision. The pump-maker is offered a machine that cuts variable cost to ₹25 but adds ₹30,000 to fixed costs. Calculate the new break-even point and say at what volume the machine pays for itself.

At the break-even point, sales are ₹3,00,000. At sales of ₹4,00,000, profit is ₹40,000. How are these linked? A handful of identities answer almost every CVP question.

Required sales for a target profit. In units: (Fixed cost + Desired profit) ÷ Contribution per unit. In rupees: (Fixed cost + Desired profit) ÷ P/V ratio. (Some books swap the two; the units formula divides by contribution per unit, and the rupees formula by the ratio.)

The angle of incidence. It is the angle at which the sales line cuts the total cost line at break-even on the chart. A wide angle means that profit grows fast once sales pass break-even, a sign of high earning power. A narrow angle means that profit builds slowly.

CVP against break-even analysis. CVP analysis studies how profit responds to changes in cost and volume. Break-even analysis finds the level of activity at which sales equal total cost, and the profit at other levels. The two are so closely linked that the terms are often used for each other.

What CVP is used for. To forecast profit, to plan it, to find the break-even point, to build flexible budgets, and to judge performance against plan.

Don’t assume the margin of safety is a profit. The margin of safety is a sales figure. Only the contribution on it, the profit, is money. In the example, the margin of safety is ₹1,00,000 of sales, and the profit is ₹40,000, which is 40% of that.

Where it breaks. The identities hold only while selling price, variable cost per unit and fixed costs stay constant. A firm with a mix of products needs the average P/V ratio, which changes if the mix changes.

For exams. Memorise the identities, the P/V ratio from two periods, and the meaning of a wide angle of incidence.

Break-even: contribution equals fixed cost. Above it: contribution equals profit.

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Mix changes the answer. If a firm sells two products with different P/V ratios, selling more of the richer one moves break-even down, even though total sales do not change. This is why a sales manager and a finance manager may disagree on which sales to push.

A decision. A firm’s sales rose from ₹3,60,000 to ₹4,00,000 and profit from ₹24,000 to ₹40,000. Find its P/V ratio, then its fixed cost, and its break-even sales.

A buyer abroad offers ₹40 a pump for 1,000 pumps, below the usual ₹50. The cost sheet says a pump costs ₹42. Should the firm refuse? Marginal costing says to look at what changes.

In each case the fixed costs are the same whichever way the firm decides, so they should not tip the choice.

Don’t forget the limits that make the marginal view safe. The export order must use idle capacity, must not be sold in the home market at the lower price, and must not lead other customers to demand a discount. If the order displaces a full-price sale, the lost contribution is a cost of accepting it.

Where it breaks. A firm that prices every order at marginal cost never recovers its fixed costs, and will fail. The method suits the occasional, special case. The usual price must cover total cost and profit.

For exams. Use the marginal view for each decision, state its assumption of spare capacity, and say that fixed costs are ignored only because they do not change.

Ask what changes. Ignore what stays.

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Opportunity cost. If the factory is already full, an export order uses capacity that would otherwise make full-price pumps. The relevant cost is then the variable cost plus the contribution given up, which can exceed the offer.

A decision. A hotel has empty rooms in the monsoon, with variable cost of ₹600 per room-night. A travel agent offers ₹1,500 a night for 50 rooms. List what you would check before accepting, and what you would do if the agent resold the rooms on a booking site at ₹3,000.