International financial and management accounting lesson 08

UNIT III LESSON INTRODUCTION TO MARGINAL COSTING CONTENTS 8.0 8.1 8.2 8.3 8.4 8.5 8.6 8.7 8.8 8.9 8.10 8.11 8.12 Aims and Objectives Introduction Variable Costs Fixed Costs Mixed Costs/Semi-variable Costs 8.4.1 High-Low Method 8.4.2 Scattergraph Method 8.4.3 The Method of Least Squares 8.4.4 Uses of Segregation of Cost Meaning of Marginal Costing Importance of Marginal Costing 8.6.1 Method of Difference 8.6.2 Method of Coverages Problem of Decision Making 8.7.1 Incremental Analysis Approach 8.7.2 How Incremental Analysis Works 8.7.3 Types of Incremental Analysis Let us Sum up Lesson End Activity Keywords Questions for Discussion Suggested Readings 8.0 AIMS AND OBJECTIVES After studying this lesson, you will be able to: Define marginal costing Distinguish between fixed and variable costs Understand marginal cost analysis and its role in decision making 8.1 INTRODUCTION To manage a business, it is essential to understand how costs respond to changes in sales volume and the effect of costs and revenues on profit i.e., CVP relationships It is therefore essential to know how costs behave Cost behaviour analysis is the study of how specific costs respond to changes in the level of business activity As you might expect, some costs change, and others remain the same 146 A knowledge of cost behaviour helps management plan operations and decide between alternative courses of action Cost behaviour analysis applies to all types of entities For an activity level to be useful in cost behaviour analysis, changes in the level or volume of activity should be correlated with changed in costs The activity level selected is referred to as the activity (or volume) index The activity index identifies the activity that causes changes in the behaviour; in other words, by correlating costs with an appropriate activity index, it is possible to classify the behaviour of costs in response to changes in activity levels into three categories: variable, fixed, or mixed International Financial and Management Accounting 8.2 VARIABLE COSTS Variable costs are costs that vary in total directly and proportionately with changes in the activity level It is for this reason, if the level of activity increases by 25 percent, total variable costs will increase by 25 percent If the level of activity decreases by 25 percent, variable costs will decrease by 25 percent In the same way if there is no change in the activity level, total variable costs will also remain unchanged Example of variable costs include direct materials and direct labour for a manufacturer; consumption of petrol and diesel in transport companies; sales commissions for a merchandiser etc Generally it is observed that those companies which are labour intensive have high proportion of variable cost as compared to companies which are capital intensive It is important to note, although the variable cost in total will vary proportionately, yet at the same time it remains the same per unit at every level of activity y Variable Cost Vc Units of Production x Figure 8.1: Variable Costs 8.3 FIXED COSTS Fixed Costs are costs that remain the same in total regardless of changes in the activity level Examples include insurance, rent, supervisory salaries, and depreciation on buildings and equipment Since total fixed costs remain constant irrespective of activity changes, it follows that fixed costs per unit vary inversely with activity: As volume increases, per unit fixed cost declines, and vice versa Note: With the rise in use of automation in most manufacturing companies, the proportion of fixed costs has risen considerably by way of increase in the value of depreciation cost and other expenses like lease rent charges 147 y Fixed Cost Introduction to Marginal Costing Fc Units of Production x Figure 8.2: Fixed Costs In most business situations, a straight-line relationship does not exist for fixed costs throughout the entire range of possible activity At abnormally low levels of activity, it may be impossible to be cost efficient Total fixed costs also not have a straight-line relationship over the entire range of activity Some fixed costs will not change But it is possible for management to change other fixed costs 8.4 MIXED COSTS/SEMI-VARIABLE COSTS Mixed costs are costs that contain both a variable element and a fixed element They are also referred to as semi-variable costs Mixed costs change in total but not proportionately with changes in the activity level Example of mixed costs are telephone cost or electricity cost which includes a fixed rental charge and the rest of the billed amount would depend on the units of consumption For purposes of CVP analysis the costs are bifurcated into either fixed or variable costs It is therefore necessary to segregate fixed and variable elements in mixed costs In order to segregate the costs, the management must analyse the fixed and the variable element each time the cost is incurred This method of segregation is not a practical approach because of time and cost constraints Another way is to determine the total mixed costs for the period, and then, by using its past experience on the behaviour pattern of the mixed costs, segregate the fixed and the variable elements For this the following methods can be used: 8.4.1 High-Low Method STEP-1 Calculate the total costs incurred at the high and low levels of activity during a period of time STEP-2 Find out the difference between the costs of these two levels STEP-3 The result of the above step is the total variable cost, since only the variable element of the cost will change due to change in the activity level STEP-4 Variable cost per unit = (Change in total costs) ÷ (High-Low activity level) Example: The maintenance cost of Carriers Ltd for a quarter was found to be Rs 9000 for 7000 Kms during the peak period Similarly the lowest cost was Rs 8200 while running for 5400 Kms 148 The fixed and variable element in the maintenance cost is found as follows: International Financial and Management Accounting Maintenance Cost (Rs.) Kms.run Highest 9000 7000 Lowest 8200 5400 800 1600 Difference Variable cost per km = Highest Cost = Lowest Cost Highest kms = Unit = Unit 800/1600 = Rs 0.50/km Lowest kms Substituting the value of the variable cost to find out the fixed cost in any of the cost data of a period given in the question, we use it in the peak period cost data, thus: Variable costs at the peak level = 7000 km X 0.50 = Rs 3500 Fixed cost = Total cost – variable cost Rs.9000 – Rs.3500 = Rs 5500 To check let us substitute the valued in the lowest period cost Variable costs at the lowest level = 5400 km X 0.50 = Rs.2700 Fixed cost = Total cost – variable cost Rs.8200 – Rs.2700 = Rs 5500 Hence verified Drawback of this Method It assumes variable element of cost for an item per unit is constant but this does not always holds true as increase or decrease of cost may not be proportionate to the change in the activity level The high-low method does not produce a precise measurement of the fixed and variable elements in a mixed cost because other activity levels are ignored in the computation 8.4.2 Scattergraph Method This method is also known as regression line or the line of best fit Here again we take the past data but unlike the high-low method, we use all the data pertaining to the year or a period On the horizontal axis (X-axis), we take the hours or outputs or sales as the case may be On the vertical axis (Y-axis), we take the values of expenses Plot the given data on a graph After plotting all the points, a straight line is drawn through the points plotted in such a way that equal distance is maintained as far as possible from these points with same number of points on each side While drawing the regression line, abnormal costs are excluded The point where the straight line intersects the Y-axis determines the fixed expenses Example: 149 The maintenance expenses of Wye Ltd., for six months are as under: Month Machine Hours July August September October November December Semi-variable maintenance expenses (Rs.) 1400 1300 1200 1600 1500 1800 200 150 100 300 250 400 Machine Hours y x Sem i-Variable Re gre ssion Line 8.4.3 The Method of Least Squares This method uses a mathematical approach to determine the components of variable and fixed expenses It is an accurate method The steps involved in the determination of the fixed expenses under this method are illustrated by taking the same example as given under the regression line method The procedure for determining variable and fixed expenses involves the following steps: 1400 Sx or = 233 N A Monthly average output = B Monthly average expenses = C Monthly average of square of units = D Monthly average of the product of units and expenses = Sy 8800 or = 1467 N Sx2 385000 or = 64167 N S xy Rs 2170000 = = 361667 N Variable cost (V) per unit = D − (A × B) C − A2 Fixed Cost (F) = B – ( A × V) Variable Cost = 361667 - ( 233 × 1467 ) 64167 − ( 233) Introduction to Marginal Costing 150 International Financial and Management Accounting = Rs 2.0101 (say Rs p.u.) Fixed cost = Rs 1467 – (233 × 2) = Rs 1000 (approx) 8.4.4 Uses of Segregation of Cost Segregation of all expenses into fixed and variable elements is essential and is used to: Control of expenses: Since fixed expenses remain same and not vary with the level of production they are regarded as sunk cost, and are uncontrollable expenses Variable expenses are said to be controllable because they vary with the production level With full details of the fixed and variable expenses, management can try to keep them within the limits set Preparation of Budget Estimates: The distinction between fixed and variable cost helps the management to make precise estimates which helps to prepare budgets 8.5 MEANING OF MARGINAL COSTING 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.” 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 The firm XYZ Ltd incurs Rs 1000 for the production of 100 units at one level of operation By increasing only one unit of product i.e 101 units, the firm’s total cost of production amounted Rs1010 Total cost of production at first instance (C’) = Rs.1000 Total cost of production at second instance (C”) = Rs.1010 Total number of units during the first instance (U’) = 100 Total number of units during the second instance (U”) = 101 Increase in the level of production and Cost of production: Change in the level of production in units= U”-U’ = DU Change in the total cost of production MarginalCost = = C”-C’ = DC Change (Increase) in the total cost of production = Change (Increase) in the level of production ÄC ÄU = Rs.10 = Rs.10 If the same firm reduces the total volume from 100 units to 99 units, the total cost of production Rs 990/Decrease in the level of production and Cost of production: Marginal Cost = Change (Increase) in the total cost of production ∆ C Rs.10 = = ∆U Change (Increase) in the level of production = Rs.10 Why Marginal cost is called as incremental cost? From the above example, it is obviously understood that marginal cost is nothing but a cost which incorporates the incremental changes in the cost of production due to either an increase or decrease in the level of production by one unit, meant as incremental cost Why Marginal cost is called in other words as variable cost? From the following classifications of cost, the inter twined relationship in between the variable cost and marginal cost is explained as below: Table 8.1: Statement of Fixed, Variable and Total Costs and Per Unit Sl.No Units 50 100 150 Fixed Cost Rs 500 500 500 500 Fixed Cost per unit Rs 500 100 3.333 Variable Cost Rs 10 500 1000 1500 Variable Cost per unit Rs 10 10 10 10 Marginal Cost Rs ΔC/ΔU 10 10 10 10 Total Cost Rs 510 1000 1500 2000 Fixed Cost: It is a cost remains constant or fixed irrespective level of production E.g: Rent Rs 5,00/ is to be paid irrespective level of production It remains constant/ fixed irrespective of changes taken place on the level of production Y’ Total Fixed Cost Line Fixed Cost per unit Line X’ X’- Units Y’- Cost in Rupees Variable cost: It is a cost, which varies with level of production Variable Cost Variable Cost per unit X’- Units Y’- Cost in Rupees The following are the various components of variable cost Direct Materials: Materials cost consumed for the production of goods Direct Labour: Wages paid to the labourers who directly involved in the production of goods 151 Introduction to Marginal Costing 152 International Financial and Management Accounting Direct Expenses: Other expenses directly involved in the production stream Variable portion of Overheads: Generally the overheads can be classified into two categories viz Variable overheads and Fixed overheads The variable overheads is the cost involved in the procurement of Indirect materials, Indirect labour and Indirect expenses Indirect Material- cost of fuel, oil and soon Indirect Labour- Wages paid to workers for maintenance of the firm From the Table 8.1 the marginal cost is equivalent to the variable cost per unit of the various levels of production The fixed cost of Rs.500 is the cost remains the same at not only irrespective levels of production but also already absorbed at the initial level of production The initial absorption of fixed overhead led the marginal cost to become as variable cost Semi-Variable cost: Another major classification is semi variable/fixed cost which is a cost partly fixed /variable to the certain level of production or consumption e.g Electricity charges, telephone charges and so on It jointly discards the importance of the fixed cost and the semi- variable cost for analysis while ascertaining the marginal cost Marginal Costing is defined as “ the ascertainment of marginal cost and of the effect on profit of changes in volume or type of output by differentiating between fixed and variable costs.” In marginal costing, the change in the level of cost of operation is equivalent to variable cost due to fixed cost component which is fixed irrespective level of outputs 8.6 IMPORTANCE OF MARGINAL COSTING The costs are classified into two categories viz fixed and variable cost Variable cost per unit is considered as marginal cost of the product Fixed costs are charged against contribution of the transaction Selling price of the product = marginal cost + contribution Contribution Method of Difference Sales - Variable Cost Method of Meeting Fixed cost + Profit Marginal costing profitability statement as follows: Sales xxxx Variable Cost xxxx Contribution xxxx Fixed Cost xxxx Profit xxxx Sales Rs.100,000, variable cost Rs.25,000/- and fixed cost Rs.20,000 find out the contribution and profit Rs Sales 1,00,000 Variable Cost 50,000 Contribution 50,000 Fixed Cost 20,000 Profit 30,000 8.6.1 Method of Difference Under this method, the contribution can be computed through finding the differences in between Sales and Variable Cost i.e Contribution = Sales – Variable Cost = Rs.1,00,00050,000= Rs.50,000 8.6.2 Method of Coverages In this method, the contribution is equated with the summation of Fixed cost and Profit i.e Contribution=Fixed Cost + Profit =Rs.20000+30000=Rs.50,000 Marginal Costing(MC) Cost Volume Profit (CVP) Analysis Break Even Point (BEP) Analysis 8.7 PROBLEM OF DECISION MAKING Decision-making is an important managerial function An important purpose of management accounting is to provide managers with relevant information for decisionmaking This lesson explains management's decision-making process–and a decision making approach called incremental analysis In practical, all the decisions cannot be taken on a uniform pattern This is because decisions vary significantly in their scope, urgency and importance in accordance with changing external events Nevertheless, it is still possible to identify certain steps which are frequently used in the process of decision making This part of the chapter is an attempt to understand and make use of these steps in various situations in the decisionmaking process Practical business management gives due weightage to both financial and non-financial information Financial information relates to revenues and costs and their impact on the company's overall profitability Non-financial information refers to factors like employee turnover, environment etc These factors impact the overall image and efficiency of the company This part of the chapter primarily focuses on the financial factors although the non-financial factors are often as important as the financial factors 8.7.1 Incremental Analysis Approach In the decision making process financial data - which consists of cost and revenue- will change depending upon the course of action chosen In some cases only costs will vary while in others revenues will vary There are certain cases where both costs and revenues 153 Introduction to Marginal Costing 154 International Financial and Management Accounting will vary Incremental analysis is the process used to identify financial data that change under alternative courses of action Incremental analysis identifies the probable effects of alternative decisions on future earning Various means of gathering data are used for incremental analysis are analysis done by market analyst, engineers and accountants in their analysis, only aimed at their own specific areas of operation 8.7.2 How Incremental Analysis Works Suppose there are two alternatives A and B, with details regarding revenues and costs as under: In this case alternative A is being compared with alternative B The net result shows that alternative B will produce Rs 10000 more net income than alternative A Alternative A Rs 220000 120000 Rs.100000 Revenues Costs Net income Alternative B Rs 180000 70000 Rs.110000 Net Income Increase (Decrease) Rs (40000) 50000 10000 The following three cost concepts are used in incremental analysis: Relevant cost: Costs (and revenues) which change due to different alternatives chosen are known as relevant cost As their value change with the alternative courses of action, they become relevant while making decision It can include both the fixed and the variable costs Opportunity cost: While choosing one course of action, the company must often give up the opportunity to benefit from another course of action The cost of action not chosen is known as the opportunity cost While making a decision if such opportunity cost is not considered, the decisions may lose its vitality Sunk cost: Cost that has already been incurred in the past cannot be changed or avoided by any future decisions Such costs are known as Sunk costs For example if we have purchased a machinery years ago at a cost of Rs lacs, considering a decision of purchasing a new machinery at present will not in any way impact the cost of purchase of the old machine i.e., Rs.2 lacs Sunk costs are therefore not relevant in decision-making 8.7.3 Types of Incremental Analysis The following types of decisions involve incremental analysis: a) Accept an order at special price b) Make or buy c) Sell or process further d) Retain or replace equipment e) Eliminate an unprofitable segment Check Your Progress Define the following: (i) Variable Cost (ii) Fixed Cost (iii) Mixed Cost What you understand by marginal costing? 8.8 LET US SUM UP To manage a business it is essential to understand how costs respond to changes in sales volume and the effect of costs and revenues on profit It is therefore essential to know how costs behave Marginal costing is one of the important tools of management not only to take decision, but also to fix an appropriate price and to assess the level of profitability Marginal cost is nothing but a change occurred in the total cost due to small change in the quantity produced 8.9 LESSON END ACTIVITY What are the problems in marginal costing? Discuss the role of marginal costing in managerial decision-making 8.10 KEYWORDS Variable Cost: Costs that vary in total directly and proportionately with changes in the activity level Fixed Cost: Costs that remain the same in total regardless of changes in the activity level Mixed Cost: Costs that contain both a variable element and a fixed element Marginal Cost: Change occurred in the total cost due to small change in the quantity produced 8.11 QUESTIONS FOR DISCUSSION What you understand by cost behaviour analysis? Discuss its importance Distinguish between fixed cost and variable cost Discuss the methods for segregating the variable and fixed elements from total cost What are the components of variable cost? Check Your Progress: Model Answers (i) Variable Cost: Variable costs are costs that vary in total directly and proportionately with changes in activity level Although the variable cost in total will vary proportionately, yet at the same time it remains the same per unit at every level of activity (ii) Fixed Cost: Fixed costs are costs that remain the same in total regardless of changes in the activity level (iii) Mixed Cost: Mixed costs are costs that contains both a variable element and a fixed element They are also referred to as semi-variable costs Marginal Costing: Marginal costing is the ascertainment of marginal cost and of the effect on profit of changes in volume or type of output by differentiating between fixed and variable costs 155 Introduction to Marginal Costing 156 International Financial and Management Accounting 8.12 SUGGESTED READINGS M P Pandikumar, Management Accounting, Excel Books M N Arora, "Cost and Management Accounting", 8th Edition, Vikas Publishing House (P) Ltd Hilton, Maher and Selto, "Cost Management", 2nd Edition, Tata McGraw-Hill Publishing Company Ltd B.M Lall Nigam and I.C Jain, "Cost Accounting", Prentice-Hall of India (P) Ltd  ... differentiating between fixed and variable costs 155 Introduction to Marginal Costing 156 International Financial and Management Accounting 8.12 SUGGESTED READINGS M P Pandikumar, Management Accounting, Excel... understand and make use of these steps in various situations in the decisionmaking process Practical business management gives due weightage to both financial and non -financial information Financial. .. categories: variable, fixed, or mixed International Financial and Management Accounting 8.2 VARIABLE COSTS Variable costs are costs that vary in total directly and proportionately with changes in