Marginal Costing

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I.C.M.A. England has defined marginal cost as two amounts:

(1) Increase in aggregate costs, if production is increased by one unit

Or

(2) Decrease in the aggregate costs, if the production is decreased by one unit.

·         Marginal costing requires that fixed and variable costs must be kept separate at every stage of production.

·         Fixed costs must be excluded from the total costs to study Marginal Costs. Only variable costs are considered for costing of products.

·         The basic assumption of Marginal Costing is that the excess of selling price over variable costs provide a fund that firstly meets fixed costs and then the company’s profit.

·         Marginal costs ascertain the cost. Over and above this, it provides a means to calculate the change in profits due to changes in volume, cost, in selling price, in product mix or in the sales mixture.

Ø  Marginal Cost Equation

The following is the basic Marginal Cost Equation:

S – V = F + P

S is the selling price

V is the variable cost

F is the fixed cost

P is the profit

This difference is also called as the ‘contribution’ of a product line. Contribution is the excess of sales value over the marginal cost of sales.

C = S – V = F + P     Where C is the contribution

Ø  Break – even Analysis

Break – even represents the level of activity where the total cost equals total revenue. It is a point of “no profit – no loss”. The firm earns profits at a production higher than this point. The firm incurred losses when production is below this point.

Formulae Representation of Break-even point:

Considering the basic Marginal Cost Equation, a firm will be at a point of no profit – no loss when:

S – V = F (Sales price – Variable cost = Fixed Costs as P should be 0)

Or

C = F where C is the contribution

Thus the B.E.P. (for output) = Total Fixed Cost / Contribution per Unit

Ø  Cost – Volume – Profit Relationship

There is a close relationship between cost, volume and profit levels of an organization. They are interdependent as selling price depends on the cost of production and sales depend on volume of production and profits are determined by all of these factors. The C-V-P relationship is represented by the ‘Contribution to Sales Ratio’ or the ‘Marginal Income Ratio’.

Here, P/V Ratio = Contribution/ Sale

Or

Sales – Variable Costs/ Sales

Or

Fixed Cost + Profit/ Sales

The P/V ratio serves as a ready reckoner for ascertaining the changes in profits resulting from a change in sales volume. It is useful in determining the profit for a given sales volume and also the volume of sales required for a given target of profit. An increase in the selling price, favorably changing the sales mix and reducing the variable costs can improve the P/V ratio.

Ø  Margin of Safety                                                                                 

Margin of Safety represents the amount by which the volume of sales exceeds the break- even level. A higher margin of safety is better because it indicates that even if that even if there is some fall in sales, still the firm earns profit. A low margin of safety indicates a difficult business situation. The margin of safety can be improved by increasing the selling price if it is possible, increasing the production, reducing fixed cost, reducing variable cost and favorably changing the product mix.

Margin of Safety = Total sales – Sales at B.E.P

Or

F/ (P/V ratio)

Or

P/ (P/V ratio)

Where S = Sales, P = Profit and F = Fixed Cost

Marginal costing is used in evaluation of the performance of an organization. It helps to fix the selling price and make profitable use of scarce resources. It helps in determining the optimum product mix and is useful in Make or Buy decisions. Marginal costing enables comparison of methods of production and the dropping of unprofitable activities. Please refer to the chapter ‘Pricing Aspects of a Firm’ in this blog for mathematical illustrations of the application of Marginal Costing.

 

 

 

 

 

 

Standard Costing

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The Institute of Cost and Works Accountants, London have defined Standard costs, “Standard costs are prepared and used to clarify the final results of a business, particularly by measurement of the variations of the actual costs from standard costs and the analysis of the causes of variations for the purpose of maintaining efficiency by executive action”.

 Standard costing involves:

1.       Establishment of cost centers: A cost center is a location, person or equipment for which costs may be ascertained.

2.       Classification of Accounts: Accounts are classified to meet a certain purpose. This includes classification into revenue item or an asset item or a cost item.

3.       Setting the standard costs and the use of standard cost. Standard costs may be set based on current standards based on the short period of time and which is related to current conditions. Alternatively, standard costs can be set at a level in relation to a base year which is called as setting basic standards.

4.       Ascertaining the Actual costs

5.       Comparing the standard cost and actual costs that establishes the variances

6.       Analyze the causes of variances and take appropriate action whenever necessar

Working of Standard Costs

The most important managerial tool is the study of variance parameters with the help of standard costing. Variance is the difference between the ‘actual’ and the ‘standard’ and variance analysis is made to assign responsibilities for off standard performances.

There are fundamentally two types of variances:

Price Variance

a)      Material Price Variance

b)      Labor price Variance

c)       Variable Overhead Expenditure Variance

d)      Fixed Overhead Expenditure Variance

e)      Sale Price Variance

Volume Variance

a)      Material Usage Variance

b)      Labor Efficiency Variance

c)       Fixed Overhead Volume Variance

d)      Sale Volume Variance

Calculation of Variances:

(A)   Material Cost Variance = Standard Cost – Actual Cost

Standard Cost = Standard price per unit * standard quantity

Actual Cost = Actual price per unit * actual quantity consumed  

Further:

Ø  Total Material Cost Variance = Material Price Variance + Material Yield Variance + Material Mix Variance + Yield Variance

 

Ø  Material Price Variance = (Standard Unit Price – Actual Unit Price) * (Actual quantity of material used)

Price variations may be caused due to changes in prices, uneconomical purchasing, and failure to avail concessions and discounts and so on.

Ø  Material quantity or usage variance = (Standard quantity – Actual quantity) * Standard price per unit

The cause that may lead to usage variances includes use of different qualities of material, inefficiencies of labor and change in the product design and so on.

Ø  Mix Variance = Standard unit price * (Revised Standard quantity – Actual quantity)

This variance represents the difference between the actual proportion and the standard proportions of materials used in production of actual output. In other words mix variance is caused due to a change in composition of the mixture.

Ø  Yield Variance = Standard rate * (Actual yield – Standard yield)

Yield variance is an output variance while the material price, quantity and mix variance are input variances. Yield Variance represents loss in production in process industries. Yield variance occurs when actual output differs from standard output due to abnormal process losses.

(B)   Labor Cost Variance = Standard Cost – Actual Cost

Or

(Standard hours * Standard Rate) – (Actual hours * Actual Rate)

Further:

Ø  Total Labor Cost Variance = Rate of Pay Variance + Efficiency Variance + Idle Time Variance + Labor Mix Variance

Ø  Rate of Pay Variance = (Standard Rate – Actual Rate) * Actual hours per unit of output

This variance arises due to a change in the methodology of wages rate, payment at a rate higher or lower than the standard rate and so on.

Ø  Efficiency Variance = (Actual Production – Standard Production) * Standard Rate per Unit

Or

 (Standard Time for actual production –Actual Time excluding abnormal idle time) * Standard Hourly Rate

Ø  Idle Time Variance = Abnormal Idle Hours * Standard Hourly rate

This variance will always be adverse or unfavorable.  This happens when any employee remains idle due to abnormal circumstances like power failure, strikes and lockouts and so on.

Ø  Labor Mix Variance = Standard Cost of Standard Mix – Standard Cost of Actual Mix

This arises when there is a non-availability or shortage of labor or a change in the grade of labor employed.

(C)   Overheads Expenditure Variance = Standard Overheads Allowed – Actual Overheads Incurred

Overheads constitute of Variable Overheads and Fixed Overheads. Variable overhead expenses will vary directly in proportion to production. Fixed overheads are a vital element in the cost of production and by nature does not vary with variance in production.

After such a variance analysis has been made, the reasons for the deviations are then found out. This serves as an instrument of control in the hands of the management. The management will then strive to initiate actions to rectify an unfavorable variance or sustain and support a favorable variance.

Standard costing provides guidance to the management. By setting standards and acting as a yardstick for analyzing performance, it helps the management in effective cost control and also in formulating price and production policies. It makes it possible for the management to investigate into the causes of variances due to reasons such as mistakes and inefficiencies and so on. The entire exercise stimulates cost consciousness among all the executives and also enables fixing responsibilities amongst cost centers. Most importantly, whenever standard costing is implemented, the management need not concern itself with those activities that go according to the plan. The management can apply the principle of “Management by Exception” where they concentrate on points of exception. Standard costing once properly planned and introduced can help simplify the costing procedure and will enable savings in costs on the overall.

Introduction to Cost Accounting

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The institute of Cost and Works Accountants in England and Wales has defined Cost Accountancy as:

“ The application of costing and cost accounting principles, methods and techniques to the science, art and practice of cost control and ascertainment of profitability. It includes the presentation of information derived there from for the purpose of managerial decision making.”

Therefore, it can be seen that cost accounting serves at keeping costs under control, collecting cost information to help the management in decision making and ascertaining profitability and its causes.

Elements of Cost:

The elements of cost constitute the primary classification of cost according to the factor of expenditure.

1.       MaterialCosts: This refers to the cost of commodities supplied to an organization. Accounting for material cost and its proper control can enable systematic accounting and avoid funds being blocked. It is essential to have a selective inventory control or ABC analysis for materials consumed by the organization.

Category A: Materials that are rather small in number but require large investment.

Category B: Materials that are more but involve less investment.

Category C: Materials that are large in number but involve less investment.

Moreover, it is important to ascertain minimum levels or reorderinglevels of quantity of material to be kept in stock. The duty of the stores keeper is very important, as the stores ledger needs to be actively maintained.

2.       Wages(labor cost): This refers to the cost of remuneration which includes wages, salaries, commissions and bonus. This will include time recording for the workers including overtime. A job card is issued to each worker for the purpose of maintaining the time. Thus the total wages payable to each and every worker can be calculated.

 

3.       Expenses: Expenses may be direct or indirect. Direct expenses are attributable to a work center and include Travelling Expenses incurred, Royalty Paid and so on. Indirect expenses are applicable for the business as a whole and include Selling and Distribution expenses, Office and Administrative Overheads, Depreciation of plant and machinery and so on.

TechniquesofCosting:

Historical Costing: Also called traditional costing this refers to the ascertainment of costs after they have been incurred. It is more of a record rather and cannot help in controlling costs.

Standard Costing: Under this system, a standard is fixed for each item of expenditure. A variance analysis is then made by comparing the actual with the standards. The standards of predetermined costs are arrived at on the basis of information available about the factors affecting the cost. Causes for the variance are analyzed and remedial action taken. This is often used as a tool in budgetary control.

Marginal Costing:  Differentiation between fixed cost and variable costs is the crux of this approach of costing. Here ‘contribution’ is arrived at as the (Price of sales – marginal cost of sales) .Fixed costs are to be recovered from this ‘contribution’. This method of costing is useful to the management for taking policy decisions in reference to (1) pricing of a product (2) whether to make or buy decision (3) selecting the right product mix and so on.

Uniform Costing: This method of costing refers to several undertakings having similar products adopting the same costing principles and practices. This is important for the modern times as it enables inter- firm comparisons and also national and international performance comparisons.

Needof a Costing System:

An organization needs to overcome the reasons for non – implementation of installing a costing system. The reasons may be either the high costs involved or maybe the presence of an assured market.  A costing system is established with the full support of the management. Detailed records should be maintained and a costing system to suit the general nature of the business should be established. Standardization of forms and establishment of clear-cut authority and responsibility is required. This will ensure a prompt and regular reporting system. Acquiring reliable data for decision making is then enabled. Finally, reconciliation between the costing figures and the financial accounts can be made.

Fundamentals of Direct Costing

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Direct Costing is primarily used within an organization as an internal source of information for planning and control. The purpose of direct costing is to facilitate the distribution of costs among products, line of business and profit centers. The scope of direct costing can be better understood with the help of the concepts given below:

Direct Costs: These are costs incurred which are traceable to a specific product or line of business. Example: Advertisement and Publicity Expenses, Procurement Expenses, Conveyance Expenses, Travelling Expenses and fixed expenses of employees whose salaries are  charged direct.

Indirect Costs: These costs cannot be specifically assigned to a product or line of business. Example: Office Rent, Property Taxes, General Management Salaries.

Direct Costs can be Variable or Fixed Costs.                                                                           

Variable Costs: These costs change as the level of activity changes.

Fixed Costs: These costs are constant and do not change with changes in the level of activity.

Marginal Income:  This refers to the (Revenue – Direct Variable Costs)

Contribution to Indirect Cost and Profit: This refers to the (Marginal Income – Direct Fixed Cost)

Net gain before tax: This refers to the (Revenue – Direct Variable Cost – Direct Fixed Cost – Indirect Costs)

Benefits offered by Direct Costing

The Direct Costing format provides information about each product lines contribution to overheads before allocation of indirect expenses. Direct Costing allows the use of several techniques to enhance cost control and to increase the effectiveness of product planning and project monitoring.

Profit Planning:  ‘Marginal Income’ calculates the actual economic contribution of each line of business or product line. It allows the calculation of ‘contribution to indirect cost and profits’. This allows the management to make timely decisions concerning product costing and product mix.

Flexible Budgeting: Fixed costs and variable costs for a responsibility area or cost center are identified. While fixed cost is a flat dollar amount, variable costs are budgeted based on the expected or assumed activity level and the standard unit cost. This is how flexible budgeting is done and the manager is responsible for all cost over-runs for reasons like volume fluctuations due to inefficiencies.

Project Monitoring: Corrective action and reduction of losses against plans can be effected. This is made possible by the financial reporting of actual results on the same basis as planned and calculated by direct costing.

New Product Analysis: Marginal Income for the new product can be analyzed. This is significant for management to understand the expected contribution of a proposed new product to overheads and profits.

A skilled professional can mathematically distinguish variable and fixed costs within a relevant range of activity. There are various statistical method that can be used like Regression analysis, high and low points, scatter graphs and linear programming. Amongst these, linear programming is perhaps the most useful method in arriving at the variable and fixed portions of the cost. Each Company will have its own management information needs. The realization of these needs depends on the affordability of a simple or more advanced costing system.

Funds Flow and Cash Flow

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Financial statements like the profit and loss statement and the balance sheet provide only limited information about the financial activities of a business. They do not give a complete report of the financial activities of all resources provided and the uses of financial resources during the period to which they are put. Therefore we have a   Funds Flow Statement

·         A funds flow statement is a financial operation statement.

·         It reveals how a business has been financed and the category of uses of its funds over a period of time.

·         The funds flow statement indicates changes in working capital.

·         It presents funds represented between different assets and equity items during an accounting period.

·         It is a means of analyzing in detail the items contained in the Balance Sheet, by linking the increase and decrease in certain figures not found in the balance sheet.

 

FUNDS FLOW STATEMENT:

1^st Step: Showing change in working capital.

Identify current assets and current liabilities in the Balance Sheet

CURRENT ASSETS	CURRENT LIABILITIES
Cash in hand	Bank Overdraft
Cash in bank	Dividend declared and Payable
Accounts Receivable	Income Tax Provision
Pre-paid expenses	Accounts Payable
Preliminary Expenses	Outstanding Liabilities for expenses
Debtors	Creditors
Inventory or Stock in Trade,

 

·         Record the difference in amounts in Current Assets and Current Liabilities for the current and last year’s balance sheet.

·         Working capital increases with an increase in current assets and/or decrease in current liabilities and is considered as an application of funds.

·         Working capital decreases with a decrease in current assets and/or increase in current liabilities and is also considered as a source of funds.

 

2^nd Step: Construction of the fixed assets account

Compare the opening and closing balances of these accounts.

Pass the necessary entries for the

·         Sale

·         Transfer from ‘provision for depreciation account’ showing accumulates depreciation on the asset sold. Separate accounts for each of the fixed assets should have been opened and maintained

·         Subsequent transfer to the profit and loss account of any profit or loss on sale.

·         Purchases of fixed assets

·         The difference in the account if depicting additions; will be taken as an application of funds.

·         Sales proceeds will be taken as a source of funds.

Similarly, the provision for taxation accountshould be constructed.

·         The opening and closing balances of provision for taxation should be noted. This information is contained in the opening and closing balance sheet.

·         The amount of tax paid should be debited to this account.

·         The amount of provision made for the year will be noted in the credit side of this account and the debit side of profit and loss account.

Similarly, an account is to be opened in respect of investmentsto ascertain the amount of purchase and sale of investments during the year.

3^rd Step: Preparation of adjusted profit and loss account

·         The opening and closing balances of this account will be noted.

·         Profits from operations are arrived at by adjusting non- cash items as mentioned above like depreciation, provision for taxation, loss or profit from sale of assets, and others like write- off of goodwill and preliminary expenses.

4^th Step: Scrutiny of long term liabilities and non-current or fixed assets

·         Note the changes in balances at the beginning and the end of the year

·         The differences are then listed either as a source or application of funds.

·         Profit on revaluation of fixed assets will not affect working capital and is not considered in the funds statement.

·         Dividends and interim dividends paid during the year should be shown as an application and charged to the adjusted profit and loss account.

The sources and applications summarized

Sources of Funds:

1.       Funds from normal operation of the business as disclosed by the closing balance of the profit and loss account.

2.       Other funds from sale of fixed assets or investments or issue of shares and debentures

Application of Funds:

1.       Operating Loss

2.       Purchase of fixed assets

3.       Purchase of Investments

4.       Payment of dividend

5.       Redemption of shares or other long term liabilities

 

In conclusion we can observe that when the inflows and outflows of fund result in net inflow, there in an increase in working capital and vice versa.

CASH FLOW STATEMENT:

A cash flow statement explains the cash movements between two points of time. It is used in the sense that it indicates the amount of resources provided by operations, and the net income is adjusted for depreciation and certain other changes. This is useful for the management in budgeting cash requirements. It is useful for creditors and investors also. The cash statement is prepared according to the accounting standard of the country.

1.       Commence with the opening cash and bank balances

2.       Add the amount of cash received as in issue of shares and debentures, receipt from debtors and sale of fixed assets.

3.       Deduct payments: to creditors, to other liabilities and expenses, to acquire assets and to pay dividend and taxation.

4.       The balance will represent the closing cash and bank balances

When figures for purchases, sales and expenses are not available, the statement will be prepared in the same way as sources and application of funds statement. Increase and decrease in each of the current asset and current liabilities are shown in the statement of changes in Working Capital.  This movement of working capital should relate with the overall changes in the movement of sources and uses (of long term capital, operating results and fixed assets) statement.

 

 

 

 

 

 

Ratio Analysis of Financial Statements

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The American Institute of Certified Public Accountants has summarized that “The financial statements reflect a combination of recorded facts, accounting conventions and personal judgments and the judgments and conventions applied, affect them materially”

Financial statements may be classified into two categories:

1)      General Purpose which consist of Balance Sheet and Profit and Loss Account

2)      Specific Purpose statements consisting of all other statements i.e Statement of Funds Flow or working capital and Cash Flow Statement

Financial Statements are very useful because they enable the process of taking economic decisions. The users of these statements include shareholders, creditors, and financial analysts and so on, each of whom require a different type of financial information.

Ratio analysis is a handy tool that can help into analyzing, investigating and determining the causes for the performance of the financial statements. The other tools to mention are Comparative financial statements, trend percentages and specialized analysis.

Ratio Analysis is a useful tool for appraisal of financial condition, efficiency and profitability of business. Ratios in financial analysis may be classified into

a)      Liquidity Ratios

b)      Leverage Ratios

c)       Activity Ratios

d)      Profitability Ratios

LIQUIDITY RATIOS: These measure the liquid position of the firm. The liquidity ratio highlights the capacity of the firm to meet its current liabilities out of current assets. The examples of liquidity ratio are:

Current Ratio: This is a measure of short term solvency. It indicates as to how many times current liabilities are covered by current assets. A ratio of 2:1 is generally considered as normal.

Current Ratio = All current assets / (Current Liability + Bank Overdraft)

Quick Ratio: This is also known as quick ratio or acid test ratio. In this ratio, slow moving assets like inventory and slow moving liabilities like Bank OD are not considered. A quick ratio of 1:1 is considered as normal.

Quick Ratio = (Current Assets minus Inventories) / (Current Liabilities and Provisions)

Inventory Turnover Ratio: This is also an activity ratio. It indicates the efficiency and inventory control and quality of a company. A higher ratio means good profits and that a smaller amount of inventories are necessary; and vice versa.

Inventory Turnover Ratio = Sales / Ending Inventory = Times

LEVERAGE RATIOS: This ratio measures the relative interest of the owners and creditors in the capitalization of the company. Some examples include:

Debt to Equity Ratio: This ratio compares the extent of borrowings and owned resources put in the business. A very high ratio will again mean heavy burden of debt.

Total Debt to net worth or equity = (Long Term Loans + Other Loans) / (Share Capital + Reserves + Surplus) = Times

Net worth to Fixed Asset Ratio: This ratio measures the extent to which risk capital is used to acquire fixed assets. A high ratio indicates that risk capital is more in fixed assets.

Net worth to Fixed Asset Ratio = (Share Capital + Reserves + Surplus) / Net fixed assets = Times

ACTIVITY RATIOS: These ratio measures the efficiency with which the funds have been employed by the company. Some examples include:

Average (Debtors) Collection Period: This measure the relationship between credit sales and period of credit allowed. It indicates the efficiency of the credit and collection policy.

Average Collection Period = (Sundry Debtors + Bills Receivable) / Sales * 365 = Number of Days

Fixed Asset Turnover ratio: This indicates how far the company’s assets are utilized for achieving higher turnover. A trend analysis can also be taken on average basis for future projections of sales.

·         Asset Turnover Ratio = Sales or Turnover / Gross Fixed Assets = Times

·         Capital Turnover Ratio = Sales or Turnover / Capital Employed = Times

 

PROFITABILITY RATIO:  These ratios measure the profit earning capacity of the company. These ratios measure the overall efficiency of the business. Some examples include:

Operating Profits to sales: As this ratio measures the operating efficiency, the interest and depreciation are not taken into account. It indicates the margin of profitability on net sales or sales after adjustment of stocks.

Operating Profit to Sales ratio = Operating Profit (before interest and depreciation) / Adjusted Sales

Return on Net Worth: This ratio measures how much is earned on owned funds employed. The ratio shows the earning capacity of owned funds.

Return on Net Worth = (Profit after Tax / Net Worth) * 100

These ratios help to grasp the relationship between various items in the financial statements. They are helpful in pointing out the trends important items and help the management to forecast. Moreover, inter-firm comparisons are possible and future market strategies can be evolved. Comparisons can be made between standard ratios and the actual performance ratios. Management can be then make corrective measures. These ratios are useful in a simple assessment of liquidity, solvency, efficiency and profitability of a firm.