INDEX

SR
NO
1
2

PARTICULARS
INTRODUCTION
DEFINITIONS

PAGE
2
3

3
4
5

FEATURES OF MARGINAL COSTING

DISADVANTAGES OF MARGINAL COSTING:-

12

7
8
9
10

APPLICATION OF MARGINAL COSTING

CLOSING DOWN OR SUSPENDING ACTIVITIES

15
16
25
36

11

BIBLIOGRAPHY

41

INSIGHT TO MARGINAL COSTING AND ITS APPLICATION

ADVANTAGES OF MARGINAL COSTING:-

PRICING DECISION
DECISION REGARDING ACCEPT/ REJECT A SPECIAL ORDER

5
7
9

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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 fi xed and variable.
While the total fi xed 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. The technique of marginal costing helps in supplying the relevant
information to the management to enable them to take decisions in several areas. In this chapter,
the technique of marginal costing is explained in detail.

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DEFINITIONS
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. Marginal Costing has been defined
as, Ascertainment of cost and measuring the impact on profits of the change in the volume of
output or type of output.

This is subject to one assumption and that is the fixed cost will remain unchanged irrespective of
the change. Thus the marginal costing involves firstly the ascertainment of the marginal cost and
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measuring the impact on profit of alterations made in the production volume and type. To clarify
the point, let us take a simple example, suppose company X is manufacturing three products, A,
B and C at present and the number of units produced are 45 000, 50 000 and 30 000 respectively
p.a. If it decides to change the product mix and decides that the production of B is to be reduced
by 5000 units and that of A should be increased by 5000 units, there will be impact on profits and
it will be essential to measure the same before the fi nal decision is taken. Marginal costing helps
to prepare comparative statement and thus facilitates the decision-making.

This decision is regarding the change in the volume of output. Now suppose if the company has
to take a decision that product B should not be produced at all and the capacity, which will be
available, should be utilized for A and B this will be change in the type of output and again the
impact on profi t will have to be measured. This can be done with the help of marginal costing by
preparing comparative statement showing profits before the decision and after the decision. This
is subject to one assumption and that is the fixed cost remains constant irrespective of the
changes in the production. Thus marginal costing is a very useful technique of costing for
decision-making.

FEATURES OF MARGINAL COSTING

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As mentioned above, marginal costing is not a separate method of costing but it is a technique of
costing distinct from the traditional costing which is also called as Absorption Costing. The
distinguishing features of marginal costing are as follows:-

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. However this does not mean that they are ignored or not taking into
consideration at all. They are taken into consideration while computing the final profit t
or loss by debiting them to the Costing Profit t and Loss Account. The logic behind
omitting fixed costs from cost of production is that fixed costs do not remain fixed on per
unit basis. On per unit basis, the fixed cost will increase if the production decreases while
it will decrease on per unit basis if the production increases. Thus fixed cost per unit are
always variable. In view of this, a question arises; on what basis they should be charged
to the product? Similarly, there is a problem of under and over absorption of these
overheads also. Therefore it is advocated that fixed cost should be eliminated from the
cost of production but should be taken into consideration while computing the final figure
of profit by charging them to the Costing Profit and Loss Account.
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. If they are included
in the inventory valuation, they will be carried forward to the next period because the
closing inventory for a particular year is the opening inventory for the next year. Thus
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charging current years costs to the next year will be against the principle and hence fixed
costs are not included in the inventory valuation.
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. If the company is producing more than one
product, the contribution from each product is combined as a pool from which the total
fixed cost is deducted. Fixed cost is not charged to each product unless it is identifiable
with a product. If any product does not contribute anything towards the f xed cost, the
management may decide to close it down.
4) Marginal costing is used to know the impact of variable cost on the volume of production
or output.
5) Break-even analysis is an integral and important part of marginal costing.
6) Contribution of each product or department is a foundation to know the profitability of
the product or department.
7) Addition of variable cost and profit to contribution is equal to selling price.
8) Marginal costing is the base of valuation of stock of finished product and work in
progress.
9) Fixed cost is recovered from contribution and variable cost is charged to production.
10) Costs are classified on the basis of fixed and variable costs only. Semi-fixed prices are
also converted either as fixed cost or as variable cost.

INSIGHT TO MARGINAL COSTING AND ITS APPLICATION

Like process costing or job costing, marginal costing is not a distinct method of ascertainment of
cost but is a technique which applies existing methods in a particular manner so that the
relationship between profit & the volume of output can be clearly brought out. Marginal costing
ascertains marginal or variable costs & the effect on profit, of the changes in volume or type of
output, by differentiating between variable costs & fixed costs. To any type of costing such as
historical, standard, process or job; the marginal costing technique may be applied.
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Under the process of marginal costing, from the cost components, fixed costs are excluded. The
difference which arises between the variable costs incurred for activities & the revenue

those

activities is defined as the gross margin or contribution. It may relate to total sales or may relate
to one unit.
The calculation of contribution for a specific product or group of products is done as follows:

Total Sales Revenue

Less :-Variable cost of production
Contribution

XXX
XXX
XX

For the business as a whole, contributions earned by specific products or group of products, are
added so as to calculate the pool of total contribution. The fixed costs of the business are paid
from this pool & then the part of the total contribution which remains becomes the profit of the
business as a whole.
A typical format for marginal costing statement is as below:
Product types or departments A B C

Total Sales Revenue

Less :-Variable cost of production
Contribution
Less:- Fixed Costs
Total Profit

XXX
XXX
XX
XX
XX

The fixed cost does not allocated to or gets absorbed by the individual products or departments.
Thus, accounting techniques relating to the treatment of fixed costs will not influence the
decisions which are based on marginal costing system. Examples of typical problems which
require executive decisions are :

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 At a lower price should a particular order be accepted or declined?

Should purchase of a particular component be made from an outside supplier or
manufactured within the factory?
Concentration should be given on which products?
By which profit-mix, profit will be maximized?
What should be the effect on the business when an existing department is being closed
or a new department is being opened?
To make up for wage rise, what should be the additional volume of business?
How by change in sales volumes or sales prices, the level of profit of business be
influenced?

ADVANTAGES OF MARGINAL COSTING:Components and spare parts may be made in the factory instead of buying from the market. In
such cases, the marginal cost of manufacturing the components or spare parts should be
compared with market price while taking decision to make or buy. If marginal cost is lower than
the market price, it is more profitable to make than purchasing from market. Additional or
specific fixed cost may be a relevant cost. Following are the advantages of Marginal Costing:1) Cost Control:- Practical cost control is greatly facilitated. By avoiding arbitrary
allocation of fixed overhead, efforts can be concentrated on maintaining a uniform and
consistent marginal cost useful to the various levels of management.
2) Simplicity:- Marginal Costing is simple to understand and operate; it can be combined
with other forms of costing, such as, budgetary costing, standard costing without much
difficulty. Elimination of varying charge per unit:- In marginal Costing fixed overheads
are not charged to the cost of production due to this the effect of varying charges per unit
is avoided.

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3) Short-Term Profit Planning:- It helps in short-term profit planning by break-even

charts and profit graphs. Comparative profitability can be easily assessed and brought to
the notice of the management for decision-making.
4) Prevents Illogical Carry forwards:- It prevents the illogical carry-forwards in
stock-valuation of some proportion of current years fixed overhead.
5) Accurate Overhead Recovery Rate:-It eliminates large balances left in overhead
control accounts, which indicate the difficulty of ascertaining an accurate overhead
recovery rate.
6) Maximum return to the business:- The effects of alternative sales or production
policies can be more readily appreciated and assessed, and decisions taken will yield the
maximum return to the business.
7) More effective costs control:-Variable cost remains constant per unit of output and
fixed costs remain constant in total during short period. Thus control over costs becomes
more effective and easier. Standards can be set for variable costs, while Budgets can be
established for fixed cost in order to exercise full control over the total activities.
8) Policy decisions making:-Marginal costing brings out contribution or profit margin
per unit of output, and clearly brings out the effect of change in activity. It facilitates
making policy decisions in a number of management problems, such as determining
profitability of products, introducing a new product, discontinuing a product, fixing
selling price, deciding whether to make or buy, utilizing spare capacity, profit-planning.
9) Greater accuracy:-Closing inventory of work-in-progress and finished goods are
valued at marginal or variable cost only. This method leads to greater accuracy in
arriving at profit as it eliminates any carryover of fixed costs of the previous period
through inventory valuation.
10) Eliminates the process of allocating:- As a corollary to above, since fixed costs
do not enter into product-cost, it eliminates the process of allocating, apportioning and

9 | Page

absorbing overheads and adjusting under and over-absorbed overheads. Therefore, the
method is simpler to operate.
11) Easy to understand:- As there is involvement of computation of variable costs only
in marginal costing, it is easy to understand & operate the same.
12) Arbitrary apportionment of fixed costs is avoided:- Among different
products or departments, arbitrary apportionment of fixed costs is avoided & the underrecovery or over-recovery problems are eliminated.
13) Better Analysis:- Analysis of contribution, break even charts & analysis of costvolume-profit-analysis are resulted out of a marginal costing system; for making short
term decisions all of these are important.
14) More uniform & realistic figures:-More uniform & realistic figures are resulted
out of marginal costing system because fixed overhead costs are excluded from
valuation of stock & work-in-progress.
15) Stronger responsibility of control:- Apportionment of responsibility of control
can be more easily done since to each level of management only variable costs are
presented over which they have control. The effects of their decisions can be more
readily seen by all levels of management-sometimes even before taking of an action.
16) Avoids illogical carry forward:- It prevents the illogical carry forward in stock
valuation of some proportion of current years fixed overhead.
17) Useful to various levels of management Practical cost control is greatly
facilitated. By avoiding arbitrary allocation of fixed overhead, efforts can be
concentrated on maintaining a uniform and consistent marginal cost.
18) Helps in short-term profit planning:- It helps in short-term profit planning by
breakeven and profitability analysis, both in terms of quantity and graphs. Comparative
profitability and performance between two or more products and divisions can easily be
assessed and brought to the notice of management for decision making.

DISADVANTAGES OF MARGINAL COSTING:10 | P a g e

1) Misleading Results:- It is very difficult to segregate all costs into fixed and variable
costs very clearly, since all costs are variable in the long run. Hence such segregation
sometimes may give misleading results.
2) Distorted Picture of Profits:- The closing stock consists of variable cost only and
ignores fixed costs. This gives Distorted Picture of Profits.
3) Avoids Semi-Variable Costs:- Semi-Variable costs are not considered in the
analysis.
4) Problem of Recovery of Overheads:- There is problem of under or over-recovery
of overheads, since variable costs are apportioned on estimated basis and not on the
actual.
5) Ignorance of Time Factor:- Since the time factor is completely ignored;
comparison of performance between two periods on the basis of contribution alone will
give the misleading results.
6) Segregation of costs:-The technique is based on the segregation of costs into fixed
and variable ones, while many expenses are neither totally fixed nor totally variable at
various levels of activity. Thus, classifying all expenses into two categories of either fixed
or variable is a difficult task.
7) Static assumptions:- The assumptions regarding behavior of costs, such as, fixed
cost remains static, are often not realistic.
8) Different indexes:-Contribution is not the only index to take decisions. For example,
where fixed cost is very high, selling price should not be fixed on the basis of
contribution alone without considering other key factors such as capital employed.
9) Marginal cost, if confused with total cost while fixing selling price may lead to a disaster.
10) Invalid as per tax authorities:-Inventory valuation at marginal cost will understate
profits and may not be acceptable by tax-authorities. Any claim based on cost will be
very low, as it will not have a share of fixed cost.
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11) An arbitrary exercise:- The process of separating semi-variable or semi-fixed costs

into their variable & fixed elements is an arbitrary exercise which at different levels of
output may be subject to fluctuations & inaccuracy. Consequently, a substantial degree of
error may be contained in the basic cost information which is used in decision making
process.
12) Great care need to be taken:- When selling prices are based on marginal costs,
great care need to be exercised, as in the long run, all fixed overheads should be covered
by the prices & a reasonable margin over& above the total costs should be left.
13) Effectiveness of the system is lost:- Under many circumstances, the deduction of
contribution made by some production units may be difficult. Thereby the effectiveness
of the system is lost.
14) Understated valuation of stock:- Since on the basis of variable costs only the
valuation of stock of finished goods & work-in-progress is done, they are always
understated. As result profit is also understated.
15) Lack of required disclosure:-More effective utilization of present resources or by
expansion of resources or by mechanization, increased production & sales may be
effected. The disclosure of this fact cannot be done by marginal costing.
16) Affect true and fair view:- Under marginal costing, stocks and work in progress are
understated. The exclusion of fixed costs from inventories affect profit and true and fair
view of financial affairs of an organization may not be clearly transparent.
17) Unrealistic data:- Volume variance in standard costing also discloses the effect of
fluctuating output on fixed overhead. Marginal cost data becomes unrealistic in case of
highly fluctuating levels of production, e.g., in case of seasonal factories.
18) Over reliance on estimates:- application of fixed overhead depends on estimates
and not on the actual and as such there may be under or over absorption of the same.
19) Less effective:- Control affected by means of budgetary control is also accepted by
many. In order to know the net profit, we should not be satisfied with contribution and
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hence, fixed overhead is also a valuable item. A system which ignores fixed costs is less
effective since a major portion of fixed cost is not taken care of under marginal costing.
20) Unsuitable for long term:- In practice, sales price, fixed cost and variable cost per
unit may vary. Thus, the assumptions underlying the theory of marginal costing
sometimes becomes unrealistic. For long term profit planning, absorption costing is the
only answer.

APPLICATION OF MARGINAL COSTING WITH REFERENCE TO:-

1) PRICING:-

(A)

PRICING UNDER MARGINAL COSTING

Marginal costing helps the management in taking pricing decisions. In absorption costing, the
prices are fixed so as to cover the total cost which include Fixed Costs as well as Variable Costs.
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In marginal costing, however, the price can be fixed on the basis of only Variable Costs. This can
be useful in the following situations: when supply exceeds demand
pricing of new products
utility services
cut throat competition in market
export orders or special orders
(B) PRICING IN NORMAL CIRCUMSTANCES
If goods were sold in normal circumstances under normal business conditions, the price could
cover the total cost plus a margin of profit. Selling prices are not always determined by the cost
of production. They may be determined by market conditions but in the long run they tend to
become equal to the cost of production of marginal firm. Therefore, a business cannot continue
to sell below the total cost for a long period. Occasionally, a firm may have to sell below the total
cost. if the selling price equals the total cost, there will be no profit and loss. The total cost
includes variable and fixed costs. For example if the variable cost is Rs.15 per unit and fixed
expenses are Rs.1,20,000 the total cost per unit when 40,000 units are produced and sold will
be:-

Variable cost Rs.15 per unit

Fixed cost Rs. 3 per unit
Total cost Rs. 18 per unit
If the selling price is below the total cost but above the marginal cost the contribution will lead to
an under-recovery of fixed expenses. If the product is sold at marginal cost, the loss will be equal
to the fixed expenses. If sold at a price less than the marginal cost, The Loss will be greater than
fixed expenses.

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(C) PRICING IN RECESSION / DEPRESSION

I.

Pricing Above marginal cost

In period of recession, a firm may sell its articles at a price less than the total cost but
above the marginal cost for a limited period:The advantages of this price these practices are: The firm can continue to produce and use the services of skilled employees
who are well trained and will be difficult to re-employe later if discharged.
Plant and machinery can be prevented from deterioration through idleness.
The business would be ready to take advantage of improved business
conditions later.
This prevents the competitors from taking away business of the firm.
The firm producing a branded article may use the surplus capacity to produce
the same article to be sold above marginal cost in a different market.
Dumping of goods in the export market is an example of this type of pricing.
The articles sold in the home market will recover all fixed expenses. Since
price reduction in the home market is harmful to the normal sales, it is not
done normally. Any reduction in the selling prices in the export market will

not affect the price prevailing in the home market.

The firm may produce and sell of branded article, say product A, which
covers the entire fixed overheads and use the surplus capacity to produce
another product B, which may be sold at a price above its marginal cost. The
overall profitability will us increase. The manufacturer of product B,
however, should be limited to surplus capacity and it should not have the
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possibility of becoming a major product at the low price at which it is sold if

it becomes so there will be a reduction in profit.
Management should take care to see that this should not lead to a drastic price
cutting and the Orders accepted should not cover a long period extending over the production
facilities of a period when business conditions improve.

II.

Price below marginal cost

It may also be justifiable to sell the product at a price below marginal cost for a very
limited period in the following conditions: where materials are of perishable nature
Where stocks have been accumulated in large quantities and the market prices
have fallen. This will save the carrying cost of stocks
It is essential to reduce the prices to such an extent in order to popularize a
new product.
Where such reduction enables the firm to boost the sales of other products
having larger profit margin.

(D) WHEN MARGINAL COSTING IS USEFUL FOR FIXING PRICE

Marginal costing helps the management in taking price decisions. In absorption costing , the
prices are fixed so as to cover the total costs which include Fixed cost as well as variable

16 | P a g e

cost. In marginal costing, however, the price can be fixed on the basis of only variable cost.
This can be useful in the following situations: When supply exceeds demand
Pricing of new products
Utility services
Cut throat competition in market
Export orders of special orders

(E) HOW PRICES CAN BE FIXED THROUGH MARGINAL COSTING

Marginal costing technique can be used to fix the prices as to: Earn maximum contribution:- Marginal costing techniques such as profit volume ratio
are especially helpful in fixing the selling price for submitting quotations or tenders.
At least break even:- That is earn just enough to cover the costs. Thus if the product is
perishable or seasonal, it is advisable to at least break even, that is sell on no profit no
loss basis. The technique of break even charts is useful in deciding the break-even point.
It assists in deciding the minimum quantity to be sold or the minimum price to be charged
in order to break even.

Recover at least the marginal costs (or even in exceptional cases, less than marginal
cost,):- e.g. In the following circumstances
I.
Depression:- When there is trade Depression, the concern must survive
somehow. Even if the production is stopped, the fixed costs will continue. Hence
it is better to continue the production so as to retain the trained labor , staff and
the consumers. The plant will also remain in working condition. This will avoid

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the costs of closing down and re-starting again when the trade conditions
II.

improve.
Eliminate competition:- When the concern wants to eliminate competition, it
may initially sell at the marginal cost or even lower. Thereafter, once the
competition is eliminated, it will enjoy Monopoly, and can charge higher prices

III.

and recover its losses.

Establish new product :- When the concern wants to introduce a popularize a
new product, initially, it may sell at the marginal cost. Once the product is
established, it can increase its prices and recover its losses. The same strategy can

IV.

be applied in case of a special order or foreign export orders etc.

Other Circumstances :- When goods are of perishable in nature , when the
prices of raw materials, which were over-stocked earlier, are falling rapidly , to
avoid shutdown cost , to push up sale of another highly profitable product , to
capture new /foreign market and so on

SOLVED PRACTICAL EXAMPLE:QUESTION:A company which manufactures and sells three products, furnishes following details for a
month:-

Product

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No. of units budgeted

1,00,000

38,000

46,000

50

80

60

34

52

24

Selling price per unit

(Rs)
Variable costs per
unit (Rs)

It has been proposed that an intensive advertisement campaign involving an expenditure of Rs

1,20,000 per month and reduction of selling prices will increase the sales of the product C as
under:

1) If selling price is reduced to Rs 55 per unit, the sales will increase to 59,000 per
month.

2) If selling price is reduced to Rs 51 per unit, the sales will increase to 65,000 units
per month.
The fixed cost of the company amount to Rs 34,20,000 per month.

1) CALCULATE the current monthly brake even sales value of the company.
2) Evaluate the two proposals and advise which of the proposals should be implemented.
3) Calculate the sales units required per month of product C to justify the expenditure in
respect of your decision in (ii) above.

1) Current monthly break-even sales value of company (WN 1)

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= Fixed Costs of the company =

P/V Ratio

Rs. 34,20,000 =
40%

Rs. 85,50,000

2) A] EVALUATION OF PROPOSAL (1)

Particulars

Rs

Total contribution of product C ( 59,000 units into Rs. 31 ) [WN 2(a)]

18,29,000

Contribution of product A and B [ WN 1:- 16,00,000 + 10,64,000 ]

26,64,000

Total Contribution

44,93,000

Less:- Advertisement Cost

1,20,000

Net contribution

43,73,000

B] EVALUATION OF PROPOSAL (2)

Particulars

Rs

Total contribution of product C ( 65,000 units X Rs. 27 ) [WN 2 (b)]

17,55,000

Contribution of product A and B [ WN 1:- 16,00,000 + 10,64,000 ]

26,64,000

Total Contribution
Less:- Advertisement Cost
Net contribution

44,19,000
1,20,000
42,99,000
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DECISION:Proposal (1) , to reduce selling price to Rs. 55 is better as it increases the net contribution by Rs.
74,000 [ Rs. 43,73,000 Rs. 42,99,000 ]

WORKING NOTES:-

(1) STATEMENT OF TOTAL CONTRIBUTION, SALES REVENUE AND P/V RATIO:Products

A. Units
B. Selling price per unit (Rs)

1,00,000

38,000

46,000

50

80

60

Total

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C. Variable cost per unit (Rs)

34

52

24

D. Contribution per unit (Rs) [B-C]

16

28

36

E. Total contribution (Rs) [AXD]

16,00,000

10,64,000

16,56,000

F. Sales Revenue

50,00,000

30,40,000

27,60,000

P/V Ratio (%) = Contribution X 100 =

Sales

Rs.43,20,000

43,20,000
1,08,00,000

X 100 = 40 %

Rs. 1,08,00,000

(2) A] Contribution per unit of product C under proposal (1)

Contribution per unit of product C will be Rs. 31, When its selling price is Rs. 55 and
Variable cost per unit is Rs. 24.

B] Contribution per unit of products under proposal (2)

Contribution per unit of product C will be Rs. 27, when its selling price is Rs. 51 and
Variable cost per unit is Rs. 24.

2) DECISION REGARDING ACCEPT/ REJECT A SPECIAL ORDER,

EXPORTING & EXPLORING NEW MARKETS
One issue likely to be appropriate to all managers at some time in their careers is whether
to accept what is referred to as a special order. By this we mean, Are there circumstances
in which it might make sense in financial terms to sell products or services at a lower
price than normal, or alternatively, to provide a service internally at less than its full
cost?
22 | P a g e

In considering such decisions, it is most important to be quite clear about the meaning of the
term full cost. In many organizations external and internal prices for products and services are
generated with reference to the full or total cost of its provision plus a percentage margin, a
practice known as cost-plus pricing. Within the full cost, there will usually be allocated and
apportioned fixed overheads required to be covered, irrespective of whether a special order is
accepted. Such non-relevant costs must be ignored since the criteria for accepting a special order
must only consider whether the direct benefits which result, exceed those costs that could be
avoided by not taking it.
23 | P a g e

Such evidence, as exists from surveys of pricing, reveals that some organizations do accept
special orders using some form of the contribution analysis, although the bias towards its use is
not as significant as many textbooks would imply.
You should be aware that the acceptance of a special order with reference to direct costs and
benefits can be problematic if it generates a special order culture. If all orders are priced as
special, how will fixed overheads ever be recovered!
There are also other considerations to be taken into account that may have financial
consequences. For example, if it became widely known that special orders were negotiable then
the subsequent marketing and selling of products, or services, may be far more difficult, and
require a good deal more effort to be expended than currently.
Generally speaking, a special contract should not be accepted if it will affect consumer behavior
adversely within the same marketplace. General knowledge of the availability of special orders
may well lead to "consumer games" with the supplier. Special orders might relate to Government
contracts or customers in a separate market segment; possibly in an overseas market.

SOLVED PRACTICAL EXAMPLE:QUESTION:Pieco engineering company has received an once-off export order for its sole product that would
require the use of half of the factorys total capacity, which is estimated at 4 lakhs units per
annum. The condition of the export order is that it has to be accepted in full: acceptance of part
quantity is not allowed.

24 | P a g e

The factory is currently operating at 60% level to meet the demand of its domestic customers. As
against the current price of Rs. 6.00 per unit, the export offer is Rs . 4.70 per unit, which is less
than the total cost of current production . The cost breakdown is given below:

DETAILS
Direct material
Direct labour
Variable expenses
Fixed overhead
Total cost

( RS.PER UNIT )

2.50
1.00
0.50
1.00
5.00

The company has the following options :(A) Accept the export order and cut back domestic sales as necessary
(B) Remove the capacity constraint by installing necessary balancing equipment and also
by working overtime to meet both domestic and export demand. This will increase the
fixed overheads by Rs. 15000 annually, and additional cost for overtime work will
amount to Rs. 40,000 for the year.

25 | P a g e

(C) Appoint a subcontractor to manufacture the additional requirement and meet the
domestic and export requirement in full by supplying raw materials, paying a
conversion charge @ Rs. 2.00 per unit and appointing a supervisor at a salary of
rs.3,000 per month for checking the quality of the product and controlling operations at
the manufacturing unit.
(D) Refuse the order.

Required:(I)
(II)

A statement of costs and profits under each of the above four points;
Your recommendation, with reasons, as to which of these options the company should
decide upon.

SOLUTION:-

Calculation of Variable Cost/unit:-

RS
Direct Material

2.50

Direct Labor

1.00

Variable expenses

0.50

Variable cost/unit

4.00

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Calculation of Fixed cost (at 60% level):= 4,00,000 units 60/100 Rs 1 per unit = Rs.2,40,000

Evaluation of Option (a): Profitability Statement (Accept export order and cut
back domestic sales as necessary)

Rs

Sales:Export (2,00,000 units @ Rs 4.70)

Domestic (2,00,000 units @ Rs 6.00)

9,40,000
12,00,000
21,40,000

Less:- Variable cost (4,00,000 units @ Rs 4)

Contribution
Less :- Fixed Overhead
Profit

16,00,000
5,40,000
2,40,000
3,00,000

Evaluation of Option (b): Profitability Statement (Installation of balancing

equipments. & increase capacity to meet both domestic
and export demand):-

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Rs

Rs

Sales:Export (2,00,000 units @ Rs 4.70)

9,40,000

Domestic (2,40,000 units @ Rs 6.00)

14,40,000
23,80,000

Less:- Variable cost (4,40,000 units @ Rs 4)

Overtime payment

17,60,000
40,000

5,80,000

Contribution
Less : Fixed Overheads
Extra Fixed Costs

18,00,000

2,40,000
15,000

2,55,000
3,25,000

Profit

Evaluation of Option (c): Profitability Statement (Sub contracting)

Rs

Rs

Sales:-

Export (2,00,000 units @ Rs 4.70)

9,40,000

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Domestic (2,40,000 units @ Rs 6.00)

14,40,000

23,80,000

Less:- Variable cost (4,00,000 units @ Rs 4)

16,00,000

Sub-contract charges :-

Material

( Rs 2.50 40,000)

Conversion ( Rs 2.00 40,000)

1,00,000

80,000

17,80,000

Contribution
6,00,000

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Less : Fixed Overheads

Supervision charges

2,40,000

36,000
2,76,000

Profit
3,24,000

Evaluation of Option (d): Profitability Statement (Refuse Export Order)

Rs
Sales:Domestic (2,40,000 units @ Rs 6.00)
Less:- Variable cost (2,40,000 units @ Rs 4.00)
Contribution
Less :

Fixed Overhead
Profit

14,40,000
9,60,000
4,80,000
2,40,000
2,40,000

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ANALYSIS :From the above, it is observed that the Profit is maximum, by installation of balancing equipment
and increasing capacity to meet both domestic as well as export order. Hence option (b) to
Remove the capacity constraint by installing necessary balancing equipment and also by working
overtime to meet both domestic and export demand. This will increase the fixed overheads by
Rs. 15000 annually, and additional cost for overtime work will amount to Rs. 40,000 for the year.
is recommended.

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CLOSING DOWN OR SUSPENDING ACTIVITIES

Sometimes it becomes necessary o temporarily suspend or discontinue the activities of

particular product, department or a factory as a whole due to recession. The decision to suspend
or close down depends on whether the products are making any contribution towards the fixed
costs or not. If the products are making contribution, it is not advisable to suspend or close down.
If the business is shut down , certain cost may be eliminated but certain cost have to be incurred
at the time of closing, maintenance, over hauling , reopening , training of personnel etc. Such
cost must be taken into account while taking the decision. General fixed costs are likely to come
down in the event of closure.

These decisions are related to discontinuing a marginal unit. They are finalized based on
marginal cost of each option. Marginal cost denotes the cost of doing or not doing certain things.

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It helps the management in ascertaining the cost of an option and taking decisions as to which
option to accept or reject. A marginal unit should be produced, if it has a positive contribution
(which helps to meet part of the fixed costs). A marginal unit should be discontinued if its
contribution is negative. Thus by analyzing marginal cost management can decide whether to
continue or discontinue a process or a department.

Following non-cost considerations are to be taken into account while taking

the decision.
1) Competitors may establish their product and capture a huge share in the market and the
business may be lost. It may be difficult to recapture the market share.
2) Fear of retrenchment of workers. Once the workers are retrenched it may be difficult to
get the skilled workers.
3) Plant may become obsolete with the closure of business. Heavy capital expenditure may
4)
5)
6)
7)

be incurred to restart the business.

Reputation of the firm may be affected.
Relationship with suppliers may be affected.
Dues from debtors may be not be collected in time.
The contribution given by the product-- This contribution is different from profit. Profit is
arrived at after deducting fixed cost from contribution. Fixed costs are apportioned
over different products on some reasonable basis which may not be very much correct.
Hence, contribution gives a better idea about the profitability of a product as compared to

profit.
8) The capacity utilization, i.e. whether the firm is working to full capacity or below normal
capacity. In case a firm is having idle capacity, the production of any product which can
contribute toward the recovery of fixed costs can be justified.

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9) The availability of product to replace the product which the firm wants to discontinue and
which is already accounting for a significant proportion of the total capacity.
10) The long-term prospects in the market for the product.
11) The effect on sale of other products. In some cases, discontinuance of one product
may result in heavy decline in sales of other products affecting the overall profitability
of the firm.

SOLVED PRACTICAL EXAMPLE:QUESTION:A manufacturer of packing cases makes three main types- Deluxe, Luxury, and Economy.
Overheads are incurred on the basis of labour hours. Wages are paid at Re 1.00 per hour.
Estimates for the cases show the following:
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Deluxe

Luxury

Economy

Material
Wages

(Rs)
10.00
6.00

(Rs)
8.00
3.00

(Rs)
3.00
2.00

Overheads

12.00

6.00

4.00

28.00

17.00

9.00

2.00

3.00

3.00

26.00

20.00

12.00

10,000

20,000

5,000

Particulars

Net Profit/loss

Average Selling Price

Annual Sales ( Units)

The manufacture felt that he would be well advised to discontinue producing the Deluxe and
economy cases even though it would mean that some of production facilities would remain
unused. He cannot increase the sale of luxury cases. It has been ascertained that 60% of the
overheads is fixed.
You are required to advise the manufacture.

SOLUTION:STATEMENT OF COST AND CONTRIBUTION:Deluxe

Luxury

Economy

(Rs)

(Rs)

(Rs)

Material

10.00

8.00

3.00

Wages

6.00

3.00

2.00

Variable Overheads (40%)

4.80

2.40

1.60

Particulars

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Total Variable Cost

20.80

13.40

6.60

Selling Price

26.00

20.00

12.00

Contribution

5.20

6.60

5.40

Less: Fixed Cost (60%)

2.20

3.60

2.40

Net Profit / Loss

(-)2.80

3.00

3.00

P/V Ratio (Contribution*100)/Sales

5.20*100/26

6.60*100/20

5.4*100/12

= 20%

= 33%

= 45%

NOTE:
The above statement clearly explains that product Deluxe is incurring loss and also its P/V Ratio
is less as compared to other two products. Hence it is advisable, that the manufacturer should
discontinue the product Deluxe and increase the production of products Luxury and economy.

BIBLIOGRAPHY
1) www.icaiknowledgegateway.org/littledms/.../chapter-16-marginalcosting.pdf
2) http://www.yourarticlelibrary.com/cost-accounting/marginal-costing/definition-appointing-authoritiestypes-and-objectives/56168/
3) icmai.in/upload/Students/Circulars/Companies-Rules-2014.pdf
4) http://articles.economictimes.indiatimes.com/2015-0103/news/57633939_1_Absorption-costing-records-entities
5) http://taxguru.in/company-law/-marginal-costing--cost-records.html
6) RTP-2008.Revised Syllabus, Paper-17 , Marginal & Absorption Costing.
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7) http://yourfinancebook.com/applicability-of-cost-records-and-marginalcosting-to-companies/
8) BOARD OF STUDIES, JULY-2015 , COSTING AND FINANCIAL
MANAGEMENT,

SAHITYA

BHAVAN

PUBLICATION,

ICAI

BHAVAN, NEW DELHI-110002 , PP 6.2-6.9.

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