## Marginal Costing — Basic Concepts and CVP Analysis
### The Core Principle
Marginal costing separates total cost into variable and fixed components:
- Variable cost → treated as product cost (absorbed into units of output)
- Fixed cost → treated as period cost (charged entirely to the period, not to units)
Profit = Contribution − Fixed Cost
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### Key Definitions
1. Marginal Cost
The incremental change in total variable cost when output increases by exactly one unit.
> Marginal Cost = Direct Labour + Direct Material + Direct Expenses + Variable Overheads
Note: Fixed overhead is excluded from marginal cost.
2. Marginal Costing
A costing technique where only variable (marginal) costs are charged to products. Fixed costs are written off in full against the contribution earned in the period.
3. Direct Costing
All direct costs (whether fixed or variable) are charged to products; all indirect costs are written off against profits in the period they arise.
> Direct costing ≠ Marginal costing (direct costing may include fixed direct costs in product cost)
4. Differential Cost
The difference in total cost between two alternatives. Used to select the most cost-effective option.
- Example: If Alternative A costs ₹1,00,000 and Alternative B costs ₹85,000, differential cost = ₹15,000 in favour of B.
5. Contribution
> Contribution = Sales Value − Variable Cost
Fixed costs are treated as period costs and are not apportioned between products under marginal costing.
Applications of contribution analysis:
- Accept/Reject a new order: Compare contribution per unit of new order vs existing production; accept the order that gives higher contribution.
- Choose between production methods: Select the method that generates higher total contribution.
- Key factor decisions: When a limiting factor exists, rank products by contribution per unit of limiting factor.
6. Key Factor / Limiting Factor
The factor that restricts the level of activity of an undertaking at a given point in time.
- Examples: shortage of raw material, shortage of skilled labour, limited machine hours, limited sales demand.
- When a key factor exists, maximise contribution per unit of limiting factor to maximise profit.
7. Cost-Volume-Profit (CVP) Analysis
CVP analysis explores the relationship between costs, revenue, and resulting profit at different levels of output/sales.
Assumptions of CVP Analysis:
1. Revenue and cost changes arise only from changes in units produced and sold.
2. Total costs = Fixed costs (constant regardless of output) + Variable costs (proportional to output).
3. Total revenue and total cost are linear within the relevant range and time period.
4. Selling price per unit, variable cost per unit, and total fixed costs are constant.
5. Time value of money is ignored — revenues and costs at different time periods are directly comparable.
Key CVP Relationships:
- Contribution per unit = Selling Price per unit − Variable Cost per unit
- P/V Ratio (Profit Volume Ratio) = Contribution ÷ Sales × 100
- Break-Even Point (Units) = Fixed Costs ÷ Contribution per unit
- Break-Even Point (₹) = Fixed Costs ÷ P/V Ratio
- Margin of Safety = Actual Sales − Break-Even Sales
- MOS Ratio = Margin of Safety ÷ Actual Sales × 100
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### Marginal Costing vs Absorption Costing
| Feature | Marginal Costing | Absorption Costing |
|---|---|---|
| Fixed overhead treatment | Period cost — written off in full | Product cost — absorbed into units |
| Stock valuation | Variable cost only | Full cost (including fixed overhead) |
| Profit | Varies with sales | Varies with production (even if unsold) |
| Decision-making | Better (contribution highlights variable cost behaviour) | Less suitable for short-term decisions |
| Compliance | Not accepted for external reporting (AS-2) | Accepted for financial reporting |