Page 51 - DCOM206_COST_ACCOUNTING_II

Cost Accounting – II

Notes be charged to the Costing Profit and Loss Account. Thus the selling price of the product will be
fixed on the basis of variable costs of ` 5 per unit. This may result in charging the price below the
total cost but producing and selling a large volume of the product will cover the fixed costs.
Suppose, in the above example, selling price is ` 9, which covers the variable cost but not the
total cost, efforts of the company will be to maximize the volume of sales and through the
margin between the selling price and variable cost, cover the fixed cost. The difference between
the selling price of ` 10 per unit and the variable cost of ` 5 per units is the margin, which is
called as ‘Contribution’. The contribution margin in this case is ` 5 per unit. If the company is
able to produce and sell, say, 1,50,000 units it will earn a total contribution of ` 5 × 1,50,000 units
= ` 7,50,000 which will cover the fixed costs and earn profits. However if the company is not able
to sell sufficient number of units, it will incur a loss. The concept of break-even point which is
discussed in detail later in this chapter is based on the same calculation.
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
charging current year’s costs to the next year will be against the principle and hence fixed
costs are not included in the inventory valuation. Secondly, as discussed above, fixed costs
are not included in the cost of production, and so including them in the inventory valuation
is not justified from this angle. The following illustration will clarify the point.

Example: A Ltd. is currently producing 25 000 units of product ‘P’. The variable cost per
unit is ` 7 while fixed cost is ` 2,00,000. The company is able to sell 20 000 units and 5000 units are
unsold. While valuing this inventory, the valuation will be done at ` 7 per unit, the value will
be 5 000 units × ` 7 per unit = ` 35,000. It will be seen that the total cost of production is
` 7 [variable cost per unit] + ` 8 [fixed cost per unit at the present level] = ` 15 but the valuation
will be at ` 7 per unit only which is the variable cost per unit. [Principle of valuation of inventory
i.e. cost price or market price whichever is low will be applied and in the example it is presumed
that the selling price is more than the variable cost per unit].
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. The income statement is prepared as shown
below:
Income Statement Under Marginal Costing
XYZ LTD. Product P

Particulars Amount Amount
` `
Sales
Less: Variable Costs
Contribution
Less: Fixed Costs
Profit

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. The income statement [with imaginary
figures] in such case is prepared as shown below:

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