Notes on Marginal Costing
Please refer to a text book for more detailed information. These are only short notes
All costs (expenses) in a manufacturing business can be classified as
(i) Direct and Indirect Costs AND
(ii) Variable and Fixed Costs
Direct costs are those costs that can be easily identified with the product i.e. we can see or touch or
know the presence of certain elements of the production process in the final product. (eg) raw
material, labour to produce the finished product, consumables that have been used in making the
product etc. If we consider a readymade shirt, we know about the fabric that is used for the shirt,
the thread used in stitching the shirt, buttons that have been used and the time and effort of the
person who stitched the shirt. These are all direct costs.
Indirect costs are those costs that are necessary for making of the product but are not directly
associated with the product (eg) electricity consumed in the factory, the cost of security guards in
the factory, transportation of raw materials to the factory, communication expenses in the factory. It
is not possible to directly attribute these costs to the finished product.
Variable costs are those costs that vary in proportion to the volume of production. The words ‘in
proportion’ are important in understand variable costs.
(eg) cost of raw material is proportional to volume of production of the finished product.
If we consider a readymade shirt, to make one shirt let’s say 2 metres of cloth is required. So, to
make 100 shirts, 200 metres of cloth and to make 1000 shirts, 2000 metres of cloth are required. If
the cost of 1 metre of cloth is Rs. 200, the cost of cloth varies in proportion to number of shirts
made. This is an example of a variable cost.
Fixed costs are those costs that do not vary with the volume of production. Irrespective of the
volume of production, the fixed cost remains the same. (eg) rent for a readymade garment making
factory. Whether the factory produces 1000 shirts or 10,000 shirts, the rent is constant.
We can use this distinction between variable and fixed cost to determine price of the product.
Let’s consider the equations,
Sales less variable cost = contribution
Contribution = fixed cost + profit
Contribution is not the same as profit. Contribution is only sales value (or selling price per unit of the
product) less total variable cost (or variable cost per unit of the product)
If selling price per unit of the product is Rs. 100 and variable cost per unit of the product is Rs. 25,
contribution is Rs. 75. This is not the same as profit.
If total sales value is Rs. 10,000 and total variable cost is Rs. 2500, total contribution is Rs. 7500.
This amount of Rs. 7500 goes towards paying for the fixed cost. If the fixed cost is Rs. 4000, then
profit = Rs. 7500 less Rs. 4000 = Rs. 3000.
So, in the short term, if we want to lower the price of the product to increase sales volume, we can
reduce the selling price. How much can we reduce? The reduction can be to the extent of the
amount of contribution i.e. till contribution becomes zero.
(eg) in the above case , we can reduce the selling price by Rs. 75 per unit of the product so that the
contribution becomes zero. We cannot reduce the price below this. Even at this level we are making
a loss to the extent of the fixed cost but we don’t mind incurring the loss to increase sales. This is
only in the short-term.
In the long term, we cannot adopt this policy.
Breakeven
The volume of sales at which the business makes neither profit or loss is known as breakeven sales
volume.
In the above example, where fixed cost is Rs. 4000 and contribution per unit is Rs. 75, to breakeven,
contribution should be equal to Rs. 4000.
To have a contribution of Rs. 4000, we should have sales of Rs. 4000/Rs. 75 = 53 units approx..
Cross verification
If we sell 53 units of the product, we get 53 X 100 = Rs. 5300 as sales value
Less variable expenses 53 X 25 = Rs. 1325
Contribution = Rs. 3975
Which is approx. equal to fixed cost of Rs. 4000
