Question

Marginal costing is a technique that distinguishes between variable costs and fixed costs. In this approach to costing, only the variable costs of production are charged to cost units. Marginal costing and the concept of contribution are fundamental to the breakeven analysis or ‘cost-volume-profit’ (CVP) technique.

Required:
(a) Explain the concept of contribution and its importance to the CVP technique.
(b) Describe the nature of each of the ‘dropping a product or service’ and ‘special contract’ decisions for which the CVP technique can be useful.
(c) Critically evaluate the CVP technique and explain the limitations of its use in the context of both the different interpretations offered by the economist’s model of CVP and other limitations.

Answer 1

a) Marginal costing is the one of the important technique of analysing cost behaviour and understanding the profitablity of an organisation. In Marginal costing cost is classified into variable cost and fixed cost. Contribution is calculated by subtracting variable cost from sales price. Contribution margin ratio is calculated by dividing contribution by selling price

Importance of contribution margin

· It helps in calculating breakeven point of the firm. At breakeven point there is no profit or no loss.

· It helps in calculating sales revenue or units needed to achieve target operating profit

· It helps in calculating margin of safety. Margin of safety indicates profitable sales for the firm

· It helps in various decision making like make or buy, acceptance of special order, continue or discontinue division or product,

· It helps in new product launches through product pricing

b) Dropping a product or service

Marginal costing technique can be applied to decision making of whether to continue or discontinue a product or service level. The contribution of product line is compared with avoidable cost. If contribution is higher than avoidable cost the product should not be discontinued .If contribution is lower than avoidable cost there product should be immediately discontinued since there is savings. Avoidable cost are the cost which are incurred for specific product and they can be avoided if product is discontinued

Special contract decision:

In special contract decision the special order sales value is compared with variable cost of manufacturing and selling. If there is incremental contribution after deducting specific expenses the special order should be accepted. If the incremental contribution is negative the special order should be rejected

c) CVP techniques is one of the most widely technique used in managerial decision making. It helps in day to day operational decision making and helps in improving the profitablity of the firm. However CPV techniques works with lot of assumptions and hence it has below limitations

· It assumed cost can be classified into fixed cost and variable cost. In real world all cost cannot be classified into fixed and variable

· It assumes volumes drive the cost but in reality non volume factors can drive the cost behaviour

· It assumes the cost relationship with volume in linear but in practical it is not always true

· It is difficult technique to apply in case of multi product firms.

· It ignores the external factors in analysis like competitor actions, technological changes, regulations, etc