MARGIN OF SAFETY

The margin of safety can be defined as the difference between the expected level of sale
and the breakeven sales. The larger the margin of safety , the higher are the chances of
making profits. In the above example if the forecast sale is 1,700 units per month, the
margin of safety can be calculated as follows,
Margin of safety = Projected sales – Breakeven sales
= 1,700 units – 1,000 units
= 700 units or 41 % of sales.
The Margin of Safety can also be calculated by identifying the difference between the
projected sales and breakeven sales in units multiplied by the contribution per unit. This is
possible because, at the breakeven point all the fixed costs are recovered and any further
contribution goes into the making of profits.

THE BREAKEVEN POINT

The word contribution has been given its name because of the fact that it literally
contributes towards the recovery of fixed costs and the making of profits. The contribution
grows along with the sales revenue till the time it just covers the fixed cost. This point
where neither profits nor losses have been made is known as a break-even point. This
implies that in order to break even the amount of contribution generated should be exactly
equal to the fixed costs incurred.

COST-VOLUME-PROFIT ANALYSIS

cost, volume and profit. Such an analysis explores the relationship between costs,
revenue, activity levels and the resulting profit. It aims at measuring variations in cost and
volume.
CVP analysis is based on the following assumptions:
1. Changes in the levels of revenues and costs arise only because of changes in the
number of product (or service) units produced and old – for example, the number of
television sets produced and sold by Sony Corporation or the number of packages
delivered by Overnight Express. The number of output units is the only revenue driverand the only cost driver. Just as a cost driver is any factor that affects costs, a revenue
driver is a variable, such as volume, that causally affects revenues.
2. Total costs can be separated into two components; a fixed component that does not vary
with output level and a variable component that changes with respect to output level.
Furthermore, variable costs include both direct variable costs and indirect variable costs
of a product. Similarly, fixed costs include both direct fixed costs and indirect fixed costs
of a product.

MARGINAL COST EQUATION

The contribution theory explains the relationship between the variable cost and selling price. It
tells us that selling price minus variable cost of the units sold is the contribution towards fixed
expenses and profit. If the contribution is equal to fixed expenses, there will be no profit or
loss and if it is less than fixed expenses, loss is incurred. Since the variable cost varies in
direct proportion to output, therefore if the firm does not produce any unit, the loss will be
there to the extent of fixed expenses. These points can be described with the help of following
marginal cost equation: S × U – V × U = F + P
Where,
S = Selling price per unit
V = Variable cost per unit
U = Units
F = Fixed expenses
P = Profit

Limitations of Marginal Costing

1. It is difficult to classify exactly the expenses into fixed and variable category. Most of the
expenses are neither totally variable nor wholly fixed. For example, various amenities
provided to workers may have no relation either to volume of production or time factor.
2. Contribution of a product itself is not a guide for optimum profitability unless it is linked
with the key factor.
3. Sales staff may mistake marginal cost for total cost and sell at a price; which will result in
loss or low profits. Hence, sales staff should be cautioned while giving marginal cost.
4. Overheads of fixed nature cannot altogether be excluded particularly in large contracts,
while valuing the work-in- progress. In order to show the correct position fixed overheads
have to be included in work-in-progress.

Advantages of Marginal Costing

1. The marginal cost remains constant per unit of output whereas the fixed cost remains
constant in total. Since marginal cost per unit is constant from period to period within a
short span of time, firm decisions on pricing policy can be taken. If fixed cost is included,
the unit cost will change from day to day depending upon the volume of output. This will
make decision making task difficult.2. Overheads are recovered in costing on the basis of pre-determined rates. If fixed
overheads are included on the basis of pre-determined rates, there will be underrecovery
of overheads if production is less or if overheads are more. There will be overrecovery
of overheads if production is more than the budget or actual expenses are less
than the estimate. This creates the problem of treatment of such under or over-recovery
of overheads. Marginal costing avoids such under or over recovery of overheads.
3. Advocates of marginal costing argues that under the marginal costing technique, the
stock of finished goods and work-in-progress are carried on marginal cost basis and the
fixed expenses are written off to profit and loss account as period cost. This shows the
true profit of the period.

Presentation of Information:

In absorption costing the classification of expenses is
based on functional basis whereas in marginal costing it is based on the nature of
expenses. In absorption costing, the fixed expenses are distributed over products on
absorption costing basis, that is, based on a pre-determined level of output. Since fixed
expenses are constant, such a method of recovery will lead to over or under-recovery of
expenses depending on the actual output being greater or lesser than the estimate used
for recovery. This difficulty will not arise in marginal costing because the contribution is
used as a fund for meeting fixed expenses.