CMA Intermediate · Management Accounting

Applications of Marginal Costing in Short Term Decision Making: formula sheet

Full chapter guide

Key formulas

Contribution: Contribution = Sales − Variable cost; Also Contribution = Fixed cost + Profit. Per unit: selling price − variable cost per unit.
Profit: Profit = Contribution − Fixed cost; If contribution is less than fixed cost, the result is a loss.
P/V ratio: P/V ratio = Contribution ÷ Sales × 100; Also = Change in profit ÷ Change in sales, when fixed cost is unchanged.
Variable cost ratio: Variable cost ratio = Variable cost ÷ Sales = 1 − P/V ratio; Use it to move quickly between cost and contribution.
Break-even sales: Break-even sales = Fixed cost ÷ P/V ratio; Break-even units = Fixed cost ÷ Contribution per unit.
Margin of safety: Margin of safety = Actual sales − Break-even sales = Profit ÷ P/V ratio; Gives the sales cushion before a loss starts.
Marginal costing stock value: Stock valued at variable cost only; Absorption costing adds fixed production overhead to stock value.
Relevant cost rule: Relevant cost = future, avoidable cost that differs between alternatives; Ignore sunk and unavoidable costs.
Relevant cost of making: Variable cost (material + labour + variable overhead) + avoidable fixed cost + opportunity cost; Exclude unavoidable fixed cost and sunk cost. Add opportunity cost only if freed capacity or resources have an alternative use.
Basic decision rule (spare capacity): Make if relevant cost of making < purchase price; Buy if purchase price < relevant cost of making; Compare on the same unit basis, or on total cost for the whole volume.
Opportunity cost of freed capacity: Contribution per unit of alternative use × units that could be produced with freed capacity; Use the contribution of the best alternative use only.
Ranking under limited capacity: Extra cost of buying per unit of scarce resource = (Purchase price − Variable cost of making) ÷ Scarce resource per unit; Make the components with the highest ratio first. Buy those with the lowest ratio. Use avoidable fixed cost carefully if it depends on volume.
Total cost comparison: Cost of making all = Relevant cost × units; Cost of buying = Price × units − avoidable fixed cost saved − contribution earned from freed capacity; Use when fixed cost saved only arises if the whole volume is bought. Deducting the contribution from freed capacity on the buying side is the same as adding that opportunity cost to the cost of making. Do not do both.
Marginal cost per unit: Marginal cost = Direct material + Direct labour + Direct expenses + Variable overhead; Use only costs that vary with output.
Contribution of the order: Contribution = (Offer price per unit − Marginal cost per unit) × Order units − Specific extra costs − Contribution lost on displaced regular sales; With spare capacity, no regular sales are displaced, so the last term is nil. Accept if the result is positive. With no spare capacity, subtract the contribution lost on the regular units given up.
Minimum price (spare capacity): Minimum price = Marginal cost per unit + (Specific extra costs of the order ÷ Order units); Specific extra costs include any specific fixed costs and extra variable costs (such as packing and freight) not already in marginal cost. Divide the total by order units.
Minimum price (no spare capacity): Minimum price = Marginal cost + Contribution lost on displaced regular sales per unit of order; Opportunity cost is added when regular units are given up.
Incremental profit: Incremental profit = Incremental revenue − Incremental cost; Same answer as the contribution method, shown as a comparison of two situations.
Contribution: Contribution = Sales − Variable cost; Use total variable cost, including variable selling and distribution cost.
Continue or drop rule: Continue if Contribution > Avoidable fixed cost; Drop if Contribution < Avoidable fixed cost; If the two are equal, you are indifferent on financial grounds. Then decide on qualitative factors.
Advantage of continuing: Advantage of continuing = Contribution − Avoidable fixed cost; A positive figure is the amount by which total profit falls if you close the unit.
Shutdown point (in units): Shutdown units = Avoidable fixed cost ÷ Contribution per unit; Below this volume the unit does not recover its avoidable fixed cost.
Shutdown point (in sales value): Shutdown sales = Avoidable fixed cost ÷ P/V ratio; P/V ratio = Contribution ÷ Sales. Use it when only value data is given.
Net effect with alternative use: Gain from closing = Avoidable fixed cost saved + Alternative income − Contribution lost; Include only if the freed capacity has a real alternative use, such as renting out or making another product.
Contribution per unit: Contribution per unit = Selling price per unit − Variable cost per unit; Use only variable costs. Ignore fixed costs in ranking.
Contribution per unit of key factor: Contribution per key factor unit = Contribution per unit ÷ Units of key factor needed per unit of product; Key factor may be kg of material, labour hours or machine hours. This is the ranking basis.
Maximum units from the resource: Units that can be made = Resource available ÷ Resource needed per unit; Compare with maximum demand. Produce the lower of the two.
Profit under key factor: Profit = Total contribution − Fixed costs; Fixed costs are the same for every mix, so they do not affect the choice.
Contribution: Contribution = Sales − Variable cost; Per unit: selling price − variable cost per unit.
P/V ratio: P/V ratio = Contribution ÷ Sales × 100; Equals change in profit ÷ change in sales when fixed costs stay constant.
Break-even point (units): BEP (units) = Fixed costs ÷ Contribution per unit; Use for a single product or per mix pack.
Break-even point (sales value): BEP (₹) = Fixed costs ÷ P/V ratio; Use composite P/V ratio for several products in a given mix.
Margin of safety: MoS = Actual sales − Break-even sales = Profit ÷ P/V ratio; MoS ratio = MoS ÷ Actual sales × 100.
Target profit: Required sales (₹) = (Fixed costs + Target profit) ÷ P/V ratio; In units: (Fixed costs + Target profit) ÷ Contribution per unit. For a profit after tax, convert to before-tax profit first.
Composite P/V ratio: Composite P/V = Total contribution of mix ÷ Total sales of mix × 100; Changes whenever the mix changes.
Multi-product BEP: BEP packs = Fixed costs ÷ Contribution per pack; product BEP = packs × units of that product in the pack; Valid only if the stated mix is held constant.
Further processing rule: Process further if (Sales value after processing − Sales value at split-off) > Further processing cost; Use incremental figures only. Joint cost is excluded.
Incremental profit: Incremental profit = Incremental revenue − Incremental cost; Positive means process further. Negative means sell at split-off.
Contribution: Contribution = Sales − Variable cost; Used for plant utilisation and method comparison.
Contribution per unit of scarce resource: Contribution per hour = Contribution per unit ÷ Hours per unit; Use when plant hours are limited and several products compete.
Indifference point between two methods: Volume = Difference in fixed costs ÷ Difference in variable cost per unit; Gives the volume where total cost of both methods is equal. The method with higher fixed cost wins above this volume if its variable cost per unit is lower.

Quick revision

Contribution = Sales − Variable cost; Profit = Contribution − Fixed cost.
Relevant costs are future costs that differ between alternatives; sunk costs are ignored.
Make or buy: if fixed costs are unavoidable, compare variable cost of making with the purchase price.
Special order: accept if price exceeds the relevant cost: variable cost plus any extra specific fixed cost, plus the contribution lost on displaced sales if capacity is full.
If the order uses scarce capacity, add the contribution lost on displaced sales to the relevant cost.
Drop a product only if the avoidable fixed cost saved exceeds the contribution lost.
Continue operating if contribution exceeds the avoidable fixed costs (the costs saved on shutdown), even if full profit after allocated fixed costs is negative.
Key factor: rank products by contribution per unit of the limiting resource.
P/V ratio = Contribution ÷ Sales; Break-even sales = Fixed cost ÷ P/V ratio.
Margin of safety = Actual sales − Break-even sales.
Sell or process further: compare only the incremental revenue with the incremental processing cost; joint costs are ignored.
Always add a short note on qualitative factors.

Common mistakes

Treating fixed cost per unit as variable and multiplying it by new volume Fix: Convert fixed cost back to total (per unit × original units) and keep it constant for the new volume within the relevant range.
Deducting fixed cost when calculating contribution Fix: Contribution = Sales − Variable cost only. Fixed cost comes off afterwards.
Comparing the buying price with the full absorbed cost per unit. Fix: Use only variable cost and avoidable fixed cost. Remove apportioned fixed overheads that continue anyway.
Ignoring the opportunity cost of capacity that buying would free. Fix: Read the question for alternative uses of the plant or space. Add the contribution forgone to the cost of making.
Rejecting an order because the offer price is below total cost per unit. Fix: Compare the price with marginal cost. Fixed cost already being incurred is not relevant when capacity is spare.
Ignoring extra costs of the order such as packing, freight or a special licence. Fix: Scan the question for words like 'additional', 'special' and 'export' and list each cost that exists only because of the order.
Deciding on the net profit or loss shown in the books after allocated fixed cost. Fix: Rebuild the statement in contribution form. Judge the unit only on contribution against avoidable fixed cost.
Subtracting all fixed costs of the unit from contribution. Fix: Tag each fixed cost as avoidable or unavoidable before any calculation. Unavoidable costs still remain and fall on other units.
Ranking products by contribution per unit or by P/V ratio. Fix: When a resource is limited, rank only by contribution per unit of that resource.
Including fixed costs or absorbed overheads in unit cost. Fix: Separate variable and fixed costs first. Use only variable cost to find contribution.

Exam tips

In an MCQ, compute contribution and P/V ratio first. Most options follow from them.
Present a marginal cost statement with headings: Sales, Variable cost, Contribution, Fixed cost, Profit. It earns step marks even if the final figure slips.
In decision questions, write a short line stating which costs you ignored and why (sunk, unavoidable, committed).
When asked for the difference between marginal and absorption costing, cover cost treatment, stock valuation and profit effect in separate points.
Write the conclusion in words. ICMAI expects a recommendation, not just a number.
Underline the words 'avoidable', 'continue', 'alternative use' and 'limited hours' in the question. They decide which costs are relevant.
Show a short table of relevant costs. Examiners give step marks for correct inclusion and exclusion of fixed cost.
In limited-capacity problems, show the per-hour ranking column clearly even if your arithmetic slips later.