A business concern exists with the objective of making profits, and profits are the yardstick of its success. Profit planning is therefore a part of operations planning. It is the basis of planning cash, capital expenditure, and pricing.
If growth and survival of a business are to be ensured, planning becomes an absolute necessity. Marginal costing assists profit planning through computation of contribution ratio.
It enables planning of future operations in such a way as to either maximize profits or maintain specified levels of profits. Normally, profits are affected by several factors such as the volume of sales, marginal cost per unit, total fixed costs, selling price, sales mix, etc. Hence, management can achieve their profit goals by varying one or more of the above variables.
Basic marginal costing equations, which are useful in profit planning, are as follows:
Profit/Volume Ratio [P/V Ratio]:
This is the ratio of contribution to sales. Symbolically, it is expressed as follows:
From the above equation, we may derive the following equations:
Break-Even Point [BEP]:
BEP may be defined as that level or point of sales volume at which the total revenue is equal to total costs. It is a no-profit, no-loss point.
It may be expressed as follows:
Margin of Safety [MS]:
MS may be defined as the excess of actual sales or production at the selected activity over break-even sales or production.
Margin of Safety = Actual sales – Break-even sales or point It may be calculated as follows: