What is Marginal Costing?
Marginal costing as understood in economics is the incremental cost of production which arises due to one-unit increase in the production quantity. As we understood, variable costs have direct relationship with volume of output and fixed costs remains constant irrespective of volume of production.
Hence, marginal cost is measured by the total variable cost attributable to one unit. For example, the total cost of producing 10 units and 11 units of a product is 10,000 and 10,500 respectively. The marginal cost for 11th unit i.e. 1 unit extra from 10 units is Rs 500. Marginal cost can precisely be the sum of prime cost and variable overhead.
Table of Content
- 1 What is Marginal Costing?
- 2 Definition of Marginal Costing
- 3 Applications of Marginal Costing
- 4 Features of Marginal Costing
- 5 Difference between Absorption Costing and Marginal Costing
- 6 Advantages of Marginal Costing
- 7 Limitations of Marginal Costing
- 8 Characteristics of Marginal Costing
Definition of Marginal Costing
Marginal Costing is a costing technique wherein the marginal cost, i.e. variable cost is charged to units of cost, while the fixed cost for the period is completely written off against the contribution.
Applications of Marginal Costing
- Cost Control
- Profit Planning
- Key Factor Analysis
- Decision Making
One of the important challenges in front of the management is the control of cost. In the modern competitive environment, increase in the selling price for improving the profit margin can be dangerous as it may lead to loss of market share. The other way to improve the profit is cost reduction and cost control. Cost control aims at not allowing the cost to rise beyond the present level.
Marginal costing technique helps in this task by segregating the costs between variable and fixed. While fixed costs remain unchanged irrespective of the production volume, variable costs vary according to the production volume. Certain items of fixed costs are not controllable at the middle management or lower management level.
In such situation it will be more advisable to focus on the variable costs for cost control purpose. Since the segregation of costs between fixed and variable is done in the marginal costing, concentration can be made on variable costs rather than fixed cost and in this way unnecessary efforts to control fixed costs can be avoided.
Another important application of marginal costing is the area of profit planning. Profit planning, generally known as budget or plan of operation may be defined as the planning of future operations to attain a defined profit goal. The marginal costing technique helps to generate data required for profit planning and decision-making.
For example, computation of profit if there is a change in the product mix, impact on profit if there is a change in the selling price, change in profit if one of the product is discontinued or if there is a introduction of new product, decision regarding the change in the sales mix are some of the areas of profit planning in which necessary information can be generated by marginal costing for decision making. The segregation of costs between fixed and variable is thus extremely useful in profit planning.
Key Factor Analysis
The management has to prepare a plan after taking into consideration the constraints, if any, on the various resources. These constraints are also known as limiting factors or principal budget factors as discussed in the topic of ‘Budgets and Budgetary Control’. These key factors may be availability of raw material, availability of skilled labour, machine hours availability, or the market demand of the product.
Marginal costing helps the management to decide the best production plan by using the scarce resources in the most beneficial manner and thus optimize the profits. For example, if raw material is the key factor and its availability is limited to a particular quantity and the company is manufacturing three products, A, B and C. In such cases marginal costing technique helps to prepare a statement, which shows the amount of contribution per kg of material.
The product, which yields highest contribution per kg of raw material, is given the priority and produced to the maximum possible extent. Then the other products are taken up in the order of priority. Thus the resultant product mix will yield highest amount of profit in the given situation.
Managerial decision-making is a very crucial function in any organization. Decision – making should be on the basis of the relevant information. Through the marginal costing technique, information about the cost behaviour is made available in the form of fixed and variable costs. The segregation of costs between fixed and variable helps the management in predicting the cost behaviour in various alternatives.
Thus it becomes easy to take decisions. Some of the decisions are to be taken on the basis of comparative cost analysis while in some decisions the resulting income is the deciding factor. Marginal costing helps in generating both the types of information and thus the decision making becomes rational and based on facts rather than based on intuition.
Some of the crucial areas of decision-making are mentioned below:
- Make or buy decisions
- Accepting or rejecting an export offer
- Variation in selling price
- Variation in product mix
- Variation in sales mix
- Key factor analysis
- Evaluation of different alternatives regarding profit improvement
- Closing down/continuation of a division
Features of Marginal Costing
The main features of marginal costing are as follows:
- Cost classification: All costs are classified on the basis of variability, that is, variable costs and fixed costs. Mixed costs are segregated into variable and fixed costs.
- Inventory valuation: Under marginal costing, inventory or stock are there is closing stock. valued at variable cost or marginal cost for profit measurement.
- Product and period costs: Under marginal costing, all variable costs under marginal costing will are treated as product cost and fixed costs are treated as period cost. be less than the one shown A product cost is charged directly to cost unit, whereas a period cost is by absorption costing. written-off against the profit of the period.
- Contribution: Marginal costing technique makes use of contribution for marking various decisions. Contribution is the difference between sales and variable cost. It is on the basis of the contribution of a product that production and sales policies are designed by a firm.
- The price is determined on the basis of the marginal cost and contribution margin.
- The contribution margin is the basis for deciding profitability of department or product.
- Fixed costs are treated as period cost and debited to profit and loss account and, thus, excluded from the production cost.
Difference between Absorption Costing and Marginal Costing
|S.No.||Marginal Costing||Absorption Costing|
|1||Only variable costs are considered for product costing and inventory valuation.||Both fixed and variable costs are considered for product costing and inventory valuation.|
|2||Fixed costs are regarded as period costs. The profitability of different products is judged by their P/V ratio.||Fixed costs are charged to the cost of production. Each product bears a reasonable share of fixed cost and thus the profitability of a product is influenced by the apportionment of fixed costs.|
|3||Cost data are presented as highlight the total contribution of each product.||Cost data are presented in conventional pattern. Net Profit of each product is determined after subtracting fixed cost along with their variable costs.|
|4||The difference in the magnitude of opening stock and closing stock does not affect the unit cost of production.||The difference in the magnitude of opening stock and closing stock affects the unit cost of production due to the impact of related fixed cost.|
|5||In case of marginal costing the cost per unit remains the same, irrespective of the production as it is valued at variable cost.||In case of absorption costing the cost per unit reduces, as the production increases as it is fixed cost which reduces, whereas, the variable cost remains the same per unit. In case of marginal costing the cost per unit remains the same, irrespective of the production as it is valued at variable cost.|
Advantages of Marginal Costing
The following are the advantages of marginal costing technique:
- Stock Valuation
- Meaningful Reporting
- Effect on Fixed Cost
- Profit Planning
- Cost Control and Cost Reduction
- Pricing Policy
- Helpful to Management
The statement propounded under marginal costing can be easily followed as it breaks up the cost as variable and fixed.
Stock valuation cab be easily done and understood as it includes only the variable cost.
Marginal costing serves as a good basis for reporting to management. The profits are analyzed from the point of view of sales rather than production.
Effect on Fixed Cost
The fixed costs are treated as period costs and are charged to Profit and Loss Account directly. Thus, they have practically no effect on decision making.
The Cost – Volume Profit relationship is perfectly analysed to reveal efficiency of products, processes, and departments. Break–even Point and Margin of Safety are the two important concepts helpful in profit planning.
Cost Control and Cost Reduction
Marginal costing technique is helpful in preparation of flexible budgets as the costs are classified into fixed and variable. The emphasis is laid on variable cost for control. The constant focus is on cost and volume and their effect on profit pave the way for cost reduction.
Marginal costing is immensely helpful in determination of selling prices under different situations like recession, depression, introduction of new product, etc. Correct pricing can be developed under the marginal costs technique with the help of the cost information revealed therein.
Helpful to Management
Marginal costing is helpful to the management in exercising decisions regarding make or buy, exporting, key factor and numerous other aspects of business operations.
Limitations of Marginal Costing
Following are the limitations of marginal costing:
- Classification of Cost
- Not Suitable for External Reporting
- Lack of Long – term Perspective
- Under Valuation of Stock
- Production Aspect is Ignored
- Not Applicable in all Types of Business
- Misleading Picture
- Less Scope for Long–term Policy Decision
Classification of Cost
Break up of cost into fixed and variable portion is a difficult problem. More over clear cost division of semi – variable or semi – fixed cost is complicated and cannot be accurate.
Not Suitable for External Reporting
Since fixed cost is not included in total cost, full cost is not available to outsiders to judge the efficiency.
Lack of Long–term Perspective
Marginal costing is most suitable for decision making in a short term. It assumes that costs are classified into fixed and variable. In the long term all the cost are variable. Therefore it ignores time element and is not suitable for long term decisions.
Under Valuation of Stock
Under marginal costing only variable costs are considered and the output as well as stock are undervalued and profit is distorted. When there is loss of stock the insurance cover will not meet the total cost.
In these days of automation and technical advancement, huge investments are made in heavy machinery which results in heavy amount of fixed costs. Ignoring fixed cost in this context for decision making is irrational.
Production Aspect is Ignored
Marginal costing lays too much emphasis on selling function and as such production aspect has been considered to be less significant. But from the business point of view, both the functions are equally important.
Not Applicable in all Types of Business
In contract type and job order type of businesses, full cost of the job or the contract is to be charged. Therefore it is difficult to apply marginal costing in all these types of businesses.
Each product is shown at variable cost alone, thus giving a misleading picture about its cost.
Less Scope for Long–term Policy Decision
Since cost, volume, and profits are interlinked in price determination, which can be changed constantly, development of long term pricing policy is not possible.
Characteristics of Marginal Costing
The essential characteristics and mechanism of marginal costing technique may be summed up as follows:
- Segregation of cost into fixed and variable elements
- Marginal cost as product cost
- Fixed costs are period costs
- Valuation of inventory
- Contribution is the difference between sales and marginal cost.
- Segregation of cost into fixed and variable elements: In marginal costing, all costs are segregated into fixed and variable elements.
- Marginal cost as product cost: Only marginal (variable) costs are charged to products.
- Fixed costs are period costs: Fixed cost are treated as period costs and are charged to costing profit and loss account of the period in which they are incurred.
- Valuation of inventory: The work–in–progress and finished stocks are valued at marginal cost only.
- Contribution is the difference between sales and marginal cost: The relative profitability of the products or departments is based on a study of “contribution” made by each of the products or departments.