MARGINAL COSTING
Marginal Costing is a technique of ascertaining cost used in any method of costing. According to this technique, variable costs are charged to cost units and the fixed cost attributable to the relevant period is written off in full against the contribution for that period. Contribution is the difference between sales value and variable cost. Thus, all expenses are classified under two groups, variable and fixed.
Variable expenses are those which vary in sympathy with increase or decrease of unit production or sales. Variable expenses are direct materials, direct labor, direct expenses, variable factory overheads and variable administration, selling & distribution overheads.
Fixed expenses include fixed factory overheads, administration overheads and fixed selling and distribution overheads. Fixed expenses have no effect on the volume of activity and are written-off to the profit and loss account at the end of the period. It is, therefore, called period cost. Variable cost, on the other hand, relates to the product, and hence, termed as product cost.
ACCORDING TO INSTITUTE OF COST AND WORKS ACCOUNTANTS OF INDIA (ICWAI)
“Marginal Costing is a method that considers only the variable cost as cost of production, leaving out period costs to be absorbed from the marginal contribution.”
ACCORDING TO J. BATTY
“Marginal Costing is a technique of cost accounting which pays special attention to the behavior of cost, with changes in the volume of output.”
ACCORDING TO ICMA, ENGLAND,
“Marginal cost in the amount at any given volume of output, by which aggregate cost are changed, if the volume of output in increased or decreased by one unit.”
INCOME STATEMENT UNDER MARGINAL COSTING
Under marginal costing technique, Income Statement is presented in the following format:
FEATURES OF MARGINAL COSTING
The essential characteristic and mechanism of marginal costing technique may be summed up as follows:
(1) Cost Classification:
The marginal costing technique makes a sharp distinction between variable costs and fixed costs. It is the variable cost on the basis of which production and sales policies are designed by a firm following the marginal costing technique.
(2) Stock/Inventory Valuation:
Under the marginal costing, inventory/stock for profit measurement is valued at the marginal cost. It is in sharp contrast to the total unit cost in costing method.
(3) Marginal Contribution:
Marginal costing technique makes use of marginal contribution for marking various decisions. Marginal contribution is the difference between sales and marginal cost. It forms the basis for judging the profitability of different products or departments.
(4) Selling Price Determination:
Selling price of the product in the marginal costing method is determined based on the cost plus the contribution always. Here, the contribution, of course, means the difference between the sales and the variable cost.
(5) Profitability:
The profitability of the product/department is based on the contribution made available by each product/department.
(6) Fixed Costs vs. Period Costs:
Fixed costs are treated as period costs and are charged to the costing. Profit and Loss Account of the period in which they are incurred.
(7) Marginal costs as products costs: Only marginal (variable) costs are charged to products costs.
PRINCIPLES OF MARGINAL COSTING
The principles of marginal costing are as follows:
a) For any given period of time, fixed costs will be the same for any volume of sales and production (provided that the level of activity is within the ‘relevant range’). Therefore, on selling an extra item of product or service, the following will happen:
- a. Revenue will increase by the sales value of the item sold,
- b. Costs will increase by the variable cost per unit,
- c. Profit will increase by the amount of contribution earned from the extra item,
b) Similarly, if the volume of sales falls by one item, the profit will fall by the amount of contribution earned from the item.
c) Profit measurement should therefore be based on an analysis of total contribution. Since fixed costs relate to a period of time, and do not change with increases or decreases in sales volume, it is misleading to charge units of sale with a share of fixed costs.
d) When a unit of product is made, the extra costs incurred in its manufacturing are the variable production costs. Fixed costs are unaffected, and no extra fixed costs are incurred when output is increased.
ADVANTAGES OF MARGINAL COSTING
1. Constant in nature: Variable costs fluctuate from time to time, but in the long run, marginal costs are stable. Marginal costs remain the same, irrespective of the volume of production.
2. Effective cost control: It divides cost into fixed and variable. Fixed cost is excluded from product. As such, management can control marginal cost effectively.
3. Uniform and realistic valuation: As the fixed overhead costs are excluded from product cost, the valuation of work-in-progress and finished goods becomes more realistic.
4. Simple Method: Marginal costing is simple to understand. It is calculated only on the basis of variable costs. By not charging fixed overhead to the cost of production, the effect of varying charges per unit is avoided.
5. Helpful to management: It enables the management to start a new line of production which is advantageous. It is helpful in determining which is profitable – whether to buy or manufacture a product. The management can take decision regarding pricing and tendering.
6. Helps in production planning: It shows the amount of profit at every level of output with the help of cost volume profit relationship. Here the break-even chart is made use of.
7. Better result: When used with standard costing, it gives better results.
8. Fixation of selling price: The differentiation between fixed costs and variable costs is very helpful in determining the selling price of the products or services. Sometimes, different prices are charged for the same article in different markets to meet varying degrees of competition.
9. Helpful in budgetary control: The classification of expenses is very helpful in budgeting and flexible budget for various levels of activities.
10. Preparing tenders: Many business enterprises have to compete in the market in quoting the lowest price. Total variable cost, when separately calculated, becomes the ‘floor price’. Any price above this floor price may be quoted to increase the total contribution.
11. “Make or Buy” decision: Sometimes a decision has to made whether to manufacture a component or a product or to buy it ready made from the market. The decision to purchase it would be have taken if the price paid recovers some of the fixed expenses.
12. Better presentation: The statements and graphs prepared under marginal costing are better understood by management executives. The break-even analysis presents the behavior of cost, sales, contribution etc. in terms of charts and graphs. And, thus the results can easily be grasped.
13. Overhead Simplification: In the stock valuation, the marginal costing prevents the illogical carry‐forward of some proportion of current years fixed overhead to the next year. It reduces the degree of over or under‐ recovery of overheads due to the separation of fixed overheads from production cost.
14. Effective for Sales and Production Policy: The effects of alternative sales or production policies can be more readily available and assessed, and decisions taken would yield the maximum return to the business.
DISADVANTAGES OF MARGINAL COSTING
1. Difficulty to analyse overhead: Separation of costs into fixed and variable is a difficult problem. In marginal costing, semi-variable or semi-fixed costs are not considered.
2. Time element ignored: Fixed costs and variable costs are different in the short run; but in the long run, all costs are variable. In the long run all costs change at varying levels of operation. When new plants and equipments are introduced, fixed costs and variable costs will vary.
3. Unrealistic assumption: Assumption of sale price will remain the same at different levels of operation. In real life, they may change and give unrealistic results.
4. Difficulty in the fixation of price: Under marginal costing, selling price is fixed on the basis of contribution. In case of cost plus contract, it in very difficult to fixprice.
5. Complete information not given: It does not explain the reason for increase in production or sales.
6. Significance lost: In capital – intensive industries, fixed cost occupy major portions in the total cost. But marginal costs cover only variable costs. As such, it loses its significance in capital industries.
7. Problem of variable overheads: Marginal costing overcomes the problem of over and under-absorption of fixed overheads. Yet there is the problem in the case of variable overheads.
8. Sales-oriented: Successful business has to go in a balanced way in respect of selling production functions. But marginal costing is criticized on account of its attaching over importance to selling function. Thus it is said to be sales-oriented. Production function is given less importance.
9. Unreliable stock valuation: Under marginal costing stock of work-in-progress and finished stock is valued at variable cost only. No portion of fixed cost is added to the value of stocks. Profit determined, under this method, is depressed.
10. Claim for loss of stock: Insurance claim for loss or damage of stock on the basis of such a valuation will be unfavorable to business.
11. Automation: Now-a-days increasing automation is leading to increase in fixed costs. If such increasing fixed costs are ignored, the costing system cannot be effective and dependable.
Marginal costing, if applied alone, will not be much in use, unless it is combined with other techniques like standard costing and budgetary control.
