EXECUTIVE SUMMARY: I begin my project by throwing light on the various concepts of marginal costing including contribution, profit and breakeven analysis. Marginal costing also helps in understanding the margin of safety and desired profile. Marginal cost is the cost management technique for the analysis of cost and revenue information and for the guidance of management. The presentation of information through marginal costing statement is easily understood by all mangers, even those who do not have preliminary knowledge and implications of the subjects of cost and management accounting. Marginal costing provides this vital information to management and it helps in the discharge of its functions like cost control, profit planning, performance evaluation and decision making. Marginal costing plays its key role in decision making.
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EXECUTIVE SUMMARY:
I begin my project by throwing light on the various concepts of marginal costing including
contribution, profit and breakeven analysis. Marginal costing also helps in understanding the
margin of safety and desired profile.
Marginal cost is the cost management technique for the analysis of cost and revenue
information and for the guidance of management. The presentation of information through
marginal costing statement is easily understood by all mangers, even those who do not have
preliminary knowledge and implications of the subjects of cost and management accounting.
Marginal costing provides this vital information to management and it helps in the discharge
of its functions like cost control, profit planning, performance evaluation and decision
making. Marginal costing plays its key role in decision making.
INTRODUCTIONCost accounting is the process of collecting, processing and presenting financial and
quantitative data within an entity to ascertain the cost of the cost centres and cost units.
Revenue expenditure can be divided into direct costs (eg direct materials) and indirect costs
(eg production overheads) and the information is used to prepare a total cost statement
Product direct costs + Indirect costs = Total cost
One problem with methods of total costing is that the classification of revenue expenditure
into direct costs and indirect costs ignores their different behaviours when production or sales
activity varies. An alternative is to use marginal costing, where the main purpose is to provide
detailed cost information for planning and short-term decisions in a business where activity
levels fluctuate Actual or budgeted/planned figures can be used
The marginal cost of an item is its variable cost. The marginal production cost of an item is
the sum of its direct materials cost, direct labour cost, direct expenses cost (if any) and
variable production overhead cost. So as the volume of production and sales increases total
variable costs rise proportionately.
Fixed costs, in contrast are cost that remain unchanged in a time period, regardless of the
volume of production and sale.
Marginal production cost is the part of the cost of one unit of production service which would
be avoided if that unit were not produced, or which would increase if one extra unit were
produced.
Marginal costing is a method of cost accounting and decision-making used for internal
reporting in which only marginal costs are charged to cost units and fixed costs are treated as
a lump sum. It is also known as direct, variable, and contribution costing.
In marginal costing, only variable costs are used to make decisions. It does not consider
fixed costs, which are assumed to be associated with the time periods in which they were
incurred.
Marginal costs include:
The costs actually consumed when you manufacture a product
The incremental increase in costs when you ramp up production
The costs that disappear when you shut down a production line
The costs that disappear when you shut down an entire subsidiary
In this technique, cost data is presented with variable costs and fixed costs shown separately
for the purpose of managerial decision-making.
Marginal costing is not a method of costing like process costing or job costing. Rather, it is
simply a way to analyze cost data for the guidance of management, usually for the purpose of
understanding the effect of profit changes due to the volume of output.
The direct costing concept is extremely useful for short-term decisions, but can lead to
harmful results if used for long-term decision-making, since it does not include all costs that
may apply to a longer-term decision. Furthermore, marginal costing does not comply with
external reporting standards.
The costs that vary with a decision should only be included in decision analysis. For many
decisions that involve relatively small variations from existing practice and/or are for
relatively limited periods of time, fixed costs are not relevant to the decision. This is because
either fixed costs tend to be impossible to alter in the short term or managers are reluctant to
alter them in the short term.
MEANING OF MARGINAL COSTINGMarginal Costing is ascertainment of the marginal cost which varies directly with the volume
of production by differentiating between fixed costs and variable costs and finally
ascertaining its effect on profit
It is a costing technique where only variable cost or direct cost will be charged to the cost unit
produced.
Marginal costing also shows the effect on profit of changes in volume/type of output by
differentiating between fixed and variable costs.
Salient Points:
Marginal costing involves ascertaining marginal costs. Since marginal costs are direct cost,
this costing technique is also known as direct costing;
In marginal costing, fixed costs are never charged to production. They are treated as period
charge and is written off to the profit and loss account in the period incurred;
Once marginal cost is ascertained contribution can be computed. Contribution is the excess
of revenue over marginal costs.
The marginal cost statement is the basic document/format to capture the marginal costs...
It is the additional cost of producing an additional unit of a product.
Marginal cost= prime cost + total variable overheads
MARGINAL COSTING - DEFINITION Marginal costing distinguishes between fixed costs and variable costs as convention ally
classified.
The marginal cost of a product –“is its variable cost”. This is normally taken to be; direct
labour, direct material, direct expenses and the variable part of overheads.
Marginal costing is formally defined as;
‘the accounting system in which variable costs are charged to cost units and the fixed costs
of the period are written-off in full against the aggregate contribution. Its special value is in
decision making’. Marginal Costing is defined as the amount at any given volume of output by which
aggregate costs can be changed if the volume of output is increased or decreased by one
unit.
J. BATTY: ‘a technique of cost accounting which pays special attention to the behavior
of costs with changes in the volume of output’.
FEATURES OF MARGINAL COSTING The main features of marginal costing are 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 marginal costing, inventory/stock for profit
measurement is valued at marginal cost. It is in sharp contrast to the total unit cost under
absorption 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.
It is a method of recording costs and reporting profits;
All operating costs are differentiated into fixed and variable costs;
Variable cost –charged to product and treated as a product cost whilst
Fixed cost treated as period cost and written off to the profit and loss account
It involves ascertaining marginal costs which is the difference of fixed cost and variable cost.
The operating costs are differentiated into fixed costs and variable costs. Semi variable costs are
also divided in the individual components of fixed cost and variable cost.
Fixed costs which remain constant regardless of the volume of production do not find place in the
product cost determination and inventory valuation.
Prices of products are based on variable cost only.
Marginal contribution decides the profitability of the products.
Costs are divided into two categories, i.e., fixed costs and variable costs.
Fixed cost is considered period cost and remains out of consideration for determination of product
cost and value of inventories.
Prices are determined with reference to marginal cost and contribution margin.
Profitability of departments and products is determined with reference to their Contribution
margin.
In presentation of cost data, display of contribution assumes dominant role.
Closing stock is valued on marginal cost
COMMON USE CASES FOR MARGINAL COSTINGMarginal costing can be a useful tool for evaluating some types of decisions. Here are some of
the most common scenarios where marginal costing can provide the most benefit:
Automation investments: Marginal costing is useful to determine how much a firm
stands to gain or lose by automating some function. The key costs to take into consideration
are the incremental labour cost of any employees who will be terminated versus the new costs
incurred from equipment purchase and subsequent maintenance.
Cost reporting: Marginal costing is very useful for controlling variable costs, because you
can create a variance analysis report that compares the actual variable cost to what the
variable cost per unit should have been.
Customer profitability: Marginal costing can help determine which customers are worth
keeping and which are worth eliminating.
Internal inventory reporting : Since a firm must include indirect costs in its inventory
in external reports, and these can take a long time to complete, marginal costing is useful for
internal inventory reporting.
Profit-volume relationship: Marginal costing is useful for plotting changes in profit
levels as sales volumes change. It is relatively simple to create a marginal costing table that
points out the volume levels at which additional marginal costs will be incurred, so that
management can estimate the amount of profit at different levels of corporate activity.
Outsourcing: Marginal costing is useful for deciding whether to manufacture an item in-
house or maintain a capability in-house, or whether to outsource it.
CRITICISM OF MARGINAL COSTING In recent years, there has been a widespread interest in marginal costing. Still very few have
adopted it as method of accounting for cost. Main points of criticism are:
It is not proper to disregard fixed cost for product for product cost determination and
inventory valuation.
Marginal costing is especially useful in short profit planning and decision-making. For
decision of far reaching importance, one is interested in special purpose cost rather than
variability of costs.
Marginal costing technique disregards the use of recovering fixed cost through product
pricing. For long run continuity of business it is not good. Assets have to be recovered of
costs.
Establishing variability of costs is not an easy. I real life situations, variable costs are rarely
completely variable and fixed costs are rarely completely fixed.
Exclusion of fixed cost from inventory valuation does not conform to accept accounting
practice.
The income tax authorities do not recognize the marginal cost for inventory valuation. This
necessitates keeping of separate books for separate purposes.
The basic assumptions made by marginal costing are following:
o Total variable cost is directly proportion to the level of activity. However, variable
cost per unit remains constant at all the levels of activities.
o Per unit selling price remains constant at all levels of activities.
o All the items produced by the organization are sold off.
THE PRINCIPLES OF MARGINAL COSTING
The principles of marginal costing are as follows. 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, by selling an extra item of product or service the following will happen.
Revenue will increase by the sales value of the item sold.
Costs will increase by the variable cost per unit.
Profit will increase by the amount of contribution earned from the extra item.
Similarly, if the volume of sales falls by one item, the profit will fall by the amount of
contribution earned from the item.
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.
When a unit of product is made, the extra costs incurred in its manufacture are the
variable production costs. Fixed costs are unaffected, and no extra fixed costs are
incurred when output is increased.
ADVANTAGES AND DISADVANTAGES OF MARGINAL COSTING
Advantage:-
Cost control: Marginal costing makes it easier to determine and control costs of production. By avoiding the arbitrary allocation of fixed overhead costs, management can concentrate on achieving and maintaining a uniform and consistent marginal cost.
Simplicity: Marginal costing is simple to understand and operate and it can be combined with other forms of costing (e.g. budgetary costing and standard costing) without much difficulty.
Elimination of cost variance per unit: Since fixed overheads are not charged to the cost of production in marginal costing, units have a standard cost.
Short-term profit planning: Marginal costing can help in short-term profit planning and is easily demonstrated with break-even charts and profit graphs. Comparative profitability can be easily accessed and brought to the notice of the management for decision-making.
Accurate overhead recovery rate: This method of costing eliminates large balances left in overhead control accounts, which makes it easier to ascertain an accurate overhead recovery rate.
Maximum return to the business: With marginal costing, the effects of alternative sales or production policies are more readily appreciated and assessed, ensuring that the decisions taken will yield the maximum return to the business.
It is a relatively simple pricing method - quick to calculate and easy to implement Can help to smooth fluctuations in demand. It can be very useful where the firm has spare capacity and may not be able to put its
resources to other, perhaps more profitable, uses. Can be a useful way to attract other different market segments into the market e.g. low
peak train travellers may be attracted by lower prices and only travel during the day because of low prices - they may not otherwise have travelled.
Can be a good way to remain in business and price-competitive in a time of difficult trading. Prices can then be raised later when the economic situation improves.
Marginal costing is simple to understand. By not charging fixed overhead to cost of production, the effect of varying charges per unit
is avoided. It prevents the illogical carry forward in stock valuation of some proportion of current
years fixed overhead. The effects of alternative sales or production policies can be more readily available and
assessed, and decisions taken would yield the maximum return to business. It eliminates large balances left in overhead control accounts which indicate the difficulty
of ascertaining an accurate overhead recovery rate. It identifies the importance of fixed costs involved in production.
Disadvantages:-
Classifying costs: It is very difficult to separate all costs into fixed and variable costs clearly, since all costs are variable in the long run. Hence such classification sometimes may give misleading results. Furthermore, in a firm with many different kinds of products, marginal costing can prove less useful.
Accurately representing profits: Since the closing stock consists only of variable costs and ignores fixed costs (which could be considerable), this gives a distorted picture of profits to shareholders.
Semi-variable costs: Semi-variable costs are either excluded or incorrectly analyzed, leading to distortions.
Recovery of overheads: With marginal costing, there is often the problem of under or over-recovery of overheads, since variable costs are apportioned on an estimated basis and not on actual value.
External reporting: Marginal costing cannot be used in external reports, which must have a complete view of all indirect and overhead costs.
Increasing costs: Since it is based on historical data, marginal costing can give an inaccurate picture in the presence of increasing costs or increasing production.
The separation of costs into fixed and variable is difficult and sometimes gives
misleading results.
Normal costing systems also apply overhead under normal operating volume and
this shows that no advantage is gained by marginal costing.
Under marginal costing, stocks and work in progress are understated. The exclusion
of fixed costs from inventories affect profit and true and fair view of financial
affairs of an organization may not be clearly transparent.
Volume variance in standard costing also discloses the effect of fluctuating output
on fixed overhead. Marginal cost data becomes unrealistic in case of highly
fluctuating levels of production, e.g., in case of seasonal factories.
Application of fixed overhead depends on estimates and not on the actual and as
such there may be under or over absorption of the same.
Control affected by means of budgetary control is also accepted by many. In order
to know the net profit, we should not be satisfied with contribution and hence, fixed
overhead is also a valuable item. A system which ignores fixed costs is less
effective since a major portion of fixed cost is not taken care of under marginal
costing.
In practice, sales price, fixed cost and variable cost per unit may vary. Thus, the
assumptions underlying the theory of marginal costing sometimes becomes unrealistic
Marginal cost has its limitation since it makes use of historical data while decisions by
management relates to future events;
It ignores fixed costs to products as if they are not important to production;
Stock valuation under this type of costing is not accepted by the Inland Revenue as
its€™s ignore the fixed cost element;
It fails to recognize that in the long run, fixed costs may become variable;
Its oversimplified costs into fixed and variable as if it is so simply to demarcate them;
It’s not a good costing technique in the long run for pricing decision as it ignores fixed
cost. In the long run, management must consider the total costs not only the variable
portion;
Difficulty to classify properly variable and fixed cost perfectly, hence stock valuation
can be distorted if fixed cost is classify as variable
TECHNIQUES OF COSTINGBesides the methods of costing, following are the types of costing techniques which
are used by management only for controlling costs and making some important
managerial decisions. As a matter of fact, they are not independent methods of cost
finding such as job or process costing but are basically costing techniques which can
be used as an advantage with any of the methods discussed above.
1. Marginal CostingMarginal costing is a technique of costing in which allocation of expenditure to
production is restricted to those expenses which arise as a result of production, e.g.,
materials, labour, and direct expenses and variable overheads. Fixed overheads are
excluded in cases where production varies because it may give misleading results. The
technique is useful in manufacturing industries with varying levels of output.
2. Direct CostingThe practice of charging all direct costs to operations, processes or products and
leaving all indirect costs to be written off against profits in the period in which they
arise is termed as direct costing. The technique differs from marginal costing because
some fixed costs can be considered as direct costs in appropriate circumstances.
3. Absorption or Full CostingThe practice of charging all costs both variable and fixed to operations, products or
processes is termed as absorption costing.
4. Uniform CostingA technique where standardized principles and methods of cost accounting are
employed by a number of different companies and firms is termed as uniform costing.
Standardization may extend to the methods of costing, accounting classification
including codes, methods of defining costs and charging depreciation, methods of
allocating or apportioning overheads to cost centres or cost units. The system, thus,
facilitates inter- firm comparisons, establishment of realistic pricing policies, etc.
PROCESS OF MARGINAL COSTINGUnder marginal costing, the difference between sales and marginal cost of sales is
found out. This difference is technically called contribution. Contribution provides for
fixed cost and profit. Excess of contribution over fixed cost is profit emphasis remains
here on increasing total contribution. Variable Cost. Variable cost is that part of total
cost, which changes directly in proportion with volume. Total variable cost changes
with change in volume of output. Variable costs are very sensitive in nature and are
influenced by a variety of factors.
Main aim of ‘marginal costing’ is to help management in controlling variable cost
because this is an area of cost which lends itself to control by management
Fixed Cost. It represents the cost which is incurred for a period, and which,
within certain output and turnover limits tends to be unaffected by fluctuations in
the levels of activity (output or turnover). Examples are rent, rates, insurance and
executive salaries.
Variable Costs Variable costs are those costs which vary directly with the level
of output. They represent payment output-related inputs such as raw materials,
direct labour, fuel and revenue-related costs such as commission. A distinction is
often made between "Direct" variable costs and "Indirect" variable costs.
Direct variable costs are those which can be directly attributable to the production
of a particular product or service and allocated to a particular cost centre. Raw
materials and the wages those working on the production line are good examples.
Indirect variable costs cannot be directly attributable to production but they do
vary with output. These include depreciation (where it is calculated related to
output - e.g. machine hours), maintenance and certain labour costs.
Semi-Variable Costs Whilst the distinction between fixed and variable costs is
a convenient way of categorising business costs, in reality there are some costs
which are fixed in nature but which increase when output reaches certain levels.
These are largely related to the overall "scale" and/or complexity of the business.
For example, when a business has relatively low levels of output or sales, it may
not require costs associated with functions such as human resource management or
a fully-resourced finance department. However, as the scale of the business grows
(e.g. output, number people employed, number and complexity of transactions)
then more resources are required. If production rises suddenly then some short-term
increase in warehousing and/or transport may be required. In these circumstances,
we say that part of the cost is variable and part fixed.
Variable cost = It changes directly in proportion with volume