Marginal Costing Final

RECIEVED GUIDANCE BY:

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ROYAL COLLEGE OF ARTS, SCIENCE

& COMMERCE (2010-11)

SUBJECT: 4.7 {COST ACCOUNTING}

TOPIC: MARGINAL COSTING & ITS MERITS

AND DEMERITS

S.Y.BANKING & INSURANCE

SEMESTER - 4 SUBMITTED BY

GROUP NO: O2

GROUP MEMBERS:

AZIM SAMNANI (37)

SHIFA SHAIKH {27}

SAMA KHAN {08}

DHAVAL SHAH {38}

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Acknowledgement

We would like to express our profound gratitude to our

project guide

Prof: KAMAL ROHRA, who has so ably guided our research

project with his vast fund of knowledge, advice and

constant encouragement, which made us, think past the

difficulties and lead us to successful completion of the

project.

We have tried to cover all the aspects of the project & every

care has been taken to make the project faultless. We have

tried to write the project in our words as far as possible and

simplified all the concepts by presenting it in a different

form. We’ll be looking forward in future for such type of

project. We are eagerly waiting for fruitful comments &

constructive suggestions.

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SR.NO PARTICULARS PG.NO.

1. INTRODUCTION 05

2. DEFINATION 06

3. THEORY OF MARGINAL COSTING 08

4. THE PRINCIPLES OF MARGINAL

COSTING

10

5. FEATURES OF MARGINAL COSTING 11

6. PRESENTATION OF COST DATA UNDER

MARGINAL COSTING

12

7. CRITICISM AGAINST MARGINAL

COSTING:

15

8. ADVANTAGES AND DISADVANTAGES OF

MARGINAL COSTING

17

9. PRACTICAL APPLICATION OF MARGINAL

COSTING TECHNIQUE

20

10. DISCONTINAUNCE OR DIVERSIFICATION

OF PRODUCT LINE

26

11. CONCLUSION 29

12. WEBLIOGRAPHY & BIBLIOGRAPHY 30

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Marginal costing

Introduction 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.

Marginal costmeans the cost of the marginal or last unit produced. It is

also defined asthe cost of one more or one less unit produced besides

existing level of production. In this

Connection, a unit may mean a single commodity, a dozen, a gross or any

other measureof goods.

For example, if a manufacturing firm produces X unit at a cost of 300

and X+1 units at a cost of 320, the cost of an additional unit will be 20

which is marginal cost.

Similarly if the production of X-1 units comes down to 280, the cost of

marginal unit,

Will be 20 (300–280).

The marginal cost varies directly with the volume of production and

marginal cost perunit remains the same. It consists of prime cost, i.e.

cost of direct materials, direct laborand all variableoverheads. It does

not contain any element of fixed cost which is keptseparate under

marginal cost technique.

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Definition Marginal costing Marginal costing distinguishes between fixed costs and variable costs

as convention allyclassified.

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 fixedcosts of the period are written-off in full against

the aggregate contribution. Its specialvalue is in decision making‟.

(Terminology).

The term „contribution‟ mentioned in the formal definition is the term

given to thedifference between Sales and Marginal cost. Thus

MARGINAL COST = VARIABLE COST

DIRECT LABOUR

+

DIRECT MATERIAL

+

DIRECT EXPENSE

+

VARIABLE OVERHEADS

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The term marginal cost sometimes refers to the marginal cost

per unit and sometimes tothe total marginal costs of a

department or batch or operation. The meaning is usually

Clear from the context.

Alternative names for marginal costing are the contribution approach

and direct costing

In this lesson, we will study marginal costing as a technique quite

distinct fromabsorption costing.

Marginal costing may be defined as the technique of presenting cost

data whereinvariable costs and fixed costs are shown separately for

managerial decision-making. Itshould be clearly understood that

marginal costing is not a method of costing like processcosting or job

costing. Rather it is simply a method or technique of the analysis of

costinformation for the guidance of management which tries to find

out an effect on profitdue to changes in the volume of output.There

are different phrases being used for this technique of costing. In UK,

marginalcosting is a popular phrase whereas in US, it is known as direct

costing and is used inplace of marginal costing. Variable costing is

another name of marginal costing.Marginal costing technique has given

birth to a very useful concept of contribution where

Contribution is given by: Sales revenue less variable cost (marginal

cost)Contribution may be defined as the profit before the recovery of

fixed costs. Thus,contribution goes toward the recovery of fixed cost

and profit, and is equal to fixed cost

Plus profit (C = F + P).

In case a firm neither makes profit nor suffers loss, contribution will

be just equal to fixedcost (C = F). This is known as breakeven point.The

concept of contribution is very useful in marginalcosting. It has a fixed

relation withsales. The proportion of contribution to sales is known as

P/V ratio which remains thesame under given conditions of production

and sales.

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Theory of Marginal Costing The theory of marginal costing as set out in “A report on Marginal

Costing”, London is as follows:

In relation to a given volume of output, additional output can normally

be obtained at lessthan proportionate cost because within limits, the

aggregate of certain items of cost will

Tend to remain fixed and only the aggregate of the remainder will tend

to riseproportionately with an increase in output. Conversely, a

decrease in the volume ofoutput will normally be accompanied by less

than proportionate fall in the aggregate cost.

The theory of marginal costing may, therefore, by understood in

the following two steps:

1. If the volume of output increases, the cost per unit in normal

circumstances reduces. Conversely, if an output reduces, the cost per

unit increases. If a factoryproduces 1000 units at a total cost of

3,000 and if by increasing the output by one unit the cost goes up to

3,002, the marginal cost of additional output will be2.

2. If an increase in output is more than one, the total increase in marginal

cost per unit. If, for example, the output is increased to 1020 units from

1000 units and the total cost to produce these units is 1,045, the average

marginal cost per unit is 2.25. It can be described as follows:

Additional cost =Additional units

1045 = 2.25

20

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The ascertainment of marginal cost is based on the classification and

segregation of costinto fixed and variable cost. In order to understand

the marginal costing technique, it isessential to understand the

meaning of marginal cost.

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The 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 salesand production (provided that the level of activity is

within the „relevant range‟).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 extraitem.

b. Similarly, if the volume of sales falls by one item, the profit will

fall by theamount 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 ordecreases in sales volume, it is misleading

to charge units of sale with a share offixed costs.

d. When a unit of product is made, the extra costs incurred in its

manufacture are thevariable production costs. Fixed costs are

unaffected, and no extra fixed costs areincurred when output is

increased.

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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 costsand fixed costs. It is the variable cost on the basis of

which production and salespolicies are designed by a firm following the

marginal costing technique.

2. Stock/Inventory Valuation

Under marginal costing, inventory/stock for profit measurement is

valued atmarginal cost. It is in sharp contrast to the total unit cost

under absorption costingmethod.

3. Marginal Contribution

Marginal costing technique makes use of marginal contribution for

markingvarious decisions. Marginal contribution is the difference

between sales andmarginal cost. It forms the basis for judging the

profitability of different productsor departments.

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Presentation of Cost Data under Marginal Costing

Marginal costing is not a method of costing but a technique of

presentation of sales andcost data with a view to guide management in

decision-making.The traditional technique popularly known as total cost

or absorption costing technique does not make any difference between

variable and fixed cost in the calculation ofprofits. But marginal cost

statement very clearly indicates this difference in arriving at thenet

operational results of a firm.

Following presentation of two Performa shows the difference between

the presentation ofinformation according to absorption and marginal

costing techniques:

Marginal Costing Pro-Forma Sales

LESS:-

VARIABLE COST

Direct material

Direct labour

Direct expenses etc.

Variable factory overheads

Selling overheads

Less: Closing stock

Contribution

Less:-

Fixed cost

Net profit

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Argument in favour of Marginal Costing: The supporterof marginal costingtechnique put forth the following

points in support of their argument:

1) Fixed costs are period costs in nature and it should be charged to the

concerned period irrespective of the quantum or level of production or

sale.

2) Marginal costing method is simple in application and is easy for

exercise of cost control. It is more informative and simple to understand.

3) It helps the management with more appropriate information in taking

vital business decisions like make or buy, sub-contracting, export order

pricing, pricing under recession, continue or discontinue a product/

division/ sales territory, selection of suitable product.

4) Inclusion of fixed cost in the product cost distorts the comparability

of products at different volume and disturbs control actions. It highlights

the significance of fixed costs on profits. In a highly competitive

situation, it may be wise to take an order which covers marginal cost and

makes some contribution towards fixed costs, rather lose the order and

the contribution by insisting upon a price above full cost.

5) Profit-volume analysis is facilitated by the use break even charts and

profit-volume graphs, and so on. 6) The analysis of per key factor or

limiting resources is a useful aid in budgeting and production planning.

7) Pricing decisions can be based on the contribution levels of individual

product.

8) The profit and loss statement is not distorted by changes in stock

levels. Stock valuations are not burdened with a share of fixed overhead,

so profits reflect sales volume rather than production volume.

9) Responsibility accounting is more effective when based on marginal

costing because managers can identify their responsibilities more clearly

when fixed overhead is not charged arbitrarily to their departments or

division.

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Criticism against Marginal costing:

1) Difficulty may be experienced in trying to separate fixed and

variable elements of overhead costs. Unless this can be done with

reasonable accuracy, marginal costing cannot be very accurate.

Application of common sense and judgment will be necessary. 2)

The misuse of marginal costing approach may result in setting

selling prices which do not aloe for the full recovery of overhead.

This may be most likely in times of depression or increasing

competitors when prices set to undercut competitors may not allow

for a reasonable contribution margin.

3) The main assumption of marginal costing is that variable cost

per unit will be same at any level of activity. This is partly true

within a limited range of activity. With a major change in activity

there may be considerable change in the rates and prices of men,

material due to shortage of material, shortage of skilled labour,

concessions of bulk purchase, increased transportation costs,

changes in production of men and materials etc. 4) The assumption

that fixed costs remain constant in total regardless of changes in

volume will be correct up to a certain level of output. Some fixed

costs are liable to change from one period to another. For example,

salaries bill may go up because of annual increment or due to

change in the pay rates and due to pay structure. If there is a

substantial drop in activity, management may take immediate

action to cut the fixed costs by retrenchment of staff, renting

office-premises, warehouse taken lease may be given up etc.

5) Exclusion of fixed overheads from costs may lead to erroneous

conclusions. It may create problems in interfirm comparison,

higher demand for salaries and other benefits by employees, higher

demand for tax by Government authorities etc.

6) The exclusion of fixed overhead from inventory cost does not

constitute an accepted accounting procedure and, therefore,

adherence to marginal costing will involve deviation from accepted

accounting practices.

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7) Increased automation and mechanization has resulted the

reduction in labour costs and increased fixed costs like installation,

maintenance and operation costs, depreciation of machinery. The use of

marginal costing creates a tendency to disregard the need to recover cost

through product pricing. For long-run continuity of the business, it is not

good. Assets have to be replaced in the long-run.

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Advantages and Disadvantages of Marginal Costing

Advantages 1. Marginal costing is simple to understand.

2. By not charging fixed overhead to cost of production, the effect of

varyingcharges per unit is avoided.

3. It prevents the illogical carry forward in stock valuation of some

proportion of current years fixed overhead.

4. The effects of alternative sales or production policies can be more

readilyavailable and assessed, and decisions taken would yield the

maximum return tobusiness.

5. It eliminates large balances left in overhead control accounts which

indicate thedifficulty of ascertaining an accurate overhead recovery

rate.

6. Practical cost control is greatly facilitated. By avoiding arbitrary

allocation offixed overhead, efforts can be concentrated on

maintaining a uniform andconsistent marginal cost. It is useful to

various levels of management.

7. It helps in short-term profit planning by breakeven and profitability

analysis, bothin terms of quantity and graphs. Comparative profitability

and performancebetween two or more products and divisions can easily

be assessed and brought to the notice of management for decision

making.

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Disadvantages 1. The separation of costs into fixed and variable is difficult and

sometimes givesmisleading results.

2. Normal costing systems also apply overhead under normal operating

volume andthis shows that no advantage is gained by marginal costing.

3. Under marginal costing, stocks and work in progress are

understated. The exclusion of fixed costs from inventories affect

profit and true and fair view offinancial affairs of an organization may

not be clearly transparent.

4. Volume variance in standard costing also discloses the effect of

fluctuating outputon fixed overhead. Marginal cost data becomes

unrealistic in case of highlyfluctuating levels of production, e.g., in case

of seasonal factories.

5. Application of fixed overhead depends on estimates and not on the

actual and assuch there may be under or over absorption of the same.

6. Control affected by means of budgetary control is also accepted by

many. In orderto 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 lesseffective since a major portion of

fixed cost is not taken care of under marginalcosting.

7. In practice, sales price, fixed cost and variable cost per unit may

vary. Thus, theassumptions underlying the theory of marginal costing

sometimes becomes unrealistic. For long term profit planning,

absorption costing is the only answer.

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Limitations of Marginal Costing

Marginal costing however, suffers from the following limitations:

1. Marginal costing assumes that all costs can be classified into fixed

and variables. But there may be certain costs which are neither fixed

nor variable.

2. The application of marginal costing in certain industries such as

ship building, construction, etc. may show no profit or loss during

the year work is in progress, but huge profit in the year the work is

completed. This is due to non-inclusion of overheads in the value of

closing work-in-progress.

3. In the long run, true selling price should be based on total cost i.e.,

inclusive of fixed cost also. In the short run or in special situations

when a product is sold below the total cost, customers may insist on

the continuation of reduced prices forever and this may not be

possible in all cases.

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Practical application of Marginal costing

technique

1) Key or limiting factor analysis.

2) Profit planning

3) Optimizing product mix

4) Contribution analysis

5) Make or buy decisions

6) Price fixation

7) Discontinuance or diversification of product line

8) Accept or reject special offer and sub-

contracting

9) Break-even analysis

10) Cost-volume profit analysis

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PRACTICAL APPLICATIONS OF MARGINAL COSTING

TECHNIQUE

1) Key or limiting Factors analysis:

Marginal costing can be used in budgeting to help management to determine what

the profit –maximizing budget. Plan should be made when one or more factors of

production or other business resources are in short supply . Marginal costing really

shows its merit when scarce resources are being considered. Examples of resource

restrictions which may apply are as follows:

a) Limit to the availability of a particular grade of labour.

b) Shortage of raw materials.

c) Limit to machine capacity.

d) Shortage of cash to finance production.

If labour supply , materials availability , machine capacity or cash availability limit

production to less than the volume which could be achieved ,management is faced

with the problem of deciding what to produce and what not to produce , because

there are insufficient resources to make everything. The limiting factor is often

sales demand itself in which the business should produce enough goods or services

to meet the demand in full, provided that sales of the goods earn a positive

contribution towards fixed costs and profits.

However , when the limiting factor is a production resource, the business must

decide which part of sales demand it should meet , and which part must be left

unsatisfied. Marginal costing analysis can be used to indicate the profit-

maximizing.

a) Analysis when only one limiting factor:

If fixed costs are constant , regardless of the level of output and sales within a

relevant range of output , marginal costing principles should lead us to the

conclusion that profits will be maximized if total contribution is maximized.

If there is a shortage of one particular production resource, it is inevitable that all

the available supply of that resource will be used up. For example, if a business has

a chronic shortage of skilled manpower, it will plan to use all the skilled manpower

that it does have available.

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Total contribution will be maximized if the maximum possible contribution is

obtaines per unit of that scarce resource. In other words, a business should get the

best possible value out of the scarce resources that it uses up. In dealing with a

limiting factor problem, the steps to be taken care are as follows:

Identify the possibility that there sre may be a limiting factor other than

sales demand. There may be the maximum availability of one or (more)

resources, so that sales demand cannot be met . this is done quite simple as

follows:

i) Calculate the volume of resources required to produce enough unit to satisfy

sales demand.

ii) Calculate the volume of resources available.

iii) Compare the two totals. If (i) exceeds (ii) there is a limiting factor.

If there is only one such limiting factor, the next step is to calculate the

contribution earned by each product per unit of the scarce resource. The

products with the highest contribution per unit of scarce resource should

receive priority in the allocation of the resource in the production budget.

2) Profit Planning:

The behavioural study of costs in marginal costing technique helps the

management in profit planning exercise. Constant development in science and

technology makes the long run situation more uncertain and highly unpredictable.

Long-run consists of a series of short-runs and one must aim at maximizing

contribution in each short-run which will lead to profit maximization in long-run.

Profit figure is planned and activity level is determined to achieve that planned

profit. It helps in doing sensitivity analysis by observing different cost and revenue

situations and its resultant impact on profit and guides in the determination of

activity level to achieve target profit.

The profit of a business concern can be improved in the following ways:

1. By increasing volume

2. By increasing selling price

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3. By decreasing variable costs, and

4. By decreasing fixed costs.

3) Contribution analysis:

The analysis of the contribution per unit each product makes towards fixed or

current period costs and profit leads to the preparation of statements showing the

total contribution each product class has made towards the recovery of period

costs. These statements may be further refined by deducting any discretionary or

separable period costs (i.e., costs such as annual tooling and product advertising)

which should be avoided if the product line were dropped.

4) Make or buy decisions:

Make or buy decision is simply the choice between making a part or article within

the company or purchasing it from outside. The following considerations apply

when taking a make or buy decision:

The capability of the company to make the item in terms of the capacity

(people, plant and space) available and the ability to achieve required

quality standards.

The availability of outside suppliers who can deliver the item in the

quantities, quality and time required.

The differential cost of making or buying the item. This means that

consideration has to be given to these conditions:

-If items which are currently purchased are manufactured, what additional

or incremental costs will be incurred and how do these compare with the

costs being saved?

- If items are purchased which could be manufactured, what costs will be

avoided and how do these compare with the costs will be incurred?

The opportunity cost of using existing capacity to manufacture alternative

items which would make a greater contribution to profit and fixed costs than

the item under consideration. A make or buy decision is often essentially

about how best to utilize existing facilities.

The impact of a decision to make the item on aggregate volumes, an increase

in which should contribute to overhead recovery and facilitate the balancing

of demand and operations capacity overtime.

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The level of variable overheads which are charged to the part or article.

Procedure:

The procedure for taking a make or buy decision is as follows:

Produce a precise specification of the item and define the quantities

required, the timing of deliveries and the maximum acceptable unit cost.

Analyse existing capacity to find out if the item can be made in

accordance with specifications for quality, quantity and delivery dates.

Analyse tenders made by outside suppliers to find out which ,if any , can

best satisfy requirements for quality, cost limits and delivery.

Calculate the incremental cost of making the item –that is, the full

accounting cost of the labour and direct materials used to make it. The

incremental cost will equal marginal cost if, and only if, factory capacity

is sufficiently under-utilised before the make or buy decision is take to

render all fixed costs irrelevant to the decision.

Calculate the cost to buy, which is the purchase cost invoiced by the

supplier (total cost less any trade discount),plus any delivery and

inspection costs and costs of buying (office-staff time).

Assess the opportunity cost of making the component as measured by the

total contribution that would have been earned by using the resources

required to make the item to manufacture instead of an alternative more

profitable product.

Weigh the results of the various assessments listed above.

A thorough make or buy analysis, as outlined above , will ensure that all

the capacity , capability, differential cost and opportunity cost factors will

have been taken fully into consideration before the choice is made.

5) Price fixation:

Under this method fixed costs are ignored and prices are determined on the basis

of marginal cost. A firm seeks to fix its prices so as to maximize its total

contribution. Marginal cost is the change in total costs that results from production

of additional unit of a product or service. Marginal costing is more effective than

full cost pricing for the following reasons:

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Prevalence of multi-product, multi-process and multi-market

concerns makes the absorption of fixed costs into product costs is

difficult.

Constant development in science and technology makes the long run

situation more uncertain and highly unpredictable. Long-run consists

of a series of short runs and we must aim at maximizing contribution

in each short run which will lead profit maximization in the long-run.

6) Accept or reject new order and sub-contracting:

In times of taking decisions to accept or reject new order or in sub-

contracting, the contribution analysis us made as to whether it is profitable to

accept or reject new order or in sub-contracting.

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DISCONTINAUNCE OR DIVERSIFICATION OF

PRODUCT LINE

The MC technique is used in taking decision regarding discontinuance of a

product. If any product is not impressive, then such should be discontinued only it

there is no contribution margin from that product. In other words, any contribution

from that product will reduce the burden of total fixed cost of the firm and this will

help in better product than if such product is discontinued.

When a firm intend to introduce a new product into the market, the major

consideration in taking such decision is to see whether that particular product is

able to recover at least its variable cost and any contribution in excess of variable

cost from such new product will improve the overall profitability of firm. Here the

important point to remember is that all the present fixed costs of the firm are being

borne by the existing products.

Illustration:

The Skyrock.Ltd produces and sells three types of products P,Q & R. the

management committee has decided to discontinue the production of ‘Q’ since

there is no much profit in it. From the following set of information find out the

profitability of the products and give your short comments on the decision of the

management.

Products Selling

price per

unit

Rs./-

Direct

material

per unit

Rs./-

Direct wages per unit

Dept. A Dept. B Dept. C

P 300 60 20 15 10

Q 275 30 20 20 10

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R 305 70 12 10 20

The absorbtion rates of overheads on direct wages are:

Dept. A Dept. B Dept. C

Variable overhead 150% 12% 200%

Fixed overhead 200% 240% 150%

Profitability statement of Skyrock Ltd.

Particulars P Q R

1. Selling price per unit 300 275 305

2. Direct material 60 30 70

3. Direct wages: Dept. A

Dept. B

Dept. C

20

15

10

20

20

10

12

10

20

4. Prime cost (2+3) 105 80 112

5. Variable overhead

Dept. A (150% of D.

wages)

Dept. B (120% of D.

wages)

Dept. C (200% of D.

wages)

30

18

20

30

24

20

18

12

40

Total 68 74 70

6. Total variable cost 173 154 182

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(4+5)

7. Contribution (1-

6)

127 121 123

8. Fixed cost

Dept. A (200% of D.

wages)

Dept. B (240% of D.

wages)

Dept. C (150% of D.

wages)

40

36

15

40

48

15

24

24

30

Total 91 103 78

9. Profit (7-8) 36 18 45

10. P.V. ratio 42% 44% 40%

Comments:

The management has taken a view to discontinue product Q based on unitary

profit. This is a wrong decision. This decision should be based on P.V. ratio, which

is highest in Product Q. Management should explore the possibility of increasing

the production of product Q, because this step will increase the total profit of the

company owing to better P.V. ratio of Product Q. by discontinuing Product Q its

share of fixed cost will be borne by Product P and R thus profit of company will

reduce.

Accept or reject new order and sub-contracting:

In times of taking decision to accept or reject new order or in sub-contracting, the

contribution analysis is made as to whether it is profitable to accept or reject new

order or in sub-contracting. The following problems demonstrate the use of the

contribution technique.

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In this unit, we have discussed generally the concept of marginal costing. We also looked at the features of contributions. These features make it distinctive with conventional profit. Finally, we tried to identify merits and demerits and also the application area of the marginal costing techniques.

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COST AND MANAGEMENT ACCOUNTING:

AUTHOR: - RAVI M. KISHORE

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