RECIEVED GUIDANCE BY:

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. Well 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 1. 2. 3. 4. 5. 6. 7. 8. 9. 10. 11. 12.

PARTICULARS INTRODUCTION DEFINATION THEORY OF MARGINAL COSTING THE PRINCIPLES OF MARGINAL COSTING FEATURES OF MARGINAL COSTING PRESENTATION OF COST DATA UNDER MARGINAL COSTING CRITICISM AGAINST MARGINAL COSTING: ADVANTAGES AND DISADVANTAGES OF MARGINAL COSTING

PG.NO. 05 06 08 10 11 12 15 17

PRACTICAL APPLICATION OF MARGINAL 20 COSTING TECHNIQUE DISCONTINAUNCE OR DIVERSIFICATION OF PRODUCT LINE CONCLUSION WEBLIOGRAPHY & BIBLIOGRAPHY 26 29 30

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Introduction

Marginal costing

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 (300280). 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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Marginal costing

Definition

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 fall by theamount of contribution earned from the item. will

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 subcontracting 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 profitmaximizing. 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 subcontracting, 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 P Q 300 275 60 30 20 20

Dept. B 15 20

Dept. C 10 10

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305

70

12

10

20

The absorbtion rates of overheads on direct wages are:

Dept. A Variable overhead Fixed overhead 150% 200%

Dept. B 12% 240%

Dept. C 200% 150%

Profitability statement of Skyrock Ltd. Particulars 1. Selling price per unit 2. Direct material 3. Direct wages: Dept. A Dept. B Dept. C P 300 60 20 15 10 4. Prime cost 5. Variable overhead Dept. A (150% of D. wages) Dept. B (120% of D. wages) Dept. C (200% of D. wages) Total 6. Total variable cost (2+3) 105 30 18 20 Q 275 30 20 20 10 80 30 24 20 R 305 70 12 10 20 112 18 12 40

68 173

74 154

70 182

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(4+5) 7. Contribution 6) 8. Fixed cost Dept. A (200% of D. wages) Dept. B (240% of D. wages) Dept. C (150% of D. wages) Total 9. Profit 10.P.V. ratio 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. (7-8) (1127 121 123

40 36 15

40 48 15

24 24 30

91 36 42%

103 18 44%

78 45 40%

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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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www.globusz.com/ebooks/Costing/00000012.htm www.nou.edu.ng/noun/NOUN_OCL/pdf/bhm%2068 0.pdf

COST AND MANAGEMENT ACCOUNTING: AUTHOR: - RAVI M. KISHORE

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