Introduction

Marginal costing is not a distinct method: Marginal costing is not a distinct method of costing like job costing, process costing, operating costing, etc., but a special technique used for management decision making. Marginal costing is used to provide a basis for the interpretation of cost data to measure the profitability of different products/ Processes and costs centres in the course of decision making. It can therefore be used in conjunction with the different methods of costing such as standard costing or budgetary control.

Cost Ascertainment as on the basis of nature of cost: In marginal costing, cost ascertainment is made on the basis os the nature of control. It gives consideration to behavior of costs. In other words, the technique has developed from a particular conception and expression of the nature and behavior cost and their effect upon the profitability of an undertaking.

Marginal costing facilitates decision making: In the orthodox or total cost method, as opposed to marginal costing method, the classification of costs is based on functional basis. Under this method the total cost is the sum of the cost direct material, direct labour. Direct expense, manufacturing overheads, administrating overheads, selling and distribution overheads. In this system other things being equal, the total cost per unit will remain constant only when the level of output or mixture is the same from period to period. Since these factors are continually fluctuating, the actual total cost will vary from one period to another. Thus it is possible for the costing department to say one day that an item cost Rs 20 and the next day it costs Rs 18.This situation arises because of changes in volume of output and the peculiar behavior of fixed expense included in the total cost. Such fluctuating manufacturing activity and consequently the variations in the total cost from period to period or even from day to day, poses a serious problem to the management in taking sound decisions. Hence the application of marginal costing has been wide recognition in the field of decision making.
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Basic Characteristics of Marginal Costing

The technique of marginal costing is based on the distinction between product costs and period costs. Only the variables costs are regarded as the costs of the product while the fixed costs are treated as period costs which will be incurred during the period regardless of the volume of output. The main characteristics of marginal costing are as follows: 1. All elements of costs are classified into fixed and variable components. Semi-variable costs are also analyzed into fixed and the variable elements.

2. The marginal or variable costs (as direct material, direct labour, direct expenses) are treated as the cost of product.

3. Under marginal costing, the value of finished goods and work-in-progress is also comprised only of marginal costs. Variable selling and distribution are excluded for valuing these inventories. Fixed costs are not considered for valuation of closing stock or finished goods and closing WIP.

4. Fixed cost are treated as period costs and is charged to profit and loss account for the period for which they are incurred.

5. Prices are determined with reference to marginal costs and contribution margin.

6. Profitability of departments and products is determined with reference to their contribution margin.

Definitions

In order to appreciate the concept of marginal costing, It is necessary to study the definition of marginal costing and certain other items associated with this technique. The important terms have been defined as follows:

1. Marginal Costing: The ascertainment of marginal cost and the effect on profit of changes in volume of type of output by differentiating between fixed costs and variable costs.

2. Marginal Cost: The amount at any given volume of output by which aggregate variable costs are changed if the volume of output is increased by one unit. In practice this is sum of prime cost and variable overhead.

3. Direct Costing: direct costing is the practice of changing all direct cost to operations, Processes of products, Leaving all indirect costs to be written of against profits on the period in which they arise. Under firect costing the stocks are valued at direct costs, ie., costs whether fixed or variable which can be directly attributable to the cost units.

4. Differential Cost: It may be defined as the increase or decrease in total cost or the change in specific elements of cost that result from any variation in operations. It represents an increase or decrease in total cost resulting out of:

(a) Producing or distributing a few more or few less of the products. (b) A change in the method of production or of distribution. (c) An addition or deletion of a product or a territory and (d) Selection of additional sales channel.

5. Incremental Cost: It is defined as the additional costs of a change in the level or nature of activity. As such for all practical purposes there is no difference between incremental cost and differential cost. However, from a conceptual point of view, differential cost refers to both incremental as well as decremental cost. One aspect which is worthy to note is that incremental cost is not the same at all levels. Incremental cost between 50% an 60% level of output may be different from that which is arrived at between 80% and 90% level of output.

Ascertainment of Marginal Cost

Under marginal costing, fixed expenses are treated as period costs and are therefore charged to profit and loss account. In order to ascertain the marginal cost, we classify the expenses as under:

1. Variable Expenses: Apart from prime costs which are variable, the overhead expenses that change in proportion to the change in the level of activity are also variable expenses. Thus when expense go up or come down in proportion to a change in volume of output, such that, with every increase of 20% in output, expenses fluctuate in total with fluctuations in the level of output tend to remain constant per unit of output. Examples os such expenses are raw material, power, commission paid to salesmen as a percentage of sales etc.

2. Fixed Expenses: Fixed expenses or constant expenses are those which do not vary in total with the change in volume of output for a given period of time. Fixed cost per unit of output will, however, Fluctuate with changes in the level of production. Examples of such levels of fixed costs at different levels of output. As for example, where

after certain level of output extra expenditure may be needed, in the case of introduction of additional shift working, fixed expenses will be incurred, say, for the appointment of additional supervisors. Fixed expenses are treated as period costs and are therefore charged to profit and loss account.
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3. Semi-Variable Expenses: these expense (also known as semi-fixed expenses) do not change eithin the limits of a small range of activity but may change when the output reaches a new level in the same direction in which the output changes. Such increases or decreases in expenses are not in proportion to output. An example of

such an expense is delivery van expense. Semi-variable expenses may remain constant at 50% to 60% level of activity and may increase in total from 60% to 70% level of activity. These expenses can be segregated into fixed and variable by using any one of the method, as given under next heading. Depreciation of plant and machinery depends partly on effux of time and partly on wear and tear. The former is fixed ant the latter is variable. The total cost is arrived at by merging these three types of expenses.

Separating Fixed and Variable Costs

Uses of segregation of cost

Segregation of all expenses into fixed and variable elements is the essence of marginal costing. The primary objective of the classification of expenses into fixed and variable elements is not to find out the marginal cost for various types of managerial decesions. A number of such decesions will be discussed later in the chapter. The other uses of it are below:

(a) Control of Expenses: the classification of expenses helps in controlling expenses. Fixed expenses are said to be sunk costs as these are incurred irrespective of the level of production activity and they are regarded as un controllable expenses. Since variable expenses vary with the production they are said to be controllable. By this classification therefore, responsibility for incurring varialble expenses is determined in relation to activity and hence the management is acle to control these expenses. The departmental heads always try to keep these expenses within limits set by the management.

(b) Preparation of Budget Estimates: This distinction between fixed and variable cost also helps the management to estimate precisely, the budgeted expenses to gauge the actual efficiency of the business bu comparing the actual with budgets.

Advantages and Limitations of Marginal Costing

Advantages of Marginal Costing

1. Simplified pricing policy:

The marginal cost remains constant per unit of output

whereas the fixed cost remains constant in total. Since marginal cost per unit is constant from period to period within a short span of time, firm decesions on pricing policy can be taken. If fixed cost is included, the unit cost will change from day to day depending upon the volume of output. This will make decision making task difficult.

2. Proper recovery of Overheads: Overheads are recovered in costing on the basis of predetermined rates. If fixed overheads are included on the basis of pre determined rates, there will be under recovery of overheads if production is more than the budget or actual expenses are less than the estimate. This creates the problem of treatment of such under or over recovery of overheads. Marginal Costing avoids such under or over recovery of overheads

3. Shows Realistic Profit: Advocates of marginal costing argues that under the marginal costing technique, the stock of finished goods and work-in-progress are carried on marginal cost basis and the fixed expenses are written off to profit and loss account as period cost. This shows the true profit for the period.
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4. How much to produce: marginal costing helps in the preparation of break-even analysis which shows the effect of increasing or decreasing production activity on the profitability of the company.

5. More control over expenditure: segregation or expenses as fixed and variable helps the management to exercise control over expenditure. The management can compare the actual variable expenses with the budgeted variable expenses and take corrective action through analysis of variances.

6. Helpa in Decision Making: Marginal costing helps the management in taking a number of business decesions like make or buy, discontinuance or a particular product, replacement of machines, etc.

Limitations of Marginal Costing

1.

Difficulty in Classifying fixed and variable elements: It is difficult ot classify exactly the expenses into fixed and variable category. Most of the expenses are neither totally variable nor wholly fixed. For example, various amenities provided to workers may have no relation either to volume of production or time factor.

2. Scope for Low Profitability: Sales staff may mistake marginal cost for total cost and sell at a price; which will result in loss or low profits. Hence, sales staff should be cautioned while giving marginal cost.

3. Faulty valuation: Overheads of fixed nature cannot altogether be excluded particularly in large contracts. While valuing the work-in-progress. In order to show the correct position fixed overheads have to be included in work-in-progress.

4. Unpredictable nature of cost: Some of the assumptions regarding the behavior of the various costs are not necessary true in a realistic situation. For example, the assumption that fixed cost will remain static throughout is not correct. Fixed cost may change from one period to another. For example salaries bill may go up because of annual increment or due to change in pay rate etc. The variable costs do not remain constant per unit of output. There may be changes in the prices of the raw materials, wage rate, etc. after a certain
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level of output has been reached due to shortage of material, shortage of skilled labour, concessions of bulk purchases etc.

5. Marginal costing ignores time factor and investment: the marginal cost of two jobs may be the same nut the time taken for their completion and the cost of machines used may differ. The true cost of a job which takes longer time and uses costlier machine would be higher. The fact is not disclosed by marginal costing.

6. Contribution of a product itself is not a guide for optimum profitability unless it is linked with the key factor.

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Cost-Volume-Profit Analysis

It is a managerial tool showing the relationship between various ingredients of profit planning viz, cost, selling price and volume of activity.

As the name suggests, cost volume profit (CVP) analysis is the analysis of three variables cost, volume and profit. Such an analysis explores the relationship between costs, revenue, activity levels and the resulting profit. It aims at measuring variations in cost an volume.

CVP analysis is based on the following assumptions:

1. Changes in the levels of revenues and cost arise only because of changes in the number of product (or service) units produced and sold- for example, the number of television sets produced and sold by sony corporation or the number of packages delivered by overnight express. The number of output unit is the only revenue driver and the only cost driver. Just as a cost driver is any factor that affects costs, a revenue driver is variable, such as volume, that casually affects revenues.

2. Total costs can be separated into two components: a fixed component that does not vary with output level and a variable component that changes with respect to output level. Furthermore, variable cost include both direct cariable cost and indirect variable cost of a product. Similarly fixed cost include both direct fixed cost and indirect fixed cost of a product.
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3. When represented graphically, the behaviours of total revenues and total cost are linear (meaning they can be represented as a straight line) in relation to output level within a relevant range (and time period).

4. Selling price, variable cost per unit, and total fixed costs (within a relevant range an time period) are known and constant.

5. The analysis either covers a single product or assumes that the proportion of different products when multiple products are sold will remain constant as the level of total units sold changes.

6. All revenues and costs can be added, subtracted and compared without taking into account the time value of money.

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Importance of CVP analysis

It provides the information about the folloeing matters:

1. The behavior of cost in relation to volume. 2. Volume of production or sales, where the business will be break even. 3. Sensitivity of profits due to variation in output 4. Amount of profit for a projected sales volume. 5. Quantity of production and sales for a target profit level.

An understanding of CVP analysis is extremely useful to management in budgeting and profit planning. It elucidates the impact of the following on the net profit:

(i) (ii) (iii) (iv)

Changes in selling prices Changes in volume of sales Changes in variable cost Changes in fixed cost

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Break Even Analysis

Break even analysis is a generally used method to study the cvp analysis. This technique can be explained in two ways:

1. In narrow sense it is concerned with computing the break-even point. At this point of production level and sales there will be no profit and loss i.e. total cost is equal to total sales revenue.

2. In broad sense this technique is based to determine the possible profit/loss at any given level production or sales.

Methods of Break-Even Analysis

Break even analysis may be conducted by the following two methods:

1. Algebraic Computation 2. Graphic Presentation

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Marginal Cost Equation

The contribution theory explains the relationship between the variable cost and selling price. It tells us that selling price minus variable cost of the units sold is the contribution towards fixed expenses and profit. If the contribution is equal to fixed expense, there will be no profit no loss and it is less than fixed expenses, loss is incurred. Since the variable cost varies in direct proportion to output, therefore if the firm does not produce any unit, the loss will be there to the extend of fixed expense. These points can be described with the help of the following marginal cost equation: S-V=C-F+P

Where,

S= Selling price per unit

V= Variable cost per unit

C= Contribution

F= Fixed cost

P= Profit/Loss

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Principles of Marginal Costing

Period fixed costs are the same, for any volume of sales and production (provided that the level of activity is within the relevant tange). Therefore by selling an extra item of product or service of the following will happen:

1. Revenue will increase by the sales value of the item sold, 2. Cost will increase by the variable cost per unit, 3. 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 increase or decrease in sales volume, it is misleading to charge units of sale with a share of fixed costs from total contribution for the period to derive a profit figure.

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. It is therefore argued that the valuation of closing stock should be variable production cost (direct material, direct labour, direct expenses and variable production overhead) because there are the only costs properly attributable to the product.

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Margin of Safety

The margin of safety can be defined as the difference between the expected level of sale adn the breakeven sales. The larger the margin of safety, the higher are the chances of making profits. In the above example if the forecast sale is 1700 units per month, the margin of safety can be calculated as follows,

Margin of Safety= Projected sales- Breakeven sales =1700 units- 1000 units =700 units or 41% of sales.

The margin of safety can also be calculated by identifying the difference between the projected sales and breakeven sales in units multiplied by the contribution per unit. This is possible because, at the breakeven point all the fixed costs are recovered and any further contribution goes into the making of profits. It also can be calculated as

P / PV ratio

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Distinction between Marginal and Absorption Costing

Absorption Costing Approach

Direct Material Direct labour Variable Factory overheads fixed factory overheads Charged to cost of goods purchased

Charged as expense when goods are sold

All Selling and Administrative overheads

Charged as expenses when incurred

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Marginal Costing Approach

Direct Material Direct Labour Direct Factory overheads Charged to cost of goods purchased

Charged as Expenses when goods are sold

Fixed Factory Overheads And All Selling and distribution Overheads

Charged as Expenses when Incurred

Marginal Costing Approach

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Marginal Costing 1. Only variable costs are considered for product costing and inventory valuation.

Absorption Costing Both fixed and variable costs are considered for product costing and inventory valuation.

2.

Fixed costs are regarded as period costs. The profitability of different products is judged by the P/V ratio.

3.

Cost data highlight the total contribution of each product.

4.

5.

The difference in the magnitude of opening stock and closing stock does not affect the unit cost of production. In case of marginal costing the cost per unit remains the same, irrespective of the production as it is valued at variable cost.

Fixed costs are charged to the cost of production. Each product bears a reasonable share of fixed cost and thus the profitability of a product is influenced by the apportionment of fixed costs. Cost data are presented in conventional pattern. Net profit of each product is determined after subtracting fixed cost along with their variable cost. The difference in the magnitude of opening stock and closing stock affects the unit cost of production due to the impact of related fixed cost. In case of absorption costing the cost per unit reduces, as the production increases as it is fixed cost which reduces, whereas, the variable cost remains the same per unit.

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Difference in Profit under Marginal and Absorption costing

The above two approaches will compute the different profit because of the difference in the stock valuation. This difference is explained as follows in different circumstances.

1. No opening and closing stock: In this case, Profit/loss under absorption and marginal will be equal.

2. When opening stock is equal to closing stock: In this case, Profit/loss under two approaches will be equal provided the fixed cost element in both the stock is same amount.

3. When closing stock is more than opening stock: In other words when production during a period is more than sales, then profit as per absorption approach will be more than by marginal approach. The reason behind this difference is that a part of fixed overhead included in closing stock value is carried forward to next accounting period.

4. When opening stock is more than the closing stock: In other words when production is less than the sales, profit shown by marginal costing will be more than that shown by absorption costing. This is because a part of fixed cost from the preceding period is added to the current years cost of goods sold in the form of opening stock.
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