Marginal Costing Notes

Marginal Costing: DBB2203 Management Accounting - Unit 5

Introduction

  • Marginal costing focuses on the change in total cost resulting from adding one more unit to output.
  • This unit could refer to a single item or a method of production itself.
  • It is not a cost ascertainment method like job or contract costing but is a technique used alongside these methods.
  • Marginal costing is valuable for management's decision-making processes.
  • Synonyms for marginal costing include direct costing, differential costing, incremental costing, and comparative costing.
  • Only variable costs are considered; fixed costs are treated as period costs and charged to the profit and loss account.

Objectives

  • Explain the meaning and features of marginal costing.
  • List the advantages and limitations of marginal costing.
  • Describe how marginal costing is applied in practice.

Meaning and Definitions of Marginal Costing

  • Marginal cost is the extra cost of producing one more unit at each production level.
  • It varies with production level and time period.
  • Marginal costing is a technique to determine the marginal or variable cost of a product.
  • Accountants' marginal cost differs from economists'; economists include an element of fixed cost.
  • Economists' marginal cost may not be uniform due to diminishing or increasing returns, while accountants' marginal cost is constant per unit.
  • ICWA defines marginal cost as the aggregate cost change when output increases or decreases by one unit.
  • Elements to ascertain marginal cost:
    • Direct materials
    • Direct labor
    • Other direct expenses
    • Total variable overheads
  • MarginalCost=PrimeCost+TotalVariableOverheadsMarginal Cost = Prime Cost + Total Variable Overheads
  • MarginalCost=TotalCost−FixedCostMarginal Cost = Total Cost - Fixed Cost
  • Dr. Joseph: Marginal costing determines the change in aggregate costs due to a one-unit increase over existing production.
  • Batty: Marginal costing is a technique that pays special attention to cost behavior with output changes.
  • Example:
    • 800 units @ Rs. 5 variable cost = Rs. 4,000
    • Fixed cost = Rs. 1,000
    • Total cost = Rs. 5,000
    • If production increases to 801 units, the variable cost becomes Rs. 4,005, total cost Rs. 5,005.
    • Marginal cost of one unit: Rs. 5
  • Fixed costs do not change with production volume within a certain range and are also known as period costs.
  • Variable costs vary directly with the production volume.
  • Principles of marginal costing:
    • Fixed costs are constant for a given period.
    • Selling an extra product increases revenue, variable cost per unit increases costs, and contribution increases profit.
    • Decreasing sales volume decreases profits by the contribution amount.
    • Profits are measured based on total contribution.
    • Units of sale should not be charged with a share of fixed costs.
    • Extra production costs form variable production costs.
    • Fixed costs remain unaffected even when output increases.
  • Marginal costing can be used for pricing and make-or-buy decisions.
  • Companies can manufacture components or buy them from the market.
  • Decisions depend on free capacity and profitability.

Features of Marginal Costing

  • Marginal costing informs managerial decisions related to production, cost, and sales policies.
  • Distinction between variable and fixed costs.
  • Inventory/stock is evaluated at marginal cost to measure profit, unlike absorption costing where it's at total unit cost.
  • Decisions based on marginal contribution (sales less marginal cost).
  • It's a technique for analysis and presentation of cost data used with other costing methods.
  • Fixed and variable costs are separated at every stage; semi-variable costs are also split.
  • Fixed costs are excluded from product cost or cost of sales as they are period costs.
  • Finished goods and work-in-progress are valued at variable costs only.
  • Fixed costs are charged to the profit and loss account in the period they incur.
  • Marginal income or marginal contribution represents income or profit.
  • Net profit or loss is the result of contribution less fixed costs.
  • Fixed costs remain constant irrespective of activity level.
  • Sales price and variable cost per unit remain constant.
  • Cost-Volume-Profit (CVP) relationship is used to show profitability at different activity levels.
  • Prices are based on marginal costs plus contribution.
  • Example: Johnson Tires increased production from 10,000 to 15,000 units, increasing costs from $5 million to $7.5 million. The marginal cost per additional unit is 500 ($2,500,000 / 5,000).

Advantages of Marginal Costing

  • Helps management make decisions by providing information on cost behavior and its impact on profitability.
  • It's a technique used to aid management decision-making.
  • Also known as Direct Costing, Variable Costing, Differential Costing, or Out-of-Pocket Costing.
  • Performance appraisal: Contribution analysis facilitates the evaluation and comparison of profitability and efficiency.
  • Constant in nature: Marginal costs remain stable irrespective of production volume.
  • Effective cost control: Management can easily control costs as fixed costs are excluded and cost drivers are known.
  • Treatment of overheads simplified: Reduces over or under-recovery of overheads.
  • Uniform and realistic valuation: Valuation of work-in-progress and finished goods becomes more realistic.
  • Helpful to management: Helps start new production lines, determine whether to make or buy a product, and make pricing and tendering decisions.
  • Helps in production planning: Shows profit at every output level using CVP relationship via break-even charts.
  • Better results when used with standard costing.
  • Fixation of selling price: Helps determine selling prices.
  • Helpful in budgetary control: Classification of expenses is helpful in budgeting.
  • Preparing tenders: Total variable cost becomes the 'floor price' for bidding.
  • ‘Make or Buy’ decision: Helps decide whether to manufacture or buy components.
  • Reporting cost data: Statements and graphs are better understood by management executives.

Limitations of Marginal Costing

  • Negligence of time factor: Time is not considered as fixed expenses connected with time are excluded.
  • Difficulty to analyze overheads: Separating costs into fixed and variable is challenging.
  • Unrealistic assumption: Assumes constant sale price at different operation levels.
  • Difficulty in price fixation: Selling price is fixed on contribution basis, difficult for cost-plus contracts.
  • Incomplete information: Doesn't explain increases in production or sales.
  • Significance lost: Less significant in capital-intensive industries where fixed costs dominate.
  • Problem of variable overheads: Overcomes fixed overhead issues but variable overheads remain.
  • Sales-oriented: Criticized for being sales-oriented, giving less importance to production.
  • Unreliable stock valuation: Stock is valued at variable cost only, leading to lower profit determination.
  • Claim for loss of stock: May lead to unfavorable insurance claims.
  • Automation: Increasing automation increases fixed costs, which might be ignored.
  • Suitable only for short-term assessment of profitability: Absorption costing is better for long-term assessment.
  • Marginal costing is more effective when combined with standard costing and budgetary control.

Absorption Costing

  • Ascertaining cost per unit of goods produced or service rendered.
  • Charging all costs, both fixed and variable, to operations, processes, or products.
  • Also called full costing.
  • Administrative, selling, and distribution overheads form part of total cost.
  • Features:
    • Ascertaining cost per unit.
    • Traditional technique.
    • All costs are allocated to cost units.
    • Inventories are valued at full cost.
    • Profits may not have a direct relationship to sales.
  • Advantages:
    • Includes fixed costs, giving a better idea of total production costs.
    • Managers are more aware of total costs.
    • Concepts of over and under absorption offer insights on effective resource use.
    • Widely used and accepted by accounting standards boards.

Differences between Absorption and Marginal Costing

  • Absorption costing charges all costs to the product, while marginal costing charges only variable costs.
  • Profit calculation differs: Absorption Costing uses Profit=Sales−CostofGoodsSoldProfit = Sales - Cost of Goods Sold, Marginal Costing uses ContributionMargin=Sales−VariableCostContribution Margin = Sales - Variable Cost and Profit=Contribution−FixedCostsProfit = Contribution - Fixed Costs
  • Absorption costing does not reveal the cost volume profit relationship.
  • Closing inventories are valued at full cost in absorption costing and at variable cost in marginal costing.
  • Marginal costing may reveal less profit compared to absorption costing due to inventory valuation.
  • Absorption costing can lead to over- or under-absorption; marginal costing avoids this for fixed costs.
  • Net profits differ due to:
    • Over- and under-absorbed overheads.
    • Difference in stock valuation.
  • Profit differences due to stock valuation:
    • Profits will not differ if there are no opening and closing stocks, and fixed cost element is the same.
    • Profits higher under absorption costing if closing stock is higher than opening stock.
    • Profits lower under absorption costing if closing stock is less than opening stock.
  • Key distinctions:
    • Absorption costing includes a 'fair share' of fixed production overhead in stock items; marginal costing uses variable production cost.
    • Absorption costing carries fixed production overheads forward in closing stock values.
    • Marginal costing is period costing, charging the actual fixed costs to the profit and loss account.
    • Absorption minimizes unit costs by producing greater quantities; marginal costing is unaffected by production volume.
  • Marginal costing allows management to identify variable costs and contribution for decision-making.
  • Absorption costing does not easily show the effects on profit from changes in production and sales volume.

Presentation of Cost Data

  • Marginal costing presents sales and cost data for decision-making.
  • Total cost technique (absorption costing) is traditional but less useful in calculating profits.
  • Marginal cost statements help determine the difference between variable and fixed costs.
  • Marginal Costing Pro-Forma:
    • Sales revenue
    • Less marginal cost of sales:
      • Opening stock (valued @ marginal cost)
      • Add production cost (valued @ marginal cost)
      • Total production cost
      • Less closing stock (valued @ marginal cost)
      • Marginal cost of production
      • Add selling, admin, and distribution cost
      • Marginal cost of sales
    • Contribution
    • Less fixed cost
    • Marginal costing profit
  • Absorption Costing Pro-Forma:
    • Sales revenue
    • Less absorption cost of sales:
      • Opening stock (valued @ absorption cost)
      • Add production cost (valued @ absorption cost)
      • Total production cost
      • Less closing stock (valued @ absorption cost)
      • Absorption cost of production
      • Add selling, admin, and distribution cost
      • Absorption cost of sales
    • Un-adjusted profit
    • Fixed production O/H absorbed
    • Fixed production O/H incurred
    • (Under)/over absorption
    • Adjusted profit
  • Reconciliation statement:
    • Marginal costing profit
    • Add (Closing stock – opening Stock) x OAR
    • = Absorption costing profit
    • Where OAR=BudgetedFixedProductionOverheadBudgetedLevelsofActivitiesOAR = \frac{Budgeted Fixed Production Overhead}{Budgeted Levels of Activities}