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
Marginal Cost = Prime Cost + Total Variable Overheads
Marginal 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.