Marginal costing, as one of the tools of management accounting helps management in making certain decisions. It provides management with information regarding the behavior of costs and the incidence of such costs on the profitability of an undertaking. Marginal costing is defined as “the ascertainment of marginal costs and of the effect on profit of changes in volume or type of output by differentiating between fixed costs and variable costs”.
Marginal costing is not a separate costing. It is only a technique used by accountants to aid management decision. It is also called as “Direct Costing” in U.S.A. This technique of costing is also known as “Variable Costing”, “Differential Costing” or “Out-of-pocket” costing. Marginal cost is the cost of one unit of product or service which would be avoided if that unit were not produced or provided.
According to CIMA Terminology Marginal Costing is the ascertainment of marginal costs and of the effect on profit of changes in volume or type of output by differentiating between fixed costs and variable costs in this technique of costing only variable costs are charged to operations, processes or products leaving all indirect costs to be written off against profits in the period in which they arise.
Thus marginal costing is the accounting system in which variable costs are charged to cost units and fixed costs of the period are written-off in full against the aggregate contribution. Its special value is in decisionmaking. It is a technique of applying the existing methods in a particular manner in order to bring out the relationship between profit and volume of output.
Features of Marginal Costing
Advantages of Marginal Costing
Limitations of Marginal Costing
Marginal costing technique has the following limitations:
Thus the above limitations indicate that fixed costs are equally important in certain cases.
Factor affecting, Criticism, Impact
Criticism against Marginal Costing:
The criticism levelled against marginal costing is summarized below:
(a) 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.
(b) The misuse of marginal costing approach may result in setting selling prices which do not allow 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.
(c) The main assumption of marginal costing is that variable cost per unit will be same at any level of activity. This is only 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 productivity of men and materials etc.
(d) 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 increments 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 of office-premises, warehouses taken on lease may be given-up etc.
(e) 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.
(f) Exclusion of fixed overheads from costs may lead to erroneous conclusions. It may create problems in inter-firm comparison, higher demand for salaries and other benefits by employees, higher demand for tax by the Government authorities etc.
(g) 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.
(h) The income-tax authorities do not recognize the marginal cost for inventory valuation.
Absorption Costing and Marginal Costing: Impact on Profit:
In absorption costing, stock is valued at total cost while in marginal costing stock valuation is done at variable cost only. This means that in absorption costing, stock valuation is higher than in marginal costing. When production exceeds sales, profit under absorption costing is higher than that of marginal costing. But when sales exceed production, profit under absorption costing is lower than that of marginal costing.
Absorption costing is a principle whereby fixed, as well as, variable costs are allotted to cost units and total overheads are absorbed according to activity level. Absorption costing confirms with the accrual concept by matching costs with revenue for a particular accounting period. Stock valuation complies with the accounting standard and fixed production costs are absorbed into stocks.
Absorption costing method avoids separation of costs into fixed and variable elements, which is not easily and accurately achieved. Cost plus pricing under absorption costing ensures that all costs are covered.
Pricing at the marginal cost may, in the long-run, result in failing to cover the fixed costs. It is important to note that in absorption costing sales must be equal to or exceed the budgeted level of activity otherwise fixed costs will be under absorbed.
The absorption of production overheads under absorption costing has the following impacts:
(i) When production exceeds sales during the period, a higher profit is shown under absorption costing, since the fixed overhead is absorbed over more number of units produced, and carried to next accounting period along with closing inventory.
(ii) When sales are in excess of production, a lower profit is reported under absorption costing. Since, less portion of fixed production overhead is recovered in valuation of closing stock and current period’s cost of production is higher.
The following generalizations to be made on the impact on profit of these two different methods of costing:
(a) Where sales and production levels are constant through time, profit is the same under the two methods.
(b) Where production remains constant but sales fluctuate, profit rises or falls with the level of sales, assuming that costs and prices remain constant, but the fluctuations in net profit figures are greater with marginal costing than with absorption costing.
(c) Where sales are constant but production fluctuates, marginal costing provides for constant profit, whereas under absorption costing, profit fluctuates.
(d) Where production exceeds sales, profit is higher under absorption costing than under marginal costing for the reason that absorption of fixed overheads into closing stock increases their value thereby reducing the cost of goods sold.
(e) Where sales exceeds production, profit is higher under marginal costing. The fixed costs, which previously were part of stock values, are now charged against revenue under absorption costing. Therefore, under absorption costing the value of fixed costs charged against revenue is greater than that incurred for the period.
The choice between using absorption costing and marginal costing will be determined by the following factors:
(a) The system of financial control in use e.g., responsibility accounting is inconsistent with absorption costing.
(b) The production methods in use e.g., marginal costing is favoured in simple processing situations in which all products receive similar attention; but when different products receive widely differing amounts of attention, the absorption costing may be more realistic.
(c) The significance of prevailing level of fixed overhead costs.
Marginal Costing Practical Questions and Answers
A company producing 500 units its variable cost $200 per unit and sale price 250 per unit, fixed expenses are $12,000 per month.
Calculate BEP in units and sales and show profit at 90% capacity.
(i). BEP (units) = Fixed Expenses / C
= ($5,42,000 + $2,52,000) / 6
= 7,92,000 / 6 = 1,32,000 units
BEP (Sales) = 1,32,000 x 20 = $26,40,000
(ii) Sales for examining profit $60,000
BEP (units) = (Fixed Exp. + Desired Profit) / C
= (7,92,000 + 60,000) / 6
= 8,52,000 / 6
= 1,42,000 units
BEP Sales = 1,42,000 x 20 = $28,40,000
How would you calculate the following:
(i). PVR (ii). BEP (Sales) (iii). Margin of Safety (iv). Profit
When sales are $80,000, variable costs $4,000 and Fixed Costs $ 4,000.
(i). PVR = (C / $) x 100 = (4,000 x 100) / 8,000 = 50%
C = 8,000 – (4,000) = $4,000
(ii). BEP (Sales) = Fixed Cost / PVR
= (4,000 x 100) / 50
(iii). MOS = Actual Sales – BEP Sales
= 8,000 – 8,000
MOS = Profit / PVR = 0 / 8,000 = Nil
(iv). Profit = Sales – Variable Cost – Fixed Cost
= 8,000 – 4,000 – 4,000
From the following information find out sales at BEP and PVR
Variable cost per unit = $15
Sales per unit = $20
Fixed expenses = $54,000
What should be the new selling price if BEP unit is brought down to 6,000 units.
PVR = (C x 100) / S
= ((20 – 15) x 100) / 20
PVR = 25%
BEP (Sales) = Fixed expenses / PVR
= (54,000 x 100) / 25
New selling price if BEP is brought down to 6,000 units.
New SP = (Fixed Exp. + Variable Cost ) / New BEP (units)
= (54,000 + 15) / 6,000
Calculate (i). PV Ratio (ii) BEP (iii) Margin of Safety when:
Sales = $1,00,000
Total Cost = $80,000
Fixed Cost = $20,000
Net Profit = 80,000
(i). PVR = (C x 100) / S
C = Sales – Variable Cost
1,00,000 – 60,000 = 40,000
Variable cost = Sales – Profit – Fixed Cost
(1,00,000 – 20,000 – 20,000) = 60,000
PVR = (C / S) x 100
= (40,000 / 1,00,000) x 100
(ii). BEP = Fixed Exp. / PVR
= 20,000 / 40%
= (20,000 x 100) / 40
(iii). Margin of Safety = Present Sales – Break-Even Sales
= 1,00,000 – 50,000
Profitability = (40 x 50,000) / 100
The National Company has just been formed. They have a patented process which will make them the sole suppliers of Product A. During the first year the capacity of their plant will be 9,000 units and this is the amount they will be able to sell. Their costs are:
Direct Labor = $15 per unit
Raw material = $5 per unit
Other variable costs = $10 per unit
Fixed costs = $2,40,000
(a). If the company wishes to make a profit of 2,10,000 during the first year, what should be the selling price? What is the contribution margin at this price?
(b). If at the end of first year, they wish to increase their volume and an increase or $1,00,000 in the annual fixed costs will increase their capacity to 50,000 units, how many units will they have to sell to realise a profit of $7,60,000, if their selling price is $70 per unit and no other costs change, except that invest $5,00,000 in advertising with a view to achieve this end?
(a). Calculation of selling price
Direct labor (9,000 x 15) = $1,35,000
Raw material (9,000 x 5) = $45,000
Other variable costs (9,000 x 10) = $90,000
Total variable costs (PU 30) = 2,70,000
Add: Fixed Cost = 2,40,000
Profit = 2,10,000
Total sale value of 9,000 units @ $80 per unit = 7,20,000
(b). Sales in Units
(Fixed expenses + Desired profit) / (Sales – Variable cost)
Fixed Expenses = 2,40,000 (given) + 1,00,000 (extra) + 50,000 (advertisement cost)
= 8,40,000 + Desired Profit (7,60,000) = $16,00,000
= 16,00,000 / (70 – 30) = 40,000 units