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Marginal Costing
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

1. Costs are separated into the fixed and variable elements and semi-variable costs are also differentiated like wise.
2. Only the variable costs are taken into account for computing the value of stocks of work-in-progress and finished products.
3. Fixed costs are charged off to revenue wholly during the period in which they are incurred and are not taken into account for valuing product cost/inventories.
4. Prices may be based on marginal costs and contribution but in normal circumstances prices would cover costs in total.
5. It combines the techniques of cost recording and cost reporting.
6. Profitability of departments or products is determined in terms of marginal contribution.
7. The unit cost of a product means the average variable cost of manufacturing the product.

Advantages of Marginal Costing 

1. Cost-volume-profit relationship data wanted for profit planning purposes is readily obtained from the regular accounting statements. Hence management does not have to work with two separate sets of data to relate one to the other.
2. The profit for a period is not affected by changes in absorption of fixed expenses resulting from building or reducing inventory. Other things remaining equal (e.g. selling prices, costs, sales mix), profits move in the same direction as sales when direct costing is in use.
3. Manufacturing cost and income statements in the direct cost form follow management’s thinking more closely than does the absorption cost form for these statements. For this reason, management finds it easier to understand and use direct cost reports.
4. The impact of fixed costs on profits is emphasised because the total amount of such cost for the period appears in the income statement.
5. Marginal income figures facilitate relative appraisal of products, territories, classes of customers, and other segments of the business without having the results obscured by allocation of joint fixed costs.
6. Marginal costing lies in with such effective plans for cost control as standard costs and flexible budgets.
7. Marginal costing furnishes a better and more logical basis for the fixation of sales prices as well as tendering for contracts when business is at low ebb.
8. Break-even point can be determined only on the basis of marginal costing.

Limitations of Marginal Costing
Marginal costing technique has the following limitations:

1. In marginal costing, costs are classified into fixed and variable. Segregation of costs into fixed and variable is rather difficult and cannot be done with precision.
2. Marginal costing assumes that the behaviour of costs can be represented in straight line. This means that fixed costs remains completely fixed over a period at different levels and variable costs change in linear pattern i.e. the change is proportion to the change in volume. In real life, fixed costs are liable to change at varying levels of production especially when extra plant and equipments are introduced and hence variable costs may not vary in the same proportion as the volume.
3. Under marginal costing technique fixed costs are not included in the value of stock of finished goods and work-in-progress. As fixed costs are incurred, these should also form part of the costs of the product. Due to this elimination of fixed costs from finished stock and work-in-progress, the stocks are understated. This affects the results of profit and loss account and the balance sheet. Thus, profit may be unnecessarily deflated.
4. In the marginal costing system monthly operating statements will not be as realistic or useful as under the absorption costing system. This is because under this system, marginal contribution and profits vary with change in sales value. Where sales are occasional, profits fluctuate from period to period.
5. Marginal costing fails to give complete information, for example rise in production and sales may be due to extensive use of existing machinery or by expansion of the resources or by replacement of the labour force by machines. The marginal contribution of P/V ratio fails to bring out reasons for this.
6. Under marginal costing system the difficulties involved in the apportionment and computation of under and over absorption of fixed overheads are done away with but problem still remains as far as the under absorption or over absorption of variable overheads is concerned.
7. Although for short term assessment of profitability marginal costs may be useful, long-term profit is correctly determined on full costs basis only.
8. Marginal costing does not provide any standard for the evaluation of the performance. Marginal contribution data do not reveal many effects which are furnished by variance analysis. For example, efficiency variance reflects the efficient and inefficient use of plant, machinery and labour and this sort of valuation is lacking in the marginal cost analysis.
9. Marginal costing analysis assumes that sales price per unit will remain the same on different levels of production but these may change in real life and give unrealistic results.
10. In the age of increased automation and technology advancement, impact of fixed costs on product is much more than that of variable costs. As a result a system that does not account the fixed costs is less effective because a substantial portion of the cost is not taken into account.
11. Selling price under the marginal costing technique is fixed on the basis of contribution. This may not be possible in the case of ‘cost plus contracts’.

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

Question 1.
A company producing 500 units its variable cost $200 per unit and sale price 250 per unit, fixed expenses are $12,000 per month.
Required
Calculate BEP in units and sales and show profit at 90% capacity.
Answer:
(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

Question 2
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.
Answer
(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
= $8,000
(iii). MOS = Actual Sales – BEP Sales
= 8,000 – 8,000
= Nil
Or
MOS = Profit / PVR = 0 / 8,000 = Nil
(iv). Profit = Sales – Variable Cost – Fixed Cost
= 8,000 – 4,000 – 4,000
= Nil

Question 3
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.
Answer :
PVR = (C x 100) / S
Thus,
= ((20 – 15) x 100) / 20
PVR = 25%
BEP (Sales) = Fixed expenses / PVR
= (54,000 x 100) / 25
= $2,16,000
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
= $24

Question 4
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
Answer:
(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
Thus,
PVR =  (C / S) x 100
= (40,000 / 1,00,000) x 100
= 40%
(ii). BEP = Fixed Exp. / PVR
= 20,000 / 40%
= (20,000 x 100) / 40
= $50,000
(iii). Margin of Safety = Present Sales – Break-Even Sales
= 1,00,000 – 50,000
= 50,000
Profitability = (40 x 50,000) / 100
= $20,000

Question 5
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?
Answer:
(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)
Thus,
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