MARGINAL
COSTING
INTRODUCTION
Marginal costing
is a technique of costing. It is widely used by management in profit planning,
cost control and decision making.
Marginal Cost
Marginal cost is the change in total cost when the output
is increased by one unit. The ICMA, England
Thus
marginal cost of Nth unit = Total Cost of Nth unit – Total Cost of N -1 unit.
Since Fixed
costs remain constant at different levels of output, the change in total cost
when the output is increased by unit is the variable cost of producing that
additional unit. Therefore, marginal cost is the variable cost of production of
one unit of output. It comprises of prime cost and variable overheads.
MC = Dir.
Material + Direct Labour + Other Variable Costs
Marginal costing
Marginal costing is defined by the ICWA, India
Features of Marginal Costing/ Assumptions of Marginal
Costing
The following are the special features of Marginal Costing:
- All
elements of costs can be divided into fixed and variable. Semi – Variable
costs are also separated into fixed and variable elements.
- Variable
cost per unit remains constant irrespective of level of output and
fluctuates directly in proportion to changes in the volume of output.
- Fixed
costs remains constant irrespective of the level of activity.
- Only
variable costs are considered as the cost of the product and are charged
to products, processes or outputs. Fixed costs are treated as ‘period costs’ and they are charged to profit and loss
account during the period in which they are incurred.
- The work –
in – progress and finished stocks are valued at marginal cost only.
- The
relative profitability of the products or departments is based on the “contribution” they give. Contribution is the difference between
sales and marginal cost.
- The
selling price per unit remains the same at all levels
of output.
Advantages of Marginal Costing
The following are the advantages of marginal costing
technique:
1. Simplicity
The concept of marginal costing can be easily understood as it breaks up the cost as variable and
fixed.
2. Stock Valuation
Stock valuation cab be easily done and understood as it
includes only the variable cost.
3. Meaningful Reporting
Marginal costing serves as a good basis for reporting to
management. The profits are analyzed from the point of view of sales rather
than production.
4. Effect on Fixed Cost
The fixed costs are treated as period costs and are charged
to Profit and Loss Account directly. Thus, they have practically no effect on
decision making.
5. Profit Planning
The Cost – Volume Profit relationship is perfectly analysed
to reveal efficiency of products, processes, and departments. Break – even
Point and Margin of Safety are the two important concepts helpful in profit
planning.
6. Cost Control and Cost Reduction
Marginal costing technique is helpful in preparation of
flexible budgets as the costs are classified into fixed and variable. The
emphasis is laid on variable cost for control. The constant focus is on cost
and volume and their effect on profit pave the way for cost reduction.
7. Pricing Policy
Marginal costing is immensely helpful in determination of
selling prices under different situations like recession, depression,
introduction of new product, etc. Correct pricing can be developed under the
marginal costs technique with the help of the cost information revealed
therein.
8. Helpful to Management
Marginal costing is helpful to the management in exercising
decisions regarding make or buy, exporting, key factor and numerous other
aspects of business operations.
Limitations of Marginal Costing
Marginal costing has the following
limitations:
1.Difficulty
in Classification: In
marginal costing, costs are segregated into fixed and variable. In actual
practice, this classification scheme proves to be superfluous in that, certain
costs may be partly fixed and partly variable and certain other costs may have
no relation to volume of output or even with the time. In short, the
categorisation of costs into fixed and variable elements is a difficult and
tedious job.
2.Difficulty
in Application: The
marginal costing technique cannot be applied in industries where large stocks
in the form of work-in-progress (job and contracting firms) are maintained.
3.Defective
Inventory Valuation:
Under marginal costing, fixed costs are not included in the value of finished
goods and work in progress. By eliminating fixed costs from finished stock and
work-in-progress, marginal costing techniques present stocks at less than their
true value. 2. Profits will be lower than that shown under absorption costing
and hence may be objected to by tax authorities.
4. Misleading
Financial Statements: The balance sheet may not present a true and fair
view of the state of financial affairs of the business.
5. Wrong
Basis for Pricing: In
marginal costing, sales prices are arrived at on the basis of contribution
alone. This is not appropriate especially in the long run.
5. Limited
Scope: Marginal
costing is useful in the short-run
profit planning and decision-making.
Marginal Costing and Absorption Costing
Absorption costing charges all the costs i.e., both the
fixed and variable fixed to the products, jobs, processes, and operations.
Marginal costing technique charges variable cost. Absorption costing is not any
specific method of costing. It is common name for all the methods where the
total cost is charged to the output.
Absorption Costing is defined by I.C.M.A, England
Distinction between Absorption Costing and Marginal Costing
Absorption Costing
|
Marginal Costing
|
1. Total cost technique is the practice of charging all
cost, both variable and fixed to operations, process or products.
|
1. Marginal costing charges only
variable cost to products, process, or operations and
excludes fixed cost entirely.
|
2. It values stock at the cost which includes fixed cost
also.
|
2. It values stock at total variable cost only. This
results in higher value of excess of sales over the total costs in solving
managerial problems
|
3. It is guided by profit which is the
|
3. It focuses its attention on
Contribution which is excess of sales over variable cost.
|
4. In total cost technique, there is a problem of
apportionment of fixed costs which may result in under or over recovery of
expenses.
|
4.It excludes fixed cost. Therefore, there is no question
of arbitrary apportionment.
|
The difference between marginal costing and absorption
costing is shown with the help of the following examples.
Contribution
The difference
between selling price and variable cost (or marginal cost) is known as
`Contribution’ or `Gross Margin’. It may be considered as some sort of fund
from out of which all fixed costs are met. The difference between contribution
and fixed cost represents either profit or loss, as the case may be.
Contribution is calculated thus:
Contribution = Selling price – Variable
cost, = Fixed Cost + Profit or – Loss
Marginal Cost Equation
Marginal Cost
Equation can be expressed thus:
S – V = C, C = F + P and in case of loss C = F – L
Profit Volume Ratio (P/V Ratio)
The
profitability of business operations can be found out by calculating the P/V
Ratio. It shows the relationship between contribution and sales and is usually
expressed in percentage. It is also known as `marginal-income ratio’,
`contribution-sales ratio’ or `variable-profit ratio’. P/V Ratio thus is the
ratio of contribution to sales, and is calculated thus:
P/V Ratio = Contribution / Sales
The ratio can
also be shown by comparing the change in contribution to change in sales, or
change in profit to change in sales. Any increase in contribution, obviously,
would mean increase in profit, as fixed expenses are assumed to be constant at
all levels of production.
P/V Ratio=Change
in Contribution/Change in Sales=Change in Profit/Change in Sales
The importance
of P/V Ratio lies in its use for evaluating the profitability of alternative
products, proposals or schemes. A higher ratio shows greater profitability.
Management should, therefore, try to increase P/V ratio by widening the gap
between the selling price and the variable costs. This can be achieved by
increasing sale price, reducing variable costs or switching over to more
profitable products.
Marginal Cost Statement
In marginal costing, a statement of marginal cost and
contribution is prepared to ascertain contribution and profit. In this
statement, contribution is separately calculated for each of the product or
department. These contributions are totaled up to arrive at the total
contribution. Fixed cost is deducted from the total contribution to arrive at
the profit figure. No attempt is made to apportion fixed cost to various
products or departments.
Marginal Cost Statement Rs.
Sales xxxxx
Less: Variable Cost (xxxx)
-----
Contribution xxxxx
Less: Fixed Cost (xxxx)
-----
Profit / Loss xxxx
-----
Differential Costing
The concept of differential cost is a relevant cost concept
in those decision situations which involve alternative choices. It is the
difference in the total costs of two alternatives. This helps in decision
making. It can be determined by subtracting the cost of one alternative from
the cost of another alternative. Differential costing is the change in the
total cost which results from the adoption of an alternative course of action.
The alternative may arise on account of sales, volume, price change in sales
mix, etc decisions. Differential cost analysis leads to more correct decisions
than more marginal costing analysis. In this technique the total costs are
considered and not the cost per unit. Differential costs do not form part of
the accounting system while marginal costing can be adapted to the routine
accounting itself. However, when decisions involve huge amount of money
differential cost analysis proves to be useful.
Differential cost is generally confused with marginal cost.
Of course, these two techniques are similar in some aspects but these also
differ in certain other respects.
Similarities
(i) Both the differential cost analysis and marginal cost
analysis are based on the classification of cost into fixed and variable. When
fixed costs do not change, both differential and marginal costs are same.
(ii) Both are the
techniques of cost analysis and presentation and are used by the management in
formulating policies and decision making.
Dissimilarities
(i) Marginal cost may be incorporated in the accounting
system where as differential cost are worked out for reporting to the
management for taking certain decisions.
(ii) Entire fixed cost are excluded from costing where as
some of the relevant fixed costs may be included in the differential cost
analysis.
(iii) In marginal costing, contribution and p/v ratio are
the main yardstick for evaluating performance and decision making. In
differential cost analysis emphasis is made between differential cost and
incremental or decremental revenue for making policy decisions.
(iv) Differential cost analysis may be used in absorption
costing and marginal costing.
Break-even analysis
Break-even
analysis is a specific method of presenting and studying the inter relationship
between costs, volume and profits. (Hence, the name C-V-P Analysis). It is an
important tool of financial analysis whereby the impact on profit of the
changes in volume, price, costs and mix can be found out with a certain amount
of accuracy. A business is said to break even when its total sales are equal to
its total costs. It is a point of no profit or no loss. At this point
contribution is equal to fixed costs.
Fixed Costs
Break-Even Point (in units) = ------------------------
Contribution per unit
Fixed Costs
Break-Even Point (in Rupees) = ------------- (OR)
P/V Ratio
Fixed Costs x Sales
Break-Even Point (in Rupees) = ------------- ----------
Contribution Margin
BREAK-EVEN CHART
The break-even
point can also be shown graphically through the break-even chart. The
break-even chart `shows the profitability or otherwise of an undertaking at
various levels of activity and as a result indicates the point at which neither
profit nor loss is made’. It shows the relationship, through a graph, between
cost, volume and profit. The break-even point lies at the point of intersection
between the total cost line and the total sales line in the chart.
Angle of Incidence
This is the angle of intersection between the sales line
and the total cost line. The larger the angle the greater is the profit or
loss, as the case may be.
Margin of Safety
This is the difference between the actual sales level and
the break even sales. It represents the “cushion” for the company. The larger
the distance between the break even sales volume and the actual sales volume,
the company can afford to allow the fall in sales without the danger of
incurring losses. If the margin of safety is low, even a small fall in the
sales volume will drive the company into the loss area. It should be noted that
beyond the break even point all contribution (Sales – Marginal Cost) will
directly increase the profits.
Margin of safety = Actual Sales - Break-even Sales
The effect of a price reduction will always reduce the P /
V ratio, raise the break – even point shorten the margin of safety.
CONSTRUCTION OF BREAK-EVEN CHART
The following steps are required to be
taken while constructing the break-even chart:
1. Sales volume is plotted on the X-axis.
Sales volume can be shown in the form of
rupees, units or as a percentage of capacity. A horizontal line is drawn
spacing equal distances showing sales at various activity levels.
2. Y axis represents revenues, fixed and
variable costs. A vertical line is also spaced in equal parts.
3. Draw the
sales line from point O onwards. Cost lines may be drawn in two ways (i) Fixed
cost line is drawn parallel to X axis and above it variable cost line is drawn
from zero point of fixed cost line. This line is called the Total cost line
(ii) In the second method the variable cost line is drawn from point O and
above this, fixed cost line is depicted running parallel to the variable cost
line. This line may be called Total cost line.
4. The point at which the total cost cuts
across the sales line is the break-even point and volume at this point is break-even
volume.
5. The angle of
incidence is the angle between sales and the total cost line. It is formed at
the intersection of the sales and the total cost line, indicating the profit
earning capacity of a firm. The wider the angle the greater is the profit and
vice versa. Usually, the angle of incidence and the margin of safety are
considered together to show that a wider angle of incidence coupled with a high
margin of safety would indicate the most suitable conditions.
Cash Break-Even Chart
It is the level of output or sales where
the cash inflow will be equivalent to
cash needed to
meet immediate cash liabilities. Fixed expenses are to be classified as those
involving cash payments and those not involving cash payments like
depreciation. Cash break-even point can be calculated thus:
Cash Break-even Point (of output)
Cash fixed costs
=
-----------------------------
Cash contribution per unit
Illustration
10: The following
information is available in respect of Graphics Ltd. Ghaziabad, for the budget
period.
Sales- 10,000
units at Rs.10 per unit.
Variable costs
Rs.4 per unit.
Fixed costs
Rs.25,000 including depreciation of Rs.5,000
Preference
Dividend to be paid Rs.5,000
Taxes to be paid
Rs.5,000
Prepare a cash break-even chart.
Composite Break-even Point
Where a firm is
dealing with several products, a composite breakeven point can be calculated
using the following formula:
Composite Break-even point (Sales)
Cash fixed costs
= ----------------------------------
Composite P/V Ratio
Total Fixed Costs x Total Sales
or =
--------------------------------------
Total Contribution
Total Contribution
or = ------------------------- x 100
Total Sales
PROFIT VOLUME GRAPH
Profit volume graph is a pictorial representation of the
profit volume relationship. It shows profit and loss account at different
volumes of sales. In this
graph X axis represents sales. However, the sales line bisects the graph
horizontally to form two areas. The ordinate above the zero sales line, shows
the profit area, and the ordinate below the zero sales line indicates the loss
or the fixed cost area. The profit-volume-ratio line is drawn from the fixed
cost point through the break-even point to the point of maximum profit. In
order to construct this graph, therefore, data on profit at a given level of
activity, the break-even point and the fixed costs are required.
COST-VOLUME-PROFIT (CVP) ANALYSIS
The relationship between cost, volume and profit is
explained in CVP analysis. Break even analysis is alternatively called as CVP
analysis also. But it is said that the study up to the state of equilibrium is
called as break even analysis and beyond that point we term it as CVP analysis.
Cost – Volume Profit analysis helps the management in profit planning or
deciding the volume of sales required to earn a particular level of profit.
APPLICATION OF MARGINAL COSTING
The following are some of the managerial decisions which
are taken with the help of marginal costing decisions:
- Fixation
of selling price under different market conditions.
- Profit
planning
- whether to
accept a special offer or not
- whether to
accept an export offer or not
- Make or
buy decision
- Selection
of a suitable product mix or sales mix.
- decision
making under a Key factor
- Alternative
methods of production.
- Suspending
activities or closing down of a
department
- replace a
product by another one
- merger of
plant capacities
- shut down
vs. statusquo
- whether to
sell or further process
1. Profit Planning
Profit planning is the planning of the future operations to
attain maximum profit or to maintain level of profit. Whenever there is a
change in sale price, variable costs and product mix, the required volume of
sales for maintaining or attaining a desired amount of profit may be
ascertained with the help of P / V ratio.
Fixed Cost + Profit
Expected Sales = -------------------------
P / V Ratio
2. Introduction of a New Product
Sometimes, a
product may be added to the existing lines of products with a view to utilise
idle facilities, to capture a new market or for any other purpose. The
profitability of this new product has to be found out initially. Usually, the
new product will be manufactured if it is capable of contributing something
toward fixed costs and profit after meeting its variable costs.
3. Level of Activity Planning
Marginal costing
is of great help while planning the level of activity. Maximum contribution at
a particular level of activity will show the position of maximum profitability.
4. Key Factor
A concern would
produce and sell only those products which offer maximum profit. This is based
on the assumption that it is possible to produce any quantity without any
difficulty and sell likewise. However, in actual practice, this seems to be
unrealistic as several constraints come in the way of manufacturing as well as
selling. Such constraints that come in the way of management’s efforts to
produce and sell in unlimited quantities are called `key factors’ or `limiting
factors’. The limiting factors may be materials, labour, plant capacity, or
demand. Management must ascertain the extent of the influence of the key factor
for ensuring maximisation of profit. Normally, when contribution and key
factors are known, the relative profitability of different products or
processes can be measured with the help of the following formula:
Profitability =
Contribution/ Key Factor
5. Make of Buy Decisions
A company might
be having unused capacity which may be utilized for making component parts or
similar items instead of buying them from the market. In arriving at such a
decision, the cost of manufacturing component parts should be compared with
price quoted in the market. If the variable costs are lower than the purchase
price, the component parts should be manufactured in the factory itself. Fixed
costs are excluded on the assumption that they have been already incurred, and
the manufacturing of components involves only variable cost. However, if there
is an increase in fixed costs and any limiting factor is operating while
producing a component, that should also be taken into account. In case a firm decides to get a
product manufactured from outside, besides savings in cost, it must also take
into account the following factors:
(a) Whether the outside supplier would be in a position to
maintain the quality of the product?
(b) Whether the supplier would be regular in his supplies?
(c) Whether the supplier is reliable? In other words is the
financially and technically sound?
7. Fixation
of selling price
Although prices are determined by market conditions and
other factors, marginal costing technique assists the management in the
fixation of selling prices under various circumstances which is as follows.
a) Pricing under normal conditions.
b) Pricing during stiff competition.
c) Pricing during trade depression.
d) Accepting special bulk orders.
e) Accepting additional orders to utilize idle capacity.
8. Accepting Export Order
Marginal costing
technique can also be used to take a decision as to whether to accept a foreign
offer or not. The speciality of this situation is that normally foreign order
is requiring the manufacturer to supply the product at a price lower than the
inland selling price. Here the decision is taken by comparing the marginal cost
of the product with the foreign price offered. If the foreign order offers a
price higher than the marginal cost then the offer can be accepted subject to
availability of sufficient installed production capacity. The following
illustration highlights this decision:
9. Closing down of department
When a firm is operating for loss sometime, the management
has to decide upon its shut down.
a) Complete shut down: The firm may be permanently closed
any intention to revive it. Such a decision is warranted.
i) When the selling price does not even cover the variable
cost: or
ii) The demand for the output is very low and the future
prospects are bleak.
Complete shut down saves the management from the fixed of
running the factory or division or firm.
b) Partial or temporary shut down: Here the intention is to
close down for sometime and reopen the firm when circumstances favour it. Some
fixed cost will continue in the form of irreducible minimum, like Skelton staff
to maintain the factory, some managerial remuneration, salaries, irreplaceable
technical experts, etc. The saving from the partial shut down should be
compared with the position if the firm continues. If there is substantial
savings, shut down may be preferable. Minor savings in expenditure does not
warrant shut down because reviving a firm is a cumbersome process.
