Meaning of Marginal Cost and Marginal Costing

Marginal Cost: The term Marginal Cost means the additional cost incurred for producing an
additional unit of output. It is the addition made to total cost when the output is increased by one
unit. Marginal Cost of the nth unit = Total Cost of nth unit-total cost of n-1unit. E.g. When 100 units
are produce, the total cost is Rs. 5000. When the output is increased by one unit, i.e, 101 units, total
cost is Rs. 5040. Then marginal cost of 101th unit is Rs. 40 {5040-5000}.

Marginal cost is also equal to the total variable cost of production or it is the aggregate of prime cost
and variable overheads. The character Institute of management Accountants [CIMA] England defines
marginal as “the amount at any given volume of output by which aggregates costs are changes if the
volume of output is increased or decreased by one unit.

Marginal Costing: it is the techniques of costing in which only marginal cost or variable are changes
to output or production. The cost of the output includes only variable costs. Fixed costs are not
charged to output. These are regards as ‘Period Costs’. These are incurred for a period. Therefore,
these fixed costs are directly transferred to Costing Profit and Loss Account.

According to CIMA. Marginal Costing is “the ascertainment, by differentiating between fixed and
variable costs, of marginal costs and of the effect of profit of changes in volume or types of output.
Under marginal Costing, it is assumed that all costs can be classified into fixed and variable costs.
Fixed costs remain constant irrespective of the volume of output. Variable costs changes in direct
proportion with the volume of output. The variable or marginal cost per unit per unit remains
constant at all levels of output.”

Thus, Marginal Costing is defined as the ascertainment of marginal cost and of the ‘effect on profit of
changes in volume or type of output by differentiating between fixed cost and variable costs.
Marginal costing is mainly concerned with providing information to management to assist in decision
making and to exercise control. Marginal costing is also known as ‘variable costing’ or ‘out of pocket
costing’.

The main Features (Characteristics) of Marginal Costing are as follows:

1. Cost Classification: The Marginal Costing techniques makes a sharp distinction between
variable costs and fixed costs. It is the variable cost on the basis of which production and
sales policies are designed by a firm.
2. Managerial Decisions: It is a technique of analysis and presentation of costs which help
management in taking many managerial decisions such as make or buy decision, selling
prices decisions.
3. Inventory Valuation: Under marginal costing, inventory for profit measurement is valued at
marginal cost only.
4. Price Determination: Prices are determined on the basis of marginal cost by adding
contribution which is the excess of selling price over variable costs of sales.
5. Contribution: Marginal costing techniques makes use of contribution for taking various
decisions. Contribution is the difference between sales and marginal cost. It forms the basis
for judging the profitability of different products or departments.

Assumption of Marginal Costing

1. All costs can be classified into fixed and variable elements. Semi variable costs are also
segregated into fixed and variable elements.
 2. The total variable costs changes in direct proportion with units of output. It follows a
linear relation with volume of output and sales.
3. The total fixed costs remain constant at all levels of output. These are incurred for a
period and have no relation with output.
4. Only variable costs are treated as product costs and are charged to output, product,
process or operations.
5. Fixed costs are related as ‘period costs’ and are directly transferred to costing Profit and
loss Account.
6. The closing stock is also valued at marginal cost and not at total cost.
7. The relative profitability of product or department is based on the contribution it gives
and not based on the profit.
8. It is also assumed that the selling price per unit remains the same i.e, any number of
units can be sold at the current market price.
9. The product or sales mix remains constant over a period of time.

Advantages of Marginal Costing:

a) Simple and Easy: It is very simple to understand and easy to operate.

b) Helpful in Cost Control: Marginal Costing divides total cost into fixed and variable cost.
Marginal Costing by concentrating all efforts on the variable costs can control total Costs.
c) Profit Planning: It helps in short term profit planning by making a study of relationship
between cost, volume and profits, both in terms of quantity and graphs.
d) Evaluation of Performance: The different products and divisions have different profit
earning potentialities. Marginal cost analysis is very useful for evaluating the performance of
each sector.
e) Helpful in Decision Making: It is techniques of analysis and presentation of costs which
help management in taking many managerial decisions decision such as make or buy
decision, selling price decisions, Key or limiting factor, selection of suitable Product mix etc.
f) Productions Planning: It helps the management in production planning. The effect of
alternative production policy can be readily available and decision can be taken that would
yield the maximum return to business.
g) It removes the complexities of under absorption of overheads.
h) The distinction between product cost and period cost helps easy understanding of marginal
cost statement.

Disadvantages of Marginal Costing

1. It is based on an unrealistic assumption that all costs can be segregated into fixed and
variable costs. In the long-term sales price, fixed cost and variable cost per unit may vary.
2. All Costs are not divisible into fixed and variable. There are certain costs which are semi
variable in nature. The separation of costs into fixed and variable is difficult and sometimes
gives misleading results.
3. Under marginal costing, stock and work in progress are understand. The exclusion of fixed
costs from stock valuation affects profit, and true and fair view of financial affairs of an
organization.
4. Marginal cost data becomes unrealistic in case of highly fluctuating level of production, e.g.
in case of seasonal factories.
5. It can correctly assess the profitability on a short term basis only, but for only term it is not
effective.
6. It does not provide any effective yardstick for evaluation of performance.
7. Contribution of marginal costing is not a fool proof indicator of profitability.
8. Marginal cost, if confused with total cost while fixing selling price may lead to a diaster.

“ Marginal Costing” is a valuable aid to Management

Marginal costing and break-even analysis are very useful to management. The important
uses of marginal costing and Break Even analysis are the following:
1) Cost Control: Marginal costing divides total cost into fixed and variable cost. Fixed Cost
can be controlled by Top management to a limited extent and variable costs can be
controlled by the lower level of management. Marginal costing by concentrating all
efforts on the variables costs can control total costs.
2) Profit Planning: It helps in short term profit planning by making a study of relationship
between cost, volume and profits, both in terms of quantity and graphs. An analysis of
contribution made by each product provides a basis for profit planning in an
organization with wide range of products.
3) Fixations of selling price: Generally, prices are determined by demand and supply of
products and services. But under special market conditions marginal costing in helping in
deciding the prices at which management should sell. When marginal cost is applied to
fixation of selling price, it should be remembered that the price cannot be less than
marginal cost. But under the following situation, a company shall sell its products below
the marginal cost:
 To maintain production and to keep employees occupied during a trade depression.
 To prevent loss of future orders.
 To dispose of perishable goods.
 To eliminate competition of weaker rivals.
 To introduce a new product.
 To helps in selling a co joined product which is making substantial profit?
 To explore foreign market.
4) Make and Buy: Marginal costing helps the management in deciding whether to make a
component part within the factory or to buy it form an outside supplier. Here, the
decision is taken by comparing the marginal cost of producing the component part with
the price quoted by the supplier, if the marginal cost is below the supplier’s price, it is
profitable to produce the component within the factory. Whereas if the supplier’s price
is less than the marginal cost of producing the component, then it is profitable to buy
the component from outside.
5) Closing down of a department or discontinuing a product: The firm that has several
departments or products may be faced with this situation, where one department or
product shows a net loss. Should this product or department be eliminated? In marginal
costing, so far as a department or product shall not be discontinued, If that department
or product is discontinued the overall profit is decreased.
6) Selection of a Product/Sales Mix: The marginal costing techniques is useful for deciding
the optimum, product/ sales mix. The product which shows higher P/V ratio is more
profitable. Therefore, the company should produce maximum units of that product
which shows the highest P/V ratio so as maximize profits.
 7) Evaluation of Performance: The different product and divisions have different profit
earning potentialities. The Performance of each product and division can be brought out
by means of Marginal Cost analysis, and improvement can be made where necessary.
8) Limiting Factor: When a limiting factor restricts the output, a contribution analysis
based on the limiting factor can help maximizing profit. For example, if machine
availability is the limiting factor, then machine hour utilization by each product shall be
ascertained and contribution shall be expressed as so many rupees per machine hour
utilized. Then, emphasis is given on the product which gives highest contribution.
9) Helpful in taking key Managerial Decisions: In addition to above, the following are the
important areas where managerial problems are simplified by the use of marginal
costing:
 Analysis of Effect of change in price.
 Maintaining a desired level of profit.
 Alternative methods of production
 Diversifications of product.
 Alternative course of action etc.

Cost-Volume-Profit Analysis
Cost-Volume-Profit analysis is analysis of three variables i.e, Cost, volume and profit which explores
the relationship existing amongst costs, revenue, activity levels and the resulting profit. It aims at
measuring variations of profits and costs with volume, which is significant for business profit
planning.

CVP analysis makes use of principles of marginal costing. It is an important tool of planning for
making short term decisions. The following are the basic decision making indicators in marginal
Costing:

1) Profit Volume Ratio (PV ratio)/ Contribution margin Ratio

2) Break Even Point
3) Margin of Safety (MOS)
4) Indifference Point or Cost Break Even Point
5) Shut down Point

Assumptions of CVP Analysis

The assumptions in CVP analysis are the same as that under marginal costing.

a) Cost can be classified into fixed and variable components.

b) Total fixed cost remains constant at all levels of output.
c) The variable cost change in direct proportion with the volume of output,
d) The product mix remains constant.
e) The selling price per unit remains the same at all levels of sales.
f) There is synchronization of output and sales, i.e, what ever output is produced, the same is
sold during that period.

Contribution

Contribution is the excess of sales over marginal cost. It is not purely profit. It is not purely profit.
It is the profit before recovery of fixed assets. Fixed costs are first met out of contribution and
 only the remaining amount is regarded as profit. Contribution is an index of profitability. It has a
fixed relationship with sales. Larger the sales more will be the contribution and vice versa.

Contribution=Sales-Marginal Cost

Profit/Volume Ratio:

Profit Volume Ratio express the relationship between contribution and sales. It indicates the
relative profitability of different product, processes and departments. Higher the P/V ratio, more
will be the profit and lower the P/V ratio lesser will be the profit. Hence, it should be the aim os
every concern to improve the P/V ratio which can be done by increasing selling price, reducing
variable cost etc.

It can be calculated as follows:

P/V Ratio=(S-VC)/S*100

=Cont./Sales*100

= Change in profit or loss/Change in sales

Uses of P/V Ratio:

1. To compute to variable costs for any volume of sales.

2. To measure the efficiency or to choose a most profitable line. The overall profitability of the
firm can be improved by increasing the sales/output of product giving higher PV ratio.
3. To determine break line point and the level of output required to earn a desired profit.
4. To decide more profitable sales mix.

Break Even Point:

Break Even Point is the level of sales required to reach a position of no profit, no loss. At Break Even
point, the contribution is just sufficient to cover the fixed cost. The organization starts earning profit
when the sales cross the Break Even point. Break Even Pint can be calculated either in terms of units
or in terms of cash or in terms of capacity utilization. It can be calculated as follows:

BEP in units= Fixed Cost/Contribution per unit

BEP in cash= Fixed Cost/ PV Ratio

BEP in terms of capacity utilization = (BEP in units/Total capacity) * 100

Margin of Safety:

The positive difference between the sales volume and the break-even volume is known as the
margin of safety. The larger the difference, the safer the organization is from a loss-making situation.
It can be calculated either in cash or in units.

Margin of safety can be derived as follows:

Margin of safety=Actual Sales-Break even Sales or.

Margin of safety (in Cash) = Profit/P/V Ratio

Margin of Safety (In units) = Profit/Contribution Per Unit

Introduction of Absorption Costing

As the name suggests, absorption costing is the methods of Costing in which the entire cost of
manufacturing a product or providing a service is absorbed in it. In contrast to the variable costing
method, it includes both fixed and variable costs for abortion in addition to the direct costs. As all
the costs insurers are absorbed, this method is also sometimes referred to as full absorption costing
or Total absorption Costing.

Variable costing is generally used for the managerial decision making whereas as per the generally
Accepted Accounting Principles (GAAP), an organization is bound to use the absorption costing
method for financial reporting purposes.

Advantages and Disadvantages of Absorption Costing system

Advantages of Absorption Costing System

1. Absorption costing recognizes the fixed costs in fixed costs in product cost. As it is suitable
for determining price of the product. The pricing based on absorption costing ensures that
all costs are covered.
2. Absorption Costing will show correct profit calculation than variable costing in a situation
where production is done to have sales in future.
3. Absorption costing confirms to accrual and matching accounting concept which requires
matching costs with revenue for a particular accounting period.
4. Absorption costing has been recognized for the purpose of preparing external reports and
for stock valuation purposes.
5. Absorption costing avoids the separating of costs into fixed and variable elements.
6. The allocation and apportionment of fixed factory overheads to cost centers makes manager
more aware and responsible for the cost and service provided to others.

Disadvantages of Absorption Costing system

1. Absorption costing is not useful for decision making. It considers fixed manufacturing
overhead as product cost which increase the cost of output. As a result, it does not help
accepting specially offered price for the product. Various types of managerial problems
relating to decisions making can be solved only with the help of variable costing system.
2. Absorption costing is not helpful in control of cost and planning and control functions. It is
not useful in fixing the responsibility for incurrence of costs. It is not practical to hold a
manger accountable for costs over which he/she has not control.
3. Some current product costs can be removed from the income statement by producing for
inventory. As such, managers who are evaluated on the basis of operating income can
temporarily improve profitability by increasing production.
 Difference between Marginal costing and Absorption Costing

BASIS FOR
MARGINAL COSTING ABSORPTION COSTING
COMPARISON

Meaning A decision making technique for Apportionment of total costs to the cost
ascertaining the total cost of center in order to determine the total cost
production is known as Marginal of production is known as Absorption
Costing. Costing.

Cost Recognition The variable cost is considered as Both fixed and variable cost is considered
product cost while fixed cost is as product cost.
considered as period costs.

Classification of Fixed and Variable Production, Administration and Selling &

Overheads Distribution

Profitability Profitability is measured by Profit Due to the inclusion of fixed cost,

Volume Ratio. profitability gets affected.

Cost per unit Variances in the opening and Variances in the opening and closing stock
closing stock does not influence the affects the cost per unit.
cost per unit of output.

Highlights Contribution per unit Net Profit per unit

Cost data Presented to outline total Presented in conventional way.

contribution of each product.