Notes

Program Name- MBA

Course Name-Managerial Accounting Sem- I

Unit Number-05 Unit Name- Managerial Decision Making Techniques

Topic Name- Marginal Costing

Introduction

In the conventional system of cost ascertainment, the direct cost may be identified with the
individual cost centre. However, the indirect costs, i.e. the overheads, are identified with the
individual cost centre on the most equitable basis. This results into some problems in the process
of managerial decisionmaking.
a) The above process does not take into consideration the behaviour of cost. All the costs in the
practical circumstances do not behave in the same manner. Some of the costs tend to remain
constant despite the changes in the level of activity or volume of operations. These types of costs
are comparatively irrelevant in the managerial decision-making.
b) The above process results into under absorption or over absorption of overheads.
The said limitations have given rise to a managerial decision-making technique that tries to classify
the costs based upon the behaviour of cost. The technique is referred to as Marginal Costing. The
basic proposition made by this technique is that the costs should be classified on the basis of
behaviour of the costs. From this angle, the costs can be viewed as fixed costs and variable costs.

Concept of Marginal Costing

Marginal cost is defined as the amount at any given volume of output by which the aggregate costs
are changed if the volume of output is increased or decreased by one unit. The aggregate cost
consists of both fixed cost and variable cost. In the short run, fixed costs remain constant
irrespective of changes in the volume, aggregate costs may increase or decrease with the changes
in volume, specifically due to variable cost. As such, in simple words, marginal cost indicates the
Per Unit Variable Cost.
Marginal costing is defined as the ascertainment, by differentiating between fixed and variable
costs, of the marginal costs and of the effect on profit of changes in volume and type of output.

Basic assumptions made by marginal costing

The entire technique of marginal costing is based upon the following assumptions.
a) Variable cost varies in direct proportion with the level of activity. However, per unit variable
cost remains constant at all the levels of activities.
b) Per unit selling price remains constant at all the levels of activities.
c) Whatever is produced by the organization is sold off. In other words,
there are no variations due to the stock.

Features of Marginal Costing

1. The product costs are classified as fixed costs and variable costs. Semivariable
costs are also classified in their individual components of fixed cost and variable cost.
2. Only variable costs are considered while computing the product costs. The closing stock of
finished goods and semi-finished goods is valued after considering variable costs only.
3. Fixed costs are written off during the period of incurrence and hence do not find a place in the
product cost determination or the inventory valuation.
4. Prices of the products are based on variable costs only.
5. Profitability of the products or departments is decided in terms of marginal contribution.

Marginal costing and cost-volume-profit relationship

The definition of the term “marginal costing” requires the computation of:
a) Marginal Cost
As stated earlier, marginal cost is the additional cost for manufacturing one additional unit, which
is nothing else but the variable cost per unit. Thus, the marginal cost or variable cost includes the
direct cost plus the variable overheads. Fixed overheads are clubbed with the fixed cost.
b) Cost volume-profit relationship
The intention of every business activity is to earn and maximize profit. Determination of the profits
depends upon the interplay between the following factors and there exists a close relationship
among these factors:
(1) Selling price per unit and total sales amount.
(2) Total cost, which in its turn may be in the form of variable cost or fixed cost.
(3) Volume of sales.
Cost-volume-profit analysis aims at studying the relationships existing among these factors and its
impact on the amount of profits.
The relationships existing among these factors may be basically presented in two forms.
(a) In statement or report form
(b) In graphical form, the graphs or charts taking the form of breakeven chart,
contribution breakeven chart or profit chart.

BASIC CONCEPTS OF MARGINAL COSTING

(1) Basic equation of Marginal Costing:
The basic intention of the business is to earn the profit, which is the excess
of sales over the total costs.
∴ Profit = Sales - Total Cost
However, total cost can be either fixed cost or variable cost. As such, the
basic equation takes the following forms.
∴ Profit = Sales - (Variable Cost + Fixed Cost)
∴ Profit = Sales - Variable cost - Fixed cost
∴ Profit + Fixed cost = Sales - Variable cost
This is the basic equation of marginal costing. Both the expressions
of (Sales - Variable Cost) and (Profit + Fixed cost) are technically termed as
contribution.
∴ Sales - Variable Cost = Contribution = Fixed Cost + Profit
∴ Contribution - Fixed cost = Profit
(2) Contribution:
As discussed earlier, the term contribution can be expressed in two ways:
(a) Sales - Variable Cost
(b) Fixed cost + Profit
As in the short period, fixed costs are ineffective due to their stagnant nature; variable cost becomes
the most important cost in deciding the profitability. As such, the situation that generates higher
contribution is treated as profitable situation.
Further, the term contribution plays an important role in a situation where there are more than one
product and the profits on individual products cannot be ascertained due to the problems of
apportionment of fixed costs to different products. This is because the fixed costs are ignored by
marginal costing.

(3) Profit Volume (P/V) Ratio:

This ratio indicates the contribution earned with respect to one rupee of
sales. As such, it is expressed as
(Contribution/ Sales)X 100
As, in the short run, fixed cost remains the same, if there is any change in profits, that is only due
to change in contribution. Hence, P/V ratio may also be expressed as:
(Change in Profits/Change in Sales)*100

Limitations of marginal costing

(1) The classification of total cost in variable and fixed cost is difficult. No cost can be completely
variable or completely fixed. In some cases, the cost that is considered variable may not be variable
in practical terms, for example, direct labour cost. Under normal situations, this cost is treated as
variable cost. However, in India, considering the tremendous legal backing the workers have, the
direct labour cost may not be variable in nature. As such, it may be necessary to consider the direct
labour cost as a part of fixed cost.
(2) Under the marginal costing, the fixed costs are eliminated for the valuation of inventory of
finished goods and semi-finished goods, in spite of the fact that they might have been actually
incurred. As such, it is not correct to eliminate the fixed costs. Further, such elimination affects
the profitability adversely.
(3) In the age of increased automation and technological development, the component of fixed
costs in the overall cost structure may be sizeable.
Any technique such as marginal costing, which ignores the fixed costs altogether, may not be
proper under these circumstances as a major portion of cost is not taken care of.
Budgeting

The term ‘Budget’ is defined as a financial and/or quantitative statement, prepared prior to a
defined period of time, of the policy to be pursued during that period for attaining a given objective.
The analysis of this definition reveals the following characteristics of the budget.
1. It may be prepared in terms of quantity or money or both.
2. It is prepared for a fixed or set period of time.
3. It is prepared before the defined period of time commences.
4. It spells out the objects to be attained and the policies to be pursued to achieve that objective.
The term ‘Budgetary Control’ is defined as the establishment of budgets, relating the
responsibilities of executives to the requirements of a policy and the continuous comparison of
actual with budgeted results, either to secure by individual action the objective of that policy or to
provide the basis for its revision.
The analysis of this definition reveals the following facts about budgetary control.
1. It deals with the establishment of the budgets.
2. It deals with the comparison of budgeted results with the actual results.
3. It deals with computation of the variations and the actions to be taken for maintaining the
favourable variations, removing the adverse variation or revising the Budgets themselves.

Budgetary control is advantageous for the following reasons:

It is a powerful tool available to the management for the purpose of cost control and maximization
of profits through the same. It enables the management to utilize the available resources in the
most profitable manner.
A budget sets the plan of action. Plans in respect of various functional areas of operations are
expressed in the form of the budgets. As such, the budgetary control system acts as a means of
declaration of the policies of the management.
It acts a means of communication. The plans and objects laid down by top-level management are
communicated to the middle level and lower level management by way of budgets. As such, each
and every person working in the organisation is aware of his duties and responsibilities in relation
to those of the others. This maximises the utilization of resources.
It acts as a means of improving the co-ordination. The budgets prepared in the various functional
areas of operations are prepared in such a way that the efforts are coordinated in the direction of
achievement of common and defined objective. It develops the team spirit and help of various
people can be sought to solve the common problem.
Comparison between the budgeted results and the actual results may reveal the areas where there
are adverse variations, which may be identified as weak areas or delicate areas. As such, efforts
can be made to remove these adverse variations, keeping aside the areas where there are no
variations. This enables the concentration of efforts of the management on a smaller portion of
activities, which facilitates ‘Management by exception.’
Budgetary control system enables the delegation of authority and makes possible the principles of
Responsibility Accounting.

TYPES OF BUDGETS
There can be basically four areas in which management can function and the types of budgets can
be studied with respect to these functional areas of management. They are discussed below.
1 . Production Budgets
The budgets in this area may be of the following types:
a. Production Budget
It is a forecast of production for the budget period. It may be prepared from two
angles.
i. Production Budget in terms of Quantity
ii. Production Budget in terms of money, i.e. the production Cost Budget further classified under
each element of cost such as Direct Material Cost, Direct Labour Cost and Overheads Cost.

The material cost can be estimated by preparing the materials budget, which indicates the estimated
quantities as well as costs of various materials required for carrying out production as per
production budget.
The labour cost can be estimated by preparing the Direct Labour Cost
budget, which indicates the direct labour requirements required to produce the quantity as specified
in the production budget. For the purpose of this budget,
labour requirement in terms of number of workers of different grades will be
decided first. Afterwards, the rates of pay and allowances will be considered to
decide the labour cost.

The production overheads can be estimated by preparing production overhead budget, which
indicates all items of production overheads classified as fixed, variable and semi-variable. The
process of allocation and apportionment can be followed to decide the loading of overheads to
each budget centre.

Following factors will have to be considered before preparing the production budget in terms of
quantity.
i. Coordination with Sales Forecast: Before the quantity to be produced is decided, it
will be necessary to confirm whether it is possible to sell the quantity which is produced
during the budget period. If it is not possible to sell whatever can be produced, in spite
of all the sales promotion efforts, then the production budget should be adjusted to
conform to the sales forecast. If the expected sales exceed existing production capacity,
possibility of overtime working or extra shift working should be considered.
ii. Production Capacity: Production Budget estimates the quantity to be produced. If it
is not possible to produce the quantity with the existing capacity available, it will be
necessary to increase the capacity by incurring additional capital expenditure.
iii. Consideration of Stocks: Whatever is to be sold need not be produced necessarily.
The quantity to be produced, after giving due consideration to the sales forecast, may
depend upon the opening and closing stock of finished goods. The quantity to be
produced during the budget period may be decided as:
Estimated Closing stock of finished goods
Add: Quantity to be sold,
Less: Opening Stock of Finished Goods.
iv. Management Policy: Sometimes, the policy decisions taken by the management are
required to be considered before setting the production budget. For example, it will
 have to be considered whether certain components are decided to be produced instead
of purchasing or vice versa.

2. Finance Budgets
The most important budget which is prepared under this functional area is the cash budget. It is an
estimate of the expected cash receipts and cash payments during the budget period. Thus by
preparing the cash budget, it is possible to predict whether at any point of time, there is likely to
be excess or shortage of cash. If the shortage of cash is estimated, it may be required to arrange
the cash from some other source. If the excess of cash is estimated, it may be possible to explore
the investment opportunities.
Before preparing the cash budget, the following principles should be kept in mind.

a. The period for which cash budget is prepared should be selected very carefully. There is no fixed
rule as to the period to be covered by the cash budget. It may vary from company to company
depending upon the individual requirements. As a general rule, the period covered by the cash
budget should neither be too long or too short. If it is too long, it is possible that the estimate will
not be accurate. If it is too short, the factors which are beyond the control of management will not
be given
due consideration.
b. The items that should appear in the cash budget should be carefully decided. Naturally, all those
items, which do not involve cash flow, will not be considered while preparing the cash budget. For
example, as the cost of depreciation does not involve any cash outflow, it does not affect the cash
budget, though the amount of depreciation affects the determination of tax liability which involves
cash outflow.

Standard Costing

The determination of the actual cost on the basis of the various costing records maintained is no
doubt important, but such actual cost (or historical cost) involves some limitations as to its utility.
The actual cost information is available only after the completion of the job, process or service and
hence is of no practical utility from control point of view, as no basis is provided with which the
actual costs can be compared.
There are various kinds of managerial decisions where cost is an inevitable basis as in price fixation
or submission of quotations. However, if the details of actual costs are available too late, such cost
details are of no practical utility for the purpose of price fixation or submission of quotation. The
actual costs may be affected due to inefficient functioning. The actual costs may be excessive due
to abnormal expenses, avoidable wastes, inefficient use of labour and excessive use of materials.
As such, actual costs are not useful for providing a yardstick for measuring efficiency of
performance. Actual costing is comparatively expensive, as it
involves the maintenance of various records and documents. The above stated
limitations involved with the determination of actual costs have given rise to
the technique of standard costing.

Advantages of Standard Costing

Standard costing provides a yardstick with reference to which the efficiency/ inefficiency in
performance may be established. This facilitates the basic management function of cost control.
Other advantages of Standard Costing are given below.
1. Standard costing provides the incentive and motivation to work with greater effort for achieving
the standard.
2. Standard costs may be used as the basis for the process of price fixation, filing tenders and
offering quotations. If the prices are to be quoted on cost plus basis, actual costs may not be
available, in which case standard costs can be the base for fixation of selling prices.
3. Standard costing system facilitates delegation of authority and fixation of responsibility for each
individual or department. This also tones up the general organization of the concern.
4. Variance analysis and reporting is based on the principle of management
by exception. The top management may not be interested in details of actual performances but
only in the variations from the standard, so that
corrective measures may be taken in time.

Limitations of Standard Costing

Establishment of standard costs is difficult in practice. Even though standards are fixed after
defining them properly, there is no guarantee that the standards established will have the same
tightness or looseness as envisaged.

Followings are the limitations of standard costing:

1. In the course of time, even in a short period, the standards become rigid. It may not be
possible to maintain the standards to keep pace with the changes in manufacturing
conditions. Revision of standards is costly.
2. Sometimes, standards set create adverse effects. If standards are set tightly
and there is non-achievement of the same, it creates frustration.
3. The standard costing may not be suitable in all types of organizations, for example,
(i) In case of small concerns, where the production cannot be properly scheduled. In small
concerns, personal contacts may be more effective than the standard costing.
(ii) In case of industries having non-standardized products.
(iii) In case of industries having repair jobs, which keep changing as per customer requirements.
(iv) In case of industries where products take more than one accounting
period to complete, for example, contract jobs.

4. Due to the play of random factors, it may be difficult to properly examine the variance and
distinguish between controllable and uncontrollable variances. For example, adverse labour time
variance may be due to poor grade of labour, poor quality of material, defective plant and
machinery and lack of trained workers.

5. Lack of interest in standard costing on the part of the management makes

the system ineffective and cannot be used as a proper means of cost
control.

The difference between standard cost and actual cost is termed as ‘variance’. If the actual
cost is less than the standard cost, the variance is a favourable variance.

Variances can be classified into the following categories:

  Material Variance

 Labour Variance

 Variable Overhead Variance

 Fixed Overhead Variances

 Sales Variances

 Profit Variances

 Material Cost Variance

Material cost variance is the difference between standard material cost and actual material cost.
Material variances can be calculated by-

Material Cost Variance:

Standard Cost of Material- Actual Cost of Material

Material Price Variance:

Actual Quantity (Standard Price Per Unit- Actual Price Per Unit)

Material Usage Variance:

Standard Price Per Unit (Standard Quantity-Actual Quantity)

Materials Mix Variance:

Standard Price (Revised Standard Quantity- Actual Quantity)

 Labour Cost Variances: Labour cost variance is the difference between standard
direct wages specified and actual wages paid. Which may be-

Labour Cost Variance:

Standard Cost- Actual Cost

Labour Rate Variance:

Actual Hours(Standard Rate-Actual Rate)

Labour Efficiency Variance:

Standard Rate ( Standard Hours- Actual Hours)

Labour Mix Variance:

Standard Rate ( Standard Hours- Revised Actual Hours)

Summary-

• Marginal costing basically tries to classify the cost on the basis of behavior of cost. From
this angle, the costs can be viewed as fixed costs and variable costs. Fixed cost is the cost
that tends to remain constant irrespective of the level of activity or volume of operations.
• Fixed cost tends to vary with time rather than with level of activity. Basic characteristic
feature of fixed cost is that this cost in terms of amount may remain constant at all the
levels of activities; however per unit fixed cost goes on decreasing with the increasing level
of activity and vice-a-versa.
• Budget is defined as a financial and/or quantitative statement, prepared prior to a defined
period of time, of the policy to be pursued during that period for the purpose of attaining a
given objective.
• Budgetary Control’ is defined as the establishment of budgets, relating the responsibilities
of executives to the requirements of a policy and the continuous comparison of actual with
budgeted results, either to secure by individual action the objective of that policy or to
provide the basis for its revision.

Self-Assessment Questions-(Objective/Subjective- Minimum 5 questions)

1. What do you understand by the terms breakeven point, contribution and margin of safety?
Explain your answer by drawing a chart with assumed figures.
2. How does breakeven analysis help in business decisions?
3. Explain what breakeven analysis means. Also discuss the assumptions involved in this
technique and various uses of this technique.
4. Explain any four circumstances in which the technique of marginal costing will help the
management in making decisions. What are the limitations of this technique?
5. What do you mean by Budget and Budgetary Control? What are the advantages of budgetary
control as a cost control technique? What are the prerequisites for the successful
implementation of the Budgetary Control System?