Marginal Costing definition
Marginal costing refers to the method of costing which is concerned with changes in costs resulting from changes in the volume or range of output and sales. Increase or decrease in total costs which are brought about by an increase or decrease in the volume of production and sale is known as marginal cost or differential cost or incremental cost. Thus, marginal costs relate to future costs and can be determined by subtracting the total at one level of output or sale from that at another level.
It should be noted that marginal costs refer to the increase or decrease in costs on account of block of units produced or sold. The marginal costs per unit remain the same.
Explanation of Marginal cost with figures as: A company is producing 10,000 radios the fixed cost being $1,00,000 per annum, variable cost per radio is $300.
The total variable cost 10,000 x 300 = $3,00,000
Add fixed cost = 1,00,000
Total Cost = $4,00,000
Extra one radio cost = $300
Total = $4,00,300
Thus, the marginal cost per radio is $300, variable cost and marginal cost are also known as direct costs or activity cost or volume cost.
D. Joseph: “Marginal costing is a technique of determining the amount of change in the aggregate cost due to an increase of one unit over the existing level of production.
Harold J. Wheldon: “Other things being equal, the fixed overhead will, in total remain fix during changes in production achieved and the rate per unit will consequently vary whereas that variable overhead will remain constant per unit of production and vary in total”.
Main Characteristics of Marginal Costing
The following are the characteristics of marginal costing:
(1). Classification of costs. All costs are classified as fixed and variable costs.
(2). Focus on variable costs. The fixed costs are constant. They do not fluctuate with output whereas variable costs always go up or down with output of course, per unit cost remains the same.
(3). Treatment of finished and semi-finished goods. The value of finished goods and work-in-progress is included in the marginal cost.
(4). Treatment of fixed costs. The fixed expenses are shown in the debit side of profit and loss account of that particular period in which those are incurred.
(5) Basis of pricing. The prices are based on marginal cost plus contribution. Thus, contribution is the excess of selling price over marginal cost of sales.
(6) Determination of profitability. The profitability of a product is determined after a close study of contribution made available by each unit of output.
Utility/Merits of Marginal Costing
The following advantages are claimed for marginal costing:
(1). Knowledge of cost classification. It is suitable to management in knowing cost classification. Fixed Cost is more or less uncontrollable and variable cost always controllable. The cost data needed for decision making and profit planning are easily available to the management.
(2). Simple operation. Marginal costing is simple to operate because it avoids the complexities of apportionment of fixed costs which is really arbitrary.
(3). No danger of over and under charges of overheads. In this technique of cost control chances of over and under allocation of overheads are minimized.
(4). Relationship of fixed and variable costs. The fixed costs are related to time, no reference to output while variable costs are always associated to output. Thus, increase in output will show how much extra fund will be available for additional output.
(5). Knowledge of minimum output. The technique of marginal cost is suitable to know the minimum output to equate fix and variable cost. This point is known as BEP (Break-even point) where costs and revenues are always equal.
Fixed expenses $80,000 variable cost $15, sale price per unit $20.
BEP = Fixed Expenses / C
= 80,000 / 5 = 16,000 units.
If the output is less than 16,000 units, there are.chances of loss. The Break Even sale variable will be 16,000 x 20 = $3,20,000.
(6). Knowledge of desired profit. Once BEP is known, it is not difficult to know the minimum output for the desired profit. Let us take an example to illustrate:
Desired profit is $10,000, how much will minimum output?
(Fixed Expenditure + desired profit) / C
= (80,000 + 10,000) / 5
= 18,000 units.
(7). Knowledge of expansion. Once BEP is known, it is simple to calculate the possibilities of expansion.
Example. The desire for profit will tell how many extra units be produced to have that desired profit:
Fixed expenses = $1,00,000
Desired profit = $50,000
Sale per unit = $20
Variable per unit = $15
(Fixed expenditure + Desired profit) / C
= (1,00,000 + 50,000) / 5
= 30,000 units Production will be sufficient
When fixed expenses were $1,00,000, $20,000 units were produced thus an additional output is recommended for 10,000 units.
(8). Knowledge of loss. When BEP, output and sale is not achieved there are chances of loss.
Example: In the previous example 20,000 units are of BEP units, when output is 20,000, no profit, no loss, when output is less than 20,000 units, there are chances of loss. Let us assume output comes down to units:
Calculation of loss:
|Sale value of 18,000 x 20 =||$3,60,000|
|Fixed cost = $1,00,000|
|Variable Cost (18,000 x 15) = 2,70,000||$3,70,000|
|Total cost = $3,70,000||Loss = $10,000|
Limitations of Marginal Costing
The marginal costing suffers from the following limitations:
(1). Wrong assumption of classification of expenses. Here it is assumed that the expenses are grouped as fix and variable while certain expenses, such as Bonus to employees, welfare activities expenditure are purely caused by management decisions and have no reference to output or time.
(2). Marginal costing technique does not give due attention to time factor. There are cases where the marginal cost of two output is the same yet one takes twice time than the other thus, job taking more time is costly than the lesser time.
(3). Not applicable to all industries. The technique of marginal costing is not applicable to all industries such as Ship Building and Contracts.
(4) Fixed expenses are controllable. Marginal costing technique ignores the fact that fixed costs are always controllable. The technique of budgetary control can be helpful in controlling the amount of fixed overheads.
(5) Lack of calculation. The technique of marginal costing does not provide any standard for the evaluation of performance. A system of budgetary control and standard costing gives more effective control than the technique of marginal costing.
(6). Wrong basis of stock and work in progress. Under marginal costing, stock and work in progress are valued on the basis of marginal cost and the fixed costs are taken into account thus these expenses are lesser charge.
(7). Limited output. The study of marginal costing is suitable upto a limited extent. There is every possibility that beyond a specific limit of output, fixed expenses can show unusual jump.
(8). Various factors that affect production cost. The BEP is effected by fixed and variable costs. Yet there are other factors that affect output such as: efficiency of man and machinery, plant capacity and technical ability.