Marginal Costing: Definition
An increase or decrease in total costs that is caused by an increase or decrease in the volume of production and sales is known as marginal cost, 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 the block of units produced or sold. The marginal costs per unit remain the same.
A company produces 10,000 radios at a fixed cost of $100,000 per annum. The variable cost per radio is $300.
Total variable cost = 10,000 x 300 = $300,000
Add fixed cost = 100,000
Total Cost = $400,000
Extra cost of one radio = $300
Total = $400,300
Thus, the marginal cost per radio is $300. The variable cost and marginal cost are also known as direct costs, activity costs, or volume costs.
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: Fixed costs are constant. They do not fluctuate with output. By contrast, variable costs always go up or down with the output, while the 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: Fixed expenses are shown on the debit side of the profit and loss account for the period in which they are incurred.
(5) Basis of pricing: Prices are based on marginal cost plus contribution. Thus, the contribution is the excess of the selling price over the marginal cost of sales.
(6) Determination of profitability: The profitability of a product is determined after a close study of the contribution made available by each unit of output.
Utility/Merits of Marginal Costing
Several advantages are associated with marginal costing, including:
(1) Knowledge of cost classification: Fixed costs are more or less uncontrollable and variable cost are always controllable. The cost data needed for decision-making and profit planning are made readily available for 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 cost control technique, the risk of over- and under-allocating overheads is minimized.
(4) Relationship of fixed and variable costs: Fixed costs are related to time with no reference to output, while variable costs are always associated with output. Thus, an increase in output will reflect how much extra funds will be available for additional output.
(5) Knowledge of minimum output: Marginal costing can indicate the minimum output required to equate fixed and variable cost. This point is known as the break-even point (BEP), where costs and revenues are always equal.
Fixed expenses are $80,000, variable cost is $15, and sale price per unit is $20.
BEP = Fixed expenses / C
= 80,000 / 5 = 16,000 units.
If the output is less than 16,000 units, there is a chance of loss. The break-even sale variable will be 16,000 x 20 = $320,000.
(6) Knowledge of desired profit: Once the BEP is known, it is easy to work out the minimum output for the desired profit.
The desired profit is $10,000. What is the minimum output?
(Fixed expenditure + desired profit) / C
= (80,000 + 10,000) / 5
= 18,000 units.
(7) Knowledge of expansion: Once the BEP is known, it is simple to calculate expansion possibilities.
Using the information below, determine how many extra units need to produced to achieve the desired profit:
- Fixed expenses = $1,00,000
- Desired profit = $50,000
- Sale per unit = $20
- Variable per unit = $15
(Fixed expenditure + Desired profit) / C
= (100,000 + 50,000) / 5
= 30,000 units will be sufficient
When fixed expenses were $100,000, $20,000 units were produced. Hence, 10,000 extra units are recommended to achieve the desired profit.
(8) Knowledge of loss: When the BEP, output, and sales targets are not achieved, there is a risk of loss.
In the previous example, 20,000 units are BEP units. That is to say, when the output is 20,000, there is no profit and no loss. When the output is less than 20,000 units, there is the chance of loss. Let’s assume that the output comes down to units.
Calculation of loss:
|Sale value of 18,000 x 20 =||$360,000|
|Fixed cost = $100,000|
|Variable cost (18,000 x 15) = 270,000||$370,000|
|Total cost = $370,000||Loss = $10,000|
Limitations of Marginal Costing
Marginal costing suffers from the following limitations:
(1) Incorrect assumptions for classification of expenses: It is assumed that the expenses are grouped as fixed and variable, while certain expenses (e.g., employee bonuses) are purely caused by management decisions and have no reference to output or time.
(2) Marginal costing does not give due attention to the time factor: There are cases where the marginal cost of two outputs is the same, yet one takes twice the time to produce as the other. However, in reality, jobs that take more time are more costly.
(3) Not applicable to all industries: Marginal costing cannot be applied suitably in certain industries, including ship building and contracts.
(4) Fixed expenses are controllable: Marginal costing 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: Marginal costing does not provide any standard for performance evaluation. A system of budgetary control and standard costing gives more effective control compared to marginal costing.
(6) Wrong basis of stock and work-in-progress: Under marginal costing, stock and work-in-progress are valued based on the marginal cost, and fixed costs are taken into account. Thus, these expenses are a lesser charge.
(7) Limited output: The study of marginal costing is suitable only to a limited extent. There is every possibility that beyond a specific limit of output, fixed expenses will show an unusual jump.
(8) Various factors affect production cost: The BEP is affected by fixed and variable costs under marginal costing. However, other factors may affect output, including the efficiency of men and machinery, plant capacity, and technical capabilities.
About the Author
True Tamplin, BSc, CEPF®
True Tamplin is a published author, public speaker, CEO of UpDigital, and founder of Finance Strategists.
True contributes to his own finance dictionary, Finance Strategists, and has spoken to various financial communities such as the CFA Institute, as well as university students like his Alma mater, Biola University, where he received a bachelor of science in business and data analytics.