CHAPTER VI
MARGINAL COSTING
In marginal costing, only variable
items of costs are taken into account. These variable costs will change in
direct relation to the change in the volume of production or change in the
production by one unit. As such, variable costs are called product costs and
are changed to production. Fixed costs are not allocated to cost unit; and
these are charged directly to profit and loss account during the period and are
called as period costs or capacity costs.
Definition of Marginal Cost and
Marginal Costing
The Institute of Cost and Works
Accounts of India defined marginal costs as, “the amount at any given volume of
output by which aggregate costs are changed, if the volume of output is
increased or decreased by one unit”. To ascertain to marginal cost, we need the
following elements of cost:
a) Direct
materials
b) Direct
labour
c) Other
direct expenses, and
d) Total
variable overheads.
That
is, Marginal Cost = Prime cost + Total variable overheads.
OR
Marginal Cost = Total cost – Fixed
cost
Advantages
1.
Constant
in nature: Variable
cost fluctuates from time to time, but in the long run, marginal costs are
stable. Marginal costs remain the same, irrespective of the volume of
production.
2.
Effective
cost control: It divides cost into fixed and
variable. Fixed cost is excluded from product. As such, management can control
marginal cost effectively.
3.
Treatment
of overheads simplified: It reduces the degree of over or
under-recovery of overheads due to the separation of fixed overheads from
production cost.
4.
Uniform
and realistic valuation: As the fixed overhead costs are
excluded from product cost, the valuation of work-in-progress and finished
goods becomes more realistic.
5.
Helpful
to Management: It enables the management to start a
new line of production which is advantageous. It is helpful in determining
which is profitable-whether to buy or manufacture of product. The management
can take decision regarding pricing and tendering.
6.
Helps
in production planning: It shows the amount of profit at
every level of output with the help of cost volume profit relationship. Here
the break-even chart is made use of.
7.
Better
results: When used with standard costing, it gives better
results.
8.
Fixation
of selling price: the differentiation between fixed cost
and variable cost in very helpful in determining the selling price of the
products or services. Sometimes different prices are charged for the same
article in different markets to meet varying degree of competition.
9.
Helpful
in budgetary control: The classification of expenses in very
helpful in budgeting and flexible budget for various levels of activities.
10. Preparing tenders:
Many business enterprises have to compete in the market in quoting the lowest
price. Total variable cost, when separately calculated, becomes the ‘floor
price’. Any price above this floor price may be quoted to increase the total
contribution.
11. “Make or Buy” decision:
Sometimes a decision has to be made whether to manufacture a component or a
product or to buy it readymade from the market. The decision to purchase it
would be having taken if the price paid recovers some of the fixed expenses.
12. Better presentation:
The statement and graphs prepared under marginal costing are better understood
by management executives. The break-even analysis presents the behavior of
cost, sales, contribution etc. in terms of charts and graphs. And, thus the
results can easily be grasped.
Disadvantages
1.
Difficulty
to analysis overhead: Separation of cost into fixed and
variable is a difficult problem. In marginal costing, semi-variable or
semi-fixed costs are not considered.
2.
Time
element ignored: Fixed costs and variable costs are
different in the short run; but in the long run, all costs are variable. In the
long run all cost are change at varying levels of operation. When new plants
and equipments are introduced, fixed costs and variable costs will vary.
3.
Unrealistic
assumption: Assumption of sale price remains the
same at different levels of operation. In real life, they may change and give
unrealistic results.
4.
Difficulty
in the fixation of price: Under marginal costing, selling
price is fixed on the basis of contribution. In case of case of cost plus
contract, it is very difficult to fix price.
5.
Complete
information not given: It does not explain the reason for
increase in production or sales.
6.
Significance
lost: In capital-intensive industries, fixed cost
occupies major portions in the total cost. But marginal costs over only
variable costs. As such, loses its significance in capital industries.
7.
Problem
of variable overheads: Marginal costing overcomes the
problem of over and under-absorption of fixed overheads. Yet there is the problem
in the case of variable overheads.
8.
Sales-oriented:
Successful
business has to go in a balanced way in respect of selling production
functions. But marginal costing is criticized on account of its attaching
over-importance to selling function. Thus it is said to be-sales oriented.
Production function is given less importance.
9.
Unreliable
stock valuation: Unser marginal costing stock of
work-in-progress and finished stock is valued at variable cost only. No portion
of fixed cost is added to the value of stocks. Profit determined, under this
method, is depressed.
10. Claim for loss of stock:
Insurance claim for loss or damage of stock on the basis of such a valuation
will be unfavorable to business.
11. Automation:
Now-a-days increasing automation is leading to increase in fixed costs. If such
increasing fixed costs are ignored, the costing system cannot be effective and
dependable.
Marginal costing is applied alone, will
not be much is use, unless it is combined with other techniques like standard
costing and budgetary control.
Absorption costing and Marginal
costing
Absorption costing is the practice
of charging all costs, both fixed and variable to operations, process or
products. In marginal costing, only variable costs are charged to production. The
Institute of Cost and Management Accountants (U. K) defines it as “The practice
of charging all costs, both variable and fixed to operations, process or
products”. This explains why this technique is also called full costing.
Administrative, selling and distribution overheads as much from part of total
cost as prime cost and factory burden.
Difference between absorption
costing and marginal costing
Absorption costing
1. All
cost-fixed and variable are charged to product.
2. Profits
= Sales-Cost of goods sold
3. It
does not reveal the cost volume profit relationship.
4. Closing
inventories are valued at full cost. Absorption costing reveals more profit
since the inclusion of fixed costs in inventories.
5. Costs
are included in the products, this leads to over or under-absorption.
Marginal
costing
1.
Only variable costs are charged to
products; fixed costs are transferred to Profit & Loss Account.
2. Contribution
margin = S-VC. Profit = Contribution – FC.
3. Cost
volume profit relationship is an important part of marginal costing.
4. Closing
inventories are valued at variable cost. Marginal costing reveals less profit,
when compared to absorption cost.
5. Fixed
costs are not included in the product; so it will not lead to the problem of
under-absorption.
Cost-Volume-Profit
Analysis
As the term itself suggests, the
cost-volume-profit (CVP) analysis is the analysis of three variable, viz. cost,
volume and profit. In CVP analysis, an attempt is made to measure variations of
cost and profit with volume.
The
cost volume profit analysis helps or assists the management in profit planning.
In order to increase the profit, a concern must increase the output. When the
output is at maximum, within are installed capacity, it adds to the
contribution. When volume of output increase, unit cost of production decrease
the fixed cost per unit decrease. therefore, profit will be more, when sales
price remains unaffected. When the output increase, the fixed cost per unit
decrease. Therefore, profit will be more, when sales price remains constant.
Generally, costs may not change in direct proportion to the volume. Thus a
small change in the volume will affect the profit. The management is always
interested in knowing that which product or product mix is most profitable, what
effect a change in the volume of output will have on the cost of production and
profit etc. all these problems are solved with the help of the
cost-volume-profit analysis.
Marginal Cost Equations
Sales = Variable Cost + Fixed Cost
+_ Profit or loss
Sales – Variable Cost = Fixed cost
+_ Profit or loss
Sales
– Variable Cost = Contribution
Contribution
= Fixed Cost + Profit
From
the above equation, we can understand that in order to earn profit, the
contribution must be more than the fixed cost. To avoid any loss, the
contribution must be equal to fixed cost.
Break- Even Analysis
Break-even point is equilibrium
point or balancing point of no-profit no-loss. This is a point at which loss
ceases and profit begins. This is a point where income is exactly equal to
expenditure. Break-even point: Break-even point is a point where the total
sales are equal to total cost. In this point there is no profit or loss in the
volume of sales. The formula to calculate break-even point is:
B.E.P
(in units) = Total fixed cost or
B.E.P (in sales or rupees) = Total fixed
cost
Contribution per unit
p/v ratio
Or
B.E.P (in sales or rupees) = B.E.P in units X selling price per unit
Profit volume Ratio
Profit volume ratio, which is
popularly known as P/V ratio, expenses the relationship of contribution to
sales. Another name for this ratio is contribution-sales ratio or
marginal-income ratio or variable-profit ratio. The ratio, expressed as a
percentage, indicated the relative profitability of different products. The
formula for computing the P/V ratio is given below:
P/V Ratio = contribution X 100 or P/V Ratio = Change in profit X100
Sales Change in sales
The
profit of a business can be increased by improving P/V ratio. As such
management will make efforts to improve the ratio. A higher ratio means a
greater profitability and vice versa.
Sales required
in units to maintain a desired profit = F.C + Desired
profit
P/V ratio
Margin of Safety -
Total sales minus the sales at break-even point are known as the margin of
Safety (M/S) that is, Margin of Safety is the excess of normal or actual sales
over sales at break-even point. In other words, sales over and above breakeven
sales are known as Margin of Safety. If the Margin of Safety is large, it is a
sign of soundness of the business and vice-versa. Margin of safety of can be
expressed in absolute sales amount or in percentage.
Margin
of Safety=Actual sales – Break even sales or Margin of Safety = Profit
P/v ratio
Application of Marginal Costing
Techniques
Marginal costing is an extremely
valuable technique with the management. The cost-volume-profit relationship has
served as a key to locked storehouse of solutions to many situations. It enables
the management to tackle many problems which are faced in the practical
business. “All the introduction of marginal cost principles does is to give the
management a fresh, and perhaps a refreshing, insight into the progress of
their business.” Now, we explain the application of the technique of marginal
costing in certain important spheres: Marginal costing helps the management in
decision-making in respect of the following vital areas:
1.Cost control:
The two types of costs-variable and fixed- are controllable and
non-controllable respectively. The variable cost is controlled by production
department and the fixed cost is controlled by the management.
2.Fixation of selling price:
Product pricing is a very important function of management. One of the purposes
of cost accounting is the ascertainment of cost for fixation of selling price.
Marginal cost of a product represents the minimum price for that product and
any sale below the marginal cost would entail a loss of cash. There are cyclic
periods in business boom, depression, recession etc. during normal circumstances;
price is based on full cost. The theory is that only those products should be
produced or sold which make the largest contribution towards the recovery of
fixed costs. The selling price fixation is also done under different
circumstances.
3.Closure of a Department or
Discounting a Product: Marginal costing technique shows
the contribution of each product to fixed costs and profit. If a department or
a product contributes the least amount, then the department can be closed or
its production can be discontinued. It means the product which gives a higher
amount of contribution may be chosen and the rest should be discontinued.
4.Selection of a Profitable Product
Mix:
In a multiproduct concern, a problem is faced by the management as to which
product mix or sales mix will give the maximum profit. The product mix which
gives the maximum profit must be selected. Product mix is the ration in which
various products are produced and sold. The marginal costing technique helps
the management in taking decision regarding changing the ratio of product mix
which gives maximum contribution or in dropping unprofitable product line. The
product which has comparatively less contribution may be reduced or
discontinued.
Profit
Planning: Profit planning is a plan for future operation or
planning budget to attain the given objective or to attain the maximum profit.
The volume of sale required to maintain a desired profit can be known from the
formula: Desired profit = F. C + Desired profit
P/V ratio
5.Decision to make or buy:
A firm may make some products, parts or tools or sometimes it may buy the same
thing from outside. The management must decide which is more profitable to the
firm. If the marginal cost of the product is lower than the price of buying
from outside, then the firm can make the product.
6.Decision to accept a bulk order or
foreign market order: Large scale purchasers may demand products
at less than the market price. A decision has to be taken now whether to accept
the order or to reject it. By reducing the normal price, the volume of output
and the sales can be increased. If the price is below the total cost, rejection
of the order is aimed at. In marginal costing, the offer may be accepted, if
the quoted price is above marginal cost, because of the reason that existing
business contribution can recover the fixed costs and the margin of profits. In
such cases, the contribution made by foreign market or bulk orders will be an
addition to the profit. But the price should not be less than the marginal
cost. However, it should not affect the normal market price.
7.Introduction of a new product: A
producing firm may add additional products with the available facility. The new
product is sold in the market at a reasonable price, in order to sell it in
large quantities. It may become popular. If favorable, the sales can be
increased; thus the total cost comes down and contributes some amount towards
fixed cost and profits.
8.Choice of technique:
Every management wished to manufacture the products at the most economical way.
For this, the managerial costing is a good guide as to the products at
different stages of production, that is to say whether the management has to
adopt hand operated system or semi-automatic system or complete automatic
system. When operations are done by hand, fixed cost will be lower than the
fixed cost incurred by machines and incomplete automatic system fixed costs are
more than variable cost.
9.Evaluation of performance: marginal costing help the management
in measuring the performance efficiencies of a department or a product line or
sales division. The department or the product or division which gives the
highest P/V ratio will be the most profitable one or that is having the highest
performance efficiency.
10.
Decision
making: Price must not be less than total cost under normal
conditions. Marginal costing acts as a price fixer and a high margin will
contribute to the fixed cost and profit. But this principle cannot be followed
at all times. Prices should be equal to marginal cost plus a reasonable amount,
which depends upon demand and supply, competition, policy of pricing etc. if
the price is equal to marginal cost, then there is a loss equal to fixed costs.
Sometimes, the businessman has to face loss when, (a) there is cut-throat
competition, (b) there is the fear of future market, (c) the goods are of
perishable nature, (d) the employees cannot be removed, (e) a new product is
introduced in the market, (f) competitors cannot be driven out etc.
11.
Maintaining
a desired level of profit: An industry has to cut prices of
its products from time to time on account of competition, government
regulations and other compelling reasons. The contribution per unit on account
of such cutting is reduced while the industry is interested in maintaining a
minimum level of its profits. Marginal costing technique can ascertain how many
units have to be sold to maintain the same level of profits. Charles points out
“when desired profits are agreed upon, their attainability may be quickly
appraised by computing the number of units that must be sold to secure the
wanted profits. The computation is easily made by dividing the fixed costs plus
desired profits by the contribution margin per unit”.
12.
Level
of activity planning: Where different levels of production
and or selling activities are being considered and the management has to decide
the optimum level of activity, the marginal costing technique helps the
management. What level of activity is optimum for a business to adopt is an
important problem faced by businesses.
13.
Alternative
methods of production: Marginal costing techniques are
also in comparing the alternative methods of manufacture i. e. machine work or
hand work, whether one machine is to be employed instead of another etc. many a
time, management has to choose a course of action from among so many
alternatives, the change in the marginal contribution under each of the
proposed methods are worked out and the method which gives the greatest contribution
is obviously adopted keeping in view the limiting factor if any.
14.
Introduction
of new product or product line: The technique to
assess the profitability of line extension products is the incremental
contribution estimates. The same technique of contribution analysis would be
followed in assessing the profitability of a new product line. Sales forecast
would result from a market survey and market research.
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