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Marginal costing - definition

Marginal costing is formally defined as: The accounting system in which variable costs are charged to cost units and the fixed costs of the period are written-off in full against the aggregate contribution. Its special value is in decision making. Marginal costing distinguishes between fixed costs and variable costs as conventionally classified. Variable costing is another name of marginal costing. Marginal costing may be defined as the technique of presenting cost data wherein variable costs and fixed costs are shown separately for managerial decision-making. It should be clearly understood that marginal costing is not a method of costing like process costing or job costing. Rather it is simply a method or technique of the analysis of cost information for the guidance of management which tries to find out an effect on profit due to changes in the volume of output.

MARGINAL COST
The marginal cost of a product is its variable cost. This is normally taken to be; direct labour, direct material, direct expenses and the variable part of overheads. Marginal cost means the cost of the marginal or last unit produced. It is also defined as the cost of one more or one less unit produced besides existing level of production The marginal cost varies directly with the volume of production and marginal cost per unit remains the same. It consists of prime cost, i.e. cost of direct materials, direct labour and all variable overheads. It does not contain any element of fixed cost which is kept separate under marginal cost technique. The term contribution mentioned in the formal definition is the term given to the difference between Sales and Marginal cost. Thus MARGINAL COST =VARIABLE COST DIRECT LABOUR + DIRECT MATERIAL + DIRECT EXPENSE + VARIABLE OVERHEADS Marginal costing technique has given birth to a very useful concept of contribution where contribution is given by: Sales revenue less variable cost (marginal cost) Contribution may be defined as the profit before the recovery of fixed costs. Thus, contribution goes toward the recovery of fixed cost and profit, and is equal to fixed cost plus profit (C = F + P). In case a firm neither makes profit nor suffers loss, contribution will be just equal to fixed cost (C = F). This is known as break even point. The concept of contribution is very useful in marginal costing. It has a fixed relation with sales. The proportion of contribution to sales is known as P/V ratio which remains the same under given conditions of production and sales.

Theory of Marginal Costing


The theory of marginal costing as set out in A report on Marginal Costing published by CIMA, London is as follows: In relation to a given volume of output, additional output can normally be obtained at less than proportionate cost because within limits, the aggregate of certain items of cost will tend to remain fixed and only the aggregate of the remainder will tend to rise proportionately with an increase in output. Conversely, a decrease in the volume of output will normally be accompanied by less than proportionate fall in the aggregate cost. The theory of marginal costing may, therefore, by understood in the following two steps: 1. If the volume of output increases, the cost per unit in normal circumstances reduces. Conversely, if an output reduces, the cost per unit increases. If a factory produces 1000 units at a total cost of $3,000 and if by increasing the output by one unit the cost goes up to $3,002, the marginal cost of additional output will be $.2. 2. If an increase in output is more than one, the total increase in cost divided by the total increase in output will give the average marginal cost per unit. If, for example, the output is increased to 1020 units from 1000 units and the total cost to produce these units is $1,045, the average marginal cost per unit is $2.25. It can be described as follows: Additional cost = $ 45 = $2.25 Additional units 20

THE PRINCIPLES OF MARGINAL COSTING

The principles of marginal costing are as follows: a. For any given period of time, fixed costs will be the same, for any volume of sales and production (provided that the level of activity is within the relevant range). Therefore, by selling an extra item of product or service the following will happen: Revenue will increase by the sales value of the item sold. Costs will increase by the variable cost per unit. Profit will increase by the amount of contribution earned from the extra item.

b. Similarly, if the volume of sales falls by one item, the profit will fall by the amount of contribution earned from the item. c. Profit measurement should therefore be based on an analysis of total contribution. Since fixed costs relate to a period of time, and do not change with increases or decreases in sales volume, it is misleading to charge units of sale with a share of fixed costs. d. When a unit of product is made, the extra costs incurred in its manufacture are the variable production costs. Fixed costs are unaffected, and no extra fixed costs are incurred when output is increased.

Features of Marginal Costing


The main features of marginal costing are as follows: 1. Cost Classification

The marginal costing technique 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 following the marginal costing technique. 2. Stock/Inventory Valuation Under marginal costing, inventory/stock for profit measurement is valued at marginal cost. It is in sharp contrast to the total unit cost under absorption costing method. 3. Marginal Contribution Marginal costing technique makes use of marginal contribution for marking various decisions. Marginal contribution is the difference between sales and marginal cost. It forms the basis for judging the profitability of different products or departments.

Advantages and Disadvantages of Marginal Costing Technique


Advantages:
1. Marginal costing is simple to understand. 2. By not charging fixed overhead to cost of production, the effect of varying charges per unit is avoided.

3. It prevents the illogical carry forward in stock valuation of some proportion of current years fixed overhead. 4. The effects of alternative sales or production policies can be more readily available and assessed, and decisions taken would yield the maximum return to business. 5. It eliminates large balances left in overhead control accounts which indicate the difficulty of ascertaining an accurate overhead recovery rate. 6. Practical cost control is greatly facilitated. By avoiding arbitrary allocation of fixed overhead, efforts can be concentrated on maintaining a uniform and consistent marginal cost. It is useful to various levels of management. 7. It helps in short-term profit planning by breakeven and profitability analysis, both in terms of quantity and graphs. Comparative profitability and performance between two or more products and divisions can easily be assessed and brought to the notice of management for decision making.

Disadvantages:
1. The separation of costs into fixed and variable is difficult and sometimes gives misleading results. 2. Normal costing systems also apply overhead under normal operating volume and this shows that no advantage is gained by marginal costing. 3. Under marginal costing, stocks and work in progress are understated. The exclusion of fixed costs from inventories affect profit, and true and fair view of financial affairs of an organization may not be clearly transparent. 4. Volume variance in standard costing also discloses the effect of fluctuating output on fixed overhead. Marginal cost data becomes unrealistic in case of highly fluctuating levels of production, e.g., in case of seasonal factories. 5. Application of fixed overhead depends on estimates and not on the actual and as such there may be under or over absorption of the same. 6. Control affected by means of budgetary control is also accepted by many. In order to know the net profit, we should not be satisfied with contribution and hence, fixed overhead is also a valuable item. A system which ignores fixed costs is less effective since a major portion of fixed cost is not taken care of under marginal costing. 7. In practice, sales price, fixed cost and variable cost per unit may vary. Thus, the assumptions underlying the theory of marginal costing sometimes becomes unrealistic. For long term profit planning, absorption costing is the only answer.

ABSORPTION COSTING
Absorption costing means that all of the manufacturing costs are absorbed by the units produced. In other words, the cost of a finished unit in inventory will include direct materials, direct labour, and both variable and fixed manufacturing overhead. As a result, absorption costing is also referred to as full costing or the full absorption method. According to this method, the cost of a product is determined after considering both fixed and variable costs. The variable costs, such as those of direct materials, direct labour, etc. are directly charged to the products, while the fixed costs are apportioned on a suitable basis over different products manufactured during a period. Thus, in case of Absorption Costing all costs are identified with the manufactured products.

Marginal Costing versus Absorption Costing

The net profits in Marginal Costing and Absorption Costing are not same because of the following reasons: 1. Over and Under Absorbed Overheads In absorption costing, fixed overheads can never be absorbed exactly because of difficulty in forecasting costs and volume of output. If these balances of under or over absorbed/recovery are not written off to costing profit and loss account, the actual amount incurred is not shown in it. In marginal costing, however, the actual fixed overhead incurred is wholly charged against contribution and hence, there will be some difference in net profits. 2. Difference in Stock Valuation In marginal costing, work in progress and finished stocks are valued at marginal cost, but in absorption costing, they are valued at total production cost. Hence, profit will differ as different amounts of fixed overheads are considered in two accounts. The profit difference due to difference in stock valuation is summarized as follows: When there is no opening and closing stocks, there will be no difference in profit. When opening and closing stocks are same, there will be no difference in profit, provided the fixed cost element in opening and closing stocks are of the same amount. When closing stock is more than opening stock, the profit under absorption costing will be higher as comparatively a greater portion of fixed cost is included in closing stock and carried over to next period. When closing stock is less than opening stock, the profit under absorption costing will be less as comparatively a higher amount of fixed cost contained in opening stock is debited during the current period.

The features which distinguish marginal costing from absorption costing are as follows:
In absorption costing, items of stock are costed to include a fair share of fixed production overhead, whereas in marginal costing, stocks are valued at variable production cost only. The value of closing stock will be higher in absorption costing than in marginal costing. As a consequence of carrying forward an element of fixed production overheads in closing stock values, the cost of sales used to determine profit in absorption costing will: include some fixed production overhead costs incurred in a previous period but carried forward into opening stock values of the current period; exclude some fixed production overhead costs incurred in the current period by including them in closing stock values.

In contrast marginal costing charges the actual fixed costs of a period in full into the profit and loss account of the period. (Marginal costing is therefore sometimes known as period costing.) In absorption costing, actual fully absorbed unit costs are reduced by producing in greater quantities, whereas in marginal costing, unit variable costs are unaffected by the volume of production (that is, provided that variable costs per unit remain unaltered at the changed level of production activity). Profit per unit in any period can be affected by the actual volume of production in absorption costing; this is not the case in marginal costing. In marginal costing, the identification of variable costs and of contribution enables management to use cost information more easily for decision-making purposes (such as in budget decision making). It is easy to decide by how much contribution (and therefore profit) will be affected by changes in sales volume. (Profit would be unaffected by changes in production volume). In absorption costing, however, the effect on profit in a period of changes in both: i. production volume; ii. sales volume; is not easily seen, because behaviour is not analysed and incremental costs are not used in the calculation of actual profit.

Arguments in favour of marginal costing


(a) It is simple to operate. (b) There are no apportionments, which are frequently done on an arbitrary basis, of fixed costs. Many costs, such as the marketing director's salary, are indivisible by nature. (c) Fixed costs will be the same regardless of the volume of output, because they are period costs. It makes sense, therefore, to charge them in full as a cost to the period. (d) The cost to produce an extra unit is the variable production cost. It is realistic to value closing inventory items at this directly attributable cost. (e) Under or over absorption of overheads is avoided. (f) Marginal costing provides the best information for decision making. (g) Fixed costs (such as depreciation, rent and salaries) relate to a period of time and should be charged against the revenues of the period in which they are incurred. (h) Absorption costing may encourage over-production since reported profits can be increased by increasing inventory levels.

Arguments in favour of absorption costing

(a) Fixed production costs are incurred in order to make output; it is therefore 'fair' to charge all output with a share of these costs. (b) Closing inventory values, include a share of fixed production overhead, and therefore follow the requirements of the international accounting standard on inventory valuation. (c) Absorption costing is consistent with the accruals concept as a proportion of the costs of production are carried forward to be matched against future sales. (d) A problem with calculating the contribution of various products made by an enterprise is that it may not be clear whether the contribution earned by each product is enough to cover fixed costs, whereas by charging fixed overhead to a product it is possible to ascertain whether it is profitable or not. This is particularly important where fixed production overheads are a large proportion of total production costs. Not absorbing production would mean that a large portion of expenditure is not accounted for in unit costs. (e) In a job or batch costing environment (see section 5 below), absorption costing is particularly useful in the pricing decision to ensure that the profit mark up is sufficient to cover fixed costs.

MARGINAL COSTING AS A MANAGEMENT ACCOUNTING TOOL


1. Marginal Costing is clearly the core aspect of traditional management accounting. Some of the classical applications of management accounting, however, have begun to lose their significance. 2. Businesses today frequently voice their disapproval of the traditional cost accounting approaches. At the beginning of the 1990s, these criticisms were taken up by researchers involved with the applications of cost accounting concepts. The main thrust of the dissatisfaction with conventional cost accounting methods is that they are too highly developed and too complex, and furthermore are no longer needed in their current form since other tools are now available. Calls for increased use of cost management tools, investment analyses, and value-based tool concepts are frequently

associated with criticism of the functionality of current cost accounting approaches as management tools. This line of criticism sees little relevance in traditional cost accounting tasks such as monitoring the economic production process or assigning the costs of internal activities. At their current level of detail, such tasks are neither necessary nor does their perceived pseudo accuracy further the goals of management. 3. To assess the present-day value of Marginal Costing, the changes occurring in the business world must be analyzed more closely. First, cost planning takes precedence over cost control. The effort involved in planning and monitoring costs is increasingly being seen as excessive. Second, cost accounting must be employed as a tool for cost control at an early stage. The relative significance of traditional cost accounting as a management accounting tool will decline as it is applied mainly to fields where costs cannot be heavily influenced. More significant than influencing the current costs of production with cost centre controlling and authorized-actual comparisons of the cost of goods manufactured is timely and market-based authorized cost management. The greatest scope for influencing costs is at the early product development phase and when setting up the production processes. 4. The shift in the purposes of cost accounting is being accompanied by a shift in the main applications of standard costing. Costing solutions for market-oriented profitability management and life-cycle-based planning and monitoring should be developed further. They should be implemented both in indirect areas and at the corporate level. In addition, cost accounting must be integrated into performance measurement. Long-term cost planning based on the idea of lifecycle costing is gaining in prominence compared with short-term standard costing. Product decisions are increasingly based on more than just the cost of goods manufactured and sales costs and now tend to include pre-production costs (such as development costs) and phasing-out costs (such as disposal costs). Product decisions are viewed strategically. Whether or not a product is successful is determined by the amortization of its overall cost. Furthermore, the cost and revenue trend forecasts should be more dynamic to support the lifecycle pricing policy. This shift in cost and revenue planning is moving cost and revenue accounting in the direction of investment-related calculations. Industrial production and marketing are increasingly being handled by groups of affiliated companies. To plan and monitor the costs of these activities calls for the

establishment of independent group cost accounting. This necessity results mainly from the requirements of inventory valuation, the costing basis of transfer prices, and to further the consistency of corporate cost accounting. Group cost accounting leads to the definition of independent group cost categories. Marginal Costing and its tools have been developed for individual companies and are the suitable platform for this expansion. While top management benefits most from financial success indicators that it examines in monthly or longer intervals and that can consist of multidimensional aggregate figures, lower management must necessarily be concerned mainly with nonfinancial, operational, and very short-term data at the day or shift level. In concrete terms, measures in the categories of time, quantity, and quality--such as equipment downtime, lead time, response time, degree of utilization (ratio of actual output quantity to planned output quantity), sales orders, and error rate--are becoming increasingly significant for controlling business processes.

THE BASIC DECISION MAKING INDICATORS IN MARGINAL COSTING


1. PROFIT VOLUME RATIO (P/V RATIO)
The profit volume ratio is the relationship between the Contribution and Sales value. It is also termed as Contribution to Sales Ratio Formula: P/V Ratio = Contribution X 100 Sales

Significance of P/V Ratio

It is considered to be the basic indicator of profitability of business.

The higher the P/V Ratio, the better it is for the business. In the case of the firm enjoying steady business conditions over a period of years, the P/V Ratio will also remain stable and steady. If P/V Ratio is improved, it will result in better profits.

Improvement of P/V Ratio P/V Ratio can be improved:


By reducing the variable costs. By increasing the selling price By increasing the share of products with higher P/V Ratio in the overall sales mix. (where a firm produces a number of products)

Uses of P/V Ratio


To compute the variable costs for any volume of sales 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 a higher P/V Ratio. To determine the Break Even Point and the level of output required to earn a desired profit. To decide the most profitable sales mix.

2. BREAK - EVEN ANALYSIS

Break-Even Analysis is a mathematical technique for analyzing the relationship between sales and fixed and variable costs. Break-even analysis is also a profit-planning tool for calculating the point at which sales will equal total costs.
The Break Even Point is the point or a business situation at which there is neither a profit nor a loss to the firm. In other words, at this point, the total contribution equals fixed costs. The break-even point is the intersection of

the total sales and the total cost lines. This point determines the number of units produced to achieve breakeven.

A break-even chart is constructed with a horizontal axis representing units produced and a vertical axis representing sales and costs. Represent fixed costs by a horizontal line since they do not change with the number of units produced. Represent variable costs and sales by upward sloping lines since they vary with the number of units produced and sold. The break-even point is the intersection of the total sales and the total cost lines. Above that point, the firm begins to make a profit, but below that point, it suffers a loss. It depicts the following:
(1)Profitability of the firm at different levels of output. (2)Break-even point No profit no loss situation. (3)Angle of Incidence: This is the angle at which the total sales line cuts the total cost line. It is shows as angle (theta). If the angle is large, the firm is said to make profits at a high rate and vice versa. (4)Relationship between variable cost, fixed expenses and the contribution. (5)Margin of safety representing the difference between the total sales and the sales at breakeven point.

3. COST VOLUME PROFIT ANALYSIS (CVP Analysis)

Analysis that deals with how profits and costs change with a change in volume is known as Cost Volume Profit Analysis. More specifically, it looks at the effects on profits of changes in such factors as variable costs, fixed costs, selling prices, volume, and mix of products sold. CVP analysis involves the analysis of how total costs, total revenues and total profits are related to sales volume, and is therefore concerned with predicting the effects of changes in costs and sales volume on profit. It is also known as 'breakeven analysis'. By studying the relationships of costs, sales, and net income, management is better able to cope with many planning decisions. For example, CVP analysis attempts to answer the following questions: (1) What sales volume is required to break even? (2) What sales volume is necessary in order to earn a desired (target) profit? (3) What profit can be expected on a given sales volume? (4) How would changes in selling price, variable costs, fixed costs, and

output affect profits? (5) How would a change in the mix of products sold affect the break-even and target volume and profit potential?

Cost-volume-profit analysis (CVP), or break-even analysis, is used to compute the volume level at which total revenues are equal to total costs. When total costs and total revenues are equal, the business organization is said to be "breaking even." The analysis is based on a set of linear equations for a straight line and the separation of variable and fixed costs.

USES OF CVP ANALYSIS


a) Budget planning: The volume of sales required to make a profit (breakeven point) and the 'safety margin' for profits in the budget can be measured. b) Pricing and sales volume decisions. c) Sales mix decisions, to determine in what proportions each product should be sold. d) Decisions that will affect the cost structure and production capacity of the company.

4. Margin of Safety
Margin of Safety (MOS) represents the difference between the actual total sales and sales at break-even point. It can be expressed as a percentage of total sales, or in value, or in terms of quantity.

SIGNIFICANCE
Up to Break Even point the contribution earned is sufficient only to recover fixed costs. However beyond the Break even point. The contribution is called profit (since fixed costs are fully recovered by then) Profit is nothing but contribution carried out of Margin of Safety Sales. The size of the margin of safety shows the strength of the business. If the margin of safety is small, it may indicate that the firm has large fixed expenses and is more vulnerable to changes in sales. If the margin of safety is large, a slight fall in sales may not affect the business very much but if it is small even a slight fall in sales may adversely affect the business.

5. SHUT DOWN POINT

Shut Down Point indicates the level of operations (sales), below which it is not justifiable to pursue production. For this purpose fixed costs of a business are classified into (a) Avoidable or Discretionary Fixed Costs and (b) Unavoidable or Committed Fixed Costs. A firm has to close down if its contribution is insufficient to recover the avoidable fixed costs. The focus of shutdown point is to recover the avoidable fixed costs in the first place. By suspending the operations, the firm may save as also incur some additional expenditure. The decision is based on whether contribution is more than the difference between the fixed expenses incurred in normal operation and the fixed expenses incurred when plant is shut down. Key Factor is an important factor that should be considered before shutting down production.

KEY FACTOR
Key factor or Limiting factor represents a resource whose availability is less than its requirement. It is a factor, which at a particular time or over a period limits the activities of a firm. It is also called Critical Factor (Since it is vital or critical to the firms success) and Budget Factor (since budgets are formulated by reference to such limitations or restraints). Some examples of key Factor are (a) Shortage of raw material; (b) Labour shortage; (c) Plant capacity; (d) Sales Expectancy; (e) Cash availability etc.