Marginal costing is one of the techniques of costing which guides Management in

pricing, decision making and assessment of profitability; it differentiates the total cost of production into variable expenses and fixed expenses. Variable expenses increase or decrease with the proportional increase or decrease in output. Thus as the increase in variable expenses is proportional to the increase in production the per unit cost does not change. In case of fixed expenses they remain constant at certain level of production and they go on changing per unit with every increase in out put. Thus, Marginal costing by differentiating between the variable cost and fixed cost explains managerial problems on the basis of the difference between Variable Overheads, Fixed Overheads and Sales. Definition: (CIMA London): Marginal costing is The ascertainment of marginal cost and of the effect on Profit of changes in volume or type of output by differentiating between fixed and variable cost. Point to be noted: In this method of costing only variable costs are charged to operations, process of products while fixed costs is written off against profit in the period in which they arise. Concept of Marginal Costing: The basic assumption of marginal costing is that the difference between the aggregate sales value and the aggregate marginal cost of the output sold provides funds to meet the fixed cost and profit of the firm. This difference so obtained is known as contribution. Contribution = selling price - Marginal cost Contribution = Fixed cost + profit. Therefore if more than one product are produced, contribution of all the products are merged into the fund out of which fixed expenses are deducted to get the profit. Characteristics of Marginal Costing: 1. It is an independent method of costing, a technique of analysis and presentation of cost in a disintegrated form. 2. It involves differentiation of Fixed and variable costs variable costs are taken for any kind of analysis but fixed cost are excluded from computation. 3. It analyses or solves any kind of Managerial problems on the basis of the contribution so acquired. It is the difference between the sales and the variable expenses. 4. In marginal costing the finished goods and working in progress are valued at marginal cost only. 5. The Fixed cost incurred are recovered against the contribution without being carried forward. 6. The difference between contribution and fixed cost is either profit or loss. Excess of contribution over fixed cost is profit and loss is vice versa. ASSUMPTIONS OF MARGINAL COSTING: The cost accounting technique is based on certain assumption. They are:

1) The costs can be bifurcated in two clear cut divisions on the basis of behaviour in relation to volume of production (i.e.) variable and fixed. 2) The variable cost per unit remains constant irrespective of the level of activity and therefore, varies in direct relation with volume. 3) The fixed costs remain constant for the entire volume of production but fixed cost per unit varies inversely with the change in volume of output. 4) The selling price per unit keeps constant at any level of activity. 5) The volume is the only factor which influences the costs. 6) The costs and revenue functions are linear over the entire output range. Advantages of marginal Costing: 1) It helps, assists in taking decisions such as pricing, accepting foreign orders at low price, to make or buy, profitable product mix, change in market etc. 2) There is no problem of arbitrary apportionment of fixed cost. 3) It enables effective cost control by dividing costs into fixed cost and variable cost. 4) The fixed cost is charge to current years profit in marginal costing rather than carrying a part of such fixed cost to next year by including in value of closing stock. 5) Stock is valued at marginal cost and does not include fixed costs like rent, insurance which are incurred on time basis. 6) It yields better results when used with standard costing. 7) Contribution analysis enables evaluation and comparison of profitability and efficiency of product lines, departments, productive facilities, sales divisions or of alternative policies and guides effectively in taking apt decisions. 8) By differentiating fixed and variable costs and by means of break-even charts it depicts convincingly the interrelationship between cost, volume and profit and there by aids in optimising the level of activity and helps in profit planning. 9) It is a unique system of reporting various facts to management. Limitations of marginal costing: 1) Sometimes it is difficult to separate fixed cost and variable costs clearly. 2) There are also semi-variable costs which are not considered in the analysis. 3) Sales revenue and variable costs do not increase in rigid proportions with the volume of production. At higher level of production they are less proportionate than what they should be. This is due to trade discounts, economies of bulk buying, concessions or higher sales. 4) Since apportionment of overheads is done on basis of estimations, over and under absorption cannot be ruled out. 5) Fixed costs cannot be ignored in the process of fixation of prices and comparison between two jobs. 6) Contribution of two periods over a long time gap cannot be taken as the basis for comparison of performance between two periods as time element cannot be ignored during which all costs (Including fixed costs) change. 7) The comparison between the two firms on the basis of contribution is not possible if the fixed cost of the two firms are not same. 8) Sometimes there are chances that on the basis of or Guidance of Marginal cost principle, a firm may accept excessive orders at lower price, ignoring its plant capacity which may lead to overtime working, extension of production capacity which may in turn Increase cost of production leading to losses.

9) Indiscriminate acceptance of orders at lower price may affect local market price. 10) Valuation of closing stock at marginal cost will lead to underestimating it in the final accounts. Consequently profits are suppressed and the Balance Sheet is distorted. 11) In controlling costs, Marginal costing is not useful in concerns where fixed costs are huge in relation to variable cost. 12) In case of loss by fire, full loss cannot be recovered from insurance company since stock is under valued at marginal costs. 13) It is found unsuitable in Industries -like ship building, contract etc. Where the value of work-in-progress is high in relation to turnover. If fixed expenses are ignored in valuation of work-in-progress, losses may occur every year till the contract is completed and would earn huge profits on completion.

Application of Marginal Costing:

1) Profit Planning Profit planning involves forecasting activity level in order to gain or maintain specified amount of profit. Under profit planning start is made from the end result. profit figure is planned and activity level necessary for yielding that profit is attempted. It should be noted that the activity level will involve working out how that level will yield specified profit. In this exercise sale, cost and production activities are all reviewed in harmony with each other to determine how they will yield the desired profit figure. 2) Presentation of cost data for control purpose- Under marginal costing cost data is presented in such a way that it confirms to all the requirements of management to effect control. Data presentation is based on the behavioural study of cost. This leads the management to exercise better control over the cost. Under absorption costing cost data may be misleading for the purpose of decision making. 3) Make or Buy decision-Decision to make or buy should involve comparison of sellers price with marginal cost of that component. But this approach will lead to wrong conclusion. When a component is produced, a art of plant capacity is utilized, i.e. some contribution is earned. If a company is running at its full capacity the contribution thus earned will be lost \by not manufacturing the component. But this approach will lead to wrong conclusion. When a component is produced a part of plant capacity is utilized,i.e. some contribution is earned. If a company is running at full capacity the contribution thus earned will be lost by not manufacturing the component. Of course, if company is not working at its full capacity the question of lost contribution will become another factor of consideration 4) Optimizing the product mix- When a concern manufactures a number of products, a problem arises as to which product or sale mix will yield maximum profit. Such a problem can be solved by marginal contribution analysis. Product mix, which gives the maximum contribution, will be the optimum mix. 5) Alternative use of production facilities-When an alternative method of manufacturing a product or alternative is available, marginal contribution analysis should be made to arrive at the decision. The alternative yielding the highest contribution will be selected. 6) Evaluation of performance- A company may have different departments or product lines. All these departments and product lines may have different revenue earning potential. A company always concentrates on the departments or the product lines which yields more contribution than others. The relative performance of each department or product is studied by marginal contribution analysis. This analysis will help the company to take decision that will maximize the profits.

Marginal Costing can be applied in the context of Decision Making

MARGINAL COSTING PRO-FORMA

Sales Revenue( 2 ) Less Marginal Cost of Sales(no) Opening Stock (Valued @ marginal cost)(1sr) Add Production Cost (Valued @ marginal cost) (1sr) Total Production Cost(1sr) Less Closing Stock (Valued @ marginal cost) (1sr) Marginal Cost of Production(1sr) Add Selling, Admin & Distribution Cost(1sr) Marginal Cost of Sales( 2nd) Contribution( 2nd) Less Fixed Cost( 2nd) Marginal Costing Profit( 2nd)
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