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Marginal costing (unit 4)
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Marginal costing (unit 4)



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  • 1. Marginal costingMeaning: According to CIMA terminology Marginal costing is ascertainment ofmarginal cost and of the effect on the profit of changes in volume or the type ofoutput by differentiating between the fixed and the variable cost. In this techniqueonly variable cost are changed to operation, processes or products, leaving all theindirect cost to be written off against profits in period in which they arise. OrMarginal costing refers to increase or decrease in amount of cost on account ofincrease or decrease of product by single unit. It is clear from above that only variable cost form part of product in thetechnique of marginal costing because only variable cost are changed if output isincreased or decreased and fixed cost remain the same. With the increase of one unit of production may be single or batch ofarticle’s the total cost of production increased and this increase in the total cost ofproduction from existing level to new level if known as marginal cost.This will be clear from the following example: A factory produces 500 fans perannum. The variable cost per fan is Rs 50 .fixed expenses are Rs 10000per annum.Thus the cost sheet of 500 fans will be as follows:Variable cost (500 *50) 25000Fixed cost 10000Total cost 35000If the production is increased by one unit i.e. it becomes 501 fans per annum, Costsheet will appear as follows:Variable cost (510*50) 25050Fixed cost 10000Total cost 35050Therefore marginal cost per unit is Rs 50Formula:Marginal cost= direct material +direct labour cost+ other variable costFeatures of Marginal costing:1) It is a technique of costing which is used to ascertain marginal cost and to knowthe impact of variable cost on the volume of output.2) All cost is classified into fixed and variable cost on the basis of variability .Evensemi-fixed cost is segregated into fixed and variable cost.3) Variable cost alone are changed to production .fixed cost are recovered fromcontribution.4) Valuation of stock of work in progress and finished goods is done on the basis ofmarginal cost.
  • 2. 5) Selling price is based on the marginal cost plus contribution.6) Profit is calculated by deducting the marginal cost and fixed cost from the sales.7) Cost volume profit (break even) analysis is one of the integral parts of themarginal costing.8) The profitability of product is based on the contribution made available by eachproduct.Advantages of Marginal costing:With the help of marginal costing technique managerial decisions can be takenregarding the several matters are discussed as under:1) How much to produce: The level of output which is most profitable for a runningconcern can be determined. Therefore production capacity can be utilized to themaximum possible extent. Ascertainment of most profitable relationship between cost, price andvolume of business shall also assist management in fixing the best selling prices.Thus maximization of profit can be achieved and profit planning becomes easier onthe basis of applying marginal costing technique2) What to produce: The manufacture of which product should be undertaken canbe decided upon after comparing profitability results of different products. Certainproducts or activities may turn to be unprofitable with the passage of time. When existing capacity is to be utilized for producing the different productin varying quantities marginal costing is the good guide for deciding the optimumcombination of products to match the available capacity and resources. Thus for thechoice of alternative products and introduction of new products marginal costingtechnique is helpful to a great extent.3)Whether to produce: The decision whether a particular product should bemanufactured in factory or bought from outside sources can be taken at comparingprices at which it can from outside and marginal cost of producing that article in thefactory.4) How to produce.a) Method of manufacture: When a particular product can be manufactured by twoor more methods the ascertainment of marginal cost of manufacturing productunder each method shall be helpful in deciding as to which method should beadopted for its manufacture.
  • 3. b) Hand or machine labour: The problem of employing machine or to produceentirely by hand labour can be solved with the help of marginal costing technique.5) When to produce: In periods of trade recession whether the productionOn the plant is to be suspended temporarily or permanently closed down can bedecided upon after carefully examining marginal cost structure.6) At what cost to produce a) Efficiency and economy of plants: The marginal cost indicates efficiency andeconomy of different plants over different ranges of products volume and outputb) No profit no loss point: With the help of technique of break even charts involvedunder the marginal costing system point of no profit on loss can be raveled andinformation can be presented to the management so as to facilitate the comparisons.c) Lease or ownership of plant: The cost of lease and ownership are studied andbetter alternative is adopted after judging and assessing the minimum sacrifice andmaximum differential gain through technique of marginal costing.d) Cost control: cost control can be affected through comparing fixed and variableelements of cost with the budgeted costs.e) Inventory valuation: Becomes the more realistic when it is based on the marginalcost. Fruitful results can be derived by combining this technique with the standardcosting and budgetary control technique. T Thus we can see technique of marginal costing is of immense value formanagerial decisions.Limitations of marginal costing:1)Classifications into fixed into variable elements a difficult task It is tough job toanalysis cost under the fixed and variable elements since the nature of the cost is notcertain in some cases. Certain cost may be partly fixed and partly variable and thedivision of such cost into fixed and variable parts separately is based in theassumptions and not facts. Certain overheads have no relations to volume of outputor even with the time thus they cannot be categorized either fixed or variable.Management decisions regarding bonus to workers ,facilities to administrative staffetc. are taken without an consideration of time or production volume.2) Faulty decisions: If the fixed overheads are not taken into considerationmanagement decision regarding the price fixing manufacturing the product etc.may prove to be faulty and deceptive. Marginal costs of the different products maybe same, still manufacture of a particular product may not be profitable on accountof heavy fixed costs.3) Difficult application: The application of marginal costing technique is difficult inmost concerns. It cannot be easily applied in the job costing.
  • 4. 4) Under or over recovery of overheads: As variable overheads are estimated andnot based on the actual, there under and over recovery of overheads may results.5) Better technique available: The system of budgetary control and the standardcosting serve the purpose better than the marginal costing system. Throughvariance analysis impact on the profitability due to changes in the volume and theefficiency can be studied and hence this technique is not required.Application of Marginal costing:Marginal costing is a very useful tool for the management because of its followingapplications:1) Cost control: Marginal costing divides the total cost into fixed and variable costand bring out the reason as to why profits are decreasing in spite of increasing insales. Moreover in marginal costing fixed cost are not eliminated at all. These areshown separately as deduction from contribution instead of merging with cost ofsales. This helps management to control fixed cost in long period as these costs areprogrammed in advance.2)Profit planning: i.e. planning for the future operation in such a way as tomaximize the profit .Absorption costing fails to bring out the correct effect ofchange in sales price, variable cost or product mix on profit of concern but that ispossible with the marginal costing.3) Evaluation of performance: It is useful for evaluating performance of each sectorof concern by making difference fixed and variable expenses. A product or thedepartment will give the higher contribution should be performed if the fixedexpenses remain the same.4) Decision makinga)Fixation of selling price :Marginal cost of product represents minimum price forthat product and any sale below the marginal cost would lead to loss .The price ofproduct should be fixed at a level which not only covers the marginal cost but alsomake the reasonable contribution to cover the fixed overheads.b) Maintaining a desired level of profit: The industry has to cut its price of productfrom time to time on account of competition, government regulations and otherreasons. So the contribution per unit is reduced while industry is interested inmaintaining the minimum level of its profit. So the volume of sales at whichcompany earned desired level of profit can be determined through the marginalcosting.c) Selection of suitable product mix: When the factory manufactures more than oneproduct, a problem is faced by the management as to which product mix will givethe maximum profit. The best product mix is that which yield maximum
  • 5. contribution and the production of that product should be increased .The productwhich give the less contribution should be reduced or closed down. The effect f salesmix can be seen by comparing p/v ratio and break even point.d) Make or buy decision: Whether a particular part of finished product is to bemanufactured within the industry or it has to be brought from outside will dependon the consideration of marginal cost. Marginal cost of manufacturing is to becompared with purchase price of relevant material and if the cost is more than thepurchase price a decision is to buy product from market .However certain non costfactors must be considered:1) In favor of making:A) Ideal facility availableb) Quality of market supplyc) Desirability of maintaining certain facilities2) In favor of buyinga) Lack of capacity requiredb) Wider selection etc.e) Alternate method of production: Marginal costing is helpful in comparing thealternative method of production i.e. machine work or hand work. The methodgives the greatest contribution (assuming fixed cost remain the same) is to beadopted where however fixed expenses change the decision will be taken on the basisof profit planning.f) Exploring the new markets: Decision regarding selling goods in the new markets(whether Indian or foreign) should be taken after considering following factors:1) Whether firm has surplus capacity to meet new demand?2) What price is being offered by new market?3) Whether sale of goods in new market will affect present market for goods?g) Shut down or continue: While deciding whether to shut down not a comparisonhas been made between costs. E.g. loss of goodwill, compensation to workerspacking and storing the cost of plant 2 benefits. E.g. saving of fixed cost etc. onaccount of shut down .In case benefits exceed the cost it is advisable to shut down orvice- versa.