E-module on

Marginal costing Part 1

Submitted by:

Binoo Gupta

Associate professor

PG Department of Commerce and Management

Hans Raj Mahila Maha Vidyalaya, Jalandhar

​

Marginal cost is the total of variable costs i.e., prime cost plus variable overheads.

It is based on the distinction between fixed and variable costs.

Fixed costs are ignored and only variable costs are taken into consideration for determining cost of products and value of work-in-progress and finished goods

Marginal cost

The Institute of Cost and Works Accountants of India defines marginal cost 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”.

Batty defines Marginal Costing as

“a technique of cost accounting which pays special attention to the behaviour of costs with changes in the volume of output”.

Marginal cost is the change in the aggregate costs due to change in the volume of output by one unit.

​

For example, suppose a manufacturing company produces 10,000 units and the aggregate costs are Rs. 25,000, if 10,001 units are produced the aggregate costs may be Rs. 25,050 which means that the marginal cost is Rs. 50

Marginal cost is also termed as variable cost and hence per unit marginal cost is always same, i.e. per unit marginal cost is always fixed. Marginal cost can be effectively used for decision making in various areas.

Marginal cost = Prime cost + Total variable overheads

​

​

​

​

​

​

​

​

​

​

​

​

Marginal Cost = Total Cost – Fixed Cost.

• All elements of cost—production, administration and selling and distribution—can be segregated into fixed and variable components.
• Variable cost remains constant per unit of output irrespective of the level of output and thus fluctuates directly in proportion to changes in the volume of output.
• The selling price per unit remains unchanged or constant at all levels of activity.
• Fixed costs remain unchanged or constant for the entire volume of production.
• The volume of production or output is the only factor which influences the costs.

​

ASSUMPTIONS OF MARGINAL COSTING

FEATURES OF MARGINAL COSTING:

• Marginal costing is a technique of costing which is used in conjunction with other methods of costing like process or job costing.
• Only marginal costs i.e., variable costs are charged to products. These include direct material, direct labour, direct expenses and variable over heads.
• Fixed costs are treated as period costs and are directly charged to profit and loss account for the period for which they are incurred. They are not charged to products.

�

FEATURES (contd.)

• In marginal costing prices are determined on the basis of marginal cost plus contribution.
• Profitability of departments and products is determined with reference to their contribution margin.
• Fixed costs remain constant irrespective of level of activity.
• Cost-volume-profit relationship is fully employed to reveal the state of profitability at various levels of activity.
• It highlights the effect of costs on the level of output planned.
• Break-even point is the prime component of marginal costing technique

​

ADVANTAGES OF MARGINAL COSTING:

• Helps Management in Decision making:

This technique helps the management in taking various decisions. Marginal costing is more useful in taking decisions like price fixation, make or buy, introduction of new product line, selection of product mix etc.

• Relationship of net income with sales:

Marginal costing system establishes direct relationship of net income with the sales. The marginal contribution technique provides a better and more logical basis for the fixation of sales prices with intending profits.

• Treatment of Overheads simplified:

It reduces the degree of over or under recovery of overheads due to separation of fixed overheads from production cost.

ADVANTAGES (Contd.)

• Helps in preparing Flexible Budget:

Marginal costing facilitates the preparation of flexible budget by differentiating variable costs and fixed costs. It also helps in the evaluation of performance of responsible person.

• Stock Valuation:

Marginal costing inventory is valued at variable cost. Thus, unrealized profits are not taken into account. Under this method stock valuation will be uniform and realistic.

• Aid to profit planning:

Marginal costing technique provides data relating to cost-volume-profit relationship. This facilitates profit planning in future.

ADVANTAGES (Contd.)

​

​

• Helps in pricing:

Marginal costing is very helpful in fixation of selling price of products under various conditions. It gives a better and more logical base for ths fixation of sales price as well as for tendering contracts when the business is at low level.

• Profitability Appraisal:

Marginal costing helps the management in evaluating the profitability of alternative

operations.

• Simply to operate and easy to understand:

Marginal costing is a simple technique. It is very simple to operate and easy to understand. It is constant in nature. Complications involved in allocation, apportionment and absorption of overheads are avoided.

• Cost control:

In marginal costs are divided into fixed and variable costs. Variable costs are always controllable. Thus greater control may be exercised over these costs. Further, effective control on fixed costs becomes easier by treating them as a whole in the determination of profit.

�

LIMITATIONS OF MARGINAL COSTING:

​

​

• Practical Difficulty In Dividing Cost:

The whole concept of marginal costing is based on the classification of total cost into fixed and variable cost which is very difficult task. In marginal costing semi- variable and semi-fixed costs are not considered.

• Time Factor Ignored:

Marginal costing technique does not attach much importance to time factor. If time taken for completing two different jobs is not the same, costs will naturally will be higher for the job which has taken longer time. Though marginal cost may the same for the both jobs.

• Improper basis of pricing:

Marginal costing gives impression that as long as the price is more than the marginal cost of production is profitable. But it may result in over all losses. In long run the price without covering total cost will not yield profit to the firm.

• Not suitable to all industries:

Marginal costing technique is not suitable to all types of industries. For example in capital intensive industries fixed cost like depreciation is more. If fixed costs are ignored proper results cannot be ascertained.

With the increase of automation the scope of marginal costing is decreasing.

​

• Fluctuations in Profits:

Marginal costing technique cannot be applied in industries where there is large stock of work-in-progress. As fixed overheads are not included in the value of stock , firm will get losses in some years. This results in wide fluctuations in profits.

• Difficulty in fixation of price:

Under marginal costing, selling price is fixed on the basis of contribution. In case of cost plus contract is very difficult to fix price.

• Under or over absorption:

Application of variable overheads depends on estimate and not on actual as such there may be under or absorption.

• Full insurance claim cannot be claimed:

Since stock is valued at marginal cost, in case of fire full amount of loss cannot be recovered from the insurance company.

• Not suitable for external reporting:

This technique is not suitable for external reporting viz., for tax authorities, where marginal income is not considered to be taxable profit.

• Significance Lost:

In capital intensive industries fixed costs occupy major portion in the total cost. But marginal costs cover only variable costs. As such, it loses its significance in capital intensive industries.

• Full information is not given:

Marginal costing does not explain reasons for increase in production or sales.