Course Name: Cost and Management

Accounting
Module 4: Marginal Costing

Introduction

Marginal Costing is a costing technique wherein the marginal cost, i.e. variable cost is charged to
units of cost, while the fixed cost for the period is completely written off against the contribution.

The term marginal cost implies the additional cost involved in producing an extra unit of output,
which can be reckoned by total variable cost assigned to one unit.
It can be calculated as:

Marginal Cost = Direct Material + Direct Labor + Direct Expenses + Variable Overheads

Marginal cost is the change in the total cost when the quantity produced is incremented by one.
That is, it is the cost of producing one more unit of a good.

For example
Characteristics/Features of Marginal Costing
 Classification into Fixed and Variable Cost: Costs are bifurcated, on the basis of variability
into fixed cost and variable costs. In the same way, semi variable cost is separated.
 Valuation of Stock: While valuing the finished goods and work in progress, only variable
cost are taken into account. However, the variable selling and distribution overheads are not
included in the valuation of inventory.
 Determination of Price: The prices are determined on the basis of marginal cost and
marginal contribution.
 Profitability: The ascertainment of departmental and product’s profitability is based on the
contribution margin.
In addition to the above characteristics, marginal costing system brings together the techniques
of cost recording and reporting.

Need for Marginal Costing:

 Variable cost per unit remains constant; any increase or decrease in production changes
the total cost of output.
 Total fixed cost remains unchanged up to a certain level of production and does not vary
with increase or decrease in production. It means the fixed cost remains constant in
terms of total cost.
 Fixed expenses exclude from the total cost in marginal costing technique and provide us
the same cost per unit up to a certain level of production.

Advantages of Marginal Costing

The advantages of marginal costing are as follows:

 Easy to operate and simple to understand.
 Marginal costing is useful in profit planning; it is helpful to determine profitability at
different level of production and sale.
 It is useful in decision making about fixation of selling price, export decision and make
or buy decision.
 Break even analysis and P/V ratio are useful techniques of marginal costing.
  Evaluation of different departments is possible through marginal costing.
 By avoiding arbitrary allocation of fixed cost, it provides control over variable cost.
 Fixed overhead recovery rate is easy.
 Under marginal costing, valuation of inventory done at marginal cost. Therefore, it is not
possible to carry forward illogical fixed overheads from one accounting period to the
next period.
 Since fixed cost is not controllable in short period, it helps to concentrate in control over
variable cost.

Disadvantages of Marginal Costing

• Classifying costs: It is very difficult to separate all costs into fixed and variable costs
clearly, since all costs are variable in the long run. Hence such classification sometimes may
give misleading results. Furthermore, in a firm with many different kinds of products,
marginal costing can prove less useful.

• Accurately representing profits: Since the closing stock consists only of variable
costs and ignores fixed costs (which could be considerable), this gives a distorted picture of
profits to shareholders.

• Semi-variable costs: Semi-variable costs are either excluded or incorrectly analyzed,

leading to distortions.

• Recovery of overheads: With marginal costing, there is often the problem of under or
over-recovery of overheads, since variable costs are apportioned on an estimated basis and
not on actual value.

• External reporting: Marginal costing cannot be used in external reports, which must
have a complete view of all indirect and overhead costs.

• Increasing costs: Since it is based on historical data, marginal costing can give an
inaccurate picture in the presence of increasing costs or increasing production.
Distinction between absorption costing and marginal costing

Marginal costing applies only those costs to inventory that were incurred when each
individual unit was produced, while absorption costing applies all production costs to all
units produced.

This results in the following differences between the two methods:

 Cost application. Only the variable cost is applied to inventory under marginal costing,
while fixed overhead costs are also applied under absorption costing.
 Profitability. The profitability of each individual sale will appear to be higher under
marginal costing, while profitability will appear to be lower under absorption costing.
 Measurement. The measurement of profits under marginal costing uses the contribution
margin (which excludes applied overhead), while the gross margin (which includes
applied overhead) is used under absorption costing.
 Overhead costs are charged to expense in the period under marginal costing, whereas
they are applied to products under the absorption costing method (which may defer
expense recognition to a later period).
 Absorption costing is required by the applicable accounting frameworks for financial
reporting purposes, so that factory overhead will be included in the inventory asset.
Marginal costing is not allowed for financial reporting purposes, so its use is restr icted to
internal management reports.

Cost volume profit (CVP) Analysis

Cost-Volume-Profit (CVP) Analysis is also known as Break–Even Analysis. Every business

organization works to maximize its profits. With the help of CVP analysis, the management
studies the co-relation of profit and the level of production.
CVP analysis is concerned with the level of activity where total sales equals the total cost and it
is called as the break-even point. In other words, we study the sales value, cost and profit at
different levels of production. CVP analysis highlights the relationship between the cost, the
sales value, and the profit.

Let us go through the assumptions for CVP analysis:

  Variable costs remain variable and fixed costs remain static at every level of production.
 Sales volume does not affect the selling price of the product. We can assume the selling
price as constant.
 At all level of sales, the volume, material, and labor costs remain constant.
 Efficiency and productivity remains unchanged at all the levels of sales volume.
 The sales-mix at all level of sales remains constant in a multi-product situation.
 The relevant factor which affects the cost and revenue is volume only.
 The volume of sales is equal to the volume of production.

Cost-volume-profit (CVP) analysis is used to determine how changes in costs and volume
affect a company's operating income and net income. CVP analysis requires that all the
company's costs, including manufacturing, selling, and administrative costs, be identified as
variable or fixed.

CVP analysis is also used when a company is trying to determine what level of sales is necessary
to reach a specific level of income, also called targeted income.

Equations for elements of cost are as follows:

Contribution margin

The contribution margin is the excess between the selling price of the product and total variable
costs.
The contribution margin is the amount of money a business has to cover its fixed costs and
contribute to net profit or loss after paying variable costs. It also measures whether a product is
generating enough revenue to pay for fixed costs and determines the profit it is generating. The
contribution margin can be calculated in dollars, units, or as a percentage.

Additionally, the contribution margin is used to determine the break-even point, which is the
number of units produced or revenues generated to break even. It also lets you know how much a
particular product is contributing to your overall business profit.

Contribution = Sales – Marginal Cost

Profit-Volume Ratio

Profit / Volume (P/V) ratio is calculated while studying the profitability of operations of a
business and to establish a relation between Sales and Contribution. It is one of the most
important ratios, calculated as under:

The P/V Ratio shares a direct relation with profits. Higher the P/V ratio, more the profit and
vice-a-versa.

Break Even Analysis

The break‐even point represents the level of sales where net income equals zero. In other words,
the point where sales revenue equals total variable costs plus total fixed costs, and contribution
margin equals fixed costs.
When the total cost of executing business equals to the total sales, it is called break-even point.
Contribution equals to the fixed cost at this point. Here is a formula to calculate break-even
point:

Composite Break Even Point

A company may have different production units, where they may produce the same product. In
this case, the combined fixed cost of each productions unit and the combined total sales are
taken into consideration to find out BEP.
 Constant Product - Mix Approach In this approach, the ratio is constant for the
products of all production units.
 Variable Product - Mix Approach In this approach, the preference of products is based
on bigger ratio.

Margin of Safety
In break-even analysis, from the discipline of accounting, margin of safety is how much output
or sales level can fall before a business reaches its break-even point.
Margin of safety (MOS) is the difference between actual sales and break even sales. In other
words, all sales revenue that a company collects over and above its break-even point represents
the margin of safety.
Excess of sale at BEP is known as margin of safety.
Therefore,
Margin of safety = Actual sales – Sales at BEP
Margin of safety may be calculated with the help of the following formula:

Margin of safety is also expressed in the form of ratio or percentage that is calculated by using
the following formulas/equations:

MOS ratio = MOS/Actual or budgeted sales

MOS percentage = (MOS/Actual or budgeted sales) × 100

Break-Even Chart is the most useful graphical representation of marginal costing. It converts
accounting data to a useful readable report. Estimated profits, losses, and costs can be
determined at different levels of production.