Marginal Costing

The term 'marginal cost' is defined 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. It is a variable cost of one unit of product or service, i.e. a cost, wh8ich would be avoided is that unit was not produced or provided".

According to CIMA terminology, " Marginal costing is the ascertainment of marginal costs of the effect on profit changes in volume or type of output by differentiating between fixed costs and variable costs."

It is a technique of decision making, which involves

• the ascertainment of total costs.
• classification of costs into one fixed and variable.
• use of such information for analysis and decision-making..

Marginal costing is mainly concerned with providing information to management to assist in decision-making and to exercise control.

Marginal costing is also known as 'variable costing' or 'out of pocket costing'.

Important Factors to be Considered in Marginal Costing Decisions:

In all recommendations of marginal costing decisions, the following factors are to be considered

Contribution: Whether the product or production line in question makes a contribution.

Specific fixed Cost: Where a choice is to be made between two alternatives, the additional fixed overhead. If any should be taken into account.

Cost Volume Profit Relationship: The effect of an increase in volume on profits and the rate of earning, additional profits, should be analysed.

Incremental Contribution: Where additional prices can be sold only at reduced prices, the incremental contribution will be more effective in decision-making, as it takes into account the additional sale quantity and additional contribution per unit.

Capacity: Whether acceptance of the incremental order or additional product line is within the firms capacity or whether key factor comes into play, should be analysed.

Non-cost Factors: Non-cost factors should be considered, wherever applicable.

Advantages of Marginal Costing:

Pricing Decisions: Since marginal cost per unit is constant from period to period within a short span of time, firms decisions on pricing policy can be taken.

Overhead Variance: Marginal costing avoids under-recovery or over-recovery of fixed overheads since these costs are recognised as period costs.

True Profit: Under the marginal costing technique, the stock of finished goods and work-in-progress are carried on a marginal cost basis and the fixed expenses are written off to profit and loss account as period cost. This shows the true profit of the period.

Break-even analysis: Marginal costing helps in break-even analysis, which shows the effect of increasing or decreasing production activity on the profitability of the company.

Control over expenditure: Segregation of expenses as fixed and variable helps the management to exercise control over expenditure.

Business Decision-making: Marginal Costing helps management in taking a number of business decisions like make or buy, discontinuance of a particular product, acceptance of export offers etc.

Limitation of Marginal Costing:

Difficult to Classify: It is difficult to classify exactly the expenses into fixed and variable categories.

Wrong Priced Decisions: Sales staff may mistake marginal cost for total cost and sell at a price, which will result in loss or low profits.

Stock valuation: overheads of fixed nature cannot altogether be excluded particularly in large contracts while valuing the work-in-progress. In order to show the correct position, fixed overheads may also have to be included in work-in-progress.

Ignores Time Value: Marginal costing ignores time factors and investment. e.g.The marginal cost of two jobs may be the same, but the time taken for their completion and the cost of machines used may differ.