Marginal Costing- An Overview.sept.20121

8/10/2019 Marginal Costing- An Overview.sept.20121

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Prof. V. Ramachandran.

SIESCOMS.NERUL (E)

Navi Mumbai-400706

( September-2013)

MARGINAL COSTING

AN OVERVIEW


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Concept of MarginalCost Contribution

Break Even Analysis

Application of Marginal Costing in managerialdecision making.


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Cost can be classifiedinto two groups

viz. fixed cost and variable cost.

Variable cost varieswith the changesin thevolume of outputor level of activity. E.g Material,Power etc per unit of output

Fixed costrelates to timeand does not vary withthe changes in the level of activitybut varies with

changes in the period. E,g Rent, Salary for themonthThis feature cost behavior has given rise to the

concept of Marginal Costing.


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Marginal costingis concerned withdetermination of product cost which consistsof direct material, direct labor, direct

expenses and variable overheads.

Variable costs are fixed per unit and Total

Variable costs varies with the change in the

level of output.


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The ICMA has defined marginal cost asthe amount at any given volume of output bywhich the aggregate costs are changed when the

volume of output is increased or decreased by

one unit."

From the above 'definition it is clear that theincrease /decrease by one unit of outputincreases /reduces the total cost from the

existing level to the new level.

This increase/decrease in cost from existing level

to the new level is called as marginal cost.


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Suppose the cost of producing 100 units isRs. 200.

If 101 units are manufactured the cost goes

up by Rs.1.50 and becomes Rs. 201.50 and

If 99 units are manufactured, the cost isreduced to Rs. 198.50 i.e.by Rs 1.50

This increase/Decrease of Rs.1.50 in cost is

called as the marginal cost.


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Marginal costing technique involves: the ascertainment of marginal costs and

Study of its impact on profit due to change

in volume or type of output by differentiating

between fixed and variable costs".

Marginal costing is not a method of costing.

It is a technique of controlling cost by study

& analysis of relationship between profit and

volume.


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The elements of costare differentiated betweenfixed costs and variable costs.

Fixed costs do not find place in the product

cost

Only the variable or marginal cost is considered

while calculating product costs.

Stock of finished products and work-in-

progress are valued at variable cost.

Contribution is the difference between salesand marginal or Variable cost.

.


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Pricesare based on marginal cost pluscontribution.

It is a technique of costrecording and costreporting.

Profitability of various products is determinedin terms of marginal contribution.

Presentation of data is oriented to highlight

the total contribution and contribution from

each product.


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1.Constant in nature:Marginal cost remains the sameper unit of output whether there is increase ordecrease in production.

2. Realistic:It is realistic as fixed cost is eliminated.

Inventory is valued at marginal cost. Therefore, it ismore realistic and uniform. No fictitious profit arises.

3. Simplified Overhead Treatment:There is nocomplication of over-absorption and under-absorption of overheads.

4. Facilitates Control:Classification of cost as fixed andvariable helps to have greater control over costs.


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5. Meaningful Reporting:The reporting made tomanagement is more meaningful as the reports arebased on sales figures rather than production.Comparison of efficiency can be done in a better way.

6. Relative Profitability:In case a number of productsare manufactured, marginal costing helpsmanagement in the determination of relativeprofitability of each product.

7. Aid to Profit Planning:The technique of marginalcosting helps management in profit planning. Themanagement can plan the volume of sales for earninga required profit.


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8. Break-even point:It can be determined onlyon the basis of marginal costing.

9. Pricing decisions:These decisions can be

based on contribution levels of individualproducts.

10. Responsibility Accounting:It becomes

more effective when based on marginalcosting. Managers can identify theirresponsibilities clearly.


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Analysis of overheads:In marginal costing, costsare to be classified into fixed and variable costs.Considerable difficultiesare experienced inanalysing overheads into fixed and variablecategories. Therefore, segregation of costs into

fixed and variable is rather difficult and cannot

be done with precision.

Greater emphasis on Sales:Marginal costingtechnique lays greater emphasis on sales rather

than production. In fact, efficiency of business isto be judged by considering both sales andproduction.


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Difficulty in Application:Marginal costing isnot applicable in those concerns where largestocks have to be carried by way of work-in-progress.

Improper basis for fixation of selling price:Inmarginal costing selling price is fixed on the

basis of contribution alone which is notproper.


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Less effective in Capital Intensive Industry:Marginal costing technique is less effective incapital intensive industry where fixed cost ismore.

Lack of standard for control:Marginal costingdoes not provide any standard for controlpurpose. In fact, budgetary control andstandard costingare more effective tools incontrolling costs.


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Elimination of Fixed Cost: In marginal costingtechnique fixed costs are not included in thevalue of finished goods and work-in-

progress.

.Elimination of fixed costs from finished stockand work-in-progress results into the undervaluation of the stocks. The understating ofthe stocks and have adverse impact on the

profit and loss account and the balance

sheet, which results in the deflation of

profits.


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Incomplete Information:Marginal cost doesnot give complete information. For example,increase in production and sales may be dueto so many factors such as extensive use of

machinery, expansion of resources and byautomation. The exact cause is not disclosedby marginal costing.


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Useful only for short term assessment:Marginal costing is useful for short-termassessment of profitability. However, long-term assessment of profit can be correctly

determined on full costs basis only.

Not acceptable for tax:Income tax

authorities do not recognise marginal costingfor inventory valuation.


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Contribution is the excess of selling price over

variable costs. It is known as contribution because it

contributes towards recovery of the fixed costs

and profits.

Contribution is a pool of amount from whichtotal fixed costs will be deducted to arrive atthe profit or loss.

By equation the concept of contribution can bestated as follows :


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Profit is known as 'Net Margin'. Net Margin iscalculated after deducting fixed cost fromtotal contribution or gross margin. Profit is anexcess of contribution over fixed cost.

Profit = Contribution - Fixed Cost


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Contribution is not profit. It covers fixed costand the balance left out after meeting fixedcost is profit.

Contribution plays a very important role indecision making.

It is the criteria of deciding profitability ofvarious alternatives.

The alternative which gives maximumcontribution is considered as most profitable.


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The contribution is the difference betweensales and variable cost. In other words,products sold provide fund to meet fixedcosts and profits. Therefore, contribution is

equal to fixed cost plus profit. From this thefollowing equation has been derived:


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If any three factors are given, the fourth canbe ascertained.

This equation is also used for ascertainmentof Break-Even-Point". (B.E.P.) i.e. the point orlevel where there is no profit or no loss.


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This is popularly known as P/V Ratio. Itexpresses the relationship betweencontribution and sales. It is expressed inpercentage. P/V ratio is given by the formula:

Where C = Contribution, (being the difference

between sales and variable costs) S = Sales

V = Variable Costs


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P/V ratio can be determined by expressingchange in profit or loss in relation to change in

sales.

P/V ratio indicates the relative profitability ofdifferent products, processes and

departments.

If information about two periods is given, P/V

ratio is calculated as follows:


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P/V ratio is most important to watch inbusiness. It is the indicator of the rate atwhich the organization is earning profit.

A high ratio indicates high profitability and a

low ratio indicates low profitability.

It is useful for calculating

Break Even Point,

profit at a given level of sales,

sales required to earn a certain amount ofprofit etc.


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Higher P.V. Ratio is an index of soundfinancial health of company's product.

P/V s Ratio can be improved by improvingcontribution which can be improved by taking

the following steps: Increase in sales

Reduction in marginal cost

Concentration on sale of profitable product.


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Following limitations should be kept in mindwhile using P.V. Ratio.

The concept will hold good only when otherconditions are constant

Heavy dependence on contribution.

Fails to consider the capital outlays if

required for additional capacity.

It indicates only relative profitability. Over simplification may lead to erroneous

conclusion,


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Break-even-point is the point at which totalrevenue is equal to total cost.

It is that level of output (or sale) where thereis no profit or no loss.

At this stage contribution is just sufficient toabsorb fixed cost.

The organization starts earning profit onlywhen the output or sales activity crosses this

point. Output or sales below this profit results in a

loss.


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Algebraic MethodThere are two ways of calculating breakeven point : Contribution Approach Following formulae are used in this approach :

B.E.P. (units) = Fixed cost

Selling Price - Variable CostPer unit per unit

B.E.P. (Sales in Rs)= Fixed CostContribution per unit

Or = Break Even Sales (Rs.)Selling price per unit


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Refer Illustrations & problemsin Marginal costing

Marginal Costing- An Overview.sept.20121

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