by Marginal costing is a costing technique in which only the variable costs of a product or service are considered while computing the cost of production. It is also known as variable costing or direct costing. In marginal costing, fixed costs are treated as period costs and are not included in the cost of production. Marginal costing helps in analyzing the effect of changes in the volume of production on the cost of production and the profit of the business. It provides useful information to the management for decision-making, such as pricing, make or buy decisions, sales mix decisions, etc.
Definitions of Marginal Costing given by Different Authors:
According to CIMA (Chartered Institute of Management Accountants), “Marginal Costing is the ascertainment of marginal costs and of the effect on profit of changes in volume or type of output by differentiating between fixed costs and variable costs.”
According to J.R. Batliboi, “Marginal Costing is a technique of presenting cost data wherein variable costs and fixed costs are shown separately for managerial decision-making.”
According to Horngren, Foster, and Datar, “Marginal Costing is a technique that separates fixed costs from variable costs in the accounting records and reports only variable costs as the cost of the product.”
According to Lucey, “Marginal Costing is the ascertainment of marginal cost and the effect on profit of changes in volume or type of output by differentiating between fixed costs and variable costs.”
According to R.N. Anthony and G.H. Reece, “Marginal Costing is a system of costing in which only variable costs are charged to products or services, while fixed costs are treated as period costs and charged against profits of the period in which they are incurred.”
Characteristics of Marginal Costing
- Separation of costs: Marginal costing separates costs into fixed and variable components. This enables management to make decisions on how to optimize costs and profitability.
- Focus on contribution: Marginal costing focuses on the contribution margin, which is the difference between sales revenue and variable costs. This provides a more accurate picture of the profitability of a product or service.
- Fixed costs are treated as period costs: Under marginal costing, fixed costs are not allocated to products or services. They are treated as period costs and are charged against revenue in the period in which they are incurred.
- Break-even analysis: Marginal costing uses break-even analysis to determine the level of sales required to cover fixed costs. This helps management in planning and decision making.
- Relevant cost: Marginal costing considers only the relevant costs in making decisions. This includes variable costs and any additional costs that would be incurred as a result of a decision.
- Profit planning: Marginal costing is useful for profit planning and decision making. It provides information on the contribution margin and break-even point, which helps management in determining the optimal level of sales and production.
- Marginal cost as basis for decision-making: Marginal costing provides a basis for decision-making by considering the impact of a decision on the contribution margin. This helps management to choose the most profitable course of action.
- Emphasis on short-term decisions: Marginal costing is more suited to short-term decision making as it focuses on variable costs and contribution margin. Fixed costs are treated as period costs and are not relevant in short-term decisions.
Marginal Cost formula
The formula for calculating marginal cost is:
Marginal Cost = Change in Total Cost / Change in Quantity
Or
Marginal Cost = Variable Cost per Unit
Marginal Costing Types:
There are two types of Marginal Costing:
- Marginal Costing with absorption of fixed overheads
- Marginal Costing without absorption of fixed overheads
The formulas for both types of Marginal Costing are:
Marginal Costing with absorption of fixed overheads:
Marginal Cost = Variable Cost per Unit + Fixed Overhead per Unit
Total Cost = Marginal Cost per Unit x Number of Units
Profit = Total Sales – Total Cost
Marginal Costing without absorption of fixed overheads:
Marginal Cost = Variable Cost per Unit
Total Cost = Fixed Cost + Total Variable Cost
Profit = Total Sales – Total Cost
Note: In Marginal Costing without absorption of fixed overheads, fixed overheads are treated as period costs and are not charged to the cost of production.
Advantages of Marginal Costing:
- Simple and easy to understand: Marginal costing is a simple and straightforward method of accounting. It is easy to understand and implement even for non-accounting personnel.
- Cost Control: Marginal costing helps in controlling costs by providing information about the impact of production on costs. Managers can make decisions that reduce costs by eliminating unprofitable products, reducing wastage, and maximizing output.
- Accurate pricing: Marginal costing helps in setting accurate prices by considering only variable costs. The selling price can be set by adding a margin to the marginal cost. This ensures that the product is sold at a price that covers its variable costs and contributes towards fixed costs.
- Facilitates decision-making: Marginal costing provides information about the contribution margin, which helps in making important business decisions such as pricing, product mix, and sales volume.
- Helps in break-even analysis: Marginal costing helps in determining the break-even point of the business, which is the level of sales required to cover all costs. This information helps in setting sales targets and pricing strategies.
Disadvantages of Marginal Costing:
- Does not consider fixed costs: Marginal costing only considers variable costs, and fixed costs are treated as period costs. This can lead to incorrect decisions regarding product pricing and production levels.
- Difficulty in allocation of fixed costs: In marginal costing, fixed costs are not allocated to products. This makes it difficult to compare profitability of different products and can lead to incorrect decisions regarding product mix.
- Ignores inventory valuation: Marginal costing values inventory at its variable cost only. This can result in distortions in the balance sheet, as it does not reflect the true value of inventory.
- Short-term focus: Marginal costing is focused on the short-term and may not be suitable for long-term planning.
- Does not conform to GAAP: Marginal costing is not recognized as a standard accounting method under generally accepted accounting principles (GAAP). This may lead to difficulties in financial reporting and analysis.
Marginal Costing example question with solution
XYZ Ltd produces and sells a single product, the selling price of which is Rs. 50 per unit. The variable cost is Rs. 30 per unit and the fixed costs are Rs. 10,000 per month. In the last month, the company produced and sold 1,000 units.
Required:
a) Calculate the profit for the last month using marginal costing.
b) If the company wants to earn a profit of Rs. 25,000, how many units does it need to sell in a month?
Solution:
a) To calculate profit using marginal costing, we need to first calculate the contribution per unit.
Contribution per unit = Selling price per unit – Variable cost per unit
= Rs. 50 – Rs. 30
= Rs. 20 per unit
Total contribution = Contribution per unit x Number of units sold
= Rs. 20 x 1,000
= Rs. 20,000
Using marginal costing, fixed costs are not considered while calculating profit. Hence, profit can be calculated as:
Profit = Total contribution – Fixed costs
= Rs. 20,000 – Rs. 10,000
= Rs. 10,000
Therefore, the profit for the last month using marginal costing is Rs. 10,000.
b) To calculate the number of units the company needs to sell in a month to earn a profit of Rs. 25,000, we can use the following formula:
Target profit = (Fixed costs + Target profit) / Contribution per unit
Substituting the values from the given data, we get:
Rs. 25,000 = (Rs. 10,000 + Rs. 25,000) / Rs. 20
Rs. 25,000 = Rs. 35,000 / Rs. 20
Rs. 25,000 x Rs. 20 = Rs. 35,000
500 = Number of units that need to be sold
Therefore, the company needs to sell 500 units in a month to earn a profit of Rs. 25,000 using marginal costing.
