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
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.”
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.
Characteristics of Marginal Costing
- Separation of Costs
A key characteristic of marginal costing is the clear separation of costs into fixed and variable components. Variable costs change according to the level of production or sales, while fixed costs remain constant within a certain range of activity. This classification helps management understand how costs behave and how they affect profitability. By separating costs, managers can analyze the impact of production changes on total costs and profits.
- Focus on Variable Costs
Marginal costing mainly focuses on variable costs when determining the cost of production. Only costs that vary directly with output, such as raw materials, direct labour, and variable overheads, are included in product cost. Fixed costs are not charged to individual units of production. Instead, they are treated as period costs and written off against total contribution during the accounting period.
- Contribution Concept
Another important characteristic of marginal costing is the concept of contribution. Contribution is the difference between sales revenue and variable cost. It represents the amount available to cover fixed costs and generate profit. Managers use contribution analysis to evaluate the profitability of products and make decisions regarding pricing, product mix, and production levels.
- Fixed Costs Treated as Period Costs
In marginal costing, fixed costs are considered period costs and are not included in the cost of individual products. These costs remain constant regardless of production levels and are charged directly to the profit and loss account for the period. This treatment helps provide a clearer understanding of how variable costs affect profitability and simplifies cost analysis.
- Emphasis on Cost Behaviour
Marginal costing emphasizes understanding how costs behave at different levels of production. It focuses on analyzing how variable costs increase or decrease with changes in output while fixed costs remain constant. This understanding helps managers predict the impact of production decisions on overall costs and profits. Knowledge of cost behaviour is essential for effective planning and decision making.
- Useful for Short-Term Decisions
Marginal costing is particularly useful for short-term managerial decisions. It helps managers analyze situations such as accepting special orders, determining product pricing, selecting the most profitable product mix, or deciding whether to continue or discontinue a product line. By focusing on variable costs and contribution, managers can quickly evaluate the financial impact of different alternatives.
- Simplicity in Cost Calculation
Marginal costing simplifies cost calculation by excluding fixed costs from product costs. Since only variable costs are considered, it becomes easier to determine the cost per unit of production. This simplicity makes marginal costing a practical tool for management, especially when quick decisions are required.
- Helpful in Profit Planning
Marginal costing helps managers plan profits by analyzing the relationship between cost, sales, and profit. Through tools such as break-even analysis and contribution analysis, managers can determine the level of sales required to cover costs and achieve desired profits. This characteristic makes marginal costing an effective method for financial planning and managerial decision making.
Advantages of Marginal Costing
- Simple and Easy to Understand
Marginal costing is simple and easy to understand compared to other costing methods. It focuses mainly on variable costs and treats fixed costs separately. Because of this clear classification, managers can easily calculate the cost of production and contribution. The method avoids complicated cost allocations and makes cost analysis straightforward. This simplicity helps managers quickly interpret financial information and make effective decisions.
- Helpful in Decision Making
Marginal costing provides valuable information that supports managerial decision making. By analyzing variable costs and contribution, managers can evaluate different alternatives such as accepting special orders, determining product mix, or discontinuing a product. This method helps identify the most profitable option. As a result, businesses can make better decisions that improve efficiency and profitability.
- Better Cost Control
Marginal costing helps management control costs more effectively. Since costs are clearly classified into fixed and variable components, managers can monitor how costs behave with changes in production. This allows them to identify unnecessary expenses and reduce wastage. By focusing on variable costs, organizations can improve efficiency and maintain better control over their operational expenses.
- Useful for Profit Planning
Marginal costing is very useful for profit planning and financial analysis. It helps managers understand the relationship between cost, sales, and profit through contribution analysis and break-even analysis. With this information, management can determine the level of sales required to cover costs and achieve desired profits. This helps organizations plan their operations more effectively.
- Facilitates Pricing Decisions
Marginal costing helps businesses determine appropriate pricing strategies. Since it focuses on variable costs, managers can identify the minimum price at which products can be sold without incurring losses. This is particularly useful in competitive markets or when dealing with special orders. Proper pricing decisions help maintain profitability while attracting customers.
- Eliminates Problem of Overhead Allocation
In marginal costing, fixed overhead costs are not allocated to individual products. Instead, they are treated as period costs and charged directly to the profit and loss account. This eliminates the complex process of distributing overhead costs among products. As a result, cost calculations become more accurate and easier to manage.
- Helpful in Product Mix Decisions
Marginal costing helps management determine the most profitable combination of products to produce and sell. By analyzing the contribution of different products, managers can identify which products generate higher profits. This allows the company to focus on producing products with higher contribution and discontinue less profitable ones.
- Improves Managerial Efficiency
Marginal costing provides clear and useful financial information that helps managers evaluate business performance. By understanding cost behaviour and contribution, managers can make informed decisions and improve operational efficiency. This method encourages better planning, monitoring, and control of business activities, ultimately leading to improved managerial performance and organizational success.
Disadvantages of Marginal Costing
- Ignores Fixed Costs in Product Cost
One major disadvantage of marginal costing is that it excludes fixed costs from the cost of production. Fixed costs such as rent, salaries, and insurance are treated as period costs. However, in reality these costs are also important for running the business. Ignoring them while calculating product cost may lead to incomplete cost information and can sometimes affect long-term pricing and profitability decisions.
- Not Suitable for Long-Term Decisions
Marginal costing is mainly useful for short-term decision making. In long-term planning, fixed costs also become important because they may change with business expansion or reduction. Since marginal costing focuses mainly on variable costs, it may not provide a complete picture for long-term decisions such as capacity expansion, investment planning, or major strategic changes.
- Difficulty in Cost Classification
Marginal costing requires a clear separation of costs into fixed and variable categories. In practice, many costs are semi-variable or mixed in nature, which makes classification difficult. Incorrect classification of costs can lead to inaccurate analysis and wrong managerial decisions. This limitation may reduce the reliability of marginal costing in some situations.
- Unrealistic Pricing Decisions
Since marginal costing considers only variable costs in product pricing, it may encourage managers to set prices too low. If prices are based only on variable costs without considering fixed costs, the business may fail to recover its total expenses in the long run. This can negatively affect the financial stability and profitability of the organization.
- Not Accepted for Financial Reporting
Marginal costing is generally not accepted for preparing official financial statements. Accounting standards and external reporting systems usually require absorption costing, where both fixed and variable costs are included in product costs. Therefore, companies using marginal costing for internal decision making must still maintain separate records for financial reporting purposes.
- Limited Use in Certain Industries
Marginal costing may not be suitable for industries where fixed costs are very high, such as heavy manufacturing or infrastructure businesses. In such cases, fixed costs form a large part of total costs, and ignoring them in product costing may lead to misleading conclusions about profitability.
- Difficulty in Inventory Valuation
Under marginal costing, inventories are valued only at variable cost and do not include fixed overhead costs. This may result in lower inventory values compared to other costing methods. Such valuation may not accurately represent the total cost involved in producing the inventory, which can affect financial analysis and profit measurement.
- Risk of Misinterpretation
Managers who rely heavily on marginal costing may misinterpret cost data if they do not fully understand cost behaviour. Focusing only on contribution and variable costs without considering other financial factors may lead to poor decisions. Therefore, marginal costing should be used carefully along with other financial analyses for better managerial decision making.
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.
