Marginal Costing, Formula, Advantages and Disadvantages

Marginal costing is a technique used in cost accounting that separates fixed and variable costs to determine the marginal cost of producing one additional unit of a product or service. This cost is also known as the marginal cost of production, and it helps businesses make better decisions about pricing, production, and profitability.

In marginal costing, costs are classified into two categories: fixed costs and variable costs. Fixed costs are those that remain constant, regardless of the level of production or sales, while variable costs vary with the level of production or sales. Examples of fixed costs include rent, salaries, and insurance, while examples of variable costs include direct materials, direct labor, and variable overheads.

The calculation of marginal cost involves three main steps:

• Determine Variable Costs: The first step is to identify and calculate all variable costs associated with producing one additional unit of the product or service. This includes direct materials, direct labor, and variable overheads.
• Calculate the Contribution Margin: The contribution margin is the difference between the selling price and the variable cost of producing one unit. This represents the amount of revenue that is available to cover fixed costs and generate a profit.
• Calculate Marginal Cost: The marginal cost is the sum of variable costs required to produce one additional unit of the product or service.

Once the marginal cost has been determined, businesses can use this information to make better decisions about pricing, production, and profitability. For example, businesses can use marginal cost to determine the minimum price they need to charge to break even, or to determine the optimal production level to maximize profits.

In addition to these uses, marginal costing has several advantages over traditional costing methods. These include:

• Simplicity: Marginal costing is a relatively simple and straightforward method of cost accounting that can be easily understood and applied.
• Accurate Costing: Marginal costing provides a more accurate picture of the cost of producing one additional unit of a product or service, as it separates fixed and variable costs.
• Better Decision Making: By providing a clear picture of the costs and revenues associated with each unit of production, marginal costing helps businesses make better decisions about pricing, production, and profitability.
• Improved Planning: Marginal costing can also help businesses plan for the future by providing insights into how changes in production levels or selling prices will affect costs and profits.

Marginal Costing formulas

The formulas used in marginal costing are relatively simple and straightforward. The key formulas used in marginal costing are:

Marginal Cost Formula:

Marginal Cost = Variable Costs per unit x Total units produced

Contribution Margin Formula:

Contribution Margin = Selling Price per unit – Variable Costs per unit

Break-Even Point Formula:

Break-Even Point = Fixed Costs ÷ Contribution Margin per unit

Here is a sample question and answer that demonstrates the use of these formulas:

Sample Question:

A company produces and sells 10,000 units of a product at a selling price of $50 per unit. The variable cost per unit is $30, and the fixed costs are $100,000. What is the company’s break-even point in units?

Solution:

First, we can calculate the contribution margin per unit using the formula:

Contribution Margin per unit = Selling Price per unit – Variable Costs per unit

Contribution Margin per unit = $50 – $30

Contribution Margin per unit = $20

Next, we can use the contribution margin per unit to calculate the break-even point using the formula:

Break-Even Point = Fixed Costs ÷ Contribution Margin per unit

Break-Even Point = $100,000 ÷ $20

Break-Even Point = 5,000 units

Therefore, the company’s break-even point is 5,000 units. This means that the company needs to sell at least 5,000 units to cover its fixed costs and break even. If the company sells more than 5,000 units, it will start to make a profit. If it sells less than 5,000 units, it will make a loss.

Advantages of Marginal Costing:

• Accurate Costing: Marginal costing provides accurate costing of products by separating fixed and variable costs. This helps managers make better decisions related to pricing, production, and profitability.
• Easy to Understand: Marginal costing is easy to understand and implement, and does not require much knowledge of accounting principles. This makes it accessible to both small and large businesses.
• Better Decision Making: By providing a clear picture of the costs and revenues associated with each unit of production, marginal costing helps businesses make better decisions about pricing, production, and profitability. This leads to improved efficiency and profitability.
• Improved Planning: Marginal costing helps managers plan for the future by providing insights into how changes in production levels or selling prices will affect costs and profits.
• Focus on Variable Costs: Marginal costing focuses on variable costs which can be easily controlled. By understanding the impact of variable costs on production, managers can identify areas where cost savings can be made.

Disadvantages of Marginal Costing:

• Limited Application: Marginal costing may not be applicable to all industries and businesses, especially those that have high fixed costs. In these cases, absorption costing may provide a better picture of costs.
• Ignores Fixed Costs: Marginal costing ignores fixed costs, which can be significant for some businesses. This can lead to an incomplete understanding of the total cost of production.
• No Consideration of Inventory Valuation: Marginal costing does not take into account the value of inventory, which can lead to inaccurate financial statements.
• No Consideration of Long-term Impacts: Marginal costing does not consider the long-term impact of production decisions. For example, reducing production levels to save costs may have negative effects on the company’s market share and competitiveness in the long run.
• Complex Pricing Decisions: Marginal costing can make pricing decisions complex as it only takes into account variable costs. Businesses need to consider fixed costs and other factors when setting prices to ensure profitability.