Marginal Costing

Marginal costing definition:

According to ICMA London “marginal cost is the amount for any given volume of output by which aggregate costs are changed if the volume of output is increased or decreased by one unit”. Marginal costing is the technique of applying the concept of marginal cost in decision making process. Marginal costing is a technique that distinguishes between fixed and variable costs. The “marginal” cost of a product is its variable cost.

Applications of marginal costing: marginal costing is a very useful tool for management because of its following applications and merits:

A. Cost control:

Marginal costing divides the total cost into fixed and variable cost. Fixed cost can be controlled by the top management and that to a limited extent. Variable costs can be controlled by the lower level of management. Marginal cost by concentrating all efforts on the variable costs can control and thus provides a tool to the management for control of total cost.

In marginal costing fixed costs are not eliminated at all. These are shown separately as a deduction from the contribution instead of merging with cost of sales and inventories. This helps the management to have a control on fixed costs.

B. Profit planning:

Marginal costing helps the profit planning, i.e., planning for future operations in such a way as to maximize the profits to maintain a specified level of profit. Absorption costing fails to bring out the correct effect of change in sale price, variable cost are product mix on the profits of the concern but that is possible with the help of marginal costing.

Profits are increased or decreased as a consequence of fluctuations in selling prices, variable costs and sales quantities in case there is fixed capacity to produce and sell.

C. evaluation of performance:

The different products, departments, markets and sales divisions have different profit earning potentialities. Marginal cost analysis is very useful for evaluating the performance of each sector of a concern.

Performance evaluation is better done if distinction is made between fixed and variable expenses

D. Decision making:

The information provided by the total cost method is not sufficient in solving the management problems. Material costing techniques is used in providing assistance to the management in vital decision making, especially in dealing with the problems requiring short-term. Decisions where fixed costs are excluded.

The following are the important areas, where managerial problems are simplified by use of the marginal costing:

i. Fixation of selling price.

Ii. Key or limiting factor

iii. Make or by decisions

iv. Selection of a suitable product mix.

v. Effect of change in price.

vi. Maintaining a desired level of profit

vii. Alternative methods of production

viii. Diversification of products.

ix. Closing down or suspending activities.

x. Alternative course of action

The important areas where managerial problems are simplified by use of the marginal costing are:

1. Fixation of selling Price:

Although the prices are more controlled by market conditions and other economic factors than by decisions of management yet fixation of selling prices is one of the most important functions of management. This function is to be performed:

(a) Under normal circumstances

(b) In times of competition

(c) In times of trade depression

(d) In accepting additional orders for utilizing idle capacity

(e) In exporting and exploring new markets.

2. Key (or limiting) factor:

A key factor that factor which puts a limit on production and profit of a business. Usually the limiting factor is sales. A concern may not be able to sell as much as it can produce. But sometimes a concern can sell all it produces but production is limited due to the storage of materials, labour and plant capacity or capital.

3. Make or buy decision:

A concern can utilize its idle capacity by making component parts instead of buying them from market.

Factors that influence make or buy decision:

In a make or buy decision, the following cost and non-cost factors must be considered specifically.

Cost factors:

a) Available of plant facility

b) Quality and type of item which effects the production schedule.

c) The space required for production of item

d) Any special machinery or equipment required.

e) Any transportation involved due to the location of the product, i.e., the “feeder point”.

f) Cost of acquiring special know-how required for the item.

4. Selection of a suitable product mix:

When a factory manufacturers more than one product, a problem is faced by the management as to which product mix will give the maximum profits. The best product mix is that which yields the maximum contribution.

5. Effect of change in sales price:

Management is confronted with the problem of cut in prices of products from time to time on account of competition, expansion programmed or government regulations. It is therefore, necessary to know the effect of a cutting price of the products. The effect of cutting selling price per unit will be that contribution per unit will reduce.

6. Maintaining a desired level of profits:

Management may be interested in maintaining a desired level of profits. The volume of sales needed to have a desired level of profits can be ascertained by the marginal costing technique.

7. Alternative methods of production:

Marginal costing is helpful in comparing the alternative methods of production (i.e.,) machine work or hand work. The method which gives the greatest contribution is to be adopted keeping of course, the limiting factor in view. Where fixed expenses change, the decision will be taken on the basis of profit contributed by each.

8. Diversification of products:

Sometimes it becomes necessary for a concern to introduce a new product to the existing product or products in order to utilize the idle capacity or to capture a new market or for other purposes. General fixed costs will however, be charged to the old product/products.

9. Closing down all suspecting activities:

Sometimes it becomes necessary for a firm to temporary suspends or closes the activities of a particular product, department or factory as a whole due to trade recessions. The decision to close down or suspend its activities will depend on whether products are making a contribution towards fixed costs or not.

10. Alternative course of action:

When deciding between alternative courses of action, it shall be kept in mind that whatever course of action is adopted, certain fixed expenses will remain unaffected. The criterion, therefore, which weighs is the effect of alternative course of action upon the marginal costs in relation to the revenue obtained. The course of action which yields the greatest contribution is the most profitable to be followed by the management.