Wednesday, September 16, 2009

MARGINAL COSTING

M A R G I N A L C O S T I N G


1. Other names:
Direct costing, Variable costing, Differential costing, Incremental costing, Out of pocket costing
2. Marginal cost means -
v The amount by which the total cost varies as a direct result of the change in the volume of production by one unit.
v When used in the plural as ‘marginal costs’ – it means the total of all variable costs.
v Marginal Cost is the amount at any given volume of output by which aggregate costs are changed of the volume of output is increased or decreased by one unit. In practice this is measured by the total variable cost attributable to one unit.( By the Institute of Costs and Works Accountants, London)

v Marginal costing is defined as “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”.
v Thus, all the costs attributable to a product are broadly classified into two viz. fixed costs and variable costs.
v Fixed costs are those elements of the cost of production which are not affected by variation in the volume of output – i.e. under normal conditions; fixed costs remain constant irrespective of the volume of output.
v On the other hand variable costs are those elements of cost which tend to vary directly with the volume of output. The total of all such variable elements of the cost of a product is called the marginal cost of that product.
v The difference between the selling price and the marginal cost of a product is called “contribution” which is the most significant aspect of marginal costing. All the decisions made with the help of marginal costing are based on this concept. It is also called “gross margin”. All the products are expected to “contribute” towards a fund from which the total of all fixed costs is deducted, the surplus being the profit.
v Thus, the contributions of all products (or all units of the product) represent (a) Sales less variable cost or (b) fixed costs plus profit (or fixed cost less)
v Since much emphasis is placed on this concept of contribution, we can frame an equation as follows:

Marginal Cost Equation:
Sales – Variable Costs = Fixed Costs + Profit = S-V = F+P
v The following specimen of cost statement will show the components of marginal cost and total cost (i.e. the different types of variable costs and the fixed costs)
Cost Statement Rs.
Direct Materials XXX
Direct Labour (Wages) XXX
Direct Expenses XXX
-----
Prime Cost XXX
Variable overheads XXX
Marginal cost of Production XXX
Fixed Overhead XXX

3. Special features of marginal costing method:
v Separation of fixed costs and variable costs. Marginal costs (variable) above are considered to be the cost of the product in marginal costing unlike in the orthodox system – vi. Absorption or total costs costing.
v Valuation of stock-in-trade
v Like the cost determination, calculation of the profit, also done in a special manner in marginal costing method. First the marginal cost of production will be deducted from the sales; the remaining proceeds are known as “contribution”. The Contributions of all the products are brought into a pool from which the total of fixed costs will be deducted. If there is any surplus after meeting the fixed costs, it forms the profit.
v Fixed costs are not apportioned to the individual products under marginal costing. This is the basic and salient principle of marginal costing.
v The profitability of each department or product will be determined by its contribution. From the sum total of these contributions, total fixed costs will be deducted to arrive at the profit.
v The significance of the concept of contribution is well explained in this method (marginal costing method). When fixed costs are apportioned to the cost centres individually certain products may show a loss.
4. Illustration of cost statements:
1. ABSORPTION COSTING 2. MARGINAL COSTING

ParticularsCost per 100 unitsCost per 120 unitsParticularsCost per 100 unitsCost per 120 units

Variable Expenses :1500 1800 1500 1800
Direct Materials
Direct Labour 1,000 1,200 1,000 1200
Variable overheads 600 720 600 720
Fixed Expenses 1,500 1,500 Marginal costs 3,100 3,720

Total Cost 4,600 5220 Marginal cost per unit 31 31
Cost per Unit 46 4,350


5. Uses of Marginal Costing Method:
v Fixing the price of the product :
Pricing under Trade depressions
(operate or shut down decisions)
Pricing in a special market
- Pricing in a special job (accepting a special order)
v Effect of changing the prices on profits
With the help of marginal costing technique, the following questions can be answered:
1. What is the effect of a change in price on the present profits?
2. What should be the volume of sales in order to earn a given profit?
3. What will be the profit for a given volume of sales?
4. Which is the most profitable product?
When management plans to expand output, normally the cost per unit will be reduced, enabling a price reduction. Again to attract a wider market, the selling price may be reduced. Therefore, the management is willing to know the effect of such a price change on the profits.
v Make or Buy decision
v Product Mix or Sales Mix
v Planning the volume of production (or level of activity)
6. Advantages:
v Marginal costing method clearly explains the nature and behaviour of the various costs incurred in the production of a particular product.
v Marginal cost statements provide for the data regarding the cost-volume profit factors that are required by the management for profit – planning.
v Marginal cost statements and reports give a more clear picture regarding cost of production and they are easier for the management to understand. For example, the impact of fixed costs on the volume of profit is well depicted by summarizing the fixed costs in the profit statements.
v The concept of contribution facilitates the relative appraisal of the profitability of the various products, product mixes sales territories etc. This is feasible because under the marginal costing technique, costs are classified as variable and fixed and the incidence of fixed costs is considered separately.
v Marginal costing is contributing to cost control plans such as standard costing and flexible budgeting.
v As illustrated earlier, marginal costing method is of immense use to the management in its area of decision making as in fixing the prices, determining the sales mix, closing down a business venture, planning the level of activities buying a component from outside etc.
7. Limitations of Marginal Costing:
v It is always difficult to bifurcate all the elements of costs rigidly into fixed and variable ones. Very often, arbitrary classifications are made to segregate the fixed and variable costs.
v In the long run, all the costs are variable i.e. even the fixed costs will vary at different stages in the long term. Therefore long range pricing and other policy decisions cannot rely much on the marginal cost analysis.
v Valuation of inventories and profit estimations on marginal costing basis are objected to by Tax Authorities.
8. Areas of application in the Railways
v Make or Buy decisions - in various Railways Workshops
v Fixing the tariff - Station to Station rates
v Pricing in a special job - Deposit Works.



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