Marginal Costing

The costs that vary with a decision should only be included in decision analysis. For many decisions that involve relatively small variations from existing practice and/or are for relatively limited periods of time, fixed costs are not relevant to the decision. This is because either fixed costs tend to be impossible to alter in the short term or managers are reluctant to alter them in the short term.

DEFINITION

Marginal Costing may be defined as "the ascertainment by differentiating between fixed cost and variable cost, of marginal cost and of the effect on profit of changes in volume or type of output." With marginal costing procedure costs are separated into fixed and variable cost.

According to J. Batty, Marginal costing is "a technique of cost accounting pays special attention to the behavior of costs with changes in the volume of output." This definition lays emphasis on the ascertainment of marginal costs and also the effect of changes in volume or type of output on the company's.

Marginal costing is an alternative method of costing to absorption costing. In marginal costing, only variable costs are charged as a cost of sale and a contribution is calculated (sales revenue minus variable cost of sales). Closing inventories of work in progress or finished goods are valued at marginal (variable) production cost. Fixed costs are treated as a period cost, and are charged in full to the profit and loss account of the accounting period in which they are incurred.

Marginal costing is ‘the accounting system in which variable costs are charged to cost units and the fixed costs of the period are written-off in full against the aggregate contribution. Its special
value is in decision making’. (Terminology.)

Marginal costing may be defined as the technique of presenting cost data wherein variable costs and fixed costs are shown separately for managerial decision-making.

It should be clearly understood that marginal costing is not a method of costing like process
costing or job costing. Rather it is simply a method or technique of the analysis of cost information for the guidance of management which tries to find out an effect on profit due to changes in the volume of output.

FEATURES OF MARGINAL COSTING

1.      All elements of costs are classified into fixed and variable costs.

2.     Marginal costing is a technique of cost control and decision making.

3.     Variable costs are charged as the cost of production.

4.   Valuation of stock of work in progress and finished goods is done on the basis of variable costs.

5.      Profit is calculated by deducting the fixed cost from the contribution, i.e., excess of selling
price over marginal cost of sales.

6.      Profitability of various levels of activity is determined by cost volume profit analysis.

PROCESS OF MARGINAL COSTING:
Marginal costing requires the calculation of the difference between sales and marginal cost of sales. This difference is known as the contribution which provides both the fixed cost and the profit. Excess of contribution over the fixed cost is known as the net margin or profit. Here emphasis remains on increasing the total contribution.

Variable cost
Variable is that part of total cost which in proportion with volume changes directly. With the change in volume of output, total variable cost changes. Increase in the total variable cost results from an increase in the output and reduction in the total variable cost results from a decrease in the output. However, irrespective of increase or decrease in volume of production, there
will be no change in variable cost per unit of output. Costs of direct material, direct labour, direct expenses, etc. are included in variable cost. By dividing the total variable cost by the units produced, variable cost per unit is sought. The variable cost per unit is also referred to as the variable cost ratio. By dividing the change in cost by the change in activity, the variable cost can be obtained. Variable costs are very sensitive in nature and a variety of factors can influence the same. Helping the management in controlling the variable cost is the main aim of ‘marginal costing’ because this is the area of cost which itself needs control by the management.

Fixed cost
Cost which is incurred for a period and which tends to remain unaffected by fluctuations in the level of activity, output or turnover, within certain output and turnover limits. Examples are rent, rates, salaries of executive and insurance, etc.

Difference between Marginal Costing and Absorption Costing:
The difference between marginal costing and absorption costing is as below:

1. In the marginal costing only variable cost is considered for product costing and inventory valuation, whereas in the absorption costing both fixed cost and variable cost are considered for product costing and inventory valuation.
2. In the marginal costing, there is a different treatment of fixed overhead. Fixed cost is considered as period cost and by Profit/Volume ratio (P/Vratio), profitability of different products is judged. On the other hand, in absorption costing system, the fixed cost is charged to cost of production. A reasonable share of fixed cost is to be borne by each product and thereby subjective apportionment of fixed overheads influences the profitability of product.
3. In the marginal costing, the presentation of data is so oriented that the total contribution and contribution from each product gets highlighted. In absorption costing, the presentation of cost data is on conventional pattern. After deducting fixed overhead, the net profit of each product is determined.
4. In the marginal costing, the unit cost of production does not get affected by the difference in the magnitude of opening stock and closing stock. Whereas, in the absorption costing, due to the impact of the related fixed overheads, the unit cost of production gets affected by the difference in the magnitude of opening stock and closing stock.
5. In the marginal costing, classification of expenses is based on nature, i.e. Fixed and Variable whereas, in Absorption Costing, classification of expenses is based on functions, i.e. Production, Administration and Selling & Distribution.
6. In the marginal costing, fixed overhead Expenditure Variance is to be computed for Variance Reporting. There is no Volume Variance since Fixed Overheads are not absorbed. On the other hand under the Absorption Costing, in Variance Reporting, FOH Expenditure and Volume variances can be computed. Volume Variances can also be sub‐classified into Capacity, Efficiency and Calendar variances.

Advantages of Marginal Costing:

1. Simple Method: Marginal costing is simple to understand. It is calculated only on the basis of variable costs. By not charging fixed overhead to the cost of production, the effect of varying charges per unit is avoided.
2. Overhead Simplification: In the stock valuation, the marginal costing prevents the illogical carry‐forward of some proportion of current years fixed overhead to the next year. It reduces the degree of over or under‐recovery of overheads due to the separation of fixed overheads from production cost.
3. Effective for Sales and Production Policy: The effects of alternative sales or production policies can be more readily available and assessed, and decisions taken would yield the maximum return to the business.
4. It eliminates large balances left in overhead control accounts which indicate the difficulty of ascertaining an accurate overhead recovery rate.
5. Practical cost control is greatly facilitated. By avoiding arbitrary allocation of fixed overhead, efforts can be concentrated on maintaining a uniform and consistent marginal cost. To the management, it is useful at various levels.
6. It helps in the planning of short‐term profit by break even and profitability analysis; both in terms of quantity and graphs. Comparative profitability and performance between two or more products and divisions can easily be assessed and brought to the notice of the management for decision making.

Disadvantages of Marginal Costing

1. It may be very difficult to segregation of all costs into fixed and variable costs.
2. Marginal Costing technique cannot be suitable for all type of industries. For example, it is difficult to apply in ship-building, contract industries etc.
3. The elimination of fixed overheads leads to difficulty in determination of selling price.
4.  It assumes that the fixed costs are controllable, but in the long run all costs are variable.
5. Marginal Costing does not provide any standard for the evaluation of performance which is provided by standard costing and budgetary control.
6. With the development of advanced technology fixed expenses are proportionally increased. Therefore, the exclusion of fixed cost is less effective.