Marginal Costing
Learning Objectives
Agenda
Meaning of marginal cost and marginal
costing
Marginal cost vs. Absorption cost
Ascertain Income under both marginal
costing and Absorption costing
Definition
What is Marginal cost ?
The cost of producing one more unit
Or the cost which could be avoided by
not producing a unit
What is Marginal costing ?
An approach in which only variable costs
are included in cost of sales
fixed costs are treated as period costs
and are written off as incurred
The Marginal Cost of a
product
Variablecost Direct Lab
our + Direct Material +
Direct Expenses +
Variable Overheads
Simple Steps to Understand
Marginal Cost Theory
If the volume of output increases, the cost per
unit in normal circumstances reduces.
Conversely, if an output reduces, the cost per
unit increases.
Eg: If a factory produces 1000 units at a total cost
of Rs.3,000 and if by increasing the output by
one unit the cost goes up to Rs.3,002, the
marginal cost of additional output will be Rs.2.
(3002-3000)
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If an increase in output is more than one, the total
increase in cost divided by the total increase in
output will give the average marginal cost per unit.
Eg: The output is increased to 1020 units from 1000
units and the total cost to produce these units is
Rs.1,045, the average marginal cost per unit is
Rs.2.25.
(i.e. Additional cost/Additional units=45/20=Rs.2.25)
Explanatory Definition
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.
Alternative Name for
marginal costing
DirectCosting
Variable Costing
Concept of Contribution
Contribution=
Sales Revenue-Variable Cost
(i.e. Marginal Cost)
Contribution may be defined as the profit before
the recovery of fixed costs. Thus, contribution
goes toward the recovery of fixed cost and profit,
and is equal to fixed cost plus profit (Contribution
= Fixed cost + Profit).
Break Even Point
In case a firm neither makes profit nor suffers
loss, Contribution will be just equal to fixed
cost (C = F). this is known as break even
point.
BEP in units = Fixed Cost/ Contribution per
unit
BEP in Value (In Rs.) = Fixed Cost/ P/V Ratio
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P/V ratio= Contribution/ sales *100
Contribution = Sales- Variable cost
Contribution = Fixed Cost +Profit or
Contribution = Fixed Cost-Loss
P/V ratio = Change in profit / change in
sales*100
Example 1
Sales Rs. 50,00,000
Variable Cost Rs. 30,00,000
Fixed Cost Rs. 10,00,000
You are required to calculate
a) P/V Ratio
b) BEP in Rupees
c) Sales to achieve profit Rs. 1,50,000
d) If Target sales is Rs. 75,00,000 then profit?
Example 2
Fixed cost Rs 10,00,000
Profit Rs. 15,00,000
Sales Rs. 50,00,000
You are required to
a) Calculate P/V ratio
b) BEP in units
c) Margin of safety in Rupees
d) Desired profit Rs. 12,50,000 and then sales ?
e) Target sales Rs. 75,00,000 the profit ?
Example 3
2020 2021
Sales 60,00,000 75,00,000
Profit 15,00,000 20,00,000
You are required to calculate
a) P/V ratio
b) Variables cost and fixed cost
c) BEP in Rupees
d) Sales if desired profit is 25,00,000
e) if target sales 100,00,000 then profit?
Example 4
Selling price per unit Rs. 60
Direct Material per unit Rs. 20
Direct Labour per unit Rs. 10
Variable Overhead Rs. 15
Unit Produced 1,00,000
Fixed cost 7,50,000
You are required to calculate
a) P/V Ratio
b) BEP in Units and Rs.
c) Margin of safety
d) Target units to be sold 150,000 you are required to calculate profit .
Relation with Marginal
Costing
The concept of contribution is very useful in
marginal costing. It has a fixed relation with
sales. The proportion of contribution to sales
is known as P/V ratio which remains the
same under given conditions of production
and sales
The Principles of Marginal
Costing
1. For any given period of time, fixed costs will be the
same, for any volume of sales and production
(provided that the level of activity is within the
‘relevant range’). Therefore, by selling an extra
item of product or service the following will
happen.
Revenue will increase by the sales value of the item
sold.
Costs will increase by the variable cost per unit.
Profit will increase by the amount of contribution
earned from the extra item.
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[Link], if the volume of sales falls by one
item, the profit will fall by the amount of
contribution earned from the item
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3. Profit measurement should therefore be
based on an analysis of total contribution.
Since fixed costs relate to a period of time,
and do not change with increases or
decreases in sales volume, it is misleading
to charge units of sale with a share of fixed
costs.
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4. When a unit of product is made, the extra
costs incurred in its manufacture are the
variable production costs. Fixed costs are
unaffected, and no extra fixed costs are
incurred when output is increased.
Features of Marginal
Costing
1. Cost Classification.
2. Stock/ Inventory Valuation.
3. Marginal Contribution.
[Link] Classification
The marginal costing technique makes a
sharp distinction between variable costs
and fixed costs. It is the variable cost on the
basis of which production and sales policies
are designed by a firm following the
marginal costing technique.
[Link]/Inventory Valuation
Under marginal costing, inventory/stock for
profit measurement is valued at marginal
cost. It is in sharp contrast to the total unit
cost under absorption costing method.
[Link] Contribuation
Marginal costing technique makes use of
marginal contribution for marking various
decisions. Marginal contribution is the
difference between sales and marginal cost.
It forms the basis for judging the profitability
of different products or departments.
Advantages of Marginal
Costing
Marginal costing is simple to understand.
By not charging fixed overhead to cost of
production, the effect of varying charges per unit
is avoided.
It prevents the illogical carry forward in stock
valuation of some proportion of current year’s
fixed overhead.
The effects of alternative sales or production
policies can be more readily available and
assessed, and decisions taken would yield the
maximum return to business.
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It eliminates large balances left in overhead
control accounts which indicate the difficulty of
ascertaining an accurate overhead recovery rate.
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. It is useful
to various levels of management.
Disadvantages of Marginal
Costing
The separation of costs into fixed and variable is
difficult and sometimes gives misleading
results.
Normal costing systems also apply overhead
under normal operating volume and this shows
that no advantage is gained by marginal costing.
Under marginal costing, stocks and work in
progress are understated. The exclusion of fixed
costs from inventories affect profit, and true and
fair view of financial affairs of an
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Volume variance in standard costing also
discloses the effect of fluctuating output on fixed
overhead. Marginal cost data becomes
unrealistic in case of highly fluctuating levels
of production, e.g., in case of seasonal
factories.
Application of fixed overhead depends on
estimates and not on the actual and as such
there may be under or over absorption of the
same.
Marginal Costing Pro-
forma
Sales Revenue
xxxxx
Less Marginal Cost of Sales
Opening Stock (Valued @ marginal cost) xxxx
Add Production Cost (Valued @ marginal cost xxxx
Total Production Cost xxxx
Less Closing Stock (Valued @ marginal cost) xxx
Marginal Cost of Production xxxx
Add Selling, Admin & Distribution Cost xxxx
Marginal Cost of Sales (xxxx)
Contribution
xxxxx
Less Fixed Cost
(xxxx)
Marginal Costing Profit
Absorption Costing Pro-
forma
Reconciliation Statement for Marginal
costing and Absorption Costing Profit
Marginal Costing Profit xx
ADD xx
(Closing stock – opening Stock) x OAR
= Absorption Costing Profit xx
Where OAR (Overhead Absorption Rate)= Budgeted Fixed Production Overheads/
Budgeted Levels of Activities
Marginal Costing versus
Absorption Costing
After knowing the two techniques
of marginal costing and absorption
costing, we have seen that the net
profits are not the same because
of the following reasons
Reasons for difference in net
profit in both of the cases
Over and Under Absorbed
Overheads.
Difference in Stock Valuation.