Marginal Costing

Marginal Costing

Introduction

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.

Marginal costing - definition

Marginal costing distinguishes between fixed costs and variable costs as convention ally classified.

The marginal cost of a product –“ is its variable cost”. This is normally taken to be; direct labour, direct material, direct expenses and the variable part of overheads.

Marginal costing is formally defined as:

‘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.)

The term ‘contribution’ mentioned in the formal definition is the term given to the difference between Sales and Marginal cost. Thus

MARGINAL COST = VARIABLE COST DIRECT LABOUR

DIRECT MATERIAL

DIRECT EXPENSE

VARIABLE OVERHEADS

CONTRIBUTION = SALES - MARGINAL COST

The term marginal cost sometimes refers to the marginal cost per unit and sometimes to the total marginal costs of a department or batch or operation. The meaning is usually clear from the context.

Note

Alternative names for marginal costing are the contribution approach and direct costing In this lesson, we will study marginal costing as a technique quite distinct from absorption costing.

Theory of Marginal Costing

The theory of marginal costing as set out in “A report on Marginal Costing” published by CIMA, London is as follows:

In relation to a given volume of output, additional output can normally be obtained at less than proportionate cost because within limits, the aggregate of certain items of cost will tend to remain fixed and only the aggregate of the remainder will tend to rise proportionately with an increase in output. Conversely, a decrease in the volume of output will normally be accompanied by less than proportionate fall in the aggregate cost.

The theory of marginal costing may, therefore, by understood in the following two steps:

1. If the volume of output increases, the cost per unit in normal circumstances reduces. Conversely, if an output reduces, the cost per unit increases. If a factory produces 1000 units at a total cost of 3,000 and if by increasing the output by one unit the cost goes up to 3,002, the marginal cost of additional output will be 2.

2. 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. If, for example, the output is increased to 1020 units from 1000 units and the total cost to produce these units is 1,045, the average marginal cost per unit is 2.25. It can be described as follows:

Additional cost =

Additional units 45 = 2.25

The ascertainment of marginal cost is based on the classification and segregation of cost into fixed and variable cost. In order to understand the marginal costing technique, it is essential to understand the meaning of marginal cost.

Marginal cost means the cost of the marginal or last unit produced. It is also defined as the cost of one more or one less unit produced besides existing level of production. In this connection, a unit may mean a single commodity, a dozen, a gross or any other measure of goods.

For example, if a manufacturing firm produces X unit at a cost of 300 and X+1 units at a cost of 320, the cost of an additional unit will be 20 which is marginal cost. Similarly if the production of X-1 units comes down to 280, the cost of marginal unit will be 20 (300–280).

The marginal cost varies directly with the volume of production and marginal cost per unit remains the same. It consists of prime cost, i.e. cost of direct materials, direct labor and all variable overheads. It does not contain any element of fixed cost which is kept separate under marginal cost technique.

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.

There are different phrases being used for this technique of costing. In UK, marginal costing is a popular phrase whereas in US, it is known as direct costing and is used in place of marginal costing. Variable costing is another name of marginal costing.

Marginal costing technique has given birth to a very useful concept of contribution where contribution is given by: Sales revenue less variable cost (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 (C = F + P).

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.

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

The principles of marginal costing are as follows.

a. 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.

b. Similarly, if the volume of sales falls by one item, the profit will fall by the amount of contribution earned from the item.

c. 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.

d. 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

The main features of marginal costing are as follows:

1. Cost 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.

2. Stock/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.

3. Marginal Contribution

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 and Disadvantages of Marginal Costing Technique

Advantages

1. Marginal costing is simple to understand.

2. By not charging fixed overhead to cost of production, the effect of varying charges per unit is avoided.

3. It prevents the illogical carry forward in stock valuation of some proportion of current year’s fixed overhead.

4. 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.

5. It eliminates large balances left in overhead control accounts which indicate the difficulty of ascertaining an accurate overhead recovery rate.

6. 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.

7. It helps in short-term profit planning by breakeven 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 management for decision making.

Disadvantages

1. The separation of costs into fixed and variable is difficult and sometimes gives misleading results.

2. Normal costing systems also apply overhead under normal operating volume and this shows that no advantage is gained by marginal costing.

3. 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 organization may not be clearly transparent.

4. 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.

5. Application of fixed overhead depends on estimates and not on the actuals and as such there may be under or over absorption of the same.

6. Control affected by means of budgetary control is also accepted by many. In order to know the net profit, we should not be satisfied with contribution and hence, fixed overhead is also a valuable item. A system which ignores fixed costs is less effective since a major portion of fixed cost is not taken care of under marginal costing.

7. In practice, sales price, fixed cost and variable cost per unit may vary. Thus, the assumptions underlying the theory of marginal costing sometimes becomes unrealistic. For long term profit planning, absorption costing is the only answer.

Presentation of Cost Data under Marginal Costing and Absorption Costing

Marginal costing is not a method of costing but a technique of presentation of sales and cost data with a view to guide management in decision-making.

The traditional technique popularly known as total cost or absorption costing technique does not make any difference between variable and fixed cost in the calculation of profits. But marginal cost statement very clearly indicates this difference in arriving at the net operational results of a firm.

Following presentation of two Performa shows the difference between the presentation of information according to absorption and marginal costing techniques:

MARGINAL COSTS, CONTRIBUTION AND PROFIT

A marginal cost is another term for a variable cost. The term ‘marginal cost’ is usually applied to the variable cost of a unit of product or service, whereas the term ‘variable cost’ is more commonly applied to resource costs, such as the cost of materials and labour hours.

Marginal costing is a form of management accounting based on the distinction between:

a. the marginal costs of making selling goods or services, and

b. fixed costs, which should be the same for a given period of time, regardless of the level of activity in the period.

Suppose that a firm makes and sells a single product that has a marginal cost of £5 per unit and that sells for 9 per unit. For every additional unit of the product that is made and sold, the firm will incur an extra cost of 5 and receive income of 9. The net gain will be 4 per additional unit. This net gain per unit, the difference between the sales price per unit and the marginal cost per unit, is called contribution.

Contribution is a term meaning ‘making a contribution towards covering fixed costs and making a profit’. Before a firm can make a profit in any period, it must first of all cover its fixed costs. Breakeven is where total sales revenue for a period just covers fixed costs, leaving neither profit nor loss. For every unit sold in excess of the breakeven point, profit will increase by the amount of the contribution per unit.

C-V-P analysis is broadly known as cost-volume-profit analysis. Specifically speaking, we all are concerned with in-depth analysis and application of CVP in practical world of industry management.

Cost volume profit (CVP) analysis helps in understanding the relationship and interaction between the:

Selling prices of different products.

The sale volume the company makes or needs to achieve.

The variable cost per unit and any change in it.

The fixed cost and any change in it and

The sale mix (how many units of different products produced by firm to be sold.)

Understanding CVP analysis:

Cost volume profit analysis can be understand by first understanding the basic elements that comprise it. The relationship between these three elements determines the financial planning for the firm. We will discuss these basic elements and their relationship in the subsequent paragraph.

The Basic Elements of CVP Analysis:

The basic elements of CVP analysis are cost, volume and profit. These three fundamentals elements determine the value creation for the business of long run.

1) Cost:

The first element of business is cost. Every business incurs certain costs initially and also as it carries out its business. These costs are the expanses related to making the products or providing a service.

2) Volume:

The second most important element of the business is volume i.e. how much it will produce and sell. The business must know beforehand how much to sell in order to determine how much to produce.

3) Profit:

The last but not the least is the profit element of any business. Business must know how much profit it generated by delivering a certain number of products or services to the customers. Generally the profit is determined as: selling price of the products less cost of manufacturing the products.

The CVP Relationship:

As far as the cost and sales volume are concerned, they are forecasted element that every business activities. However the profits are determined once the business knows how much revenue it has generated and the costs incurred in the process.

The foremost concept of CVP analysis is any increase in the sale volume implies increase in costs. The reason is that when sale volume increase the production also increase which in turns, increase the cost of production (materials, labor, operating expenses etc). Increase in sale volume not only increases the firm’s requirements of short-term and long term funds but many also results in increased profits.

Cost volume profit analysis helps in managerial decision making. It evaluates what-if situation that occur in business. Cost volume profit analysis is an important financial analysis that helps manager to deal with their routine problems as well as strategic issues in the course of carrying out their business activities. Such issues can come up when new sales promotions and other functional decision are taken.

The Important Of CVP Analysis:

Cost volume profit analysis has great scope in various management decisions making. It assist the management, in determining the quantity of products to be produced to attain desired , profits the quantity of products to be produced at minimum threshold level attaining desired profit under different cost and volume relationship.

Cost volume profit analysis helps the business to know about its most profitable products (s) or service (s) from amongst that many that the business offers to its customers in the market. This helps the firm to focus more on profitable products and services as compared to other ones. It also helps the firm to understand the impact of any variance in its sales volume, due to any reason on the profits. The management understands the amount of sales that the firm can afford to lose due to any contingency without falling below its breakeven.

Cost volume profit analysis also helps the firm to understand the level of fluctuation it can afford its selling price to increase their sales they must know the new level of sales; they must meet to sustain the desired profits. The firms must also know the bare basic price (s) that must be charged for its products or services from its customers.

Cost volume profit analysis also helps the firms to understand how to cover any increase in fixed cost that may arise. Many a time increased loan amount increase the fixed cost by the amount of annual interest paid. In such cases the firm must know the new level of sales that must be met to cover the increased fixed cost. Management must know the additional sales revenue required to meet additional fixed costs so that existing profits are maintained. CVP analysis also helps in estimating the level of profits for the business at a specific level of sales revenue.

Marginal Cost Equations and Breakeven Analysis

From the marginal cost statements, one might have observed the following:

Sales – Marginal cost = Contribution ......(1)Fixed cost + Profit = Contribution ......(2)

By combining these two equations, we get the fundamental marginal cost equation as follows:

Sales – Marginal cost = Fixed cost + Profit ......(3)

This fundamental marginal cost equation plays a vital role in profit projection and has a wider application in managerial decision-making problems.The sales and marginal costs vary directly with the number of units sold or produced. So, the difference between sales and marginal cost, i.e. contribution, will bear a relation to sales and the ratio of contribution to sales remains constant at all levels. This is profit volume or P/V ratio. Thus,

P/V Ratio (or C/S Ratio) = Contribution (c) ......(4)

Sales (s)

It is expressed in terms of percentage, i.e. P/V ratio is equal to (C/S) x 100.

Or, Contribution = Sales x P/V ratio ......(5)

Or, Sales = Contribution/ P/V ratio .....(6)

The above-mentioned marginal cost equations can be applied to the following heads:1. Contribution

Contribution is the difference between sales and marginal or variable costs. It contributes toward fixed cost and profit. The concept of contribution helps in deciding breakeven point, profitability of products, departments etc. to perform the following activities:

• Selecting product mix or sales mix for profit maximization

• Fixing selling prices under different circumstances such as trade depression, export sales, price discrimination etc.

2. Profit Volume Ratio (P/V Ratio), its Improvement and Application

The ratio of contribution to sales is P/V ratio or C/S ratio. It is the contribution per rupee of sales and since the fixed cost remains constant in short term period, P/V ratio will also measure the rate of change of profit due to change in volume of sales. The P/V ratio may be expressed as follows:

P/V ratio = Sales – Marginal cost of sales = Contribution =Changes in contribution = (Change in profit/Canges in sales)*100

A fundamental property of marginal costing system is that P/V ratio remains constant at different levels of activity.

A change in fixed cost does not affect P/V ratio. The concept of P/V ratio helps in determining the following:

• Breakeven point

• Profit at any volume of sales

• Sales volume required to earn a desired quantum of profit

• Profitability of products

• Processes or departments

The contribution can be increased by increasing the sales price or by reduction of variable costs. Thus, P/V ratio can be improved by the following:

• Increasing selling price

• Reducing marginal costs by effectively utilizing men, machines, materials and other services

• Selling more profitable products, thereby increasing the overall P/V ratio

3. Breakeven Point

Breakeven point is the volume of sales or production where there is neither profit nor loss. Thus, we can say that:

Contribution = Fixed cost

Now, breakeven point can be easily calculated with the help of fundamental marginal cost equation, P/V ratio or contribution per unit.

a. Using Marginal Costing Equation

S (sales) – V (variable cost) = F (fixed cost) + P (profit) At BEP P = 0, BEP S – V = F

By multiplying both the sides by S and rearranging them, one gets the following equation:

S BEP = F.S/S-V

b. Using P/V Ratio

Sales S BEP = Contribution at BEP = Fixed cost

P/ V ratio P/ V ratio

Thus, if sales is $. 2,000, marginal cost $. 1,200 and fixed cost $. 400, then:

Breakeven point = 400 x 2000 = 1000

2000 - 1200

Similarly, P/V ratio = 2000 – 1200 = 0.4 or 40%

800

= 400 / .4 = $. 1000

c. Using Contribution per unit

Breakeven point = Fixed cost = 100 units or 1000

Contribution per unit

4. Margin of Safety (MOS)

Every enterprise tries to know how much above they are from the breakeven point. This is technically called margin of safety. It is calculated as the difference between sales or production units at the selected activity and the breakeven sales or production.

Margin of safety is the difference between the total sales (actual or projected) and the breakeven sales. It may be expressed in monetary terms (value) or as a number of units (volume). It can be expressed as profit / P/V ratio. A large margin of safety indicates the soundness and financial strength of business.

Margin of safety can be improved by lowering fixed and variable costs, increasing volume of sales or selling price and changing product mix, so as to improve contribution and overall P/V ratio.

Margin of safety = Sales at selected activity – Sales at BEP = Profit at selected activity

P/V ratio

Margin of safety is also presented in ratio or percentage as follows: Margin of safety (sales) x 100 %

Sales at selected activity

The size of margin of safety is an extremely valuable guide to the strength of a business. If it is large, there can be substantial falling of sales and yet a profit can be made. On the other hand, if margin is small, any loss of sales may be a serious matter. If margin of safety is unsatisfactory, possible steps to rectify the causes of mismanagement of commercial activities as listed below can be undertaken.

a. Increasing the selling price-- It may be possible for a company to have higher margin of safety in order to strengthen the financial health of the business. It should be able to influence price, provided the demand is elastic. Otherwise, the same quantity will not be sold.

b. Reducing fixed costs

c. Reducing variable costs

d. Substitution of existing product(s) by more profitable lines e. Increase in the volume of output

e. Modernization of production facilities and the introduction of the most cost effective technology

Problem 1A company earned a profit of 30,000 during the year 2000-01. Marginal cost and selling price of a product are 8 and 10 per unit respectively. Find out the margin of safety.

Solution

Margin of safety = Profit/ P/V ratio

P/V ratio = (Contribution/Sales) x 100

Breakeven Analysis-- Graphical Presentation

Apart from marginal cost equations, it is found that breakeven chart and profit graphs are useful graphic presentations of this cost-volume-profit relationship.

Breakeven chart is a device which shows the relationship between sales volume, marginal costs and fixed costs, and profit or loss at different levels of activity. Such a chart also shows the effect of change of one factor on other factors and exhibits the rate of profit and margin of safety at different levels. A breakeven chart contains, inter alia, total sales line, total cost line and the point of intersection called breakeven point. It is popularly called breakeven chart because it shows clearly breakeven point (a point where there is no profit or no loss).

Profit graph is a development of simple breakeven chart and shows clearly profit at different volumes of sales.

Construction of a Breakeven Chart

The construction of a breakeven chart involves the drawing of fixed cost line, total cost line and sales line as follows:

1. Select a scale for production on horizontal axis and a scale for costs and sales on vertical axis.

2. Plot fixed cost on vertical axis and draw fixed cost line passing through this point parallel to horizontal axis.

3. Plot variable costs for some activity levels starting from the fixed cost line and join these points. This will give total cost line. Alternatively, obtain total cost at different levels, plot the points starting from horizontal axis and draw total cost line.

4. Plot the maximum or any other sales volume and draw sales line by joining zero and the point so obtained.

Uses of Breakeven ChartA breakeven chart can be used to show the effect of changes in any of the following profit factors:

• Volume of sales

• Variable expenses

• Fixed expenses

• Selling price

ProblemA company produces a single article and sells it at 10 each. The marginal cost of production is 6 each and total fixed cost of the concern is 400 per annum.

Construct a breakeven chart and show the following:

• Breakeven point

• Margin of safety at sale of 1,500

• Angle of incidence

• Increase in selling price if breakeven point is reduced to 80 units

Solution

A breakeven chart can be prepared by obtaining the information at these levels:

Output units 40 80 120 200

Sales .

400 800 1,200 2,000

Fixed cost 400 400 400 400

Variable cost 240 480 400 720

Total cost 640 880 1,120 1,600

Fixed cost line, total cost line and sales line are drawn one after another following the usual procedure described herein:

This chart clearly shows the breakeven point, margin of safety and angle of incidence.

a. Breakeven point-- Breakeven point is the point at which sales line and total cost line intersect. Here, B is breakeven point equivalent to sale of 1,000 or 100 units.

b. Margin of safety-- Margin of safety is the difference between sales or units of production and breakeven point. Thus, margin of safety at M is sales of (1,500 - 1,000), i.e. 500 or 50 units.

c. Angle of incidence-- Angle of incidence is the angle formed by sales line and total cost line at breakeven point. A large angle of incidence shows a high rate of profit being made. It should be noted that the angle of incidence is universally denoted by data. Larger the angle, higher the profitability indicated by the angel of incidence.

d. At 80 units, total cost (from the table) = 880. Hence, selling price for breakeven at 80 units = 880/80 = 11 per unit. Increase in selling price is Re. 1 or 10% over the original selling price of 10 per unit.

Limitations and Uses of Breakeven Charts

A simple breakeven chart gives correct result as long as variable cost per unit, total fixed cost and sales price remain constant. In practice, all these facto$ may change and the original breakeven chart may give misleading results.

But then, if a company sells different products having different percentages of profit to turnover, the original combined breakeven chart fails to give a clear picture when the sales mix changes. In this case, it may be necessary to draw up a breakeven chart for each product or a group of products. A breakeven chart does not take into account capital employed which is a very important factor to measure the overall efficiency of business. Fixed costs may increase at some level whereas variable costs may sometimes start to decline. For example, with the help of quantity discount on materials purchased, the sales price may be reduced to sell the additional units produced etc. These changes may result in more than one breakeven point, or may indicate higher profit at lower volumes or lower profit at still higher levels of sales.

Nevertheless, a breakeven chart is used by management as an efficient tool in marginal costing, i.e. in forecasting, decision-making, long term profit planning and maintaining profitability. The margin of safety shows the soundness of business whereas the fixed cost line shows the degree of mechanization. The angle of incidence is an indicator of plant efficiency and profitability of the product or division under consideration. It also helps a monopolist to make price discrimination for maximization of profit.

Multiple Product Situations

In real life, most of the firms turn out many products. Here also, there is no problem with regard to the calculation of BE point. However, the assumption has to be made that the sales mix remains constant. This is defined as the relative proportion of each product’s sale to total sales. It could be expressed as a ratio such as 2:4:6, or as a percentage as 20%, 40%, 60%.

The calculation of breakeven point in a multi-product firm follows the same pattern as in a single product firm. While the numerator will be the same fixed costs, the denominator now will be weighted average contribution margin. The modified formula is as follows:

Breakeven point (in units) = Fixed costs

________________________________________

Weighted average contribution margin per unit

One should always remember that weights are assigned in proportion to the relative sales of all products. Here, it will be the contribution margin of each product multiplied by its quantity.

Breakeven Point in Sales Revenue

Here also, numerator is the same fixed costs. The denominator now will be weighted average contribution margin ratio which is also called weighted average P/V ratio. The modified formula is as follows:

B.E. point (in revenue) = Fixed cost

_______________________________________

Weighted average P/V ratio

Application of Marginal Costing: 10 Techniques

Technique of Application # 1. Profit Planning:

Profit planning is the planning of future operations to attain maximum profit.

Under the technique of marginal costing, the contribution ratio, i.e., the ratio of marginal contribution to sales, indicates the relative profitability of the different products of the business whenever there is any change in volume of sales, marginal cost per unit, total fixed costs, selling price, and sales-mix etc.

Hence marginal costing is an useful tool in planning profits as it ensures sufficient return on capital employed.

Technique of Application # 2. Pricing of Products:

Sometimes pricing decisions have to be taken to cater to a recessionary market or to utilise spare capacity where only marginal cost is recovered. For export market, sometimes full cost is loaded to the sale price to remain competitive. Sometimes special prices are to be offered with expansion in mind, fixation of price below cost can be made on a short-term basis.

It may be advisable to fix prices equal to or below marginal cost under the following cases:

(i) To maintain production and employees occupied.

(ii) To keep plant in use in readiness to go ‘full team ahead’.

(iii) To prevent loss of future orders.

(iv) To dispose of perishable product.

(v) To eliminate competition of nearer rivals.

(vi) To popularize a new product.

(vii) To keep the sales of a conjoined product which is making a considerable amount of profit.

(viii) Where prices have fallen considerably or a loss has already been made.

Technique of Application # 3. Introduction of a Product:

When a new product is introduced without incurring any additional fixed cost the additional contribution helps to increase profitability.

Technique of Application # 4. Selection of Product Mix:

The most-profitable product mix can be determined by applying marginal costing technique. Fixed cost remaining constant, the most profitable product-mix is determined on the basis of contribution only. That product-mix which gives maximum contribution is to be considered as best product mix.

Technique of Application # 5. Problem of Key/Limiting Factor:

A key factor is a factor which limits the volume of production and profit of business. It may be scarcity of any factor of production such as material labour, capital, plant capacity etc. Usually, when there is no key or limiting factor, the product is selected on the basis of highest P/V ratio of the product. But with key factor the selection of product will be on the basis of contribution per unit of limiting/key factor of production.

Technique of Application # 6. Alternative Method of Manufacture:

When alternative use of production facilities or alternative methods of manufacturing a product are being considered, the alternative which gives the maximum marginal contribution is selected.

Technique of Application # 7. Make-or-Buy Decision:

A company may have idle capacity which may be utilised for making a component or a product, instead of buying them from outside sources. In taking such ‘make-or-buy’ decision, a comparison should be made between the variable (or marginal) cost of manufacture of the product and the supplier’s price for it.

It will be advantageous to manufacture than to purchase an item if the variable cost is lower than the purchase price provided that the decision to manufacture does not result in substantial increase in fixed costs and that the existing manufacturing facilities cannot be otherwise utilised more profitably.

When there is no idle capacity and accordingly making the item in the factory involves putting aside other work, the loss of contribution from displaced work should also be considered along with marginal cost of manufacture. Again, if the decision to manufacture involves increase in fixed cost, it should also be added to marginal cost for the purpose of comparison with purchase price of component.

So, the decision will be to purchase if the marginal cost of manufacture plus traceable fixed costs plus the loss of contribution is more than the purchase price.

Technique of Application # 8. Accepting Additional Orders and Exploring Foreign Market:

Sometimes goods are sold at a price above total cost (i.e., at a profit) and still there remains some spare or unused capacity. In such circumstances, extra order may be accepted or goods may be sold in a foreign market at a price above marginal cost but below total cost.

This will add to the profits as, after full recovery of the fixed cost, any contribution—either from additional orders or from selling in the foreign market—will make extra profit. In this way the spare plant capacity can be used to earn additional profit.

Technique of Application # 9. Increasing or Decreasing Departments or Products:

Sometimes general fixed costs are apportioned to departments or products for ascertaining total cost but it may give misleading results. However, specific fixed costs traceable to departments or products should be deducted from individual contribution to get the Net contribution. If the net contribution of a department or product is positive, then it should not be discarded.

Technique of Application # 10. Closing Down/Suspending Activities:

While taking a decision in this line, the effect of fixed cost and contribution will have to be analysed. If the contribution is more than the difference in fixed costs by working at normal operations, and when the plant or product is closed down or suspended, then it is desirable to continue operation.

Variable Costing, Direct Costing, Marginal Costing!

The variable costing is referred to, frequently in practice; by different names such as direct costing, marginal costing. However, the use of the term ‘Variable Costing’ is the most appropriate.

i. Direct Costing:

The term ‘Direct Costing’ refers to those costs which can be identified and traced directly to the units of output. The word ‘direct implies a high degree of traceability and, in this regard, both variable and fixed costs can be direct cost which are traceable to a costing centre.

For example, in a department that makes only one product, direct product costs are all costs which can be traced to the department including supervision, depreciation and other fixed costs as well as variable costs. Variable costing is a more appropriate term because it emphasises ‘cost variability’ and requires that distinction should be made between fixed and variable cost.

ii. Prime Costing:

Variable costing also differs from prime costing in which only direct materials, direct labour and direct expenses are considered for inventory valuation and variable factory overhead is excluded.

iii. Marginal Costing:

The use of the term ‘marginal costing’ interchangeably with the term ‘variable costing’ is also not appropriate. In fact, the terms ‘marginal cost’ and marginal costing originated first in the area of Economics. These terms in economics mean the aggregated costs expected to be incurred when the production quantity is increased or decreased by one more unit.

In Economics, therefore, marginal costs include both fixed and variable costs resulting from producing an extra unit if producing an additional unit results in an increase in fixed costs as well. Increase in fixed costs may be due to situations such as appointment of additional supervisor or increase in capacity due to purchase of an additional machine. Clearly, therefore, the term marginal costing has a different concept than that of variable costing which considers only variable production costs in all situations and never considers fixed costs as in marginal costing.

Some argue that if an extra unit is produced, the costs which could be incurred for producing this extra unit will be only variable costs as fixed costs remain constant. In this way, marginal costing may be interpreted in the same manner as variable costing.

However, the use of the term’ marginal costing’ in accounting will create confusion because the economists have been using this term having an accepted definition in economics. Therefore, any attempt by the accountants and accounting practitioners in using the term marginal costing (assuming their own or restricted concept) will not bring clarity to the interpretation but only add more confusion.

iv. Incremental Costing, Differential Costing:

It should be further understood that the terms incremental costing, differential costing imply similar meaning as that of marginal costing. It is better, therefore, not to use these terms also when referring to variable costing.

Variable costing is not a distinct method of cost determination as job or process costing are. It is simply a technique where the cost of goods manufactured is composed only of variable manufacturing costs-those manufacturing costs that increase or decrease as the volume of production rises or falls. This technique of variable costing can be used simultaneously in all methods of costing including job or process costing.

Besides job or process costing, variable costing can be used in historical (actual) cost system and standard cost system. With a standard costing system, scientific estimates of an efficient level of performance are established. By applying variable costing to standards, business enterprises have an excellent tool for managerial decision making.

Key Differences Between Marginal Costing and Absorption Costing

The following are the major differences between marginal costing and absorption costing.

The costing method in which variable cost is apportioned exclusively, to the products is known as Marginal Costing. Absorption Costing is a costing system in which all the costs are absorbed and apportioned to products.
In Marginal Costing, Product related costs will include only variable cost while in the case of Absorption costing, fixed cost is also included in product related cost apart from variable cost.
Marginal Costing divides overheads into two broad categories, i.e. Fixed Overheads and Variable Overheads. Look at the other term Absorption costing, which classifies overheads in the following three categories Production, Administration and Selling & Distribution.
In marginal costing profit can be ascertained through the help of Profit Volume Ratio [(Contribution / Sales) * 100]. On the other hand, Net Profit shows the profit in case of Absorption Costing.
In Marginal Costing variances in the opening and closing stock will not influence the per unit cost. Unlike Absorption Costing, where the variances between the stock at the beginning and the end will show its effect by increasing/decreasing per unit cost.
In marginal costing, the cost data is presented to outline total cost of each product. On the contrary, in absorption costing, the cost data is presented in traditional way, net profit of each product is ascertained after deducting fixed cost along with their variable cost.

Comparison Chart

BASIS FOR COMPARISON	MARGINAL COSTING	ABSORPTION COSTING
Meaning	A decision making technique for ascertaining the total cost of production is known as Marginal Costing.	Apportionment of total costs to the cost center in order to determine the total cost of production is known as Absorption Costing.
Cost Recognition	The variable cost is considered as product cost while fixed cost is considered as period costs.	Both fixed and variable cost is considered as product cost.
Classification of Overheads	Fixed and Variable	Production, Administration and Selling & Distribution
Profitability	Profitability is measured by Profit Volume Ratio.	Due to the inclusion of fixed cost, profitability gets affected.
Cost per unit	Variances in the opening and closing stock does not influence the cost per unit of output.	Variances in the opening and closing stock affects the cost per unit.
Highlights	Contribution per unit	Net Profit per unit
Cost data	Presented to outline total contribution of each product.	Presented in conventional way.

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MANAGEMENT ACCOUNTING