CHAPTER 1

INTRODUCTION

Definition
The increase or decrease in the total cost of a production run for making one additionalunit of an
item. It is computed in situations where the breakeven point has been reached: the fixed costs
have already been absorbed by the already produced items and only the direct (variable) costs
have to be accounted for.
Marginal costs are variable costs consisting of labor and material costs, plus an estimated portion
of fixed costs (such as administrationoverheads and selling expenses). In companies where
average costs are fairly constant, marginal cost is usually equal to average cost. However, in
industries that requireheavycapital investment (automobileplants, airlines, mines) and have
highaverage costs, it is comparatively very low. The concept of marginal cost is critically
important in resource allocation because, for optimumresults, management must concentrate
itsresources where the excess of marginal revenue over the marginal cost is maximum. Also
called choice cost, differential cost, or incremental cost.
It is a costing technique where only variable cost or direct cost will be charged to the cost unit
produced.
Marginal costing also shows the effect on profit of changes in volume/type of output by
differentiating between fixed and variable costs.

Salient Points:

Marginal costing involves ascertaining marginal costs. Since marginal costs are direct
cost, this costing technique is also known as direct costing;

In marginal costing, fixed costs are never charged to production. They are treated as
period charge and is written off to the profit and loss account in the period incurred;

Once marginal cost is ascertained contribution can be computed. Contribution is the

excess of revenue over marginal costs.

The marginal cost statement is the basic document/format to capture the marginal costs.

Marginal Costing is ascertainment of the marginal cost which varies directly with the volume of
production by differentiating between fixed costs and variable costs and finally ascertaining its
effect on profit.

Marginal cost is the cost associated with producing one more unit of output. Mathematically
speaking, marginal cost is equal to the change in total cost divided by the change in quantity.
Marginal cost can either be thought of as the cost of producing the last unit of output or the cost
of producing the next unit of output. Because of this, it's sometimes helpful to think of marginal
cost as the cost associated with going from one quantity of output to another, as shown by q1 and

q2 in the equation above. To get a true reading on marginal cost, q2 should be just one unit larger
than q1.

For example, if the total cost of producing 3 units of output is $15 and the total cost of producing
4 units of output is $17, the marginal cost of the 4th unit (or the marginal cost associated with
going from 3 to 4 units) is just ($17-$15)/(4-3) = $2.

Marginal fixed cost and marginal variable cost can be defined in a way similar to that of overall
marginal cost. Notice that marginal fixed cost is always going to equal zero since the change in
fixed cost as quantity changes is always going to be zero.

Marginal cost is equal to the sum of marginal fixed cost and marginal variable cost. However,
because of the principle stated above, it turns out that marginal cost only consists of the marginal
variable cost component.

Technically, as we consider smaller and smaller changes in quantity (as opposed to discrete
changes of while number units), marginal cost converges to the derivative of total cost with
respect to quantity. Some courses expect students to be familiar with and able to use this
definiton (and the calculus that comes with it), but a lot of courses stick to the simpler definition
given earlier.

The basic assumptions made by marginal costing are following:

- Total variable cost is directly proportion to the level of activity. However, variable cost per unit
remains constant at all the levels of activities.

- Per unit selling price remains constant at all levels of activities.

- All the items produced by the organization are sold off.

Features of Marginal costing:

- It is a method of recoding costs and reporting profits.
- It involves ascertaining marginal costs which is the difference of fixed cost and variable costs.
- The operating costs are differentiated into fixed costs and variable costs. Semi variable costs
are also divided in the individual components of fixed cost and variable cost

- Fixed costs which remain constant regardless of the volume of production do not find place in
the product cost determination and inventory valuation.

- Fixed costs are treated as period charge and are written off to the profit and loss account in the
period incurred
- Only variable costs are taken into consideration while computing the product cost.
- Prices of products are based on variable cost only.

- Marginal contribution decides the profitability of the products.

Assumption of Marginal Costing
The Marginal Costing technique is based on the following assumptions.:1. All elements of costs can be divided in to two parts viz.variable and fixed
2. Variable cost remain constant per unit and fluctuates directly in proportion to change in the
volume of out put.
3. Fixed Cost remain constant at all levels of production. the share of fixed cost per unit output
vary according to the volume of production.
4. The selling price per unit remains unchanged at all levels of activity
5. The volume o f output is the only factor which influences the cost.

Advantages of Marginal Costing:

It is simple to understand re: variable versus fixed cost concept;

A useful short term survival costing technique particularly in very competitive

environment or recessions where orders are accepted as long as it covers the marginal
cost of the business and the excess over the marginal cost contributes toward fixed costs
so that losses are kept to a minimum;

Its shows the relationship between cost, price and volume;

Under or over absorption do not arise in marginal costing;

Stock valuations are not distorted with present years fixed costs;

Its provide better information hence is a useful managerial decision making tool;

It concentrates on the controllable aspects of business by separating fixed and variable

costs

The effect of production and sales policies is more clearly seen and understood.

Disadvantages Of Marginal Costing:

Marginal cost has its limitation since it makes use of historical data while decisions by
management relates to future events;

It ignores fixed costs to products as if they are not important to production;

Stock valuation under this type of costing is not accepted by the Inland Revenue as its
ignore the fixed cost element;

It fails to recognize that in the long run, fixed costs may become variable;

Its oversimplified costs into fixed and variable as if it is so simply to demarcate them;

Its not a good costing technique in the long run for pricing decision as it ignores fixed
cost. In the long run, management must consider the total costs not only the variable
portion;

Difficulty to classify properly variable and fixed cost perfectly, hence stock valuation can be
distorted if fixed cost is classify asvariable
In economics and finance, marginal cost is the change in total cost that arises when the quantity
produced changes by one unit. That is, it is the cost of producing one more unit of a good. In
general terms, marginal cost at each level of production includes any additional costs required to
produce the next unit. For example, if producing additional vehicles requires building a new
factory, the marginal cost of the extra vehicles includes the cost of the new factory. In practice,
this analysis is segregated into short and long-run cases, so that over the longest run, all costs
become marginal. At each level of production and time period being considered, marginal costs
include all costs that vary with the level of production, whereas other costs that do not vary with
production are considered fixed.

If the good being produced is infinitely divisible, so the size of a marginal cost will change with
volume, as a non-linear and non-proportional cost function includes the following:

variable terms dependent to volume,

constant terms independent to volume and occurring with the respective lot size,

jump fix cost increase or decrease dependent to steps of volume increase.

In practice the above definition of marginal cost as the change in total cost as a result of an
increase in output of one unit is inconsistent with the differential definition of marginal cost for
virtually all non-linear functions. This is as the definition finds the tangent to the total cost curve
at the point q which assumes that costs increase at the same rate as they were at q. A new
definition may be useful for marginal unit cost (MUC) using the current definition of the change
in total cost as a result of an increase of one unit of output defined as: TC(q+1)-TC(q) and redefining marginal cost to be the change in total as a result of an infinitesimally small increase in
q which is consistent with its use in economic literature and can be calculated differentially.

The concept of marginal costing is practically applied in the following situations:

- Evaluation of Performance : The evaluation of the performance of various departments or

products can be evaluated with the help of marginal costing which is based on contribution
generating capacity.

- Profit Planning : This technique through the calculation of P/V Ratio helps the management to
plan the activities in such a way that the profit can be maximised.

- Fixation of Selling Price : The technique of marginal costing assists the management to fix the
price in such a way so that prices fixed can cover at least the variable cost.

- Make or Buy decision : Marginal cost analysis helps the management in making or buying
decision.

- Optimizing Product Mix : To maximise profits and increase sales volume it is necessary to
decide an optimized mix or proportion in which various products of a company can be sold.
generating
- Cost Control : Marginal Costing is a technique of cost classification and cost presentation
which enable the management to concentrate on the controllable costs.

- Flexible Budget preparation: As the marginal costing particularly classifies costs as fixed and
variable costs which facilitates the preparation of flexible budgets.

Elements of Marginal Costing

Process of marginal costing:
Under marginal costing, calculation of the difference between sales & marginal cost of sales is
done. This difference is known as contribution, which provides for fixed cost & profit. Excess of
contribution over the fixed cost is known as net margin or profit. Here on the increasing total
contribution emphasis remains.

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

Fixed Cost:
Cost which is incurred for a period & which tends to remain unaffected by fluctuations in the
level of activity, output or turnover, within certain output & turnover limits. Examples are rent,
rates, salaries of executive & insurance etc.
Break-Even Point (B/E Point):

The break-even point is the level of activity or sales at which a company makes neither profit nor
loss. Sales revenue exactly equals total costs at this level. Thus, the sales volume at which
operations break-even is indicated by the break-even point. In terms of number of units sold or in
terms of sales value, it can be expressed.
Sales Variable cost = Fixed cost + Profit
Since at break-even point, profit is nil, it follows that:
Sales at break-even point Variable cost = Fixed cost

Thus, at break-even point, contribution is just enough to provide for fixed cost. Thus, enough
contribution is necessary to be earned to cover fixed costs before any profit can be earned. If
level of actual sales is above break-even point, profit will be earned by the company. On the
other hand, if actual sales are below break-even point, loss will be incurred by the company.

By any of the following formula, the by the break-even point (B/E) can be calculated:
(a) B/E (in terms of units) = Fixed Cost
Contribution per unit

(b) B/E (in terms of sales value) = Fixed Cost * Sales

Contribution
Or, Fixed Cost
P/V ratio

When graphical presentation of cost-volume-profit relationship is made, the break-even point

will be the point at which total cost line & total sales line intersect each other.

The break-even point is important to the management because the lowest level to which activity
can be dropped without putting the continued life of the firm in jeopardy is indicated by the
break-even point. Occasionally, operating below the break-even point may not be necessarily
being fatal for a concern, but it must operate above this level in the long run.
Contribution:
On the idea of contribution, analysis of marginal costing depends a lot. In this technique, for
increasing total contribution only, efforts are directed. Contribution is a term which defines the
surplus that remains after variable cost of sales is deducted from sales revenue as indicated
below:
Contribution = Sales revenue Variable cost of sales

A product whose selling price exceeds its variable cost is said to have:
(a) Covering its variable cost &

(b) Making a contribution,

(i) towards the firms fixed cost & after these have been covered;

(ii) towards the firms profit.

Alternatively, contribution is equivalent to fixed cost plus profit. Thus, this relationship may be
expressed as under:
Sales Variable cost = Contribution
Fixed cost + Profit = Contribution
Thereby, Sales Variable cost = Fixed cost + Profit
It becomes easy to determine the missing one if any three of these four items is known to us. In
break-even analysis, some of the specific uses of contribution are:
a. Break-even point determination;
b. Profitability of products assessment;
c. Different departments selling price determination;

d. The optimum sales mix determination.

Key factor or Limiting factor:
There are always factors which, for the purpose of managerial control, do not lend themselves.
For example, if at a particular point of time, on the import of a material, which is the principal
element of companys product, there is a restriction of Government, then the production cannot
be undertaken by the company, as it wishes. Production has to be planned after taking into
consideration this limiting factor. However, towards the maximum utilization of available
sources, its efforts will be directed. Thus, limiting factor is a factor, by which, at a given point of
time, the volume of output of an organization gets influenced.
Key factor is the factor whose influence, for the purpose of ensuring the maximum utilization of
resources, must be ascertained first. Profit can be maximized by gearing the process of
production in the light of influences of key factors. Managerial action is constrained & output of
company is limited by key factor. Any of the following factors can be a limiting factor, although
usually sale is the limiting factor but:

(a) Material
(b) Labour
(c) Power
d) Capacity of plant

(e) Action of government.

When, in operation, there is a key factor & regarding relative profitability of different products, a
decision has to be taken, then for selecting the most profitable alternative, contribution for each
product is divided by key factor.

With the products or projects, the choice of management rests with, thereby showing more
contribution per unit of key factor. Thus, if the key factor is sales, then consideration should be
given to contribution to sales ratio. If labour shortage is faced by the management, then
consideration should be given to contribution per labour hour. Suppose sales of product X & Y
are $ 200 & $ 220 & variable cost of sales are $ 60 & $ 46. The labour hours (key factor)
required for these products are 4 hours & 6 hours respectively. The contribution will be: Product
X, $200 - $60 = $ 140 per unit or $ 35 per hour; Product Y, $220 - $46 = $174 per unit or $29 per
hour. In this case, P/V ratio of product Y (79%) is better than P/V ratio of product X (70%) &
producing product Y will be the normal conclusion. Here, the key factor is time. Contribution per
hour is better in product X than in product Y. Thereby, product X is more profitable than product
Y, during labour shortage.
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Other topics under Marginal Costing:

Marginal Costing - Introduction

Budgeted BES to earn the target profit

Criticism of Marginal Costing

Marginal Costing Vs. Absorption Costing

Profit/Volume Ratio, Improvement of P/V Ratio