Marginal

Costing
Marginal Cost
Definition:

 The Marginal Cost refers to the change in the

total cost as a result of the production of one more unit of the product. In other
words, the marginal cost is the increase or decrease in the total cost due to the
production of one additional unit of the product.

The marginal cost includes any cost incurred

in producing the next unit of the product and hence is expressed as:

MC = ΔTC/ ΔQ

Where,
ΔTC = Change in total cost,

ΔQ = change in quantity

The purpose of marginal cost is to determine the point where the firm reaches its
economies of scale.
The marginal cost curve is a U-shaped curve, which shows that cost starts at
higher point and declines with the increase in the production. The cost declines
with the increase in the level of output because of the economies of scale. When
the cost is lower, the firm can hire specialized labor, avail discount benefits on
bulk purchase of raw materials, enjoy the full utilization of machines and
equipment, etc.

But after some time, the marginal costs starts rising, which shows, the cost
increases with the increase in the level of output. This is because the curve
reaches the point where diseconomies of scale persist. The costs rise because
the resources from the current source might have completely exhausted and the
firm purchases raw materials from other sources at a relatively higher price, hire
more management, buy more machines and equipment, etc.

Till the price charged for the product is greater than the marginal
cost, the revenue will be greater than the added cost and the firm will
continue its production. But, as soon as the price charged is less than
the marginal cost, the revenue declines, and it is not wise to expand
production.

Marginal Costing
Definition:
Marginal Costing is a costing technique wherein the
marginal cost, i.e. variable cost is charged to units of cost, while the fixed cost for
the period is completely written off against the contribution.

The term marginal cost implies the additional cost involved

in producing an extra unit of output, which can be reckoned by total variable
cost assigned to one unit. It can be calculated as:

Marginal Cost = Direct Material + Direct Labor + Direct Expenses +

Variable Overheads
 Meaning of Marginal Costing:
According to the Institute of Cost and Management Accountants, London,
“Marginal Costing is the ascertainment, by differentiating between fixed costs and
variable costs, of marginal cost and of the effect of profit of changes in the volume
or type of output.”

An understanding of the concept of marginal cost requires a thorough

understanding of the various classes of costs and their relation with the change in
the level of activity. Under marginal costing, costs are mainly classified into fixed
costs and variable costs.

The essential feature of marginal costing is that the product or marginal costs i.e.,
those costs that are dependent on the volume of activity are separated from the
period or fixed costs i.e., costs that remain unchanged with a change in the volume
of activity.

Variability with the volume of output is the main criterion for the classification of
costs into product and period categories. Even semi-variable costs have to be
bifurcated into their fixed and variable components based on the variability
criterion.

Characteristics of Marginal Costing

 Classification into Fixed and Variable Cost: Costs are bifurcated, on the
basis of variability into fixed cost and variable costs. In the same way, semi
variable cost is separated.
 Valuation of Stock: While valuing the finished goods and work in
progress, only variable cost are taken into account. However, the variable
 selling and distribution overheads are not included in the valuation of
inventory.
 Determination of Price: The prices are determined on the basis of
marginal cost and marginal contribution.
 Profitability: The ascertainment of departmental and product’s profitability
is based on the contribution margin.
In addition to the above characteristics, marginal costing system brings together
the techniques of cost recording and reporting.

Advantages of Marginal Costing:

The important advantages of Marginal Costing are:
(a) Marginal costing is easy to understand. It can be combined with
standard costing and budgetary control and thereby makes the
control mechanism more effective.
(b) Eliminating of fixed overheads from the cost of production prevents
the effect of varying charges per unit, and also prevents the carrying
forward of a portion of the fixed overheads of the current period to
the subsequent period. As such, costs and profits are not vitiated and
cost comparisons become more meaningful.
(c) The problem of over or under absorption of overheads is avoided.
(d) A clear – cut division of costs into fixed and variable elements
makes the flexible budgetary control system easy and effective and
thereby facilitates greater practical cost control.
(e) It helps profit planning through break-even charts and profit graphs.
Comparative profitability can easily be assessed and brought to the
notice of the management for decision-making.
(f) It is an effective tool for determining efficient sales or production
policies, or for taking pricing and tendering decisions, particularly
when the business is at low ebb.
Managerial Uses of Marginal Costing:
The following may be listed as specific managerial uses:
(a) Cost Ascertainment:
Marginal costing technique facilitates not only the recording of costs but their
reporting also. The classification of costs into fixed and variable components
makes the job of cost ascertainment easier. The main problem in this regard
is only the segregation of the semi-variable cost into fixed and variable
elements. However, this may be overcome by adopting any of the methods in
this regard.

(b) Cost Control:
Marginal cost statements can be understood easily by the management than
those presented under absorption costing. Bifurcation of costs into fixed and
variable enables management to exercise control over production cost and
thereby affect efficiency.

In fact, while variable costs are controllable at the lower levels of

management, fixed costs can be controlled at the top level. Under this
technique, management can study the behaviour of costs at varying
conditions of output and sales and thereby exercise better control over costs.

(c) Decision-Making:
Modern management is faced with a number of decision-making problems
every day. Profitability is the main criterion for selecting the best course of
action. Marginal costing through ‘contribution’ assists management in
solving problems.

Some of the decision-making problems that can be solved by marginal

costing are:
 (a) Profit planning
(b) Pricing of products
(c) Make or buy decisions
(d) Product mix etc.

Limitations of Marginal Costing:

Despite its superiority over absorption costing, the marginal costing
technique has its own limitations.

(a) Segregation of all costs into fixed and variable costs is very difficult.
In practice, a major technical difficulty arises in drawing a sharp line
of demarcation between fixed and variable costs. The distinction
between them hold good only in the short run. In the long run,
however, all costs are variable.
(b)  In marginal costing, greater importance is attached to the sales
function thereby relegating the production function largely to a
secondary position. But, the real efficiency of a business is to be
assessed only by considering the selling and production functions
together.
(c) The elimination of fixed costs from the valuation of inventories is
illogical since costs are also incurred in the manufacture of goods.
Further, it results in the understatement of the value of stock, which
is neither the cost nor the market price.
(d) Pricing decision cannot be based on contribution alone. Sometimes,
the contribution will be unrealistic when increased production and
sales are effected, either through extensive use of existing machinery
or by replacing manual labour by machines. Another possibility is
 that there is danger of too many sales being affected at marginal
cost, resulting in denial to the business of inadequate profits.
(e) Although the problem of over or under absorption of fixed
overheads can be overcome to a certain extent, the same problems
still persists with regard to variable overheads.
(f) The application of the technique is limited in the case of industries
in which, according to the nature of business, large stocks have to be
carried by way of work-in-progress (e.g. contracting firms)

What is a Break-Even Analysis?

A break-even analysis is a financial tool which helps you to determine
at what stage your company, or a new service or a product, will be profitable. In
other words, it’s a financial calculation for determining the number of products or
services a company should sell to cover its costs (particularly fixed costs). Break-
even is a situation where you are neither making money nor losing money, but all
your costs have been covered.
Break-even analysis is useful in studying the relation between the variable cost,
fixed cost and revenue. Generally, a company with low fixed costs will have a low
break-even point of sale. For an example, a company has a fixed cost of Rs.0
(zero) will automatically have broken even upon the first sale of its product.

Components of Break Even Analysis

Fixed costs
Fixed costs are also called as the overhead cost. These
overhead costs occur after the decision to start an economic activity is taken and
these costs are directly related to the level of production, but not the quantity of
production. Fixed costs include (but are not limited to) interest, taxes, salaries, rent,
depreciation costs, labour costs, energy costs etc. These costs are fixed no matter
how much you sell.

Variable costs
Variable costs are costs that will increase or decrease in direct
relation to the production volume. These cost include cost of raw material,
packaging cost, fuel and other costs that are directly related to the production.

Profit-Volume Ratio
Meaning:
Profit-volume ratio indicates the relationship between contribution and sales
and is usually expressed in percentage.

The ratio shows the amount of contribution per rupee of sales. Since, in the
short-term, fixed cost does not change, the profit-volume ratio also measures
the rate of change of profit due to change in the volume of sales.

It is influenced by sales and variable or marginal cost. If the sale price

increases without a corresponding increase in marginal cost, the contribution
increases—and the profit-volume ratio improves. Similarly, if the marginal
cost is reduced with sale price remaining same— profit-volume ratio
improves.

The advantages of profit-volume ratio are that it can be used to measure

profitability of each product, or group of them, separately so that the
necessity for continuance of such production can be examined. It may also be
used to measure the profitability of each production centre, process or
operation.

One fundamental property of profit-volume ratio is that it remains same at

various levels of operation and, thus, break-even point; required selling prices
to maintain profits at various levels etc. can be easily calculated by suitable
application of this ratio.

The formula to calculate P/V ratio is:

A high P/V ratio indicates high profitability so that a

slight increase in volume, without increase in fixed cost, would result in high
profits. A low P/V ratio, on the other hand, is a sign of low profitability so
that efforts should be made to improve P/V ratio.

Uses of P/V Ratio:

(i) It helps in the determination of Break-even-point [BEP = Fixed cost ÷ P/V
ratio]
(ii) It helps in the determination of profit at any volume of sales

[Sales x P/V ratio = Contribution, Profit = Contribution – Fixed Cost]

(iii) It helps in the determination of sales to earn a desired amount of profit.

Margin of Safety
In accounting, the margin of safety, or safety margin,
refers to the difference between actual sales and  sales at the breakeven point. Managers
can utilize the margin of safety to know how much sales can decrease before the
company or a project becomes unprofitable. Margin of safety is the excess of actual sales
over sales at the breakeven point. It is nil at breakeven point as there is no profit no loss
at this point . higher the margin , lower will the profit in the business. It is calculated by
the following formula

Margin of safety = profit ÷ profit volume ratio ( p/v ratio)

OR

Actual sales – BEP sales

Decisions Regarding
determination of Sales Mix
A sales mix is the collection of all of the products and services a company offers. It
considers each individual item a company sells, and the profit margin each product
earns. While every product may have a different profit margin, the sales mix
considers the profit margin of all of the items combined. By analyzing the sales
mix, a company can determine which products should receive the most focus and
priority, based on the earning capacity, demand, and the resources needed to
produce a product.

The sales mix is a calculation that determines the proportion of each product a
business sells relative to total sales. The sales mix is significant because some
products or services may be more profitable than others, and if a company’s sales
mix changes, its profits also change. Managing sales mix is a tool to maximize
company profit.

Sales Mix Formula

To analyze the sales mix, you must understand the cost and contribution of each
item. For instance, you need to know how much it costs to create a hamburger, and
compare that to the sales price of your hamburgers. To evaluate this, let’s look at
two formulas:

Sales Price – Cost of Materials = Profit

Profit / Sales Price = Profit Margin

When to Discontinue a Product

Line

Every successful product will go through various stages in its lifetime; Introduction,
Growth, Maturity and Decline. When the majority of products in a product line reach
the late ‘maturity’ or early ‘decline’ phase, the product manager can do either of the
two things. He/She can either decide to launch a new version of it or just discontinue
and withdraw it from the market. However, deciding when exactly to discontinue a
product line is a tricky matter.

There are several factors to consider before actually discontinuing a product line. It is
important to analyze the performance of the product line as a whole as well as the
performance of the individual products within that product line.
Profit: A product line may have been around in the marketplace for many years and
have been profitable in its initial and growth stages, however, that does not guarantee
that it will be so indefinitely. If managers keep continuous track of a product's
financial performance, they may discover that its sales and profitability decline over
time, sometimes at a very rapid rate. This is the time managers need to start analyzing
other factors to see if the product has any positive effect on the business. If it is
discovered that the product's only benefit is income, which is no longer coming in,
managers may go ahead and discontinue the product.

Resource Utilization: Even if a product line is profitable, it may just drain your

resources for very little benefit. Ensuring that resources are utilized by all your
product lines optimally is very important. Managers should analyze the margin,
overhead cost, labor cost, maintenance cost, marketing expenses, etc., that are spent to
keep a product line running. If a product line merely absorbs resources in exchange
for minimal return, then it may be better to eliminate it and pave the way for other
product lines that can utilize input resources more effectively.

Product Mix: Managers should constantly assess whether the company's product

lines have the right depth and breadth to satisfy their customer's needs.  It is easier to
drop a product line if there is a wide enough product mix, since other product lines
will help retain current customers and potentially fill the gap of the dropped product
line. While discontinuing a product line, managers can also increase the breadth of
other product lines to retain current customers.

Brand Image: Market turbulence never lets a product line succeed for long unless it
is continually improved. Every brand needs a makeover eventually. It is important to
recognize if a product line no longer fits your brand image. Managers may have to
discontinue a product if they can’t take the risk of spoiling the company's overall
brand image.

Customer Demand: This is an ever changing factor and the most sensitive and
important one to consider when deciding whether or not to continue a product line. If
a product line no longer appeals to customers, then it has no value in the market and
also in the business. In this case, managers should discontinue or shrink a product line
in order to make room for other, more successful lines to flourish.  An increasing
return rate of products from either retailers or customers could be one tell tale sign of
when customer demand is waning.  Other indications could be less favorable reviews
on eCommerce sites or the need to drastically increase advertising spend to maintain
customer demand.    

If the answers for most of these criteria turn out to be negative, then managers can be
sure that they should discontinue a product line in order to have a positive effect on
their business.  If some of the criteria seem positive, while others are negative, this
decision could be much harder.  In these cases it might be helpful to build a cross
functional team across departments to assess from various vantage points what to do
about the product line.