Marginal costing - definition Marginal costing distinguishes between fixed costs and variable costs as convention ally
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‟. 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.
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
Alternatively, marginal costing is also called the contribution approach and direct costing.
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.
Alternative concepts of Marginal Cost
To the economist, marginal cost is the additional cost incurred by the production of one
extra unit. To the accountant, marginal cost is the average variable cost which is presumed
to act in a linear fashion, ie, marginal cost per unit is assumes to be constant in the short run, over the activity range being considered. These views can be contrasted in the following
Presentation of Cost Data under Marginal Costing and Absorption
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.
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)
Less Fixed Cost (xxxx)
Marginal Costing Profit xxxxx
ABSORPTION COSTING PRO-FORMA
Sales Revenue xxxxx
Less Absorption Cost of Sales
Opening Stock (Valued @ absorption cost) xxxx
Add Production Cost (Valued @ absorption cost) xxxx
Total Production Cost xxxx
Less Closing Stock (Valued @ absorption cost) (xxx) Absorption Cost of Production xxxx
Add Selling, Admin & Distribution Cost xxxx
Absorption Cost of Sales (xxxx)
Un-Adjusted Profit xxxxx
Fixed Production O/H absorbed xxxx
Fixed Production O/H incurred (xxxx)
(Under)/Over Absorption xxxxx
Adjusted Profit xxxxx
Reconciliation Statement for Marginal Costing and Absorption Costing
Marginal Costing Profit xx ADD xx (Closing stock – opening Stock) x OAR = Absorption Costing Profit xx
Where OAR( overhead absorption rate) = Budgeted fixed production overhead
Budgeted levels of activities
Marginal Costing Vs 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:
1. Over and Under Absorbed Overheads In absorption costing, fixed overheads can never be absorbed exactly because of difficulty
in forecasting costs and volume of output. If these balances of under or over
absorbed/recovery are not written off to costing profit and loss account, the actual amount
incurred is not shown in it. In marginal costing, however, the actual fixed overhead
incurred is wholly charged against contribution and hence, there will be some difference in
2. Difference in Stock Valuation
In marginal costing, work in progress and finished stocks are valued at marginal cost, but in
absorption costing, they are valued at total production cost. Hence, profit will differ as
different amounts of fixed overheads are considered in two accounts.
The profit difference due to difference in stock valuation is summarized as follows:
a. When there is no opening and closing stocks, there will be no difference in profit.
b. When opening and closing stocks are same, there will be no difference in profit, provided
the fixed cost element in opening and closing stocks are of the same amount.
c. When closing stock is more than opening stock, the profit under absorption costing will be
higher as comparatively a greater portion of fixed cost is included in closing stock and
carried over to next period.
d. When closing stock is less than opening stock, the profit under absorption costing will be
less as comparatively a higher amount of fixed cost contained in opening stock is debited
during the current period.
Important concepts in Marginal Costing
Key factor or Limiting factor
Key Factor is that which is most important one for taking decisions about profitability of a
product. The extent of its influence must be assessed first to maximize the profits. For
example, if at a particular point of time there is a Government restriction on the import of a
material, which forms the principal ingredient of company‟s product; company cannot
produce, as it wishes. It has to plan production taking into consideration this limiting factor.
However, its efforts will be directed for maximum utilization of available resources. Thus,
limiting factor is a factor which influences the volume of output of an organization at a
given point of time.
It is not the maximization of the contribution that matters, but the contribution in terms of
the key factor that is to be compared for relative profitability.Thus,it is the limiting factor
or the governing factor or principal budget factor. Thus if sale is the key factor, contribution
to sales ratio should be considered. If management is facing labour shortage, contribution
per labour hour should be considered,if production capacity is limited,contribution per unit
i.e in terms output has to be compared.Thus,profitability can be measured by:
Suppose sales of products A and B are Rs. 100 and Rs 110 and variable cost of sales are Rs.
30 and Rs. 23 respectively. The labour hours (key factor) required for these products are 2
hours and 3 hours respectively. The contribution will be:
Product A, Rs.l00-Rs. 30 = 70 per unit or Rs. 35 per hour;
Product B, Rs.110-Rs. 23= Rs. 87 per unit or Rs. 29 per hour.
Profit/volume ratio (P/V Ratio)
When the contribution from sales is expressed as a percentage of sales value, it is known as
Profit/Volume ratio (or P/V ratio). It expresses relationship between contribution and sales.
Better P/V ratio is an index of sound „financial health‟ of a company‟s product. This ratio
reflects change in profit due to change in volume. Broadly speaking, it shows how large the
contribution will appear, if it is expressed on equal footing with sales. The statement that
P/V ratio is 40% means that contribution is Rs. 40, if size of the sale is Rs.100. One
important characteristic of P/V ratio is that it remains the same at all levels of output.
P/V ratio may be expressed as:
P/V ratio = (Sales - Marginal cost of sales)/Sales
or = Contribution/Sales
or = Change in contribution/Change in sales
or = Change in profit/Change in sales
Suppose sales price and marginal cost of product are Rs. 20 and Rs. 12 respectively. Then
P/V ratio will be (Rs. 20 - Rs. 12)/20 =
(8 / 20) X 100= 40%
Marginal Costing and CVP Analysis
Cost-Volume -Profit analysis is an important tool for profit planning. It provides
information about the following matters:
a) The behavior of cost in relation to volume.
b) Volume of production or sales, where the business will break-even.
c) Sensitivity of profits due to variation in output.
d) Amount for profit for a projected sales volume.
e) Quantity of production and sales for a target profit level.
Cost-Volume-Profit analysis may therefore be defined as a managerial tool showing the relationship between profit planning, viz., cost (both fixed and variable), selling price and volume of activity.
Break –Even Analysis Break-even analysis is a widely used technique to study Cost-volume-profit relationship. The narrower interpretation of the term Break even analysis is defined as a system of determination of that level of activity where total cost equals total selling price.The broader interpretation refers to that system of analysis which determines probable profit at any level of activity.
CVP analysis is sometimes designated as Break even analysis. Actually, CVP analysis
includes the entire gamut of profit planning, while Break Even analysis is one of the techniques used in this process.
Break –even point
Break-even point is the point of sale at which company makes neither profit nor loss. The marginal costing technique is based on the idea that difference of sales and variable cost of sales provides for a fund, which is referred to as contribution. Contribution provides for fixed cost and profit. At break-even point, the contribution is just enough to provide for fixed cost. If actual sales level is above break-even point, the company will make profit if actual sales is below break-even point the company will incur loss.
Break even point (of output) = Fixed Cost/Contribution per unit
Break even point(of sales) = Fixed Cost/contribution per unit *selling price per unit
= fixed Cost/P/V ratio
Formulae of CVP Analysis
The make-or-buy decision must be investigated in the broader perspective of available facilities. The alternatives are: (1) leaving facilities idle; (2) buying the parts and renting out idle facilities; or (3) buying the parts and using unused facilities for other products.
Lease or buy decision
Obviously, leasing has more than its share of disadvantages. Among the most serious are: 1) Companies lose depreciation tax deductions, which can be costly to a firm with large taxable income and only a small amount of debt.
2) The salvage value of a purchased asset, which increases the cash flow of the operation when the asset is sold, is also lost.
3) Small-ticket leases generally charge higher interest rates than financial institutions do for loans of similar amounts, since the lease amounts to 100 percent financing. In many cases, the increase can be anywhere from 3-10 percent, depending on the size of the loan. A comparison of figures for both purchase and leasing options doesn't always provide all of the information needed for an accurate picture. The actual decision to lease or buy rests in matching a company's needs with those of all available funding resources.
The cash-flow patterns of the operation, the tax situation, interest rates, degree of financial leverage, long-term business strategies, and the asset itself are all key factors to consider. Leasing companies, banks, and financial institutions seek to cover their risk exposure; ensure a company's ability to pay; gain repeat business; and, naturally, turn a profit. Regardless of the option selected, today's leasing and financing alternatives are tremendously flexible, so you should make sure that every prospective financing partner is aware of what you are attempting to accomplish. The business operation's long-term strategic plans and cash position obviously play an important role in the lease/buy decision. A company pursuing a growth strategy over the next 30 years that has strong cash flows and cash reserves may be more inclined to purchase an asset. On the other hand, a company pursuing the same strategy, but with a weaker cash position, may turn to leasing since it doesn't require a substantial down payment and generally offers lower monthly payments. Leasing is an increasingly popular choice. It can benefit the growing or expanding business in several areas: cash flow, cash management, financial reporting, income tax, ownership, and equipment obsolescence. Remember, however, it is the use of the equipment or asset, not the ownership, that generates income.
Leasing provides great benefits to companies, including small businesses and even home
offices. Although individuals such as the self-employed can lease, the current tax laws do
not provide as much benefit, and the approval process can be difficult in terms of proving
the ability to repay. Other benefits include:
1) Conserving cash. Leasing allows every growing or expanding company to use its cash elsewhere in the business, where it may generate better capital returns.
2) Preserving credit lines. Leasing is considered an alternative credit source; it will usually
not interfere with the operation's established credit lines. Leasing, in effect, expands the
operation's available working capital.
3) Flexibility. A wide array of custom-tailored lease programs are available above and
beyond the standard (10 percent purchase option) plan; one of them may fit the specific
needs of your business. Extend the term or use a stretch lease to lower monthly payments.
Additional buyout options or seasonal payment plans can often be arranged.
4) Overcoming budget restrictions. If your business operates within set budget allocations,
a lease payment may be one way of obtaining the asset or equipment now, when it is
needed, while staying within your budget limits.
5) Replacement. Leasing reduces the burden of obsolescence, since the lease term often matches the useful life of the equipment. At the expiration of the lease term, the company
simply leases any new equipment required.
6) Pay as you profit. Leasing allows a company to pay for the asset or equipment as it is being used in the business and as it generates revenue. Leasing also allows you to deter
paying sales or use taxes up front in one lump sum; such taxes are usually paid over the
term of the lease.
7) Simplified accounting. A monthly lease payment is a routine expense - easy to control and forecast. The payment is also a fixed cost, so you benefit from accurate bookkeeping
and minimized administrative requirements.
8) Tax deductibility. In most situations, the tax rules for determining whether a transaction is a lease or a disguised purchase look to the economic substance of the transaction, not to
its form. Merely being labeled a lease doesn't make it so in the eyes of the Internal Revenue
Service. Fortunately, leasing companies are aware that the tax benefits of a lease could be
lost and structure the transaction properly.
Sell or further processing decision
Short-term, non routine decision about whether to sell a product at a particular stage of
production or to process it further in the hope of obtaining additional revenue. When two or
more products are produced simultaneously from the same input by a joint process, these
products are called Joint Products. The term Joint Costs is used to describe all the manufacturing costs incurred prior to the point where the joint products are identified as
individual products, referred to as the Split-Off Point. At the split-off point some of the joint products are in final form and salable to the consumer, whereas others require
additional processing. In many cases, the company might have the option to sell the
products at the split-off point or process them further for increased revenue. In connection
with this type of decision, joint costs are considered irrelevant, since the joint costs have
already been incurred at the time of the decision, and therefore are Sunk Costs. The
decision will rely exclusively on additional revenue compared to the additional costs
incurred due to further processing.
Joint Input Should the company process further? Costs
Separate Product B
Joint products point
Sell or process further decision Products
Sales value at split-off $240,000 $300,000
Sales value after additional processing 320,000 480,000
Allocated joint product costs 160,000 200,000
Cost of further processing 100,000 120,000
Incremental revenue from processing $80,000 $180,000