Concept of Marginal Cost, Marginal Costing

Marginal cost is defined as, “the variable cost of one unit of a

product or a service, i.e., a cost which would be avoided if the
unit was not produced or provided.”
Marginal cost, in cost accounting, means variable production
cost, that is, the cost which tends to vary in direct proportion to
the changes in the production level. If an extra unit of output is
produced, the cost which would be incurred for producing this
extra unit will only be marginal or variable costs since fixed
costs remain constant.
The term marginal costing is generally used in U.K. while in the
U.S.A direct costing is more popular term. Marginal costing is
also called as “Direct Costing”. According to marginal costing
technique variable cost are charged to cost units and the fixed
cost attributable to the relevant period is written off in full
against the contribution for that period.
Marginal costing is the costing technique in which only variable
manufacturing cost are considered and used while valuing
inventories and determining cost of goods sold. That means only
variable manufacturing costs are considered, product cost are
allocated to products manufactured. The whole technique of
marginal costing is based on this assumption that, all cost can be
divided into fixed costs and variable costs.
It is also defined as, “The amount, at any given volume of
output, by which aggregate costs are changed, if the volume of
output is increased or decreased by one unit”. The marginal cost
is composed of all variable costs, which mainly include direct
materials, direct labour, direct expenses and some portion of
indirect expenses. That means both the term marginal costs and
the direct costs are virtually the same thing. That is the reason
the term “Marginal costing is also referred to as “Direct
costing”.
Marginal costing is also defined as every expense, whether for
production, selling or distribution, incurred due to particular
decisions”, i.e. decision to increase production by one unit.
Economists define marginal cost as the additional cost of
producing one unit. However, businessmen are interested not in
one unit, but in block of units. Marginal costing has been
defined as, “The ascertainment of marginal cost and the effect
on the profit, of changes in volume or type of output, by
differentiating between fixed and variable costs”. Hence
marginal costing relates to the changes in output in the particular
circumstances under consideration.

Sales xxx
Less: variable cost xxx
Contribution xxx
Less: fixed cost xxx
Profit/Loss xxx
Absorption Costing
Absorption costing also known as full costing, is a costing
technique in which all manufacturing costs, variable and fixed,
is considered as costs of production and is used in determining
the cost of goods manufactured and inventories. All
manufacturing costs are fully absorbed into finished goods.
Marginal costing and absorption costing differs from each other.
Absorption costing influence inventory values differently.
Difference between Marginal Costing and Absorption
Costing

Marginal costing and absorption costing differ from each

other in following aspects:

1. COST ELEMENTS IN PRODUCT COST: they differ

only in the treatment of fixed factory overheads in the
accounting records and financial statement. In both the
costing techniques it is agreed that selling and
administrative expenses, whether variable of fixed, are
period cost and these costs are not treated as product cost
with the result that selling and administrative expenses
are not included in the cost of inventories, and cost of
goods sold… similarly, it is also agreed that variable
manufacturing costs are products costs, i.e. costs to be
 charged to the product. The disagreements between the
two, is only in regard to the treatment of fixed
manufacturing costs.
2. INVENTORY VALUES: they influence inventory
values differently. The values of inventories under
marginal costing are relatively at a lower figure as
inventories are determined in terms of only variable
production costs. In absorption costing, the value of
inventories is completely at a higher figure because it
considers fixed factory overheads also besides the
variable production costs.

3. DIFFERENCE IN NET INCOME: The treatment of

fixed factory overheads brings difference in the net
income figures in the two costing techniques. The
magnitude of any difference in net incomes is a function
of fixed manufacturing cost per unit
ADVANTAGES OF MARGINAL COSTING
 Constant in nature: - Marginal cost remains the same per
unit of output whether there is increase or decrease in
production.
 Realistic:-It is realistic as fixed cost is eliminated.
Therefore, it is more realistic and uniform and no
fictitious profit arises.
 Simplifies overhead treatment:-There is no complication
and over absorption and under absorption of overheads.
 It facilitates controlling:-Classification of cost as fixed
and variable helps to have greater control over cost.
 Meaningful Reporting:-The reporting makes to the
management. It is more meaningful as the reports are
based on sales figures rather than production.
Comparison of efficiency can be done in a better way.
 Relative Profitability:-In case a number of products are
manufactured, marginal costing helps management in the
determination of relative profitability of each product.
 Aid to profit planning:-The technique of marginal
costing helps management in profit planning. The
management can plan the volume of sales for earning the
required profit.
 Break-even point:-It can be determined only on the basis
of marginal costing.
 Rising decision:-These decisions can be based on
contribution levels of individual production.
 Responsibility accounting:-It becomes more effective
when based on marginal costing. Managers can identify
their responsibility clearly.
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 it 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;
 It is 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
 It is very difficult to segregate all costs into fixed and
variable costs very clearly, since all costs are variable in
the long run. Hence such segregation sometimes may
give misleading results.
 The closing stock consists of variable cost only and
ignores fixed costs. This gives Distorted Picture of
Profits.
 Semi-Variable costs are not considered in the analysis.
There is problem of under or over-recovery of
overheads, since variable costs are apportioned on
estimated basis and not on the actual.
Angle of incidence:
This is the angle at which the sales line cuts the total cost line.
Management’s aim will be to have as large an angle of incidence
as possible because a large angle of incidence shows a high rate
of profit. Higher angle of incidence shows a chance of earning
higher profits after B.E.P because the gap between total sales
line and total cost line will be wider that means profit margin
will b higher. However, it also indicates higher degree of risk
because the angle on opposite side is also equal risks & profits
are always co-related to each other. Higher risk = higher
chances of profit. A narrow angle would show that even fixed
overheads are absorbed and profit accrues at a relatively low rate
of return, indicating that variable cost form a large part of cost
of sales.

Sales:
It is necessary to know what level of sales is required to achieve
a desired level of profit .Sales can be expressed in various ways:

A) SALES=FIXED COST + VARIABLE COST+PROFIT.

B) SALES= (PROFIT + FIXED COST)/PVR.

Break-even analysis:
It is considered as an important tool of profit planning. Break
even analysis indicates at what level cost & revenue equilibrium.
The break-even point is a no profit no loss point. Their total cost
equals total selling price/total revenue. In a break even chart, the
following points are indicated: Fixed cost line & variable cost.
Break-even point may be expressed in terms of no. of units or
rupees of sales or percentage of capacity operation. The study of
cost-volume-profit relationship is frequently referred to as
‘break even analyses. It is an analysis that can be used to
determine the probable profit at any level of operation. Basic
assumptions for B.E.P. analysis cost-volume-profit data are
based upon the following basic assumptions:
1. Costs can be split into fixed and variable components.
2. Fixed cost remains constant irrespective of level of activity.
3. Variable cost changes with change in the volume of output.
4. Selling price does not change with change in volume.
The break even analysis refers to a system of determination of
that level of activity where total cost equals total sales the
broader interpretation refers to that system of analysis which
determines the probable profit at any level of activity. The
relationship among the cost of production, volume of
production, profit and sale value is by break-even analysis.
Hence the analysis is also designated as cost-volume-profit
analysis
Formula for Break-even analysis:
Fixed cost /PVR

Uses of break-even analysis:

1. It facilitates determination of selling price which will give
the desired profits.
2. It makes it possible to revive the sales value to cover a
given rate of return on capital employee.
3. The management & forecast, profit and volume at levels of
activity.
4. It suggests making a change in sales mix.
5. It helps the management to do intercomparison of
profitability
6. It shows the impact of changes in cost on profit.
7. It enables the management to plan for the optimum
utilization of capacity.
 Limitations of break even analysis:
1. The break even analysis is static in nature. It may become out-
of-date if the underlined assumptions or prevailing conditions
changes after it is being made. It ignores other factors such as
competition, demand factor, efficiency in production, policy
decision, government policies etc. which may bring about
changes in selling price, unit variable cost and total fixed cost.
In reality a break even chart may show a no. of break even
points.
2. A company which manufactures a variety of products, its total
cost, sales and profits will be of various product mixes. Break
even analysis in such a case will not be an explanatory of the
position of any one product.
3. While taking policy decisions based on break even charts, one
may go wrong because capital employed is not generally
taken into consideration in a breakeven analysis.
MARGIN OF SAFETY (MOS)

It is the excess of present sales value over break even sales.

MOS indicates the strength of a business. High MOS indicates
that the profit will be on even if there is fall in the selling price.
On the other hand if the MOS is small, a decline in sales value
will be a matter of great concern to the management. In such a
situation, management may be required to take the following
decisions:
1. increase the selling price
2. increase the level of activity
3. reduce cost
4. Substitute the existing product with more profitable
products.
MOS is also popularly known as M/S. it is the excess of
actual sales of production volume over the breakeven point.
MOS= S - B.E.P
Profit Volume Ratio (PVR):
It is popularly known as P/V Ratio. It is expressed in
relationship between contribution and sales. It is expressed in
percentage. PVR is given by the formula:
PVR= C/S × 100
It is most important to watch in business. It is the indicator of
the rates at which the organization is earning profit. Higher ratio
means high profitability and low ratio indicates low profitability.
It is useful for calculating B.E.P and profit at given level of
sales, sales required to earn a certain amount of profit, etc.
Higher PVR is an index of sound financial health of a
company’s product.

PVR can be improved by improving the contribution which

can be improved by taking the following course of action:
 Increasing the unit selling price of product.
 Reducing the product unit variable/marginal cost.
 Increasing the share of high contribution margin products
in multiproduct company.
 Reducing share of low contribution margin products in
total sale.
 Concentration on sales of profitable product
Limitations of PVR:
1. Fails to consider the capacity outlay required by additional
productive capacity.
2. Heavily depends on contribution.
3. Indicates only relative profitability.
4. Higher ratio shows most profitable item only when other
conditions remain constant.
5. Over simplification could lead to error in conclusion.
Should marginal costing be adopted by
companies or no?
 Under marginal costing all costs are classified as
either fixed or variable and it ignores the semi
variable costs.
 It is not suitable for companies which have high fixed
cost per unit because it takes into account only
variable cost per unit.
 It is suitable only where production is of uniform size
and shape and hence it is of limited use for
companies which produce goods of different shapes
and sizes.