MARGINAL COSTING
MARGINAL COST:
Marginal Cost is the change in the total cost, due to a change of one unit of output. Marginal cost is the cost which arises due
to the production of additional units of output. For example, suppose total number of units produced is 100 and the total cost
of production is Rs. 2,000. If one unit is additionally produced the total cost of production may become Rs. 2,010 and if the
production quantity is decreased by one unit, the total cost may come down to Rs. 1,990. Thus the change in the total cost is
by Rs.10 and hence the marginal cost is Rs.10 per unit.

DEFINITIONS:
 ICWA, London defines ‘Marginal Cost’ 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.
 CIMA, London defines ‘Marginal Cost’ as the cost of one unit of product or service which would be avoided if that unit were
not produced or provided.
 ICA, England defines ‘Marginal Cost’ as variable expenses (whether of production, selling or distribution) incurred by taking
a particular decision.

MARGINAL COSTING:
Marginal Costing is a technique of cost accounting, which is based on the differentiation between fixed cost and variable cost.
It is an important management tool for the decision making. It is an accounting technique which ascertains marginal cost by
bifurcating total costs into fixed costs and variable costs. While the total fixed costs remain constant at all levels of
production, the variable costs changes with the production level. Total variable cost increases with an increase in production
and vice‐versa.
In marginal costing, only the variable costs are charged to production or processes, and all fixed costs to be written off
against profits in the period in which they arise. As per principles of marginal costing, only the variable (product) costs are
distributed to the production and sales volumes. All fixed (period) costs are written‐off over the accounting period.

According to ICWA London, marginal costing is the ascertainment, by differentiating between fixed costs and variable costs, of
marginal costs and of the effect on profit on changes in the value and type of output.

Marginal Costing can be defined as a technique of measuring the impact of the change in the volume of output on the profits.
The basic assumption is that fixed cost will remain unchanged irrespective of the change in output. The purpose of this
technique is to provide meaningful information to the management for maximizing profitability. Marginal costing is a
technique that considers only the variable costs as cost of production, leaving out the fixed costs as period costs to be
absorbed from the contribution.

FEATURES OF MARGINAL COSTING:
1) Under marginal costing, all types of operating costs (factory, office and selling) are separated into fixed and variable
components and are recorded separately.
2) Variable costs are treated as product costs, i.e. they are charged to the product. Variable costs become a part of closing
stock valuation.
3) Fixed costs are treated as period costs, i.e. they are written‐off as expenses in the period in which they are incurred. They
do not enter in the stock valuations.
4) Generally, selling prices are based on marginal costs, i.e. selling prices would not be based on total costs.
5) Profitability of departments or products is determined in terms of contribution.
6) The unit cost of a product is equal to its average variable cost of producing the product.


 Marginal Costing
Absorption Costing Vs. Marginal Costing
Absorption costing is a technique of costing where all the costs (fixed + variable) are charged to production. It is also known
as ‘Full costing or Conventional or Traditional costing’. Under absorption costing, the profit emerges only after charging all the
costs to the product i.e. fixed and variable. Hence, under absorption costing, the stock valuation includes product costs as
well as fixed production and office overheads. So the stock value will tend to be higher under absorption costing.

Sr. Absorption Costing Marginal Costing
1. Under absorption costing method, both fixed and Under marginal costing, fixed production overheads
variable costs are included in product cost. are not included in product cost.
2. Profit is the difference between sales and total cost Profit is the difference between contribution and
of goods sold. fixed cost.
3. Fixed costs are included in the cost per unit. Fixed costs are treated as period cost.
4. Inventory valuation includes fixed costs, i.e. higher Inventory valuation does not include fixed expenses.
valuation.
5. Cost per unit reduces as the production increases, Cost per unit remains the same irrespective of
since fixed cost per unit reduces with high volumes. volume of output, as it is valued at variable cost.
6. The difference in the magnitude of opening stock The difference in the magnitude of opening stock and
and closing stock affects the unit cost of production closing stock does not affect the unit cost of
due to the impact of related fixed cost. production.

KEY CONCEPTS:
The concept of marginal cost is based on the important distinction between product cost and period cost. Marginal costing
considers product cost as it varies directly with the volume of output. Thus, marginal costing analyses the costs into fixed
and variable. Even the semi‐variable costs are closely and critically analysed and divided into fixed and variable components
depending upon whether they tend to remain fixed or vary. Some of these concepts are given below –

Fixed Costs:
The costs which remains fixed irrespective of the level of output are known as Fixed Costs. Such costs depend on the basis of
time and also known as Period costs. For e.g. insurance, rent, salaries etc. Nature of fixed costs –
i. Total fixed cost remains constant irrespective of volume of output,
ii. Total fixed costs depend on the installed (maximum) capacity,
iii. Fixed cost per unit decreases when the production volume increases,

Variable Costs:
The costs which change as per the volume of output are known as Variable Costs. Such cost is also known as Product Cost.
E.g. direct wages, raw materials, variable overheads etc. Nature of variable cost –
i. Per unit variable cost remains the same at any given volume of output.
ii. Total variable cost increases with the increase in the volume of output and vice versa.
iii. In the short run and within the installed (maximum) capacity, marginal cost per unit will be equal to the variable
cost per unit. Thus, within the installed capacity, marginal cost = variable cost = (prime cost + variable
overheads)

Semi‐Variable Cost:
The costs which partly remain fixed and partly variable are known as semi‐variable costs or semi‐fixed costs. E.g. telephone
bill, electricity expenses etc. If the cost varies after particular slabs, then such semi‐variable costs are known as step‐ladder
costs. For the purpose of marginal costing, it is necessary to divide such costs into variable component and fixed component.

Direct Costing:
Direct costing is a practice of charging all direct costs to the operations, processes or products. In direct costing all indirect
costs are written off as period costs in which they arise. Under direct costing the closing stocks are valued at direct costs, i.e.,
costs (whether fixed or variable) which can be directly attributable to the cost units. Generally, marginal costing and direct
costing are considered as same. However, direct costing is different from marginal costing as Direct Costing considers fixed
costs, whereas Marginal Costing considered only the variable costs. Marginal costing is also known as ‘variable costing’ or
‘out of pocket costing.

 Marginal Costing

Differential cost:
Differential cost may be defined as ‘the increase or decrease in total cost resulting from any variation in level of operations’.
It represents an increase or decrease in total cost due to any of the following –
a) producing or distributing a few more or few less of the products;
b) a change in the method of production or of distribution;
c) an addition or deletion of a product or a territory;
d) selection of an additional sales channel; and
e) increase in marketing costs etc.

Contribution:
Contribution is the difference between sales value and variable (marginal) cost. It is obtained by subtracting variable cost
from sales revenue at a given level of activity. Contribution serves as a measure of efficiency of operations of various
segments of the business. Contribution is a vital concept in the system of marginal costing. Contribution is also referred as
Gross Margin. Contribution is considered as a fund or pool out of which all fixed costs, are recovered and to which each
product has to contribute its share. The difference between contribution and fixed cost is either profit and loss.

ADVANTAGES OF MARGINAL COSTING:

1. Marginal costing provides a better and more logical basis for the fixation of selling prices. The profit margin is simply
added to the product cost (i.e. variable cost per unit)
2. The technique of marginal costing enables the management to take better and faster decisions for profit maximization.
3. The division of fixed cost and variable cost enables a better control over the expenditure.
4. Fixed costs are not included in the cost of production and hence valuation of inventories is done at marginal cost. So,
inventory valuation is more realistic.
5. Marginal costing facilitates preparation of Break‐Even Point analysis and thus helps to plan the profitability of the
company.
6. Marginal income figures facilitate relative appraisal of products, territories, classes of customers, and other segments of
the business.
7. Pricing based on variable cost helps in preparing tenders for new contracts.
8. In marginal costing there is no need for allocation, apportionment and absorption of fixed overhead, thereby avoids
accounting complications of under absorption or over absorption.

LIMITATIONS OF MARGINAL COSTING:
1. Difficulty is in dividing total costs into fixed and variable components.
2. As marginal costing distinguishes between the treatment of fixed and variable components, it is difficult to adopt this
technique in capital intensive industries, where fixed costs are very large.
3. In marginal costing, it is assumed that fixed costs remain constant in short‐term, but this assumption may not be always
true.
4. Selling prices cannot be reasonably fixed on the basis of contribution alone because then there is a danger of too much
sales being fixed at marginal cost resulting in inadequate contributions.
5. Marginal costing does not provide any standard for the performance evaluation. Marginal contribution data do not
reveal many effects which are furnished by variance analysis.
6. Selling price under the marginal costing technique is fixed on the basis of contribution. This may not be possible in the
case of ‘cost plus contracts’.

 Marginal Costing
IMPORTANCE / APPLICATIONS OF MARGINAL COSTING:
 Relative profitability – In case of multi‐product and multi‐line business activities, marginal costing facilitates the study
of relative profitability of different products. It will show where the sales efforts should be concentrated.
 Basis for pricing / tendering quotation – Marginal costing furnishes a better and more logical basis for fixation of
selling prices and tendering for contracts. In case of export orders, the selling prices have to be fixed below normal
domestic prices. Marginal costing helps to ascertain the lowest selling price per unit which can be quoted without
incurring any loss.
 Profit Planning – Marginal costing facilitates future planning of operations to attain a certain level of profits or to
maintain the current levels. The contribution ratio indicates the relative profitability of a product with respect to
changes in selling price, variable cost or product mix.
 Planning Level of Activity – Increase or decrease in production levels has to be arranged before actual manufacture
takes place. In this context, management would like to have an idea of the contribution and profitability at different
levels of capacity utilization and marginal costing proves very useful in this regard. It is also termed as Flexible
Budgeting.
 Evaluation of Performance – Every department / division / product line have separate earnings capacities.
Comparison and better evaluation of such divisions is possible based on cost‐volume‐profit analysis and contribution
approach. It will facilitate better decision making in cases of whether to discontinue the product / division or
continue production.
 Responsibility accounting becomes more effective – Responsibility accounting is more effective and transparent
when based on marginal costing since fixed overheads are not charged randomly to their departments and hence
managers’ responsibilities are evaluated based on contribution.
 Consistency – in the short‐run, the marginal cost per unit of output remains same irrespective of the level of output,
thus facilitating better decision making.
 Make or Buy decisions – Marginal costing facilitates decision making in problems such as whether to manufacture
components in‐house or to purchase from the market. Such decision making is simplified due to bifurcation of total costs
into fixed and variable components. If variable cost per unit is lower than outside purchase cost, make the product else
purchase. Absorption costing technique would give misleading results in such cases and hence marginal costing is
applied.
 Realistic Valuation of Stock – In marginal costing, finished goods stocks and work‐in‐progress inventory are valued at
their variable cost only. Therefore, it is more realistic and uniform. No fictitious profit arises.
 Maintain Desired Level of Profit – External and internal constraints may reduce the level of profits. Marginal costing
provides information about steps to be taken to either maintain the same level of profits or to achieve a desired level of
profits. Steps taken maybe reduce variable cost, increase selling price etc.
 Facilitates cost control – By separating the fixed and variable costs, marginal costing provides better means of
controlling the costs.
 Key Factor Problems – Key factors are those constraints (restrictions) which limit the operations of a business. For
example, shortage of raw material, shortage of labour hours, inadequate machine capacity, less demand for a product etc.
Key factor is also known as ‘limiting factor, scarce factor, principle budget factor or governing factor’. In such cases,
decisions are taken on the basis of highest contribution per unit of key factor. Thereafter, the product mix is decided
according to the best contribution per unit of key factor.
 Deciding the Product Mix – In a multi‐product organization, marginal costing facilitates deciding the best product mix
or sales mix to maximize the profits of the company, as a whole. The product mix is decided on the basis of contribution
earned by each product. Use of Key factory is vital in deciding the optimal product mix.

COST‐VOLUME‐PROFIT (CVP) ANALYSIS:
Cost‐Volume‐Profit (CVP) analysis is a management tool which shows the relationship between costs, volume of output and
the resultant profits achieved. The aim of an organization is to earn maximum profits. However, profit depends upon a large
number of factors such as cost of production and the volume of sales attained. Sales volume depends on the market demand
and pricing policy, whereas cost depend on production volumes, product‐mix, internal efficiency, methods of production, size
of plant etc.

 Marginal Costing
Assumptions of CVP analysis:
i. Any change in level of output results in a change in sales revenues and product costs.
ii. Total costs can be divided into fixed costs and variable costs.
iii. In the short‐run and within installed capacity fixed costs remain constant.
iv. Selling price per unit and variable cost per units remain constant.
v. Time value of money is not considered for analysis purposes.

Advantages of CVP analysis:
i. CVP indicates the relationship between profits and costs and the volume of production.
ii. It helps in better profit forecasting.
iii. It facilitates preparing flexible budgets to indicate costs at various levels of activity.
iv. CVP relationship assists in formulating pricing policies to suit particular circumstances by projecting the effect which
different price structures have on costs and profits.
v. CVP analysis helps in forecasting costs and profits as a result of change in volume.
vi. It helps fixing a sales volume level to earn a certain level of profits, return on capital employed, or rate of dividend etc.
vii. It assists determination of effect of change in volume due to plant expansion or acceptance of an order, with or without
increase in costs or in other words a quantum or profit to be obtained can be determined with change in volume of sales.
viii. CVP analysis helps in determining relative profitability of each product, line, and project or profit plan.
ix. Through CVP analysis inter‐firm comparison of profitability can be done intelligently.

PROFIT VOLUME (P/V) RATIO

Profit‐Volume (P/V) Ratio is the ratio of Contribution to Sales and is usually expresses as a percentage. This ratio is also
called as ‘margin ratio’. P/V ratio shows the profitability (profit earning capacity) of a product. Thus, higher the P/V ratio,
higher the profitability of a product or service. P/V ratio depends on the selling price per unit and marginal (variable) cost
per unit. P/V ratio can be improved by the either increasing the selling price per unit or reducing the variable cost per unit
(through efficient utilization of factors of production).

BREAK‐EVEN POINT (BEP) ANALYSIS:
Break‐even point can be defined as that level of production and sales, where there is neither profit nor loss. In other words,
at the BEP level, the total sales revenue is equal to and total cost. Thus, we can say that contribution equals fixed cost at BEP
level. Break‐Even Point may be expressed in number of units or sales amount or even as a percentage capacity. Break‐even
Analysis is an analysis that can be used to determine the probable profit at any level of operation.

Cash Break‐Even Point:
When break‐even point is calculated only with those fixed costs which are payable in cash, such a break‐even point is known
as cash break‐even point. This means that depreciation and other non‐cash fixed costs are excluded from the fixed costs in
computing cash break‐even point.

Basic assumptions for Break‐Even Point Analysis:

i. Costs can be split into fixed and variable components.

ii. Fixed cost remains constant irrespective of level of activity.
iii. Total variable cost changes with change in volume of output.
iv. Selling price per unit does not change with a change in volume.
v. The plant capacity can be predicted.
A change in any of the above factors will alter the break‐even point. Thus, break‐even analysis must be interpreted in the light
of limitations of underlying assumptions. The break‐even analysis refers to a system of determination of that level of activity
where total cost equals total sales. The relationship among cost of production, volume of production, the profit and the sale
value is established by break‐even analysis. Hence, this analysis is also known as CVP Analysis.

Breakeven Chart: A breakeven chart records costs and revenues on the vertical axis and the level of activity on the
horizontal axis. The breakeven point is that point where the sales revenue line intersects the total cost line. Other measures
like the margin of safety and profit can also be measured from the chart

 Marginal Costing
Advantages of Break‐Even Charts:
o It provides detailed and clear information in simple form. The chart visualizes the information very clearly and a glance at
the chart gives a clear picture of the whole affairs.
o The profitability of different products can be known with the help of break‐even charts. The problem of managerial
decision regarding temporary or permanent shutdown of business or continuation at a loss can be solved by break‐even
analysis.
o The effect of changes in fixed and variable costs at different levels of production or profits can be demonstrated by the
graph.
o The break‐even chart shows the relative importance of fixed cost in total cost of a product. High costs calls for higher
control.
o The economies of scale, capacity utilization, and comparative plant efficiencies can be analyzed through the break‐even
chart.
o Break‐even analysis is very helpful for forecasting, long term planning, growth and stability

Limitations of Break‐Even Analysis:

o Total fixed costs do not always remain constant.
o Variable costs do not always vary proportionately with production volume & cost per unit may change.

Composite Break Even Point:
A business undertaking may have different manufacturing establishments each having its own production capacity, and fixed
costs but producing the same product. At the same time, the concern as a whole is a unit having different establishments
under the same management. Hence, combined fixed costs have to be met by combined BEP. In this analysis, there are two
approaches mainly:
a) Constant product mix approach
b) Variable product mix approach
Under the first approach, the ratio in which the products of the various establishments are mixed is constant. The mix will be
maintained at BEP Sales also. Under the second approach the product of that establishment would be preferred where the
contribution ratio is higher.

 Marginal Costing
MARGIN OF SAFETY:
Margin of Safety is the difference between Actual Sales and Sales at Break‐Even Point. At any level of margin of safety, the
additional fixed costs are zero since fixed costs are already recovered upto Break Even Point. Margin of Safety can also be
computed by taking the different between projected future sales and BEP (Sales).

Importance of Margin of Safety:
Upto the Break‐Even point the contribution earned is sufficient to recover only the fixed costs. However, beyond the Break‐
Even point, the contribution not only recovers the fixed costs, but also contributes to the profits of the enterprise. A high
margin of safety shows the strength and sustaining capacity of a product under difficult times. It is a sign of prosperity. If the
margin of safety of an enterprise is high, a reduction in selling price per unit or rise in variable cost per unit may not convert
the profits into losses. Thus, a higher margin of safety indicated buffer to absorb the uncertain scenarios of the environment.
If the margin of safety is small, it may indicate that the firm has large fixed expenses and is more vulnerable to changes in
sales.

Improvement in Margin of Safety: The margin of safety may be improved through the following actions –
a) Increase in the selling prices, provided the demand is inelastic so as to absorb the increased prices.
b) Reduction in fixed expenses.
c) Reduction in variable expenses.
d) Increasing the sales volume provided capacity is available.
e) Substitution or introduction of a product mix such that more profitable lines are introduced

EQUATIONS OF MARGINAL COSTING:

Sr. Concept Equation / Formulae

1. Profit Profit = Sales (‐) Total Cost
Profit = Sales (‐) Variable Cost (‐) Fixed Cost
Profit = Contribution (‐) Fixed Cost
Profit = (Sales x P/V ratio) – Fixed Cost
Profit = Margin of Safety (x) P/V ratio

2. Loss Loss = Total Cost (‐) Sales
Loss = Fixed Cost (‐) Contribution

3. Contribution Contribution = Sales (‐) Variable Cost
Contribution = Fixed Cost (+) Profit
Contribution = Sales x P/V Ratio
Contribution per unit = Fixed Cost
BEP (units)

4. Sales Sales = Total Cost (+) Profit
Sales = Contribution
P/V Ratio
Sales = Contribution (+) Variable Cost

5. Profit Volume Ratio P/V Ratio = Contribution (x) 100
(P/V) Sales
P/V Ratio = Contribution per unit (x) 100
Selling price per unit
P/V Ratio = Fixed Cost (+) Profit (x) 100
Sales
P/V Ratio = Difference in Contribution (x) 100
Difference in Sales
P/V Ratio = Difference in Profit (x) 100
Difference in Sales

 Marginal Costing
P/V Ratio = Fixed Costs (x) 100
BEP (Sales)
P/V Ratio = Profit (x) 100
Margin of Safety

6. Break‐Even Point BEP (units) = Fixed Cost
Contribution Per unit
BEP (units) = BEP (Sales)
Selling price per unit
BEP (Sales) = Fixed Cost
P/V Ratio
BEP (Sales) = BEP (units) x Selling price per unit

7. Margin of Safety Margin of Safety = Actual Sales (‐) BEP (Sales)
Margin of Safety = Profit
P/V Ratio
Margin of Safety (%) = Actual Sales (‐) BEP (Sales) x 100
Actual Sales
Margin of Safety (%) = Margin of Safety x 100
Actual Sales

8. Fixed Cost Fixed Cost = Total Cost (‐) Variable Cost
Fixed Cost = Contribution (‐) Profit
Fixed Cost = BEP (Sales) x P/V Ratio
Fixed Cost = BEP (units) x Contribution per unit

9. Profit for a desired Profit = Sales (x) P/V Ratio (‐) Fixed Cost
level of Sales

10. Sales units required Sales (units) = Fixed Cost + Desired Profit
for desired profit Contribution Per unit

11. Sales units required Sales (Rs) = Fixed Cost + Desired Profit
for desired profit P/V Ratio