Meaning of Marginal Cost

It is the amount by which total cost increases when one extra unit is produced, or the amount of cost which can be avoided by producing one unit less. Accordingly, marginal cost may also be defined as the variable cost incurred due to a specific activity. It is concerned with variable costs, because fixed costs by definition do not change with the volume produced.

Definition of Marginal Costing
The Official C.I.M.A Costs of the Terminology defines marginal costing as, ³The accounting system in which variable costs are changed to costs units and fixed period are written off in full against the aggregate contribution. Its special value is in decision-making´ Accordingly, Marginal cost = Variable cost = Direct material + Direct labour + Direct expenses + Variable overheads.

Typical decision-making situations
Marginal costing can provide useful information for decision-making in a number of typical situations such as the following:

1) Suspension of activities:
Sometimes, management may be confronted with the problem of closing down an unprofitable department, branch or a line of activity. In such a situation, the guiding principle to be followed is the contribution by the product, branch or department to the pool or fund. The object of the analysis is to increase profits by dropping an unprofitable line of activity and replace the same with a profitable one. Products or departments which show a negative contribution should be closed if there is no possibility of an improvement. Negative contribution means that the variable cost per unit exceeds the price and the business would be better off without this line of activity. If there is positive contribution, the decision should be

18 7 2 5 32 40 8 26 9 3 8 46 60 14 2. 30 10 3 9 52 61 9 C Rs. They intended to discontinue the line which produces article A as it is less profitable. Similarly.000 Rs. . For instance. Accordingly.. Illustration: MOM Ltd.in the favour of its continuation.000 B 5. Thus. is engaged in three distinct lines of production. positive contribution may be considered to be insufficient and the resources tied up in the activity could be got released by suspension and invested elsewhere to earn a higher return. the application of the rule of positive contribution is not absolute. it is difficult to lay down strict rules of decision-making with regard to a situation such as this. Sometimes. Much depends upon not merely the quantitative factors but qualitative also such as the effects of suspension or closure on the other parts or activities of the concern. it becomes worthwhile to suspend the activities even if there is positive contribution or continue the line regardless of the negative contribution. the negative contribution may be temporary ant there is the possibility of its becoming positive. As otherwise it would mean loss of contribution and the consequent reduction in profits.000 Rs. The management wants to discontinue 1 line & gives you assurance that production in 2 other lines shall rise by 50%. Their production cost per unit and selling prices are as under: A Production (units) Material Cost Wages Variable Overheads Fixed Overheads Selling Price 3.

A should not be discontinued since it contributes Rs.000 97.000 76. Since maximization of revenue is the guiding factor in tactical decisions & not merely negative or positive contribution.000 45.39. the proposal to drop line A may be considered.000 76.35.000 2.73.01. Mahatma Gandhi.25. (B.000 16. of units produced & sold Contribution per unit Total Contribution Less: Fixed Cost Profit If A is discontinued No. of units Contribution per unit Total Contribution Less: Fixed Cost Profit A (Rs) 18 7 2 27 13 40 3000 13 39.000 24.000 B (Rs) 26 9 3 38 22 60 2.000 for meeting fixed cost allocated to of and shows a profit of Rs. April 1988) Solution: Marginal Cost Statement (Present Position) Material Cost Wages Variable Overhead Marginal Cost Contribution Selling Price No.000 3. 000 & profit by the same figure.000 Total (Rs) 1.000 7.a) Do you agree to the scheme in principle? Do you think that line A should be discontinued? b) Offer your comments with supporting calculations.000 18 90.000 22 66.000 45.24. b) If A is discontinued & production of B & C is increased by 50% total contribution would be more by Rs.000 15.28.000 28.000 C (Rs) 30 10 3 43 18 61 5.000 22 44.Com.500 18 1.000 a) The scheme cannot be agreed with in principle. .000.000 1.

differential pricing or productline pricing. Whether the cost plus formula of pricing. As such. iv) To assist the sale of a joint product. However. the principle underlying absorption costing. depends upon the cost which sets the lowest limit to pricing. Sometimes. before taking a decision. In these cases. However. During normal circumstances.However. It is not possible owing to market conditions. it may become necessary to reduce the price even below the marginal cost. This is in fact. then line A may be closed down. . The principle that should govern the fixation of price in these special cases is that the price should cover the marginal cost. price fixation is one of the fundamental problems that management has to face. this principle of full cost pricing cannot be followed. ii) When a foreign market is explored. and it is necessary to make use of the same to execute a bulk order at a lower price. it is clear from the problem that the selling price of A is the lowest. the question arises as to what extent the price could be reduced. The same would be the case when a buyer in a foreign country desires to buy the product at a lower price. it is the techniques of marginal costing that aids pricing decisions. Although market price is the result of market forces. the absence of perfect competition has the effect of empowering every firm to fix its own price. it is necessary to see whether the selling price could be increased with a view to increasing the contribution of A. iii) When the surplus stock of a product which is liable to deteriorate is to be disposed off. during business recession. 2) Pricing Decisions: One of the purposes of cost accounting is the ascertainment of cost for fixation of selling price. The circumstances necessitating the fixation of price at or below cost are the following: i) When it is desired to make a new product popular in the market. Further. price is based on full cost. when spare capacity exists.

000 80.000 40. Assuming that if the selling price were reduced as suggested. 3. the volume of sale would increase by 30. vi) When it is felt that lowering the price is much better to keep the business going rather than close it temporarily. cannot be retrenched.v) When there is keen competition in the market and lowering the price is business strategy adopted to drive the competitor out of the market.00. vii) To retain the old customers who may be lost to competitors in the activities are suspended.000 units) Direct Materials Direct Labour Variable Overheads Fixed Overheads 1.40. It is anticipated that if this reduction is made.000 units. and meet the costs of closing and subsequent reopening. Illustration: The following details were extracted from the budget for the forthcoming year: Rs.20.000 20. .000 Net Profit 3. vii) When employees.000 In order to improve the amount of net profit budgeted. especially skilled workers.000 1.8 per unit.000 Rs.9 to Rs.60. it is proposed to reduce the selling price from Rs. x) When it is desired to make use of the existing stock of materials likely to deteriorate. ix) To keep plant and machinery quite fit for production which could not otherwise be possible if business is stopped. Sales (40. calculate the net profit that will be achieved.

If there is a key factor.000 units Rs.000 1. Under such circumstances.000 1. 3. management may alter the existing product mix by pushing up the production or sale of the less profitable ones.000 1. 3) Selection of suitable product mix: In the case of a multi-product concern. it is necessary to select.Solution: Marginal Cost Statement Sales: (@Rs.40.20.000 4. .000 20.60. the contribution per unit of that factor has to be compared in order to know the profitability of the products.000 (@Rs. from amongst the available alternative combinations of products which gives maximum contribution. Such a question cannot be easily answered because when a concern is engaged in different lines of activity.000 Thus. it is quite unlikely that each line of activity is as profitable as the other in view of different cost structures and different sales prices. In other words. Such a combination is known as the optimum product mix.000 1.1 would increase the contribution by Rs.000 40.60.00. the question often arises as to the product mix or sales mix which will yield maximum profit.9) Less: Marginal cost Contribution Less: Fixed cost Net Profit At 40.8) 2.00.000 At 70.20. a price reduction by Re.20. 000 and the net profit also by the same amount. The reduction is desirable provided the market is capable of absorbing the additional output and there is no increase in fixed costs.000 units 5.40.

75 Plan A: Sell 1. Plan B: Sell 800 units of product X and 700 units of product Y.2.1.Illustration: The following 3 alternative plans are being considered for the next accounting year: Plan A: Sell 1.000 units of product X and 500 units of product Y.50 Y Rs.000 x Rs. 7 3 2 0.75 Total Contribution Less: Fixed cost Net Profit Rs.1. X Rs. 500. The budgeted fixed cost are Rs. Solution: Selling Price Marginal Cost Contribution per unit X 8 5.50 2.2.000 units of product X and 500 units of product Y.500 1.875 .375 1. Plan C: Sell 760 units of each product.500 875 3. Contribution: X 1. 8 3 2 0.25 1.25 Selling Price Direct Material Cost Direct Wages cost Variable overhead Calculate the budgeted profit that would result from each of the 3 alternatives and suggest the most profitable alternative.50 Y 500 x Rs.50 Y 7 5.

However. with 1.2.50 Y 760 x Rs.900 1. consideration should be given to the limiting factors if any. Contribution: X 760 x Rs.730 Rs.75 Total Contribution Less: Fixed cost Net Profit 1. before the decision.225 3.1.2.2.Plan B: Sell 800 units of product X and 700 units of product Y.000 units of product X and 500 units of product Y is the best mix since the contribution and the profit are the highest.50 Y 700 x Rs.230 1. Contribution: X 800 x Rs. .1.330 3.225 1.500 1.500 1.000 1.75 Total Contribution Less: Fixed cost Net Profit Plan C: Sell 760 units of each product.725 Plan A.

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