Introduction – Marginal Costing:
At any given level of output, additional output can normally be obtained at less than proportionate cost per unit. This is because the aggregate of certain items of cost will tend to remain fixed and only the aggregate of the remainder (variable Cost) will tend to rise proportionately with increase in output. Conversely, a decrease in the volume of output will normally be accompanied by a less than proportionate fall in the aggregate cost.
Therefore, costs should be analysed into variable and fixed components, for meaningful decision-taking. This theory, which recognizes the difference between variable and fixed costs, is called Marginal Costing.
Meaning and Definition of Marginal Costing
It is technique of decision making, which involves:
(a) Ascertainment of total costs
(b) Classification of costs into - (1) Fixed and (2) Variable
(c) Use of such information for analysis and decision making.
Marginal costing is defined by I.C.M.A. as “the ascertainment of marginal costs and of the effect on profit of changes in volume or type of output by differentiating between fixed costs and variable costs.
Thus, Marginal costing is defined as the ascertainment of marginal cost and of the ‘effect on profit of changes in volume or type of output by differentiating between fixed costs and variable costs. Marginal costing is mainly concerned with providing information to management to assist in decision making and to exercise control. Marginal costing is also known as ‘variable costing’ or ‘out of pocket costing’.
The main Features (Characteristics) 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.
2. Managerial Decisions: It is a technique of analysis and presentation of costs which help management in taking many managerial decisions such as make or buy decision, selling price decisions etc.
3. Inventory Valuation: Under marginal costing, inventory for profit measurement is valued at marginal cost only.
4. Price Determination: Prices are determined on the basis of marginal cost by adding contribution which is the excess of selling price over variable costs of sales.
5. Contribution: Marginal costing technique makes use of Contribution for taking various decisions. Contribution is the difference between sales and marginal cost. It forms the basis for judging the profitability of different products or departments.
a) Simple and Easy: - It is very simple to understand and easy to operate.
b) Helpful in Cost control: - Marginal costing divides total cost into fixed and variable cost. Marginal costing by concentrating all efforts on the variable costs can control total cost.
c) Profit Planning: - It helps in short-term profit planning by making a study of relationship between cost, volume and Profits, both in terms of quantity and graphs.
d) Evaluation of Performance: - The different products and divisions have different profit earning potentialities. Marginal cost analysis is very useful for evaluating the performance of each sector.
e) Helpful in Decision Making:- It is a technique of analysis and presentation of costs which help management in taking many managerial decisions such as make or buy decision, selling price decisions, Key or limiting factor, Selection of suitable Product mix etc.
f) Production Planning: - It helps the management in Production planning. The effect of alternative production policy can be readily available and decision can be taken that would yield the maximum return to Business.
g) It removes the complexities of under-absorption of overheads.
h) The distinction between product cost and period cost helps easy understanding of marginal cost statements.
Disadvantages of Marginal Costing:
a) It is based on an unrealistic assumption that all costs can be segregated into fixed and variable costs. In the long term sales price, fixed cost and variable cost per unit may vary.
b) All costs are not divisible into fixed and variable. There are certain costs which are semi-variable in nature. The separation of costs into fixed and variable is difficult and sometimes gives misleading results.
c) Under marginal costing, stocks and work in progress are understated. The exclusion of fixed costs from Stock Valuation affects profit, and true and fair view of financial affairs of an organization.
d) Marginal cost data becomes unrealistic in case of highly fluctuating levels of production, e.g., in case of seasonal factories.
e) It can correctly assess the profitability on a short-term basis only, but for long term it is not effective.
f) It does not provide any effective yardstick for evaluation of performance.
g) Contribution of marginal costing is not a foolproof indicator of profitability.
h) Marginal cost, if confused with total cost while fixing selling price may lead to a disaster.
Assumptions of Marginal Costing:
a) All Elements of cost can be segregated into fixed and variable cost.
b) Variable cost remains constant per unit of output irrespective of the level of output and thus fluctuates directly in proportion to changes in the volume of output.
c) The selling price remains unchanged at all levels of activity.
d) Fixed costs remain unchanged for entire volume of production.
e) The volume of production is the only factor which influences the costs.
f) The state of technology process of production and quality of output will remain unchanged.
g) There will be no significant change in the level of opening and closing inventory.
h) The company manufactures a single product. In the case of a multi-product company, the sales-mix remains unchanged.
i) Both revenue and cost functions are linear over the range of activity under considerations.