Dibrugarh University B.COM 5TH SEMESTER MANAGEMENT ACCOUNTING NOTES UNIT-3


MARGINAL COSTING 

UNIT – III

 

Q1. What is Marginal costing? What are the advantages and disadvantages of marginal costing?

Ans: Institute of Cost and Management Accountants, London, has defined Marginal cost 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.” In this technique of costing only variable costs are charged to operations, process or products, leaving all indirect costs to be written off against profits in the period in which they arise.

Thus, in this context, marginal costing is not a system of costing such as process costing, job costing, operating costing, etc. but a technique which is concerned with the changes in costs and profits resulting from changes in the volume of output. Marginal costing is also known as variable costing.

Following are the advantages or importance of marginal costing:

1. The technique of marginal costing is very simple to operate and easy to understand. Since , fixed costs are kept outside the unit cost, the cost statements prepared on the basis of marginal cost are much less complicated.

2. It does away with the need for allocation, apportionment and absorption of fixed overheads and hence removes the complexities of under-absorption of overheads.

3. Marginal cost remains the same per unit of output irrespective of the level of activity. It is constant in nature and helps the management in production planning.

4. It is a valuable aid to management for decision making and fixation of selling prices, selection of a profitable product/sales mix, make or buy decision, problem of key or limiting factor, determination of the optimum level of activity, close or shut down decisions, evaluation of performance and capital investment decision, etc.

5. It facilitates the study of relative profitability of different product lines, departments, production facilities, sales divisions, etc.

6. It is complimentary to standard costing and budgetary control and can be used along with them to yield better results.

7. It helps the management in profit planning by making a study of relationship between cost, volume and profits. Further, break-even charts and profit graphs make the whole problem easily understandable even to a layman.

8. It is very useful in management reporting. Marginal costing facilitates “management by exception’ by focussing attention of the management towards more important areas than to waste time on problems which do not require urgent attention of the higher managements.

 Following are the disadvantages or importance of marginal costing:

1. The technique of marginal costing is based upon a number of assumptions which may not hold good under all circumstances.

2. All costs are not divisible into fixed and variable. There are certain costs which are semi-variable in nature. It is very difficult and arbitrary to classify these costs into fixed and variable elements.

3. Variable costs do not always remain constant and do not always vary in direct proportion to volume of output because of the laws of diminishing and increasing returns.

4. Selling prices do not remain constant forever and far all levels of output due to competition, discounts for bulk orders, changes in the general price level, etc.

5. Fixed costs do not remain constant after a certain level of activity. Further, marginal costing ignores the fact that fixed costs are also controllable.

6. Marginal costing completely ignores the ‘time factor’.

7. Cost control can be better be achieved with the help of other techniques, viz., standard costing and budgetary control than by marginal costing technique.

8. Fixation of selling prices in the long run cannot be done without considering fixed costs. Thus, pricing decisions cannot be based on marginal cost alone.

Q2. “Marginal costing is a very useful technique to management for cost control, profit planning and decision making” Explain.

Ans: Institute of Cost and Management Accountants, London, has defined Marginal cost 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.” In this technique of costing only variable costs are charged to operations, process or products, leaving all indirect costs to be written off against profits in the period in which they arise.

Thus, in this context, marginal costing is not a system of costing such as process costing, job costing, operating costing, etc. but a technique which is concerned with the changes in costs and profits resulting from changes in the volume of output. Marginal costing is also known as variable costing.

Marginal costing technique is a valuable aid to management in taking many managerial decisions. It is a useful tool for making policy decisions, profit planning and cost control. The information supplied by the ‘total cost method’ is usually not sufficient to solve managerial problems. The following are some of the important managerial problems where marginal costing technique can be applied:

1. Diversification of products and exploring new territory: Sometimes a concern may propose to introduce a new product to the existing products to utilise its idle facilities or to capture a new market or for any other purpose, a decision is taken on the profitability of the new product.

2. Fixation of selling price: Product pricing is necessary under:

(i) Normal circumstances;

(ii) In times of competition or trade depression

(iii) In accepting additional orders for utilisation of spare capacity;

(iv) In exporting

   Under normal circumstances products are priced in order to cover all the costs – fixed and variable and to earn a margin of profit.

However in all other situations mentioned above, product pricing is made in order to cover the variable costs and to contribute towards fixed cost and profit. Marginal costing helps the management in fixing prices above the variable costs which will contribute something to fixed costs and profit, as fixed costs are considered not as production costs.

3. Selection of profitable product mix: In the absence of any limiting factor, contribution of each mix will be considered and the mix which will give the highest contribution will be the most profitable product mix. However if the changes in the product mix involve changes in fixed costs, the relative profitability of the mixes will be assessed on the basis of net profitability and not on the basis of contribution.

4. Limiting factor: Where there is a limiting factor, the selection of the profitable product will be on the basis of contribution per unit of limiting factor. Higher the contribution per unit of limiting factor, more profitable is the product.

5. Make or buy decision: Sometimes a concern has to decide whether a certain product or a component should be made in the factory itself or bought from outside from a firm which specialises in it. In taking such a ‘make or buy’ decision, the technique of marginal costing is of immense help. While deciding to ‘make or buy’ a distinction must be made between fixed cost and variable cost, and the variable cost of manufacturing it should be compared with the price at which this component or product can be bought from outside. It is advisable to make than to buy if the variable cost of the product or component is lower than the purchase price. But if the purchase price is lower than the marginal cost, it would be better to buy than to make it.

6. Effect of changes in sales price: Management is generally confronted with a problem of analysing the effect of changes in sales price upon the profitability the concern. It may be required to reduce the prices on account of competition, depression, and expansion programme or government regulations. The effect of changes in sales price can be easily analysed with the help of contribution technique.

7. Alternative method of production: Sometimes the management has to choose from among alternative methods of production. In such circumstances, technique of marginal costing can be applied and the method which gives the highest contribution can be adopted keeping in view, of course, the limiting factor.

8. Determination of optimum level of activity: The technique of marginal costing also helps the management in determining the optimum level of activity. To make such a decision, contribution at different levels of activity can be found, and the level of activity which gives the highest contribution will be the optimum level.

9. Capital investment decision: The technique of marginal costing also helps the management in taking capital investment decisions. Such decisions are very crucial for the management.

10. Cost-volume profit analysis: Cost-volume profit analysis is a technique for studying the relationship between cost, volume and profit. Profits of an undertaking depend upon a large number of factors. But the most important of these factors are the cost of manufacture, volume of sales and the selling price of the product. The Cost-volume profit relationship is an important tool used for the profit planning of a business. The three factors of Cost-volume profit analysis i.e., costs, volume and profit are interconnected and dependent on one another. For example profit depends upon sales, selling price to a large extent depends upon cost and cost depends upon volume of production as it is only the variable cost that varies directly with production, whereas fixed cost remains fixed regardless of the volume produced. In Cost-volume profit analysis an attempt is made to analyze the relationship between variations in cost with variation in volume. The Cost-volume profit relationship is of immense utility to management as it assists in profit planning, cost control and decision making.

Q3. Define marginal costing and discuss its contributions to the management in decision making.

Ans: Institute of Cost and Management Accountants, London, has defined Marginal cost 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.” In this technique of costing only variable costs are charged to operations, process or products, leaving all indirect costs to be written off against profits in the period in which they arise.

Thus, in this context, marginal costing is not a system of costing such as process costing, job costing, operating costing, etc. but a technique which is concerned with the changes in costs and profits resulting from changes in the volume of output. Marginal costing is also known as variable costing.

Marginal costing technique is a valuable aid to management in taking many managerial decisions. It is a useful tool for making policy decisions, profit planning and cost control. The information supplied by the ‘total cost method’ is usually not sufficient to solve managerial problems. The following are some of the important managerial problems where marginal costing technique can be applied:

1. Diversification of products and exploring new territory: Sometimes a concern may propose to introduce a new product to the existing products to utilise its idle facilities or to capture a new market or for any other purpose, a decision is taken on the profitability of the new product.

2. Fixation of selling price: Product pricing is necessary under:

(i) Normal circumstances;

(ii) In times of competition or trade depression

(iii) In accepting additional orders for utilisation of spare capacity;

(iv) In exporting

      Under normal circumstances products are priced in order to cover all the costs – fixed and variable and to earn a margin of profit.

However in all other situations mentioned above, product pricing is made in order to cover the variable costs and to contribute towards fixed cost and profit. Marginal costing helps the management in fixing prices above the variable costs which will contribute something to fixed costs and profit, as fixed costs are considered not as production costs.

3. Selection of profitable product mix: In the absence of any limiting factor, contribution of each mix will be considered and the mix which will give the highest contribution will be the most profitable product mix. However if the changes in the product mix involve changes in fixed costs, the relative profitability of the mixes will be assessed on the basis of net profitability and not on the basis of contribution.

4. Limiting factor: Where there is a limiting factor, the selection of the profitable product will be on the basis of contribution per unit of limiting factor. Higher the contribution per unit of limiting factor, more profitable is the product.

5. Make or buy decision: Sometimes a concern has to decide whether a certain product or a component should be made in the factory itself or bought from outside from a firm which specialises in it. In taking such a ‘make or buy’ decision, the technique of marginal costing is of immense help. While deciding to ‘make or buy’ a distinction must be made between fixed cost and variable cost, and the variable cost of manufacturing it should be compared with the price at which this component or product can be bought from outside. It is advisable to make than to buy if the variable cost of the product or component is lower than the purchase price. But if the purchase price is lower than the marginal cost, it would be better to buy than to make itself.

6. Effect of changes in sales price: Management is generally confronted with a problem of analysing the effect of changes in sales price upon the profitability the concern. It may be required to reduce the prices on account of competition, depression, and expansion programme or government regulations. The effect of changes in sales price can be easily analysed with the help of contribution technique.

7. Alternative method of production: Sometimes the management has to choose from among alternative methods of production. In such circumstances, technique of marginal costing can be applied and the method which gives the highest contribution can be adopted keeping in view, of course, the limiting factor.

8. Determination of optimum level of activity: The technique of marginal costing also helps the management in determining the optimum level of activity. To make such a decision, contribution at different levels of activity can be found, and the level of activity which gives the highest contribution will be the optimum level.

9. Capital investment decision: The technique of marginal costing also helps the management in taking capital investment decisions. Such decisions are very crucial for the management.

10. Cost-volume profit analysis: Cost-volume profit analysis is a technique for studying the relationship between cost, volume and profit. Profits of an undertaking depend upon a large number of factors. But the most important of these factors are the cost of manufacture, volume of sales and the selling price of the product. The Cost-volume profit relationship is an important tool used for the profit planning of a business. The three factors of Cost-volume profit analysis i.e., costs, volume and profit are interconnected and dependent on one another. For example profit depends upon sales, selling price to a large extent depends upon cost and cost depends upon volume of production as it is only the variable cost that varies directly with production, whereas fixed cost remains fixed regardless of the volume produced. In Cost-volume profit analysis an attempt is made to analyze the relationship between variations in cost with variation in volume.The Cost-volume profit relationship is of immense utility to management as it assists in profit planning, cost control and decision making.

 

Q4. Write short notes on:

1. Break-even point

2. Profit-volume ratio

3. Contribution

4. Differential costing

5. Cost-volume profit relationship

6. Cost-volume profit analysis

7. Assumptions of break even analysis

8. Make or buy decision

9. Margin of safety


1. Break-even point: The break-even point may be defined as that point of sales volume at which total revenue is equal to total cost. It is a point of no profit, no loss. A business is said to break-even when its total sales are equal to its total costs. The break-even point refers to that level of output which evenly breaks the costs and revenues and hence the name. At this point contribution, i.e., sales minus marginal cost, equals the fixed costs and hence this point is often called as ‘critical point’ or ‘equilibrium point’ or ‘balancing point’ or no profit no loss. If production/sales is increased beyond this level, there shall be profit to the organization and if it is decrease from this level, there shall be loss to the organization.

Formula for computing the Break-even point:


2. Profit-volume ratio: The profit/volume ratio, which is also called the ‘contribution ratio’ or ‘marginal ratio’, expresses the relation of contribution to sales and can be expressed as under:

                The P/V ratio, which establishes the relationship between contribution and sales, is of vital importance for studying the profitability of operations of a business. It reveals the effect on profit of changes in the volume.

                The concept of P/V ratio is also useful to calculate the break-even point, the profit at a given volume of sales, the sales volume required to earn a given profit and the volume of sales required to maintain the present profits if the selling price is reduced by a specified percentage. The formula is:


3. Contribution: Contribution is the difference between sales and variable cost or marginal cost of sales. It may also be defined as the excess of selling price over variable cost per unit. Contribution is also known as Contribution Margin or Gross Margin. Contribution being the excess of sales over variable cost is the amount that is contributed towards fixed expenses and profit.

Contribution can be represented as:

Contribution = Sales – Variable cost; or

Contribution = Fixed cost + profit (- loss)


Advantages of Contribution:

1. It helps the management in the fixation of selling price.

2. It assists in determining the break-even point.

3. It helps the management in the selection of a suitable product mix for profit maximization.

4. It helps in taking a decision as regards to adding a new product in the market.

4. Differential costing: Differential costs are the increase or decrease in total costs that result from producing additional or fewer units or from the adoption of an alternative course of action. The alternative course of action may arise due to change in sales volume, alternative method of production, change in product/sales mix, make or buy, refuse or accept decisions, addition of a new product, exploring a new market, decision to drop a product line etc. Hence, differential cost is the change in cost that results from adoption of an alternative course of action.

Features of differential costing:

1. The data used for differential cost analysis are cost, revenue and investments involved in the               decision making problem.

2. Differential costs do not find a place in the accounting records. These can be determined from the analysis of routine accounting records.

3. The total costs figures are considered for differential costing and not the cost per unit.

4. The differences are measured from a common base-point.

5. The alternative which shows the highest difference between the incremental revenue and the           differential cost is the one considered to be the best choice.

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5. Cost-volume profit relationship: Cost-volume profit analysis: Cost-volume profit analysis is a technique for studying the relationship between cost, volume and profit. Profits of an undertaking depend upon a large number of factors. But the most important of these factors are the cost of manufacture, volume of sales and the selling price of the product. The Cost-volume profit relationship is an important tool used for the profit planning of a business.

      The three factors of Cost-volume profit analysis i.e., costs, volume and profit are interconnected and dependent on one another. For example profit depends upon sales, selling price to a large extent depends upon cost and cost depends upon volume of production as it is only the variable cost that varies directly with production, whereas fixed cost remains fixed regardless of the volume produced. In Cost-volume profit analysis an attempt is made to analyze the relationship between variations in cost with variation in volume.

    The Cost-volume profit relationship is of immense utility to management as it assists in profit planning, cost control and decision making.


6. Cost-volume profit analysis: Cost-volume profit analysis is a technique for studying the relationship between cost, volume and profit. Profits of an undertaking depend upon a large number of factors. But the most important of these factors are the cost of manufacture, volume of sales and the selling price of the product. The Cost-volume profit relationship is an important tool used for the profit planning of a business.

    The three factors of Cost-volume profit analysis i.e., costs, volume and profit are interconnected and dependent on one another. For example profit depends upon sales, selling price to a large extent depends upon cost and cost depends upon volume of production as it is only the variable cost that varies directly with production, whereas fixed cost remains fixed regardless of the volume produced. In Cost-volume profit analysis an attempt is made to analyze the relationship between variations in cost with variation in volume.

     The Cost-volume profit relationship is of immense utility to management as it assists in profit planning, cost control and decision making.


7. Assumptions of break even analysis: The break-even analysis is based upon the following assumptions:

(i) All elements of cost, i.e., production, administration and selling and distribution can be segregated into fixed and variable components.

(ii) 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.

(iii) Fixe cost remains constant at all volumes of output.

(iv) Selling price per unit remains unchanged or constant at all levels of output.

(v) Volume of production is the only factor that influences cost.

(vi) There will be no change in the general price-level.

(vii) There is only one product or in case of multi-products, the sales mix remains unchanged.

(viii) There is synchronization between production and sales. 

8. Make or buy decision: Sometimes a concern has to decide whether a certain product or a component should be made in the factory itself or bought from outside from a firm which specialises in it. In taking such a ‘make or buy’ decision, the technique of marginal costing is of immense help. While deciding to ‘make or buy’ a distinction must be made between fixed cost and variable cost, and the variable cost of manufacturing it should be compared with the price at which this component or product can be bought from outside. It is advisable to make than to buy if the variable cost of the product or component is lower than the purchase price. But if the purchase price is lower than the marginal cost, it would be better to buy than to make it.


9. Margin of safety: The excess of actual or budgeted sales over the break-even sales is known as the margin of safety. It is the difference between actual sales minus the sales at break-even point. It represents the amount by which sales revenue can fall before a loss is incurred. As at break-even point there is no profit no loss, sales beyond the break-even point represent margin of safety because any sales above the break-even point will give some profit.

Margin of safety = Total sales – Sales at break-even point

The size of the margin of safety is an important indicator of the strength of a business. The larger margin of safety indicates that the business is sound and even if there is a substantial fall in sales, there will still be some profit. On the other hand small margin of safety indicates that position of the business is comparatively weak and even a small decline in the sales would adversely affect the profit of the business and may result into losses.


Q. 5 Marginal costing is a very useful technique to management for cost control, profit planning and decision making. Discuss it.

Ans: 1. Cost control: Marginal costing provides continuing opportunities to the management to review costs in relation to the level of sales and revenue. This opportunity for review arises from division of costs into fixed and variable. Fixed cost can be controlled by the top management and that to a limited extent. In marginal costing, the management focuses the points which are controllable at lower level of management by the use of standards, budgets, responsibility reports etc. Marginal costing provides, through the reports, all the data to the management for their interpretation and suitable action against the person responsible. Thus marginal costing is an effective tool for the controlling variable costs. It also facilitates the control of fixed costs by the management through the comparison of fixed costs with contribution. In marginal costing, fixed costs are separately shown in the Income Statement and its role in the determination of net profit can be ascertained easily by matching fixed costs against contribution. Thus marginal costing helps the management in the control of fixed costs also.

2. Profit planning: Profit planning is the planning of future operations to attain a defined profit goal i.e. the desired amount of profit or to maintain a specified level of profit. Marginal costing provides the necessary data for profit planning and decision making. It facilitates the cost-volume profit relationship by separating the fixed cost and variable cost in the income statement. It helps the management in planning and evaluating profit from:

(a) A change in volume;

(b) A change in sales mix;

(c) A change in pricing of products;

(d) A make or buy decision;

(e) Selection of most profitable products, customers, territories etc.

3. Decision making: Marginal costing helps the management in various important decisions making regarding the following matters:

(a) Introduction of a product;

(b) Whether to make or buy;

(c) Selection of most profitable product or sales mix;

(d) Price reduction in competition or depression,

(e) Utilisation of spare capacity;

(f) Selection of capital projects;

(g) Determination of most profitable level of activity; etc.


  In formulating the business policy and decision making, the management uses various tools offered by marginal costing such as contribution, break-even chart, profit-volume graphs, break-even point, cost-volume-profit ratio etc.

  In marginal costing technique, only the variable costs and not the fixed costs are considered as production costs and contribution being the difference between the sales and variable costs is the primary factor for taking decisions on the above matters. The contribution may be aggregate contribution or per unit contribution or contribution per factor of production or contribution per limiting factor.


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