Marginal Costing

GROUP 3

Marginal Costing
Marginal Cost : It is the change in the total cost that arises when the quantity produced changes by one unit. That is, it is the cost of producing one more unit of a good. Marginal Costing: Decision making approach in which marginal costs are used as the basis for choosing which product to make or which process to use.

Marginal costing categorizes costs into fixed and variable costs . The marginal cost of a product is its variable cost. This is normally taken to be; direct labor, direct material, direct expenses and the variable part of overheads.

Contribution and Profit: Distinction

Contribution

Profit

Includes Fixed Cost and profit

Does not include Fixed Cost Concept used in Accounting Only sales in excess of BEP results in profit

Concept used in Marginal Costing

At BEP contribution = FC Used in managerial decision making

Profit is computed to determine profitability of product

Formulas in Marginal costing

Sales = VC + FC + Profit Contribution = FC + Profit Sales VC = contribution

Contribution FC = Profit

Sales VC = FC + Profit

Features
Costs are categorized in FC and VC
FC are considered period cost and not included in product cost Prices are determined with reference to Marginal cost and contribution margin Stock of work in progress and finished goods are valued at marginal cost of production

Arguments in favor of MC

Fixed costs should be charged to concerned period irrespective of production level

Inclusion of FC in the product distorts comparability of them at different volumes It is simple in application and easy for exercise of cost control Pricing decisions can be based on contribution level of individual products

Criticism Against Marginal Costing

Difficulty may be experienced in trying to separate fixed and variable elements of overhead costs. Unless this can be done with reasonable accuracy, Marginal costing cannot be accurate . The misuse of marginal costing approach may result in settling selling prices which do not allow for the full recovery of overhead. This may be most likely in times of depression or increasing competitors when prices set to undercut competitors may not allow for a reasonable contribution margin. The exclusion of fixed overhead from inventory cost does not constitute an accepted accounting procedure and therefore adherence to marginal costing will involve deviation from accepted accounting practices. The income-tax authorities do not recognize the marginal cost for inventory valuation.

Differentiating Points
Absorption costing

Marginal costing

Total cost is charged to the cost of products and inventory valuation. Fixed cost is included in the cost of products.

Only variable cost is charged to products and inventory valuation. Fixed cost is not included in the cost of products. It is transferred to costing profit and loss account. Profitability is judged by the contribution made by various products and departments.

Profitability is measured by profits earned by various products or departments.

Absorption Costing and Marginal Costing: Impact on Profit.

When production exceeds sales during the period, a higher profit is shown under Absorption costing, since the fixed over head is absorbed over more number of units produced, and carried to next accounting period along with closing inventory.

When sales are in excess of production a lower profit is reported under absorption costing since less portion of fixed production overhead is recovered in valuation of closing stock and current periods cost of production is higher.

Generalizations on the methods of costing

Where sales and production levels are constant through time, profit is the same under the two methods.
Where production remains constant but sales fluctuate, profit rises or falls with level of sales assuming that costs and prices remain constant, but the fluctuations in net profit figures are greater with marginal then absorption costing. Where sales are constant but production fluctuates, marginal costing provides for constant profit where as under absorption costing profit fluctuates.

Where production exceeds sales, profit is higher under absorption costing than under marginal costing for the reason that absorption of fixed overheads into closing stock increases their value thereby reducing the cost of goods sold. Where sales exceeds production, profit is higher under marginal costing. Under absorption costing the value of fixed costs charged against revenue is greater than incurred for the period.

Choice between using Absorption costing and marginal costing

FACTORS
System of financial control in use. Example: responsibility accounting is inconsistent with absorption costing. Production methods in use. Example: marginal costing is favored in simple situations processing in which all products receive similar attention, but when different products receive widely differing amount of attention, the absorption costing may be more realistic.

Significance of prevailing level of fixed overhead costs.

Key or Limiting Factor analysis

Planning is necessary when one or two factors of production or business resources are in short supply.
Marginal Costing shows its merit when scarce resources are being considered. Examples of resource restrictions Limit to availability of a particular grade of labor Shortage of raw materials. Limit to machine capacity.

Shortage of cash to finance production.

Analysis When only one Limiting factor

If fixed costs are constant, regardless of the level of output and sale within a relevant range of output, Marginal costing principles should lead us to the conclusion that profits will be maximized if total contribution is maximized. If shortage of one resource it is inevitable that all available supply of resource will be used up.
Business should get the best possible value out of the scarce resources that it uses up. Example: Skilled man power.

Actions of management to reduce the effect or eliminate key factors.

Labor Supply can be increased : Retraining existing personnel, overtime working, shift working, incentive Schemes, subcontracting, acquiring labor saving machinery and equipment, reducing idle/non productive time, providing special facilities for working mothers with young children, recruitment from overseas labor market, etc.

Production Capacity May Be Extended

Improving plant layout.

Better production scheduling. Using quality materials which take less time manufacture. Better product designs.

To Increase Warehouse Capacity

Use subcontractors who store the raw materials which are to be used in the production process on their own premises.
Improve stores/ warehouse layout. Purchase storage racks which make better use of space. Acquire more warehouse space. Improve inventory control to keep stock levels to an acceptable minimum.

Introduce the use of sub-stores in the factory production department for various items.
Identify and dispose surplus stocks and surplus fixed assets to free space. Introduce productions systems such as JIT (Just in time) Improve distribution.

Increase or Reduce Finance

Use of alternative methods of financing assets
example: hire purchase, leasing, renting.

Acquire more finance via issue of shares, debentures or long term loans. Sale or lease of building or property. Achieving a better utilization of labor and machinery. Seeking out and applying for Government grants.

Profit Planning

It is the main goal of any business firm.

Marginal costing technique is extensively used. A profit target is fixed and management tries to achieve it by bringing changes in the factors affecting profit. The Factors are: Selling price Quantity sold Variable cost per unit Total fixed costs

Sales-mix

Selection of Profitable Product Mix

Problem faced in multi-product concern.

Product mix which gives the maximum profit must be selected. Product mix is the ratio in which various products are produced and sold. Marginal costing helps in taking decisions regarding changing ratio of product mix which gives maximum contribution or in dropping unprofitable product line. A multi product firm seeks to choose as its product mix that combination of products which will yield the largest total contribution.

Make or buy decision

When the company is working at full capacity

The contribution per unit earned by different components, assemblies or products will be arrived and the contribution thus earned will be lost by not manufacturing the component.
This contribution lost will be considered whether to manufacture a component or buy it from outside.

When the company is not working at its full capacity

The lost contribution approach is irrelevant and should manufacture if it earns contribution over variable costs incurred on it.
If variable costs in production is more than the purchase price from outside market, then only the company will prefer to procure from outside suppliers.

Consideration- Make or Buy Decision

The capability of the company to make the item in terms of the capacity available and the ability to achieve required quality standards. The availability of outside suppliers who can deliver the item in the quantities, quality and time required. The differential cost of making or buying the item i.e.

If items which are currently purchased are manufactured, what additional or incremental costs will be incurred and how do these compare with the costs being saved?
If items purchased which could be manufactured, what costs will be avoided and how do these compare with the costs which will be incurred?

The opportunity cost of using existing capacity to manufacture alternative items which would make a greater contribution to profit and fixed costs than the item under consideration. The impact of a decision to make the item on aggregate volumes, an increase in which should contribute to overhead recovery and facilitate the balancing of demand and operations capacity over time. The level of variable overheads which are charged to the part or article.

Introduction of a new product

When a firm intends to introduce a new product into the market, the major consideration in taking such decision is to see whether that particular product is able to recover its variable cost. Any contribution in excess of variable cost from such new product will improve the overall profitability of the firm.

Discontinuation of a product
The product which gives a higher amount of contribution may be chosen and the other be discontinued.
If a product/product line is dropped, there will be some disengaged capacity, which may be left unused or may be used to increase the production of products/products lines to be continued. If any factor of production is key factor(supply is short), then contribution should be expressed in terms of per unit of key factor

Decision making

Decision to drop a product

Product yielding highest contribution should be accorded top priority in production programme.
No product/product line should be dropped, if it yields any amount of positive contribution If management insists to drop a product/ product line in any case, that product/product line should be dropped which will maximize the profit. If any factor is key factor, that product/product line should be dropped-which provides least contribution per unit of key factor

Accept or reject offer

Contribution analysis is done to check whether it is profitable to accept or reject new order or in subcontracting.

Problems in contribution technique

Planning activity level Market expansion Temporary cessation of operations

Temporary cessation of operations

A factory may have to cease its operations temporarily for sometime due to various reasons like labour troubles, material shortage, financial difficulties etc.

Shutdown cost may be divided into 3 parts:

Cost incurred on suspension of operations Cost incurred during continued shutdown Cost incurred in resuming operations after reopening

Shutdown point () = Fixed cost- Shutdown cost Selling price p.u. Contribution p.u.