Marginal costing is a principle whereby variable costs are charged to cost units and the fixed costs attributable to the relevant period is written off in full against the contribution for that period.
Marginal costing is the ascertainment of marginal cost and the effect on profit of changes in volume or type of output by differentiating between fixed costs and variable cost. In marginal costing, costs are classified into fixed and variable costs.
The concept of marginal costing is based on the behaviour of costs that vary with the volume of output. Marginal costing is known as ‘variable costing’, in which only variable costs are accumulated and cost per unit is ascertained only on the basis of variable costs. Sometimes, marginal costing and direct costing are treated as interchangeable terms.
The major difference between these two is that, marginal cost covers only those expenses which are of variable nature whereas direct cost may also include cost which besides being fixed in nature identified with cost objective.
Contribution of Marginal Costing:
In marginal costing, costs are classified into fixed and variable costs. The concept marginal costing is based on the behaviour of costs with volume of output. From this approach, it is not possible to identify an amount of net profit per product, but it is possible to identify the amount of contribution per product towards fixed overheads and profits. The contribution is the difference between sales volume and the marginal cost of sales.
In marginal costing it is not possible to determine the profit per unit of product because fixed overheads are charged in total to the profit and loss account rather than recovered in product costing. Contribution is a pool of amount from which total fixed costs will be deducted to arrive at the profit or loss.
The distinction between contribution and profit is given below:
- It includes fixed cost and profit.
- Marginal costing technique uses the concept of contribution.
- At break-even point, contribution equals to fixed cost.
- Contribution concept is used in managerial decision making.
- It does not include fixed cost.
- Profit is the accounting concept to determine profit or loss of a business concern.
- Only the sales in excess of break-even point results in profit.
- Profit is computed to determine the profitability of product and the concern.
Formulas used in Marginal Costing:
Sales — Variable cost + Fixed cost + Profit
Sales – Variable cost = Contribution
Sales – Variable cost = Fixed cost + Profit
Contribution = Fixed cost + Profit
Contribution – Fixed cost = Profit
Features of Marginal Costing
(a) All costs are categorized into fixed and variable costs. Variable cost per unit is same at any level of activity. Fixed costs remain constant in total regardless of changes in volume.
(b) Fixed costs are considered period costs and are not included in product cost, only variable costs are considered as product costs.
(c) Stock of work-in-progress and finished goods are valued at marginal cost of production.
(d) In marginal process costing, products are transferred from one process to another are valued at marginal costs only.
(e) Prices are determined with reference to marginal cost and contribution margin.
(f) Profitability of departments, products etc. is determined with reference to their contribution margin.
(g) In accounting, marginal cost, the overhead control account in the cost ledger represents only the variable overhead. Fixed costs are taken as expenses in the profit and loss account and thus excluded from costs.
(h) Presentation of data is oriented to highlight the total contribution and contribution from each product.
(i) The difference in the magnitude of opening stock and closing stock does not affect the unit cost of production since all the product costs are variable costs.
Arguments in Favour of Marginal Costing:
(a) Fixed costs are period costs in nature and it should be charged to the concerned period irrespective of the quantum or level of production or sale.
(b) Inclusion of fixed costs in the product cost distorts the comparability of products at different volumes and disturbs control actions. It highlights the significance of fixed costs on profits. In a highly competitive situation, it may be wise to take an order which covers marginal costs and makes some contribution towards fixed costs, rather than loose the order.
(c) The difficulty in apportionment and absorption of fixed costs to product cost will not exist in contribution approach and it is much easier for accounting and determination of product costs.
(d) Marginal cost method is simple in application and is easy for exercise of cost control. It is more informative and simple to understand.
(e) It helps the management with more appropriate information in taking vital business decisions like make or buy, subcontracting, export order pricing, pricing under recession, continue or discontinue a product/division, selection of suitable product mix etc.
(f) Profit-volume analysis is facilitated by the use of break-even charts and profit-volume graphs, and so on.
(g) The analysis of contribution per key factor or limiting resource is a useful aid in budgeting and production planning.
(h) Pricing decisions can be based on the contribution levels of individual products.
(i) The profit and loss statement is not distorted by changes in stock levels. Stock valuations are not burdened with a share of fixed overhead, so profits reflect sales volume rather than production volume.
(j) Responsibility accounting is more effective when based on marginal costing because managers can identify their responsibilities more clearly when fixed overhead is not charged arbitrarily to their departments or divisions.
Criticism against Marginal Costing:
(a) 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 very accurate. Application of common sense and judgment will be necessary.
(b) The misuse of marginal costing approach may result in setting 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.
(c) The main assumption of marginal costing is that variable cost per unit will be same at any level of activity. This is only partly true within a limited range of activity. With a major change in activity there may be considerable change in the rates and prices of men, material due to shortage of material, shortage of skilled labour, concessions of bulk purchase, increased transportation costs, changes in productivity of men and materials etc.
(d) The assumption that fixed costs remain constant in total regardless of changes in volume will be correct up to a certain level of output. Some fixed costs are liable to change from one period to another. For example, salaries bill may go up because of annual increments or due to change in the pay rates and due to pay structure. If there is a substantial drop in activity, management may take immediate action to cut the fixed costs by retrenchment of staff, renting of office-premises, warehouses taken on lease may be given-up etc.
(e) Increased automation and mechanization has resulted the reduction in labour costs and increased fixed costs like installation, maintenance and operation costs, depreciation of machinery. The use of marginal costing creates a tendency to disregard the need to recover cost through product pricing. For long-run continuity of the business, it is not good. Assets have to be replaced in the long-run.
(f) Exclusion of fixed overheads from costs may lead to erroneous conclusions. It may create problems in inter-firm comparison, higher demand for salaries and other benefits by employees, higher demand for tax by the Government authorities etc.
(g) 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.
(h) The income-tax authorities do not recognize the marginal cost for inventory valuation.
Absorption Costing and Marginal Costing: Impact on Profit
In absorption costing, stock is valued at total cost while in marginal costing stock valuation is done at variable cost only. This means that in absorption costing, stock valuation is higher than in marginal costing. When production exceeds sales, profit under absorption costing is higher than that of marginal costing. But when sales exceed production, profit under absorption costing is lower than that of marginal costing.
Absorption costing is a principle whereby fixed, as well as, variable costs are allotted to cost units and total overheads are absorbed according to activity level. Absorption costing confirms with the accrual concept by matching costs with revenue for a particular accounting period. Stock valuation complies with the accounting standard and fixed production costs are absorbed into stocks.
Absorption costing method avoids separation of costs into fixed and variable elements, which is not easily and accurately achieved. Cost plus pricing under absorption costing ensures that all costs are covered.
Pricing at the marginal cost may, in the long-run, result in failing to cover the fixed costs. It is important to note that in absorption costing sales must be equal to or exceed the budgeted level of activity otherwise fixed costs will be under absorbed.
The absorption of production overheads under absorption costing has the following impacts:
(i) When production exceeds sales during the period, a higher profit is shown under absorption costing, since the fixed overhead is absorbed over more number of units produced, and carried to next accounting period along with closing inventory.
(ii) 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 period’s cost of production is higher.
The following generalizations to be made on the impact on profit of these two different methods of costing:
(a) Where sales and production levels are constant through time, profit is the same under the two methods.
(b) Where production remains constant but sales fluctuate, profit rises or falls with the level of sales, assuming that costs and prices remain constant, but the fluctuations in net profit figures are greater with marginal costing than with absorption costing.
(c) Where sales are constant but production fluctuates, marginal costing provides for constant profit, whereas under absorption costing, profit fluctuates.
(d) 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.
(e) Where sales exceeds production, profit is higher under marginal costing. The fixed costs, which previously were part of stock values, are now charged against revenue under absorption costing. Therefore, under absorption costing the value of fixed costs charged against revenue is greater than that incurred for the period.
The choice between using absorption costing and marginal costing will be determined by the following factors:
(a) The system of financial control in use e.g., responsibility accounting is inconsistent with absorption costing.
(b) The production methods in use e.g., marginal costing is favoured in simple processing situations in which all products receive similar attention; but when different products receive widely differing amounts of attention, the absorption costing may be more realistic.
(c) The significance of prevailing level of fixed overhead costs.