Marginal costing is a cost accounting technique that focuses on the behavior of costs and how they change with changes in the level of production. It is also known as variable costing, as it only considers the variable costs associated with the production of a product or service, and ignores fixed costs that do not vary with the level of production.
The term “marginal” refers to the additional or incremental cost incurred for producing one additional unit of a product. Marginal costing calculates the total variable costs associated with producing one additional unit of a product, which includes the direct materials, direct labor, and variable overhead costs.
The marginal cost is calculated by dividing the change in total variable costs by the change in the level of production. For example, if producing 10 units incurs a total variable cost of $100, and producing 11 units incurs a total variable cost of $110, the marginal cost of producing the 11th unit is $10.
Marginal costing is useful for making short-term decisions, such as determining the minimum selling price of a product, deciding whether to accept a special order, or choosing between alternative methods of production. It helps businesses understand the true cost of producing one additional unit of a product and how changes in the level of production affect the cost structure.
Marginal Costing Methods
Marginal costing is a cost accounting method that involves separating fixed and variable costs, and only considering the variable costs in the calculation of product costs. The following are some of the methods used in marginal costing:
Direct Costing:
Direct costing is a method of marginal costing that only considers the direct costs of production, such as direct materials, direct labor, and variable overhead. This method ignores all fixed costs, including fixed overheads and fixed selling and administrative expenses. Direct costing is useful for short-term decision making, such as setting selling prices and deciding on product mix.
Absorption Costing:
Absorption costing is a method of costing that includes both fixed and variable costs in the calculation of product costs. In this method, all costs, including fixed overheads, are allocated to the cost of the product. Absorption costing is useful for long-term decision making, such as capital budgeting, as it provides a full cost of production that takes into account all the costs incurred in producing the product.
Marginal Cost Plus Pricing:
Marginal cost plus pricing is a pricing method that adds a markup to the marginal cost of a product to determine the selling price. The markup is determined by the business’s pricing strategy, competition, and market demand. Marginal cost plus pricing is useful for short-term pricing decisions, as it ensures that the price covers the variable costs and contributes to covering fixed costs and generating a profit.
Break-Even Analysis:
Break-even analysis is a method used to determine the level of sales at which the business neither makes a profit nor incurs a loss. It is calculated by dividing the total fixed costs by the contribution margin, which is the difference between the selling price and the variable cost per unit. Break-even analysis is useful for determining the level of sales required to cover the fixed costs and the minimum selling price required to achieve a desired profit.
Marginal Costing Types
Direct Costing:
Direct costing is a type of marginal costing that considers only the variable costs of production, such as direct materials, direct labor, and variable overheads. This method ignores all fixed costs, including fixed overheads and fixed selling and administrative expenses. Direct costing is useful for short-term decision making, such as setting selling prices and deciding on product mix.
Marginal Costing for Decision Making:
Marginal costing is useful for making decisions such as whether to accept a special order, discontinue a product, or make or buy a component. In these cases, the focus is on the incremental cost of the decision, and marginal costing helps to determine the impact of the decision on the overall profitability of the business.
Marginal Costing for Pricing:
Marginal costing is also used for pricing decisions. Marginal cost plus pricing is a pricing method that adds a markup to the marginal cost of a product to determine the selling price. The markup is determined by the business’s pricing strategy, competition, and market demand. Marginal costing for pricing helps to ensure that the price covers the variable costs and contributes to covering fixed costs and generating a profit.
Marginal Costing for Profit Planning:
Marginal costing is also useful for profit planning. In this case, the focus is on determining the contribution margin, which is the difference between the selling price and the variable cost per unit. The contribution margin is used to cover fixed costs and generate a profit. Marginal costing for profit planning helps businesses to understand the impact of changes in the level of production on the contribution margin, and to make decisions that maximize profits.
Marginal Costing for Break-Even Analysis:
Break-even analysis is a method used to determine the level of sales at which the business neither makes a profit nor incurs a loss. Marginal costing is useful for break-even analysis as it considers the variable costs of production and helps to determine the contribution margin required to cover fixed costs and achieve the break-even point.
Advantages of Marginal Costing:
Simple and Easy to Understand:
Marginal costing is a simple and easy-to-understand method of cost accounting. It only considers variable costs and ignores fixed costs, which makes it easy to calculate the cost of production and determine the contribution margin.
Helps in Decision Making:
Marginal costing helps businesses to make important decisions such as pricing, make-or-buy, special order acceptance, and product mix decisions. By considering only the variable costs, businesses can determine the impact of these decisions on their profitability and make informed choices.
Focuses on Cost Behavior:
Marginal costing separates fixed and variable costs, which helps businesses to understand the behavior of their costs. This knowledge can be used to make better decisions about production, pricing, and profitability.
Useful for Short-Term Decision Making:
Marginal costing is particularly useful for short-term decision making, such as pricing decisions, because it only considers the variable costs of production. This allows businesses to quickly adjust their prices to reflect changes in the market and competition.
Facilitates Break-Even Analysis:
Marginal costing is useful for break-even analysis, which helps businesses to determine the level of sales required to cover their fixed costs and achieve their desired profit.
Disadvantages of Marginal Costing:
Ignores Fixed Costs:
Marginal costing only considers variable costs and ignores fixed costs, which can lead to incomplete cost information. This can make it difficult for businesses to determine the full cost of production and make long-term decisions such as capital budgeting.
Difficulty in Separating Costs:
It can be difficult to separate fixed and variable costs, particularly when some costs have both variable and fixed components. This can make it challenging to accurately calculate the contribution margin and make informed decisions.
Does not Conform to GAAP:
Marginal costing does not conform to Generally Accepted Accounting Principles (GAAP), which can make it difficult for businesses to present their financial statements in a standardized format.
Not Suitable for all Types of Businesses:
Marginal costing is most useful for businesses with high variable costs and low fixed costs. It may not be suitable for businesses with high fixed costs and low variable costs, such as service businesses.
Can Lead to Underpricing:
Marginal costing only considers variable costs, which can lead to underpricing if fixed costs are not adequately covered. This can result in lower profits or even losses over the long term.
Marginal Costing Uses
Costing of Production:
Marginal costing helps businesses to calculate the variable cost per unit of production, which includes only those costs that vary with changes in production levels. This information is useful for determining the selling price of products, making decisions regarding production levels, and evaluating the profitability of products.
Contribution Margin Analysis:
Marginal costing helps businesses to calculate the contribution margin, which is the difference between the selling price and the variable cost per unit of production. This analysis helps businesses to determine the profitability of individual products and make decisions regarding product mix.
Break-Even Analysis:
Marginal costing facilitates break-even analysis, which helps businesses to determine the level of sales required to cover their fixed costs and achieve their desired profit. This information is useful for setting sales targets, pricing decisions, and evaluating the financial performance of the business.
Make-or-Buy Decisions:
Marginal costing helps businesses to evaluate whether it is more cost-effective to produce a product in-house or to outsource it from a supplier. By considering only the variable costs, businesses can determine the impact of these decisions on their profitability and make informed choices.
Special Order Acceptance:
Marginal costing helps businesses to evaluate whether to accept a special order that requires a lower selling price than the regular selling price. By calculating the contribution margin, businesses can determine whether the special order will result in a profit and make an informed decision.
Pricing Decisions:
Marginal costing helps businesses to make pricing decisions by calculating the contribution margin and evaluating the impact of different selling prices on profitability. This information is useful for setting competitive prices, maintaining market share, and maximizing profits.