MARGINAL COSTING

Marginal costing is one of important technique of cost accounting to control the cost. It is used every type of company who is interested to reduce cost and increase profitability. Marginal costing is also included in all professional accounting courses. That is the reason, you should watch following frequently asked questions (FAQ) of marginal costing. 

Q: - 1. What is marginal costing? 

Ans. Marginal costing means to control the cost by calculating all variable cost and deduct it from sale. With this, we find a special reserve that is called contribution. This contribution can be used to pay fixed cost and rest will be our profit. With this we decide whether we have to produce new product or not, whether we have to diversify of producing of our product or not. Marginal costing is one of best technique, with this, we can proper use of cost-volume- profitability analysis because PV ratio is just relationship of contribution and sales. By calculating it, we can compare two products PV ratio.  Products having high PV ratio will be prefer to produce instead of producing products having  low PV ratio.


Q:- 2. What is marginal Costing formula?

Ans. Following are the main formulae which are used in marginal costing. 

Marginal Cost : Effect on total cost by producing one more or less unit of product. 

Marginal Costing  Equation 

Contribution = Sales - Variable Cost 

or 
Contribution = Fixed Cost +/- Profit

If both side will equal, then 

Contribution = contribution

Sales - Variable cost = Fixed Cost +/- Profit

S - V = F + P 

Profit Volume Ratio =  Contribution / Sale

PV Ratio = Fixed Cost  +/- Profit / Sale or F- P / S

or
PV Ratio = Sales - Variable Cost / Sale or S-V / S 


Q:- 4. What is difference between marginal costing and absorption costing? 

Ans. 1. # Absorption costing is a costing system which treats all costs of production as product costs, regardless weather they are variable or fixed. This would usually include direct materials, direct labor and variable portion of manufacturing overhead. Fixed manufacturing cost is not treated as a product costs under marginal costing.Link

2. # Main difference of marginal costing and absorption costing is of calculating profit. In marginal costing, we calculate profit by calculating contribution and then net profit by deducting fixed cost from contribution. By this, we need not to absorb fixed cost per unit. Per unit cost will be same because we give first preference to marginal cost or variable cost. It is easy to decide by how much contribution (and therefore profit) will be affected by changes in sales volume

3. # In absorption costing, we calculate profit with following formula 

Absorption Cost of Production = Opening stock + Production Cost - closing stock 

Absorption Cost of Sales = Absorption Cost of Production + Add Selling, Admin & Distribution Cost +/- Adjustment of Under or Over absorption of Overheads 

Adjusted Profit = Sales - Absorption Cost of Sales 

But, in marginal costing, we calculate first contribution and then net profit

Contribution = Sales - Variable Cost

Net Profit = Contribution - Fixed Cost 

In marginal costing, however, the actual fixed overhead incurred is wholly charged against contribution.

Q: - 5. What are the main applications of marginal costing?

Ans. Please read it at here. 

Q:- 6. What are the limitations of marginal costing? 

1. Proper classification of fixed and variable cost is not easy. If you deem any fixed cost as variable cost, it may mislead your decision. Moreover, some cost may be semi-variable. We can not classify it either in fixed cost or variable cost.

 

2.  In marginal costing, we give less preference to fixed cost. But fixed cost can also affect net flow of cash and cash from operation. So, your decision may be affected from this point.

 

3. In the area of construction or making of building or big contract, we can not use marginal costing technique for controlling the cost because fixed cost is more important and it should be take as part of cost of production for normal showing of profit every year.

 

Q :-  7. Which product would you recommend to be manufactured in a factory under marginal costing rules, time being the key factor?

 

Given information  :

 

	Per unit of product A	Per unit of product B
	$	$
Direct Material	24	14
Direct Labor at $ 1 per  hour	2	3
Variable Overheads at $ 2  per hour	4	6
Selling Price	100	110
Standard Time to Produce	2hrs.	3 hrs.

Ans. We have to calculate contribution for checking whose contribution is better as per marginal costing rules.

	Per unit of product A	Per unit of product B
	$	$
Selling Price	100	110
Less Marginal Cost  :
Direct Material	( - ) 24	( - )14
Direct Labor at $ 1 per  hour	( - ) 2	( - ) 3
Variable Overheads at $ 2  per hour	( - ) 4	(  - ) 6
Contribution	70	87
Standard Time to Produce	2hrs.	3 hrs.
Contribution Per Hour =  contribution/ standard time	$ 35 per hour	$ 29 per hour

From the above it is clear that contribution per hour of Product A is $ 35 per hour which is more than that of product B by $ 6. There product A is more profitable and is recommend to be manufactured.

Marginal costing is very helpful in managerial decision making. Management's production and cost and sales decisions may be easily affected from marginal costing. That is the reason, it is the part of cost control method of costing accounting. Before explaining the application of marginal costing in managerial decision making, we are providing little introduction to those who are new for understanding this important concept. 

Marginal cost is change in total cost due to increase or decrease one unit or output. It is technique to show the effect on net profit if we classified total cost in variable cost and fixed cost. 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 marginal costing, marginal cost is always equal to variable cost or cost of goods sold. We must know following formulae

         a)  Contribution ( Per unit) = Sale per unit  - Variable Cost per unit

                   b)  Total profit or loss = Total Contribution - Total Fixed Costs

or                Contribution = Fixed Cost + Profit 

or                 Profit = Contribution - Fixed Cost 

                  c) Profit Volume Ratio = Contribution/ Sale X 100 ( It means if we sell Rs. 100 product, what will be our contribution margin, more contribution margin means more profit)
     
                  d ) Break Even Point is a point where Total sale = Total Cost 

                  e) Break Even Point ( In unit ) = Total Fixed expenses / Contribution 
                 
                 f) Break Even Point ( In Sales Value ) = Break even point (in units)  X Selling price per unit
                  g) Break Even Point at earning of specific net profit margin

= Total Contribution / Contribution per unit 

or  = fixed cost + profit / selling price - variable cost per unit


Application of Marginal Costing in Managerial Decisions 

By effective use of marginal costing formulae, we can apply marginal costing for managerial decisions with following ways :

1st Application : Managerial Decision Relating to Determination of Optimum Selling Price 

To determine the optimum selling price of any product or service is big challenge for a manager of any company because company wants to profit of each unit of any product or service. In marginal costing  technique, fixed cost will not be changed at any level of production. Only variable cost is changed for getting optimum selling price where company can achieve  expected profit.

Example : 
Suppose a company wants to earn 15% net profit margin on 20,000 unit sold. What price will company fix? 
Following other information is give

suppose fixed cost which fixed = Rs. 180,000
suppose variable cost = Rs. 25

This decision can be easily taken with marginal costing's formula. Above, I have written 7 formula. Now we use 7th formula  of out of them. 

Break even units at desired profit = fixed cost + profit / selling price - variable cost per unit
or 

No. of units expected to sell  = Fixed cost + desired profit / contribution per unit 

20000 = 180000 +  15% X ( 20000X S.P) / selling price - 25

20000 X ( S.P. - 25) = 180000+  15% X( 20000 X S.P)

20000 S.P. - 500,000 = 180000 + 3000 S.P

20000 S.P - 3000 S.P = 180000 +500000

17000 S.P = 680000

S.P = 680000/17000 = 40

or 

Expected Selling price = Rs. 40 

2nd Application : To Check the Effect of Reducing of Current Price on  profit

We all know, this is the time of competition, customer has become king. He wants product at minimum price. One example, we can see free video on YouTube. Instead of buying costly CDs and DVD, customers of entertainment industry see free films and movies on YouTube. But on the other side, company wants to maintain his current profit. At that time, manager will be in tension because it is not possible to maintain profit even after reducing price. But if manager learns marginal costing techniques and uses it effective way, they can check the effect of reducing of current price on net profit, after this, he can decide to reduce production or increase production. It is the law of economics, variable cost will reduce by reducing units of production in same proportion but when we increase production, fixed cost will fastly decreases due to constant nature. 

Example : 
Sale of a product amount to 1000 units per annum at Rs. 500 per unit. Fixed overheads are Rs. 100000 per annum and variable cost Rs. 300 per unit. There is a proposal to reduce the price by 20% due to survive in competition. How many units must be sold to maintain total profit after reducing the price by 20%?

First of all we check the effect of reducing of current price on  profit

Our Gross profit ratio or P/V Ratio without reducing price

= Gross profit or Contribution / Sale per unit X 100 = Sale per unit - variable cost per unit / sale per unit X 100

= 500 - 300/500 X 100 = 40%

Break Even Point ( in units where profit is zero ) = Fixed cost / Contribution per unit = 100000/ 200 = 500 units

After reducing 20% of sale price , our gross profit or P/V ratio will be

= 500- 300 / 500 - 500 X 20%  X 100 = 25%

It means our Gross profit will reduce 15% ( 40% -  25%) if we reduce our sale prices 20%.

Break Even Point ( in units where profit is zero ) = Fixed cost / Contribution per unit = 100000/ 100 = 1000 units

Now No. of Units Sold at Break Even point at desired profit :-

For this we have to know present profit 

Present Gross profit or contribution = 40% gross margin on sale X( total no. of sale units X sale per unit) = 

= 40% X ( 1000 units X Rs. 500 per unit ) 

= 2,00,000

Present Net Profit = Contribution or gross profit - Fixed cost = 200,000 - 1,00,000 = 1,00,000

Now, number of units required to maintain same net profit 

= Fixed cost + Net profit / New contribution after reduction of sale prices

= 1,00,000 + 1,00,000 / Rs. 100 = 200,000 / 100 = 2000 units 

Now, manager has to take decision to produce more 1000 units if he wants to earn same gross margin 40% instead of 25%

3rd Application : Choose of Good Product Mix

It may be possible that company is producing more than one product, at that time company has to calculate each product's contribution margin or gross profit margin. After this, manager see which product is giving high contribution margin. Company manager will give preference to that product whose contribution will high. One more decision can be taken by manger. He can check contribution by producing different quantity of different products. If he see any quantity of products is producing maximum contribution, it will be equilibrium point. Production of units at that quantity will be benefited to company. 

4th Application : Calculation of Margin of Safety

 Marginal costing can be utilized for calculating margin of safety. Margin of safety is difference between actual sale and sale at break even point. According to marginal costing rules, production will follow sales. Suppose current sale is Rs. 4,00,000 and BEP is Rs. 3,00,000, margin of safety is Rs.100000. We can calculate it with following formula

= Profit/ P/V ratio

If company's sale is less than margin of safety, then manager can take step to reduce both fixed and variable cost or increase prices. 

5th Application : Decision Regarding to Sell goods at Different Prices to Different Customers 

Sometime, company has to give special discount to special customers. These customers may be govt, foreign companies or wholesaler. At that time manager has to take decision at what limit, we can give discount to special customers. Marginal costing may help in this decision.