Marginal cost is the additional cost of producing an additional unit. It is nothing but variable cost. It comprises direct materials, direct labour and variable overheads. The C.I.M.A. London has defined marginal cost as – “the amount at any given volume of output by which aggregate costs are changed, if volume of output is increased or decreased by one unit.”

Marginal costing is used for taking more business decisions such as profit planning, evaluation of performance, make or buy decisions, fixing of selling price, selection of a suitable product mix, diversion of products, closing down of certain departments or activities, accepting a foreign order, entering a new market, alternative courses of action etc.

Contents

1. Introduction to Marginal Cost
2. Meaning and Definitions of Marginal Cost
3. Features of Marginal Cost
4. Characteristics of Marginal Cost
5. Situations in Which the Technique of Marginal Costing Can be Profitably Employed
6. Assumptions Based on Technique of Marginal Costing
7. Uses of Marginal Cost
8. Cost Volume Profit Analysis
9. Formula for Calculating Contribution
10. Profit Volume Ratio
11. Break Even Analysis
12. Break Even Chart
13. Steps and Areas Involved in Decision Making
15. Fixed and Variable Costs in Marginal Costing
16. Similarities and Dissimilarities between Differential Cost Analysis and Marginal Costing
17. Difference between Absorption Costing and Marginal Costing
18. Difference between Direct Costing and Marginal Costing
19. Differential Cost
20. Margin of Safety
21. Marginal Cost Sheet Format
22. Key Factors
23. Determination of Profits Under Various Formulas
24. Formulas Used in Marginal Costing
26. Merits of Marginal Cost
27. Limitations of Marginal Cost
29. Objective Type Questions With Answers

## Marginal Cost: Meaning, Features, Assumptions, Cost Volume Profit Analysis, Break Even Analysis, Formula, Advantages, Limitations, Difference, Pricing and Examples

### Marginal Cost – Introduction

Total costs are divided into fixed and variable costs for accounting purposes. Variable costs are going to change according to the change in volume of output. If output increases, the variable cost also increases. If output decreases variable cost also decreases.

The change in output does not affect the production cost per unit. Contrary to this, fixed costs remain same for any level of volume of activity up to a certain point. Increase or decrease in production does not affect the total amount of fixed cost.

However, fixed cost per unit is going to change due to change in the output. If output increases the fixed cost per unit decreases. If output decreases the fixed cost per unit increases. Thus, fixed expenses leads to different cost per unit at different level of production. To overcome this problem, a special technique known as marginal costing has been developed.

Under marginal costing fixed expenses are excluded from cost of production which leads to the same cost per unit for all levels of output. Fixed expenses are directly charged to contribution which is the difference between sales revenue and variable cost. Under marginal costing period costs are totally charged during a particular period.

They are not carried over to the next period as it is done in absorption costing. The valuation of inventory under marginal costing is purely done on the basis of marginal cost. In order to have a thorough understanding of marginal costing, it is essential to define first what is marginal cost.

The Institute of Cost and Works Accountants of India has defined marginal cost as, “the amount at any given output by which aggregate costs are changed if the volume of output is increased or decreased by one unit”.

It represents the additional cost of production. Here a unit may be single article, an order, a process, a department or a batch. To ascertain the marginal cost, the elements of cost needed are direct material, direct labour, other direct expenses, and total variable overheads.

It is clear from the above definitions that only variable cost form the part of the product cost in the marginal costing technique because variable costs are changed if output is increased or decreased and fixed costs remain constant.

For example, if for an output of 10000 units, the unit cost is Rs.10 and the fixed cost is Rs.30000, the total cost will be Rs.130000 (i.e. Rs.10 x 10000 units + Rs.30000). If the output is 10001 units, the total cost will be Rs.130010 (i.e. Rs.10 x 10001 units + Rs.30000). Thus, an increase in the additional unit of output leads to an increase in the marginal cost whereas the fixed cost remains unchanged.

Marginal costing is defined by ICWAl as “the ascertainment by differentiating between fixed costs and variable costs, of marginal costs and of the effect on profit of changes in volume or type of output”.

According to Dr. Joseph, “marginal costing is a technique of determining the amount of change in the aggregate costs due to an increase of one unit over the existing level of production. As such, it arises from the production of additional increments of output.”

Marginal costing is used for taking more business decisions such as profit planning, evaluation of performance, make or buy decisions, fixing of selling price, selection of a suitable product mix, diversion of products, closing down of certain departments or activities, accepting a foreign order, entering a new market, alternative courses of action etc.

### Marginal Cost – Meaning and Definitions

Marginal cost is the additional cost of producing an additional unit. It is nothing but variable cost. It comprises direct materials, direct labour and variable overheads. The C.I.M.A. London has defined marginal cost as – “the amount at any given volume of output by which aggregate costs are changed, if volume of output is increased or decreased by one unit.”

For example, the cost of manufacturing 100 articles is Rs. 6,000. If 101 articles are produced, it costs Rs. 6,040. So the additional cost of producing one more article is Rs. 40. This Rs. 40 is the marginal cost. When fixed cost does not change, additional cost comprises only variable

Marginal cost is the cost of producing an extra unit of output. In other words, it is the amount by which total cost increases when one extra unit is produced.

It is also the amount by which total cost decreases by not producing one extra unit. Marginal cost is thus the amount at any given volume of output by which the aggregate costs are changed if the volume of output is changed by one unit.

The CIMA Official Terminology has defined the term ‘marginal cost’ as “the part of the cost of one unit of product or service which would be avoided if that unit were not produced, or which would increase if one extra unit were produced.” Accordingly, the term ‘marginal cost’ refers to the cost of an additional unit.

This unit may be an article or a unit of measurement. Sometimes, it may refer to the total marginal costs of a batch, a department or operation. In practice, however, marginal cost is measured by the total variable cost attributable to one unit.

Marginal cost is the variable cost per unit. Although total variable cost may increase or decrease consequent upon increase or decrease in output, variable cost per unit remains constant for all levels of output within the installed capacity.

### Marginal Cost – Top 8 Features

The features of marginal costing are as follows:

1. Closing Stock – Closing stock is valued on variable cost.

2. Stocks – The stocks of finished goods and work-in-process are valued at variable cost only.

3. Determination of Prices – Prices are determined on the basis of variable cost by adding ‘contribution’ which is the excess of sales or selling price over variable cost of sales.

4. Determination of Profitability – Profitability of departments and products is determined with reference to their contribution margin.

5. Fixed Costs – Fixed costs are treated as period costs and are charged to profit and loss account for the period for which they are incurred.

6. Variable Costs – The variable costs (marginal costs) are regarded as the costs of the products.

7. Technique – It is a technique of analysis and presentation of costs that helps management in taking many managerial decisions and is not an independent system of costing such as process costing or job costing.

8. Classification of Elements – All elements of cost-production, administration and selling and distribution – are classified into variable and fixed components. Even semi-variable cost are analyzed into fixed and variable.

### Marginal Cost – 9 Main Characteristics

The main characteristics of marginal costing are as under:

1. Period cost – Fixed costs are handled as period costs and they are written off as an expenses.

2. Recording – Marginal costing is treated as a method of recording and reporting. It requires a unique method of recording.

3. Variable cost – Variable cost will be handled as product cost. They are chargeable to products and it does not become a part of inventories values.

4. Inventories – They are treated in the way which is meant for administrative and selling expenses.

5. Separation of costs – Under this system, all types of operating costs are separated into fixed and variable costs and they are recorded separately.

6. Marginal cost – Marginal cost are treated as product cost in this system.

7. Determination of prices – Prices are determined on the basis of marginal costing and desired contribution are calculated.

8. Determination of profits – Profit is determined on the basis of marginal cost system. Total marginal costs are deducted from sales and the balance is known as contribution. After deducting fixed cost from the contribution, the balance is treated as profit.

9. Breakeven point – Break even print is the prime component of marginal costing. It is that stage which shows the profitability.

### 5 Situations in Which the Technique of Marginal Costing Can be Profitably Employed

The technique of marginal costing can be profitably employed in the following situations:

1. Evaluation of Performance:

The performance of various segments of a business, say a department or a product or a branch, can be evaluated with the help of marginal costing and the evaluation of the performance will be based upon the contribution generating capacity of these segments. If the fixed costs are apportioned over these segments on any basis whatsoever, it will be ignored while evaluating the performance.

2. Profit Planning:

Marginal costing, through the calculations of P/V ratio, enables the management to plan the activities in such a way that the profits can be maximized or to maintain a specific level of profits. As such, this technique helps the planning of profits.

3. Fixation of Selling Price:

The technique of marginal costing may be applied in the area of price fixation in such a way that prices fixed should cover at least the variable cost. As in the short run, the fixed cost is a stagnant cost; it can be ignored, though it cannot be ignored in the long run because of the simple fact that it is a cost.

In the short run, the prices fixed above the variable cost may generate some positive contribution which may help in the recovery of fixed cost. However, if the fixed cost is ignored in the long run, it may put the business into serious troubles as the business will never be able to earn the profits.

In this connection, following propositions should be kept in mind:

(a) In some exceptional circumstances, viz., during the phase of depres­sion, serious competition in the market, to introduce the new product in the market by keeping the price as low as possible in the initial stages, to dispose off the product which may deteriorate in quality, etc., it may be necessary to fix the selling price even below the vari­able cost, however, it is a deliberate decision taken by the management.

(b) The above principle is equally applicable while fixing the export price as well. The export price over and above the variable cost will result in increased amounts of profits if the fixed costs can be taken care of by the inland sales and if the home market is not likely to get affected by the export price fixed.

However, if certain specific costs, either fixed or variable, are required to be incurred specifically for the execution of the export order, they will have to be recovered while fixing the export price as if it is a part of the variable cost.

The revised amount of profit will be more by Rs. 20,000 as compared to the existing amount of profits. Hence, the export order should be accepted by the company.

If the management is facing a problem to decide whether a component or a product should be manufactured in-house which can be purchased from an outside source as well, the technique of marginal costing may render useful assistance.

For example, the following cost data is made available in respect of two components A and B:

If the above data is viewed from total cost point of view, without considering the classification of cost like fixed or variable, it may be concluded that the purchase proposition may be profitable for both the components A and B.

However, the conclusion may be misleading as the total cost in case of component A, if purchased, is not going to be only Rs. 40 per unit, but is going to be Rs. 65 (i.e., Rs. 40 purchase price per unit plus Rs. 25 fixed cost per unit) which being more than present total cost manufacturing proposition will be beneficial.

On the other hand, in case of component B, total cost, if purchased, is going to be Rs. 45 per unit (i.e., Rs. 25 purchase price per unit plus Rs. 20 fixed cost per unit) which being less than present total cost, buying proposition will be beneficial.

The above conclusions may be simplified in the following way:

If Purchase price < Variable cost, go for purchase proposition.

If Purchase price > Variable cost, go for manufacturing proposition.

Before taking any make or buy decision only on the basis of marginal cost analysis, following points should also be taken into consideration:

(a) If buying proposition is beneficial in case of a component or product the final decision to buy may depend on other factors also, viz., whether the supplier is reliable one, whether the supplier can assure required quality, whether the supplier can assure uninterrupted supply, etc.

(b) If it is decided to buy a component or a product which was being manufactured till now, the manufacturing capacity released should be profitably used for some other purposes. If it is decided to manufacture a component which was being purchased till now, there may be two possibilities. One, production capacity used for the same component or product may be diverted to manufacture another component or product.

In this case, the loss of contribution of that another component or product should be considered as a part of cost. Second, if additional production facilities are required to be acquired for the manufacturing proposition, the additional fixed costs attached with the manufacturing proposition should be considered.

5. Optimizing Product Mix:

Product mix refers to the proportion in which various products of a company can be sold. If a concern is dealing in a number of products, a problem which usually arises is to decide a mix or proportion in which the sales of various products should be made so that the profits can be maximized.

Such a problem can be solved by studying the contributions generated by various products individually and by selecting that mix which generates the maximum total contribution.

### 5 Assumptions Based on Technique of Marginal Costing

The technique of marginal costing is based upon the following assumptions:

1. Value Influencing Factor – The volume of production or output is the only factor, which influences the costs.

2. Fixed Cost Constant – Fixed costs remain unchanged or constant for the entire volume of production.

3. Segregation – Elements of cost – production, administration and selling and distribution-can be segregated into fixed and variable components.

4. Valuable Cost Constant – 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.

5. Selling Price Constant – The selling price per unit remains unchanged or constant at all levels of activity.

### Marginal Cost – Various Uses

In accordance with the CIMA Official Terminology definition of marginal costing, the technique is ‘an accounting system’. As such, it may be used in the routine work of cost ascertainment and inventory valuation. In case this accounting system is used for product costing, cost units will be valued at prime cost plus variable overheads. Fixed costs will be written off in full to profit of the period in which they are incurred.

Another use of marginal costing is profit planning. Operations planning, covering all aspects of future operations in the direction of achieving the established profit goal can be accomplished by the application of marginal costing. The readily available profit planning data on variable cost and contribution margin assist management in decision-making.

Marginal costing is also an analytical tool of reporting to management of the effects of changes in volume and type of output and the resultant behaviour of costs. It facilitates forecasting of costs and contribution margins, flexible volume analysis, relationship of costs to sales volume and price, and many other cost relationships.

The reports based on marginal costing are far more effective for managerial control than those based on absorption costing. It facilitates fixation of individual responsibility according to organisation lines. Individual performance can be evaluated on the basis of reliable data.

Operating reports can be prepared for every division of the concern and variances can be linked to particular individuals and functions.

### Marginal Cost – Cost Volume Profit Analysis (With Important Views, and Applications)

Profit maximization is one of the important objectives of majority of corporate undertakings. This profit is influenced by a number of factors. These include both the internal and the external factors. The important determinants of profit are price, sales volume, output, costs (both variable and fixed), etc.

Even these determinants influence each other. For instance, cost influences the price, price influences the demand, demand influences both the production and the sales, production influences the costs and so on and so forth.

Further, a number of changes take place in costs (both variable and fixed), price, sales volume, etc., and these changes will have an impact on profit. Since the profit is one of the important aspects which draw the attention of the managerial personnel, they (i.e., managerial personnel) would naturally like to know the effects of changes in costs, price, volume, etc., on the company’s profit and on a number of other aspects which shed light on profitability of the company.

The study of the effects of changes in volume, costs, price, etc., on profit and other aspects is the subject matter of cost-volume-profit analysis which is popularly and simply known as C-V-P Analysis. Before proceeding to delineate into the effects of changes in cost, volume and price on profit, it is better to have a look at the relationship between the Break-Even Analysis and the C-V-P Analysis.

The important views about the two are summarized here:

1. Since the term break-even analysis has the unfortunate implication that the object of the business is merely to break-even, some experts suggest usage of the term C-V-P analysis. If this opinion is put to a detailed analysis, it helps to form an idea that the C-V-P analysis is a broader one when compared to Break-Even Analysis.

2. The above fact has clearly been brought out by the opinion of Garrison which is reproduced here. Cost-volume-profit analysis is sometimes referred to simple as break-even analysis. This is unfortunate, because break-even analysis is just one part of the entire cost-volume-profit concept.

3. The same view is expressed, of course in a different tone, by Horngren which is reproduced here. The study of cost-volume-profit relationships is often called break-even analysis. The latter is a misnomer because the break-even point – the point of zero net income – is often only incidental to the planning decision at hand.

Break-Even Analysis lays more emphasis on break-even point and all other calculations are centered around this break-even point. Of course, Break-Even Analysis also determines the effect of changes in the determinants (of profit) on profit but the emphasis is on the effect of changes on the break-even point which alters the margin of safety.

Therefore, the effect on profit is studied. But, in the case of C-V-P Analysis, emphasis is on the profit. More specifically, on the effects of changes in cost, price, volume, etc., and also the effects of alternative courses of action on the company’s profit.

Further, Break-Even Analysis appears to be a static one. That means, Break-Even Analysis considers the costs (both variable and fixed), price, etc., at a particular level of activity. On the other hand, C-V-P Analysis incorporates, to the static Break-Even Analysis, the changes in the determinants of profit and studies the effects of these changes on profit.

To put it alternatively, C-V-P Analysis also studies the Break- Even Analysis as the knowledge of Break-Even Analysis provides a greater insight into the pros and cons of alternative courses of action.

Usually, the companies plan for the profit to be earned during a year. They spell out clearly the detailed plan as to how the planned profit is to be achieved. When they end up the year, they normally find some difference between the actual profit earned and the budgeted profit planned. Even if a few companies are able to achieve the profit they had planned, they may find some deviations or changes in the activities than budgeted.

Any change in the profit is primarily due to the changes in the four important factors. They are selling price, variable costs, fixed costs and volume of activities. C-V-P Analysis deals with assessing the effects of changes in these four factors on the profit and other variables. In brief, this aims at quantifying the effects of changes in the fixed costs, variable costs, selling price and sales quantity on the profit and other aspects of the companies.

#### Application of CVP Analysis:

The CVP analysis can be used to analyse the impact of change in differ­ent variables affecting profits on the BEP, P/V ratio, and margin of safety and profitability of the enterprise.

Some of the applications of CVP analysis in different business situations are discussed below:

1. Effect of Change in Fixed Cost:

The increase in fixed cost has no effect on the P/V ratio of the firm. However, the BEP shifts upward because higher sales are required to recover the increased fixed costs. The margin of safety declines as the BEP moves higher.

The decrease in fixed cost again has no effect on the P/V ratio, but the BEP shifts downward and the margin of safety improves.

2. Effect of Change in Variable Cost:

The increase in variable cost reduces the margin per unit and therefore the P/V ratio declines. The BEP shifts up due to lower P/V ratio. This also reduces the margin of safety.

The decrease in variable cost improves the margin and the P/V ratio. It brings the BEP down and improves the margin of safety.

3. Effect of Change in Selling Price:

The increase in selling-price per unit increases the margin per unit and therefore improves the P/V ratio. The BEP shifts down and the margin of safety increases.

The decrease in selling price reduces the P/V ratio. The BEP moves up and the margin of safety declines.

4. Effect of Change in Sales Volume (Quantity):

The increase in quantity sold does not affect the margin and the P/V ratio. Therefore, the BEP remains the same. But the margin of safety definitely improves due to higher sales realization.

The decrease in quantity sold reduces only the margin of safety.

5. Effect of Multiple Changes:

In case more than one variable changes at a time, the fresh calcu­lations need to be made based on the revised figures. The effect will depend upon the quantum of respective changes in the different variables.

### Marginal Cost – Formula for Calculating Contribution

Contribution is the difference between sales and the marginal (variable) cost of sales. It is also known as contribution margin (Cm) or gross margin.

Thus contribution is calculated by the following formula:

The concept of contribution is extremely helpful in the study of break-even analysis and management decision making, like fixing selling prices, selection of suitable sales mix, make or buy, etc.

### Marginal Cost – Profit Volume Ratio: Symbol, Significance, Type of Calculations, Improvement and Achievement

The Profit Volume ratio, also known as contribution/sales ratio (C/S ratio), expresses the relation of contribution to sales.

Symbolically:

Profit-Volume ratio can also be calculated by comparing the change in contribution to change in sales or change in profit to change in sales. Any increase in contribution means increases in profit because fixed costs are assumed to remain unchanged at all levels of production.

Thus:

Significance of P/V Ratio:

P/V ratio is one of the most important ratios to watch in business. It is an indicator of the rate at which profit is being earned. A high P/V ratio indicates high profitability and a low ratio indicates low profitability in the business. The profitability of different sections of the business, such as- sales areas, classes of customers, product lines, methods of production, etc., may also be compared with the help of profit-volume ratio.

The P/V ratio is also used in making the following type of calculations:

a. Calculation of break-even point.

b. Calculation of profit at a given level of sales.

c. Calculation of the volume of sales required to earn a given profit

d. Calculation of profit when margin of safety is given.

e. Calculation of the volume of sales required to maintain the present level of profit if selling price is reduced.

Improvement of P/V Ratio:

As P/V ratio indicates the rate of profitability, an improvement in this ratio, without increase in fixed cost, would result in higher profits. As a note of caution, erroneous conclusions may be drawn by mere reference to P/V ratio and, therefore, this ratio should not be used in isolation.

P/V ratio is the function of sales and variable cost. Thus it can be improved by widening the gap between sale and variable cost.

This can be achieved by:

a. Increasing the selling price

b. Reducing the variable cost

c. Changing the sales mix i.e., selling more of those products which have a larger P/V ratio, thereby improving the overall P/V ratio.

### Marginal Cost – Break Even Analysis: Assumptions, Uses, Methods, Break – Even Point Formula and Limitations

The study of cost-volume-profit analysis is often referred to as break-even analysis. Break-even analysis is an extension of the marginal costing principles. It is interpreted in broad as well as narrow sense.

In its narrow sense, break-even analysis is concerned with finding out the break-even point, i.e., the point of no profit and no loss. When used in broad sense, it is a system of analysis that can be used to determine probable profit/loss at any given level of output.

Assumptions Underlying Break-Even Analysis:

The break-even analysis is based on the following assumptions:

1. All costs can be separated into fixed and variable components.

2. Variable cost per unit remains constant and total variable cost varies in direct proportion to the volume of production.

3. Total fixed cost remains constant.

4. Selling price does not change as volume changes.

5. There is only one product. In the case of multiple products, the sales mix does not change. In other words, when several products are being sold, the sale of various products will always be in some predetermined proportions.

6. There is synchronisation between production and sales. This means whatever is produced is sold and there are no unsold stocks.

7. Productivity per worker does not change.

8. There will be no change in the general price level.

Uses of Break-Even Analysis:

Break-even analysis has the following uses:

1. It helps in determining the selling price which will give the desired profits.

2. It helps in fixing sales volume to cover a given return on capital employed.

3. It helps in forecasting costs and profit as a result of change in volume.

4. It provides suggestions for shift in sales mix.

5. Inter-firm comparison of profitability is made possible.

6. It helps in determination of costs and revenue at various levels of output.

7. It studies the impact of increase or decrease in fixed and variable costs on profits.

Methods of Break-Even Analysis:

Break-even analysis can be performed by the following two methods:

1. Algebraic Method.

2. Graphic Method (Break-even chart).

Break-Even Point (BEP):

This is that level of sales where there is no profit and no loss. At this point total cost is equal to total sales. This is also the point after which there will be profit and before which there will be loss.

#### Limitations of Break-Even Analysis:

The break-even analysis is a very useful tool for profit planning, but due to its unrealistic assump­tions, it suffers from the following limitations:

1. The assumption regarding selling prices remaining unchanged as volume changes is not true. In practice, selling prices do not remain constant at all levels of sales. The selling price differs at different locations and at different points of time.

2. The assumption that the variable cost per unit remains constant and that it is a straight line is also not always true. In practice, due to law of diminishing returns, the variable cost per unit does not remain the same.

3. Similarly, the assumption that the fixed cost remains constant is also unrealistic. Fixed costs are constant only within a limited range of output and tend to increase by a sudden jump when the capacity is increased.

4. The assumption that all costs can be clearly separated into fixed and variable components is not possible to achieve accurately in practice, thereby resulting in inaccurate break even analysis.

5. The assumption that only one product is being produced or that the product mix will remain unchanged is also not found in practice. The proportion of sales of various products in the overall sales may also change.

6. It is assumed that production and sales are equal. This is not always so. Some opening and closing stock is normally found.

7. The break even analysis completely ignores consideration of capital employed, which may be an important factor in the study of profit analysis.

Because of these assumptions, the technique may be applicable only at a given point of time (static analysis) and may not be useful in a dynamic business environment. But still, the break even anal­ysis is a very useful tool which should be used keeping in mind its limitations.

### Marginal Cost – Break Even Chart: Information, Construction, Uses and Limitations

Break-even chart is a graphic presentation of break-even analysis. This chart takes its name from the fact that the point at which the total cost line and the sales line intersect is the break-even point. A break-even chart not only shows the break-even point but also profit and loss at various levels of activity.

Thus a break-even chart portrays the following information:

i. Break-even point – the point at which neither profit nor loss is made.

ii. The profit/loss at different levels of output.

iii. The relationship between variable cost, fixed cost and total cost.

iv. The margin of safety.

v. The angle of incidence, indicating the rate at which profit is being made.

Construction of Break-even chart

The principal steps in the construction of a break-even chart are as follows:

1. Select a Scale on X-Axis:

The X-axis is a horizontal base line which is drawn and spaced into equal distances to represent any one or more of the following factors:

i. Volume of output (units)

ii. Volume of output (in rupee value)

iii. Volume of sales (units)

iv. Volume of sales (in rupees value)

v. Production capacity (in percentage)

2. Select a Scale on Y-Axis:

The Y-axis is a vertical line-at the extreme left of the chart which is spaced into equal distances.

On the Y-axis, it is usual to show cost and sales in rupees value.

3. Draw the Fixed Cost Line:

This line is drawn parallel to X-axis., starting from an appropriate point on X-axis, starting from an appropriate point on Y-axis.

4. Draw the Total Cost Line:

The variable cost is depicted in the chart by superimposing it on the fixed cost line. Thus a total cost line is drawn starting from the point on the K-axis which represents fixed cost. For example, when variable cost per unit is given, the following type of table should be prepared to calculate total cost at various assumed levels.

5. Draw the Sales Line:

This is the last step. The sales line starts from zero point and extends to the point of maximum sales (Rs. 1,00,000 in this case as calculated in the table prepared above). When X-axis and Y-axis scales are the same, the sales line will be at 45° angle.

This is shown below:

The point, at which total cost line and sales line intersect each other, is known as Break-even Point.

Uses of Break-Even Chart:

1. It helps to determine break-even point, most profitable sales-mix, comparative profitability of each profit line, selling price which will give the required profit, cost and revenue at various levels of output, effect on profits and break-even points of high proportion of variable costs with low fixed cost, and vice versa.

2. It helps to compare profitability of different firms.

3. Impact of variation in fixed and variable costs on profits can be assessed.

4. It helps to fix the sales volume to earn a required profit or return on capital employed.

5. It helps to study the effect of change in the selling price.

6. It helps to determine cash needed at various levels of operation using cash break-even charts.

7. It is an aid in management decision-making (e.g., make or buy, discontinuance of product line, introducing a product, etc.), forecasting, long-term planning and maintaining profitability. Margin of safety indicates soundness of business, the fixed cost line indicates the degree of mechanisation and the angle of incidence shows the plant efficiency.

8. It helps a monopolist to make price discrimination for maximisation of profit.

Limitations of Break-Even Chart:

1. The variable cost line need not always be a straight line due to law of increasing costs or law of decreasing returns.

2. All costs cannot be segregated accurately into fixed and variable components in practice.

3. The fixed cost remains constant within a limited range of output and tends to increase when additional plant and machinery are introduced.

4. Selling price will not be a constant factor. A variation in output is likely to have an influence on the selling price.

5. In practice, one product is not always produced or product-mix does not remain constant. When a number of products are produced, separate break-even charts are to be drawn. This makes apportionment of fixed expenses to each product difficult.

6. The break-even chart assumes that production and sales will be synchronized at all points of time, i.e., the entire production will be sold. This may not be correct in practice.

7. Break-even charts completely ignore the capital employed in business which is one of the important guiding factors in the determination of profitability of the business and its products.

Marginal Cost – Steps and Areas Involved in Decision Making

Generally the following steps are involved in making a decision:

(i) Identify the problem or subject matter of decision

(ii) Identify the alternative courses of action or various options

(iii) Identify cost and benefit of each alternative

(iv) Select an alternative, whose cost is minimum, if only cost information is available, other things remaining the same.

(v) If data about both benefit and cost of various alternatives under considerations are available, select a proposal, which generates net maximum benefit. (i.e., total relevant benefit less total relevant cost), other things remaining the same.

Marginal costing is a very useful technique of decision-making for management. Any decision which involves consideration of variable cost and revenue requires application /use of marginal costing.

Some of the important decisions taken with the help of marginal costing technique relate to areas of:

1. Product mix,

3. Pricing decisions.

Each decision area is illustrated below:

Area # 1. Product Mix Decisions:

The product mix decisions may be classified under the following heads:

(i) Decision relating to most profitable product mix

(ii) Application of key factor or limiting factor

(iii) Discontinuance or dropping of a product line

(i) Decision Relating to Most Profitable Product Mix:

In the decision relating to product mix, a most profitable product mix is chosen. If there is no market constraint or production constraint, all the products are chosen on the basis of contribution per unit of the each product. A product having higher contribution per unit is preferred to the product having lower contribution per unit.

However, if there exists market constraint or production constraint then from the available / possible product mixes, a product mix which maximizes total contribution/ profit is preferred. A production constraint exists when a factor of production is in short supply, popularly called key factor or limiting factor.

In such a situation, the product mix is decided on the basis of contribution per unit of key factor. A product that yields the highest contribution per unit of key factor is considered the most profitable and hence preferred over other products.

(ii) Application of Key Factor or Limiting Factor:

Every entrepreneur, left to him, would like to produce and sell unlimited quantity of the product(s). In practice, it is not so. There is always a factor that limits the activity level of a firm. Such factor is known as the key factor, limiting factor, governing factor or principal factor. Generally, in most cases, sales operate as the key factor and determine the volume of output of various products to be produced.

However, there may be cases where demand for the product may be very good but some other factor such as labour, machine capacity, material, finance, etc., may be available to a limited extent. In such situations, any factor that limits the quantum of activity of a firm will be known as the key factor because the decision ‘how much to produce’, will be governed by such factor.

In case of sales being the key factor, the profitability of the product is measured by computing its contribution per unit or P/V ratio. When any other factor is the key factor, the most profitable product will be that which yields the highest contribution per unit of key factor.

The profitability of any key factor other than sales can be ascertained by the following formula:

Steps to decide the most profitable product mix in case of key factor (limited resources):

(i) Calculate contribution per unit of each product

(ii) Calculate contribution per unit of key factor

(iii) Rank the products according to contribution per unit of key factor

(iv) Utilise the limited resources in the production of various products as per the ranking given in point (iii) above.

(v) Summarise the product-mix so arrived at.

Depending on the availability of data, computations may be made on the basis of P/V ratio also.

(iii) Discontinuance or Dropping of a Product Line:

Many times, firms producing and selling more than one product find that one of the products is not remunerative and causes losses. These firms wish to drop the un-remunerative product line. However decision in such a case should be based on contribution approach and not on the basis of losses according to absorption costing.

Basic principle to be followed in such decision is that till a product has positive contribution, it should not be dropped, other things remaining the same. This means that on discontinuance of so-called un-remunerative product, capacity will remain un-utilized resulting in total lower profits.

Area # 2. Make or Buy Decisions:

A decision whether a component should be produced in the factory or bought from outside is taken by comparing the marginal (variable) cost of production with the cost of buying the concerned part. In the make or buy decision, only variable cost of manufacturing and special additional cost, if any, are relevant.

Fixed costs, which have already been incurred, are sunk costs and irrelevant for the decision as they cannot be avoided (saved) if it is decided to buy the concerned part. However, the decision will be influenced by the fact whether or not the capacity released by non-manufacture of the part can be used profitably somewhere else. If yes, the contribution from the use of released capacity will also be considered as opportunity cost in taking a make or buy decision.

Area # 3. Pricing Decisions:

The marginal costing technique helps in determining the selling price in normal and special circumstances. In normal circumstances, every firm would like to sell its products at a price, which covers the total cost and yields a reasonable profit. There can be a situation when a firm may find it beneficial to sell below total cost, at marginal cost or even below marginal cost.

The determination of selling price in various circumstances is explained below:

(i) Selling Price in Normal Circumstances:

In normal circumstances, to determine the selling price of a product, a firm has first to ascertain the variable cost and desired P/V ratio. Thereafter, the selling price of the product can be determined by dividing the variable cost by (1 – P/V ratio).

(ii) Selling Price for Special Market (Export Market) or for a Special Customer:

If a company has some idle capacity, it may develop special markets to utilize the idle capacity by selling goods at a price which covers the marginal cost, but not the total cost. Thus, if a firm has surplus capacity, it may offer a concessional price to a special set of customers.

Since the price of the additional goods will be higher than the marginal cost, the firm will be able to increase its total profits because there will not be additional fixed expenses for the extra output. A firm may export goods at a price less than the total cost or it may sell to a special class of customers at a concessional price. In adopting differential selling prices, the firm has to take two precautions.

Firstly, prices for normal sales should not be adversely affected by the concessional price. Secondly, extra sales should be limited only up to the idle capacity, otherwise the fixed overheads will also rise and reduce the total profit instead of increasing it.

(iii) Selling Price during Recession:

During a recession or a depression, a concern may decide to continue to produce and sell at a price, which is below the total cost. In such a case, the principle followed should be that as long as the price is above the marginal cost, production and sale would continue.

It is obvious that selling in such a situation would give at least some margin to meet the fixed costs and therefore the losses of the firm would be lower those, that had production been stopped altogether. However, in this case, one should not sell below the marginal cost because that will only increase the losses.

(iv) Selling Price at Marginal Cost or below Marginal Cost:

A firm may sell at marginal cost or even below marginal cost merely to keep the machines in running condition or to retain high skilled workers. Similarly, if the raw materials are perishable or when the raw material prices have fallen considerably, a firm may sell the finished product at marginal cost or at a price, which is less than the marginal cost to avoid or to reduce total losses.

A firm may also do so to meet acute competition, to introduce a new product, to push up the sale of another highly profitable product, to retain future market, or to capture foreign markets. Selling at marginal cost or below marginal cost can be for a limited period only, that too keeping in view the long-term interest.

It may be noted that the situations (ii), and (iii) above are those situations when selling price below total cost is justified and circumstances mentioned in situation (iv) may justify selling price at marginal cost or even below marginal cost.

### Marginal Cost – The Traditional Revenue Statement: Comparison of Marginal Costing Format and Traditional Format, Working Notes and Tutorial Notes

The Traditional Revenue Statement / Profit and Loss Statement is not organised in terms of cost behavior. It is organized in a ‘functional’ format – showing the functions of production, administration, selling and distribution. No attempt is made to distinguish between fixed cost and variable cost.

For example, production overhead may consist both variable and fixed costs but these are not shown separately in the traditional revenue statement. This traditional approach may be useful for external reporting purposes but it has serious limitations when used for internal purposes.

In many industries today, a major part of manufacturing costs consist of fixed costs – especially costs relating to depreciation, repairs and maintenance and operation of highly sophisticated plants and equipments, along with high fixed costs for technical staffs – salaries and other benefits.

In present situation, the manager needs cost data organized in a format that will facilitate planning, control and decision making. Marginal costing format separates costs into fixed and variable categories. First, all variable costs are deducted from sales revenue. The balance is called contribution.

Modern managers frequently use the marginal costing format as an internal planning and decision making tool. This approach also helps managers to organize data pertinent to all kinds of special decision such as make or buy, product mix selection, use of scarce resources etc.

Working Notes:

(2) Selling overheads consist of both variable and fixed costs (i.e., Rs. 30,000 + Rs. 1, 25,000 = Rs. 1, 55,000)

(3) Administrative overheads consist of both variable and fixed cost (i.e., Rs. 20,000 + Rs. 75,000 = Rs. 95,000).

Tutorial Notes:

(1) Under marginal costing format, fixed cost is treated as period cost and it is not included in the valuation of closing stock.

(2) AS – 2 “Inventories – does not support marginal costing format.

(3) Marginal costing format is useful for internal purposes.

### Fixed and Variable Costs in Marginal Costing

The classification of costs into fixed and variable is of special interest and importance in marginal costing. These two types of cost behave differently with changes in the volume of output.

Fixed costs remain largely constant regardless of the actual level of production. Variable costs, on the other hand, change in proportion to the volume of output. Semi-fixed or semi-variable costs are also separated into fixed and variable elements and added to their respective categories.

Under marginal costing, fixed costs and variable costs are kept separate for all purposes. Only variable costs are taken into account for computing the cost of products and thus are treated as – “Product Costs”.

Fixed costs do not find place in the costs of products or in inventory valuation. Such costs are treated as – ‘Period Costs’ and are written off in the costing Profit and Loss Account of the period in which they are incurred.

### Similarities and Dissimilarities between Differential Cost Analysis and Marginal Costing

Generally the terms, ‘differential cost analysis’ and ‘marginal costing’ are used interchangeably since both these techniques are similar in some respects. But there is some basic difference between these two terms.

Similarities between Differential Cost Analysis and Marginal Costing:

(i) Both differential cost analysis and marginal costing are the techniques of analysing and presenting costs for specific purposes.

(ii) Both these techniques are based on the classification of costs into fixed and variable costs. When fixed costs do not change, the differential cost and the marginal cost is the same.

(iii) Both these techniques are used for providing data to the management for use in decision making and formulating business policies.

Dissimilarities between Differential Cost Analysis and Marginal Costing:

(i) Differential cost analysis includes fixed costs if fixed costs change with changes in operations, but marginal costing technique excludes fixed costs.

(ii) Marginal costing techniques may be incorporated in the accounting system while differential costs are worked out separately for reporting to management for use in decision making process and cannot form part of accounting system.

(iii) Differential cost analysis is used when there is a comparison between two or more alternative courses of action but marginal costing technique can be used independently for making evaluation of performance through contribution margin and Profit/Volume Ratio.

(iv) Under differential cost analysis the desirability of any alternative course of action (i.e., whether it should be adopted or not) is determined by comparing incremental revenues and incremental costs. Under marginal costing, the desirability or profitability of any alternative is determined with the help of contribution and P/V Ratio.

### Difference between Absorption Costing and Marginal Costing (With Illustrations and Formulas)

Absorption costing is the traditional practice of charging all costs, variable as well as fixed to operations, processes or products. On the other hand, marginal costing is the technique of charging variable costs to operations, processes or products.

Under absorption costing, the stock of finished goods and work-in-progress is valued on the basis of total cost, comprising of fixed and variable costs. But, under marginal costing valuation of stock of finished goods and work-in-progress is made on the basis of variable cost only.

Fixed cost is treated as a ‘period cost’ and is transferred to Profit & Loss Account. Absorption costing technique involves the arbitrary apportionment of fixed costs which generally leads to under-and over-absorption of costs. On account of exclusion of fixed costs from marginal costing, the problem of arbitrary apportionment of overhead does not arise at all.

Under absorption costing technique, the various managerial decisions are taken with reference to ‘profit’ which represents the excess of sales value over total cost. But under marginal costing these decisions are based on ‘contribution’ or ‘contribution margin’ which represents the excess of sales value over marginal cost or variable cost.

The determination of ‘profit’ or ‘income’ under both absorption costing and marginal costing techniques can be illustrated by means of the following Profitability Statements –

If we study the Statement of Profitability prepared under marginal costing technique, we will observe that –

Sales – Marginal Cost = Contribution.

Again, Fixed Cost + Profit = Contribution.

Similarly in case of loss –

Fixed Cost – Loss = Contribution.

Combining these two equations, we can get the fundamental marginal cost equation as follows:

Sales – Variable Cost = Fixed Cost ± Profit/Loss.

Or symbolically –

S – V = F ± P

Where,

‘S’ denotes – Sales

‘V’ denotes – Variable Cost or Marginal Cost

‘F’ denotes – Fixed Cost

‘P’ denotes – Profit

‘– P’ denotes – Loss.

This marginal cost equation is widely used in marginal costing problems since it plays an important role in profit projection. If in any given case, any three of the four factors or items (S, V, F and P) are known, the fourth can easily be found out with the help of the marginal cost equation.

### Difference between Direct Costing and Marginal Costing

The Chartered Institute of Management Accountants, London has defined direct costing as “the practice of charging ail direct costs to operations, processes or products, leaving all indirect costs to be written off against profits in the period in which they arise.”

Direct costs refer to such costs which are attributable to a cost centre or cost unit. These include direct material, direct labour, direct expenses and traceable fixed expenses, i.e., those which are direct to the activity concerned.

Therefore, marginal costing differs from direct costing. Under marginal costs, there is no question of inclusion of fixed expenses, whereas direct costs include a portion of fixed expenses which are directly attributable to a cost centre or cost unit.

For example, salary of the supervisor in a department producing only one product is an item of fixed expense. It will be included under direct costs. But marginal costs would exclude this item altogether.

On account of the difference in the concept of ‘direct cost’ and the ‘marginal cost’ which is mainly on account of the inclusion of a portion of fixed expenses under direct costs and not under marginal costs at all, the techniques of direct costing and marginal costing differ.

### Marginal Cost – Note on Differential Cost

Marginal costing is sometimes confused with ‘differential costing’. Differential cost is the net increase or decrease in total cost resulting from a variation in production. Generally, increase or decrease is in the variable or marginal cost but under certain circumstances, fixed costs may also be affected. Hence, differential cost includes an element of fixed costs also, besides the variable costs.

Thus, the term ‘differential cost’ can be compared favourably with the economist’s concept of marginal cost. The differential cost is termed as ‘increment cost’ when the cost increases and ‘decremental cost’ when the cost decreases.

Thus, ‘differential costing’, ‘incremental costing’ and ‘decremental costing’ are alternative terms, which are different from ‘marginal costing’ or ‘variable costing’ and ‘direct costing’. The manner of application of differential costing is somewhat different from that of marginal costing.

Under differential costing, differential costs of various alternatives are compared with the differential revenues and the decisions are taken on the basis of maximum net gain. While evaluating the viability of different projects and making a choice out of several alternative proposals, differential costing helps in a better way than marginal costing.

If under marginal costing, while deciding about the profitability of products or making cost benefit analysis, fixed costs are also considered at some stage, it assumes the form of differential costing.

Hence, practically the purpose of applying the two techniques is the same and here we have not made any difference in the application of these techniques to the problems which management has to face in its routine or specific decision making process.

### Marginal Cost – Margin of Safety: Absolute Terms and In Terms of Percentage (With Formulas)

Margin of safety is the difference between actual sales and sales at the break-even point. It is the excess of sales over the break-even sales. It is also the excess production over break-even production.

Margin of safety can be expressed in absolute terms as well as in terms of percentage as follows:

In Absolute Terms:

(i) Margin of safety = Sales at selected activity – Break-even sales;

(ii) Margin of safety = Profit at selected activity + P/V ratio.

In terms of percentage:

The soundness or strength of a business can be gauged by the size of the margin of safety. A high margin of safety indicates that actual sales are much above the B.E.P. and there will be profit even if there is a substantial fall in the sales or production. On the other hand, if the margin of safety is small, any loss of sales or production will be a serious matter.

Margin of safety can be improved by reducing fixed and variable costs, increasing selling price and volume of sale, and improving sales mix by increasing sale of products with larger P/V ratio. In inter-firm comparison, margin of safety may be used to show the relative position of firms.

### Marginal Cost Sheet Format

Note:

1. If the fixed overheads are less than the contribution, profit will arise. If they are excess, it will result into a loss.

2. Variable cost + Fixed overheads = Total cost.

### Marginal Cost – Key Factors: Formula and Typical Examples

A key factor is defined as the factor in the activities of an undertaking which, at a particular point of time or over a period, will limit the volume of output. Other variant terms are limiting factor,

Principal Budget factor and scarce factor.

Limiting factors are governed by both internal and external factors. It may be actual or potential. If a factor of production is in short supply, then the best-paying product becomes that which yields the highest contribution per unit of limiting factor.

Thus, contribution per unit of key factor may be ascertained and maximised according to the priority.

Typical Examples of Key Factors are:

1. Materials:

(a) Scarce raw material.

(b) Restrictions imposed by licences, quotas, etc.

2. Labour:

(a) General shortage of workers.

(b) Shortage in skilled labour, e.g., 1st class welders.

3. Plant:

(a) Imbalance in plant and equipment.

(b) Insufficient capacity due to shortage in supply.

(c) Insufficient capacity due to lack of capital.

(d) Insufficient capacity due to lack of space.

(e) Bottlenecks in certain process, operations or departments.

4. Management:

(a) Shortage of efficient staff and executives.

(b) Policy decisions.

5. Capital:

(a) Shortage of capital may reduce the productive capacity, e.g., factory space or machinery.

(b) Reduction in development or promotional expenditure.

(c) Insufficient capital restricting policy.

(d) Insufficient Research activity.

6. Sales:

(a) Market demand.

(c) Shortage of good salesmen.

7. Government policy.

8. Energy, gas, water.

In most of the companies, the limiting factor is sales. In every case, the Budget must be prepared according to the limiting factor. There may be one or more limiting factors.

### Marginal Cost – Determination of Profits Under Various Formulas

Profit under marginal cost is determined under the various formulas as under:

(i) C = S – VC

C = F + Pt

S – VC = F + Pt

S-VC = F + Pt

VC = C – Pt

Pt = C – F

Here,

C = Contribution

S = Sales

VC = Variable Cost

Pt = Profit

F = Fixed Cost

Procedure for Profit Determination:

The profit determination procedure is as under:

(1) Sales is compared with the variable cost and the difference between the two is known as contribution.

(2) Fixed cost is deducted out of the contribution, and the balance is known as profit.

(3) Unsold stock is not taken into account, while calculating profit under Marginal costing.

(4) If there is no opening or closing stock and all output of a period are sold, profit under marginal costing would not differ from profit under absorption profit.

### Marginal Cost – Main Advantages

Marginal costing technique is a very important tool in the hands of management as it helps and guides the management in solving a number of problems.

The main advantages of marginal costing may be given as follows:

Advantage # 1. Simple Valuation of Stock:

Under marginal costing technique, the valuation of stocks of work-in-progress and finished goods is made on the basis of marginal cost (or variable cost) which is more simple and helps in ascertaining the profits accurately.

Advantage # 2. Effective Cost Control:

Marginal costing involves the segregation of all costs into fixed and variable elements. Fixed costs are not treated as product costs but as period costs. The management, by concentrating more on controlling variable costs, can exercise effective cost control and ensure maximum profitability.

Under marginal costing, there is no question of under-absorption or over- absorption of fixed overhead since fixed overhead are not treated as product costs. It also simplifies the process of reconciliation of cost accounts and financial accounts.

Advantage # 4. Ascertainment of Break-Even Point:

Marginal costing technique helps in determining the level of production or sales at which a business firm breaks-even as a result of which it may plan its production at a level above the Break-even Point so as to earn profits.

Advantage # 5. Ascertainment of the Comparative Profitability of Various Products:

Marginal costing technique, by showing the comparative profitability of various products manufactured by a manufacturing concern (by measuring the amount of Contribution and P/V Ratio), helps it in planning its future production and sales.

Advantage # 6. Assistance in Taking Managerial Decisions:

Marginal costing technique helps the management in taking a number of important business decisions such as –

(i) Fixation of Selling Price:

Under normal conditions, selling price is fixed at a level which not only covers the total cost but also leaves some margin for profit. But under the conditions of trade depression, sale of production from surplus capacity etc., goods may be sold at a price below the total cost but not below the marginal cost.

Thus, marginal cost is the guiding factor in the fixation of selling price of the products under abnormal market conditions,

Marginal costing helps the management in taking a decision as to whether a component or spare part should be manufactured in the factory or bought from outside supplier through the comparison of marginal cost and the market price.

(iii) Determination of Profitable Sales-Mix:

In case of a multi-product concern selling various products in some pre-determined ratio, marginal costing technique helps in determining the most profitable sales-mix through the comparison of the total contribution available under the various alternatives of sales-mix.

(iv) Determination of Profitable Method of Production:

In case of the availability of alternative methods of production for a particular product, marginal costing helps in determining the profitable method of production by making a comparison of the contribution available under various methods of production.

(v) Problem of Limiting Factor:

Limiting factor or key factor refers to any factor which is likely to limit production or sale of a product e.g., shortage of material, labour, machine hours etc. In case of the presence of a limiting factor in a multi-product concern, marginal costing technique provides a guidance as to which line of production is least profitable and should be discontinued.

Advantage # 7. Use with Standard Costing:

Marginal costing is simple to operate and can be combined with standard costing system for exercising cost control.

Advantage # 8. Determination of Tender Price or Quotation Price:

Marginal costing helps in determining tender price or quotation price on scientific basis.

### Marginal Cost – Merits

Marginal costing has come of age. It has proved to be an extremely useful tool for planning and controlling operations. It is a gateway to decisions-making as it examines the effect of fluctuating volumes on costs and profitability.

The following may be listed as the merits of marginal costing:

Merit # 1. Assists Planning and Control:

The separation of factory overheads into its fixed and variable constituents, is a fundamental requirement of marginal costing. It assists planning, decision-making and control. Further, it guides management in making periodic profit plans. Since it examines the effect of fluctuating volumes on costs, it assesses the change in profitability which may occur under certain conditions.

Merit # 2. Enables Break-Even Analysis:

Break-even point is the point at which the sales revenue is just equal to both the fixed and variable overhead costs. In terms of units, it is determined by dividing fixed costs into the contribution margin.

The contribution margin is the difference between the unit selling price and the marginal costs. For break-even in terms of sales revenue, the division is the contribution ratio. These concepts are based on marginal costing.

Merit # 3. Competitive Pricing:

In the short-run, prices can be determined more intelligently through the application of marginal costing. Sometimes, the price of a certain product cannot be usual total cost plus something. But, in any case, it has to be above the marginal cost so that every unit sold plays some part in the recovery of fixed costs.

Merit # 4. Avoids Distortion of Profits:

Where sales do not match production, the inclusion of fixed overheads in stock valuation tends to distort recorded profit from one period to another. When a proportion of fixed overheads is carried forward in stock valuation, the real effect of selling below or above the level of production capacity tends to be concealed.

Marginal costing avoids the distortion in as much as only variable overheads are included in the unit cost.

Merit # 5. Simplified Measure of Relative Profitability:

The arbitrary apportionment of fixed cost complicates any attempt to measure profitability of different products. Marginal costing greatly simplifies the profitability analysis. It shows the product-wise contribution margin.

### Marginal Cost – Limitations

There are certain dangers, which put severe limitations and these are as under:

(1) Division of cost difficult –

It is really very difficult to separate fixed and variable cost out of total cost.

(2) Excludes fixed cost –

Marginal costing excludes fixed costs in management decision, assuming that fixed costs have already been observed by the present activity. Thus it may provide deceptive and faulty decisions.

(3) Danger of over and under recovery –

Under marginal costing there is always a danger of over or under recovery of overheads, because variable overheads are always estimated and actual expenses are not taken into consideration.

(4) Dangerous situation –

There are possibilities that fixed costs may change with a given range of capacity. Similarly, variable costs may disproportionate as per volume of production. Thus it may give dangerous situation in marginal costing.

The application of marginal costing for contract and job works is not an easier task. Thus marginal costing cannot be used in all types of businesses.

(6) Not better technique –

Marginal costing cannot be proved as a better technique in comparison to standard costing and Budgetary control technique.

### Marginal Cost – 11 Major Disadvantages

1. Difficulty to analyse overhead –

Separation of costs into fixed and variable is a difficult problem. In marginal costing, semi-variable or semi-fixed costs are not considered.

2. Time element ignored –

Fixed costs and variable costs are different in the short run; but in the long run, all costs are variable. In the long run all costs change at varying levels of operation. When new plants and equipment are introduced, fixed costs and variable costs will vary.

3. Unrealistic assumption –

Assumption of sale price will remain the same at different levels of operation. In real life, they may change and give unrealistic results.

4. Difficulty in the fixation of price –

Under marginal costing, selling price is fixed on the basis of contribution. In case of cost plus contract, it is very difficult to fix price.

5. Complete information not given –

It does not explain the reason for increase in production or sales.

6. Significance lost –

In capital-intensive industries, fixed costs occupy major portions in the total cost. But marginal costs cover only variable costs. As such, it loses its significance in capital industries.

7. Problem of variable overheads –

Marginal costing overcomes the problem of over and under-absorption of fixed overheads. Yet there is the problem in the case of variable overheads.

8. Sales-oriented –

Successful business has to go in a balanced way in respect of selling production functions. But marginal costing is criticized on account of its attaching over- importance to selling function. Thus it is said to be sales-oriented. Production function is given less importance.

9. Unreliable stock valuation –

Under marginal costing stock of work-in-progress and finished stock is valued at variable cost only. No portion of fixed cost is added to the value of stocks. Profit determined, under this method, is depressed.

10. Claim for loss of stock –

Insurance claim for loss or damage of stock on the basis of such a valuation will be unfavorable to business.

11. Automation –

Now-a-days increasing automation is leading to increase in fixed costs. If such increasing fixed costs are ignored, the costing system cannot be effective and dependable.

Marginal costing, if applied alone, will not be much use, unless it is combined with other techniques like standard costing and budgetary control.

### Marginal Cost – Objective Type Questions With Answers

1. Under marginal costing technique, marginal cost is equal to:

(i) Fixed Cost + Variable Cost

(ii) Direct Material Cost + Direct Wages + Direct Expenses

(iii) Prime Cost + Variable Overhead

Ans. iii

2. Marginal costing technique follows the following basis of classification of costs:

(i) Behaviour-wise

(ii) Element-wise

(iii) Function-wise

(iv) Identifiability-wise

Ans. i

3. ‘Contribution Margin’ is equal to:

(i) Fixed cost – Variable cost

(ii) Sales – Variable cost

(iii) Sales – Fixed cost

(iv) Sales – Profit

Ans. ii

4. Variable Cost:

(i) Remains fixed in total

(ii) Varies per unit

(iii) Remains fixed per unit

(iv) Neither increases nor decreases.

Ans. iii

5. Margin of safety is:

(i) Actual Sales – Sales at Break-even Point

(ii) Sales – Contribution

(iii) Sales – Fixed Cost

(iv) Fixed Cost + Variable Cost

Ans. i

6. P/V Ratio will increase if:

(i) there is an increase in fixed cost;

(ii) there is a decrease in fixed cost;

(iii) there is a decrease in variable cost per unit;

(iv) there is a decrease in selling price per unit.

Ans. iii

7. What distinguishes absorption costing from marginal costing?

(i) Product costs include both prime cost and production overhead.

(ii) Product costs include both production and non-production costs.

(iii) Stock valuation includes a share of all production costs.

(iv) Stock valuation includes a share of all costs.

Ans. iii

8. Contribution margin is also known as:

(i) marginal income

(ii) gross profit

(iii) net income

Ans. (i)

9. Contribution margin is:

(i) calculated by subtracting total fixed cost from revenues.

(ii) calculated by subtracting total variable costs from revenues.

(iii) the amount available after covering fixed costs that can be used to pay for variable costs and to provide a desired profit.

(iv) none of the above

Ans. (ii)

10. An increase in fixed costs will result in which of the following?

(i) A decrease in the contribution – sales ratio.

(ii) A decrease in the constitution per unit.

(iii) An increase in the breakeven point sales level.

(iv) An increase in the margin of safety.

Ans. iii

11. The margin of safety may be defined as:

(i) The difference between planned sales and break even point sales.

(ii) The extent to which sales revenue exceeds fixed costs.

(iii) The excess of planned sales over the current actual sales.

(iv) The point at which break-even point sales are achieved.

Ans. i

12. If sales are Rs.1,00,000 and variable costs are Rs.60,000, P/V Ratio is:

(i) 40%

(ii) 60%

(iii) 20%

(iv) 10

Ans. i

13. If sales are Rs.80,000 and variable cost to sales is 70%, contribution is:

(i) Rs. 56,000

(ii) Rs. 24,000

(iii) Rs. 70,000

(iv) Rs. 30,000

Ans. ii