Marginal Costing: Meaning and Advantages

Marginal Costing: Meaning and Advantages

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Chanchal
Chanchal Aggarwal
Senior Executive Content
Updated on Dec 27, 2023 15:27 IST

Marginal costing is a cost accounting technique that focuses on the variable costs associated with producing one additional unit of a product or service. It helps in determining the contribution margin and assists in making decisions related to pricing, production, and profitability.

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Understanding a company’s cost structure is crucial for success in today’s competitive business environment. Marginal costing, or variable costing, is a valuable tool for managers to make informed decisions about pricing, product mix, and profitability. By separating variable costs from fixed costs, marginal costing provides a clear picture of how changes in production volume affect a company’s bottom line. In this way, this costing method helps managers to optimize their operations and maximize profits. So, let’s dive in and explore the world of marginal costing!

Suggested read: What is Accounting?

What is Marginal Costing?

Marginal costing is a cost accounting technique that helps businesses determine the cost of producing one additional unit of a product or service. Marginal costing is also known as “variable costing. Because it only considers the variable costs associated with producing an additional unit of a product or service, such as direct labour and materials.

Under marginal costing, fixed costs, such as rent and salaries, are considered period costs that are not directly related to the production of a specific unit. Instead, fixed costs are expensed in the period they are incurred. This differs from absorption costing, another cost accounting technique that allocates fixed costs to each unit produced.

It can be useful for decision-making, as it allows businesses to determine the profitability of producing additional units of a product or service. For example, suppose a business is considering whether to produce and sell additional product units. In that case, they can use this method to determine the incremental production cost. Also, for selling those units and compare it to the expected revenue from selling those units.

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Also check: Difference Between Marginal Costing and Absorption Costing

Calculation of Marginal Cost

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  • Company: XYZ Pvt. Ltd., an Indian manufacturing firm.
  • Product: Pen
  • Initial Production: 1000 units
  • Initial Total Cost: ₹50,000 (including all fixed and variable costs)
  • Increased Production: 1100 units
  • New Total Cost: ₹54,000

Calculation:

  1. Change in Total Cost (ΔTC):
    • New Total Cost – Initial Total Cost
    • ΔTC=₹54,000−₹50,000=₹4,000ΔTC=₹54,000−₹50,000=₹4,000
  2. Change in Quantity (ΔQ):
    • Increased Production – Initial Production
    • ΔQ=1100−1000=100ΔQ=1100−1000=100
  3. Marginal Cost (MC):
    • MC=ΔTC/ΔQ​
    • MC=₹4,000100=₹40MC=100₹4,000​=₹40

The marginal cost of producing one additional pen is ₹40. This means for every extra pen produced, the cost increases by ₹40. This information is crucial for XYZ Pvt. Ltd. to make decisions about production expansion, pricing, and profitability.

Explore: Classification of Costs

Advantages of Marginal Costing

Marginal costing offers several advantages to businesses. Here are some of the key advantages of this costing technique.

Clear Cost-Volume-Profit Analysis

Marginal costing clearly explains the relationship between costs, volume, and profit. By distinguishing between fixed and variable costs, it becomes easier to calculate the contribution margin—the difference between sales revenue and variable costs. This information is crucial for determining the breakeven point and assessing the profitability of different product lines or services.

Must read: What is Cost-Volume Profit Analyses?

Effective Decision Making

Marginal costing aids decision-making by providing insights into various options’ incremental costs and revenues. Marginal costing helps assess the impact on overall profitability. It can be evaluating the profitability of a new project, pricing decisions, or make-or-buy choices. It enables managers to make informed decisions by considering the incremental contribution of each option.

Simplified Costing

Unlike absorption costing, which allocates fixed overheads to products, marginal costing only considers variable costs directly attributable to production. This simplifies the costing process, making it easier to understand and apply. It also eliminates the complexities of apportioning fixed overheads, sometimes leading to misleading cost information.

Must read: Classification of Costs: A Complete Guide

Efficient Cost Control

It facilitates effective cost control by identifying and isolating variable costs. Managers can focus on managing and controlling these costs more directly, as they tend to be more controllable in the short term. By monitoring and analyzing variable costs, businesses can identify areas of cost overruns, implement cost-saving measures, and improve overall cost efficiency.

Flexibility in Pricing Decisions

It offers flexibility by separating fixed costs from variable costs. Businesses can set prices based on incremental production costs. It ensures that each unit sold contributes towards covering the variable costs and generating a positive contribution margin. This approach helps in optimizing pricing strategies and achieving profitability objectives.

Performance Evaluation

Marginal costing facilitates performance evaluation at various levels, such as products, departments, or business segments. Focusing on contribution margins it provides a more accurate assessment of profitability. Also, it analyses the performance of different units within the organization. Managers can identify underperforming products or divisions and take necessary corrective actions.

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Disadvantages of Marginal Costing

While this costing method offers several advantages, there are also some disadvantages that businesses should be aware of. Here are some of the key disadvantages:

Doesn’t consider all costs: This approach only considers variable costs and doesn’t consider fixed costs, such as rent and salaries. This can lead to an incomplete picture of a business’s costs and profitability.

Can be misleading: It can be misleading in situations where fixed costs are high and production levels are low. In such cases, the marginal cost per unit may be high, leading to the incorrect conclusion that the product could be more profitable.

Difficult to allocate fixed costs: This costing method doesn’t allocate fixed costs to each unit produced. Hence making it difficult to determine each unit’s cost accurately.

Not suitable for long-term planning: It is primarily a short-term planning tool and may not be suitable for long-term planning. In the long term, fixed costs may change and become variable, which could affect the profitability of products.

Doesn’t account for inventory valuation: This method needs to consider the value of inventory, which can lead to distorted profitability figures.

Wrapping It Up!!

Marginal costing has limitations, and it cannot be used in isolation. It can also be a valuable tool for businesses seeking to better understand their costs and profits. It is a useful technique for businesses to analyze the cost and profitability of their products or services. By separating variable costs from fixed costs, businesses can more accurately determine the impact of changes in sales volume on their profits. This can help businesses make better decisions about pricing, production, and sales strategies.

FAQs

What is marginal costing?

Marginal costing is a costing technique that focuses on segregating costs into fixed and variable components. It considers only variable costs directly associated with production, helping businesses analyze the impact of production volume on profitability.

How does marginal costing differ from absorption costing?

Marginal costing only considers variable costs, while absorption costing includes both variable and fixed costs in the cost per unit. Absorption costing allocates fixed overheads to products, while marginal costing treats fixed costs as period costs.

What is the contribution margin in marginal costing?

The contribution margin is the difference between sales revenue and variable costs. It represents the amount available to cover fixed costs and contribute to profit. The contribution margin per unit helps in analyzing profitability at different levels of production.

What are the main advantages of marginal costing?

Marginal costing offers advantages such as clearer cost-volume-profit analysis, better decision making through incremental cost evaluation, simplified costing process, improved cost control, flexibility in pricing decisions, and enhanced performance evaluation.

Can marginal costing be used for external financial reporting?

Marginal costing is primarily used for internal management purposes and is not generally accepted for external financial reporting. Absorption costing, which includes fixed costs, is commonly used for external reporting to provide a more comprehensive view of costs.

About the Author
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Chanchal Aggarwal
Senior Executive Content

Chanchal is a creative and enthusiastic content creator who enjoys writing research-driven, audience-specific and engaging content. Her curiosity for learning and exploring makes her a suitable writer for a variety ... Read Full Bio