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Unit-3
Marginal Costing

A. Renuka
Asst. Professor, CMRCET
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Marginal costing as understood in economics is the incremental cost of

production which arises due to one-unit increase in the production

quantity. As we understood, variable costs have direct relationship with

volume of output and fixed costs remains constant irrespective of

volume of production.

Hence, marginal cost is measured by the total variable cost attributable

to one unit. For example, the total cost of producing 10 units and 11

units of a product is 10,000 and 10,500 respectively. The marginal cost

for 11th unit i.e. 1 unit extra from 10 units is Rs 500. Marginal cost can

precisely be the sum of prime cost and variable overhead.

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6 Characteristics of Marginal Costing

The essential characteristics and mechanism of marginal

costing technique may be summed up as follows:

1.Segregation of cost into fixed and variable elements

2.Marginal cost as product cost

3.Fixed costs are period costs

4.Valuation of inventory

5.Contribution is the difference between sales and marginal

cost.

6.Pricing

7.Marginal Costing and Profit

 •Segregation of cost into fixed and variable elements: In marginal costing,
7 all costs are segregated into fixed and variable elements.

•Marginal cost as product cost: Only marginal (variable) costs are charged to
products.

•Fixed costs are period costs: Fixed cost are treated as period costs and are
charged to costing profit and loss account of the period in which they are
incurred.

•Valuation of inventory: The work–in–progress and finished stocks are valued

at marginal cost only.

•Contribution is the difference between sales and marginal cost: The

relative profitability of the products or departments is based on a study of
“contribution” made by each of the products or departments.
 Features of Marginal Costing

8 The main features of marginal costing are as follows:

•Cost classification: All costs are classified on the basis of variability, that is, variable
costs and fixed costs. Mixed costs are segregated into variable and fixed costs.
•Inventory valuation: Under marginal costing, inventory or stock are there is closing
stock. valued at variable cost or marginal cost for profit measurement.
•Product and period costs: Under marginal costing, all variable costs under marginal
costing will are treated as product cost and fixed costs are treated as period cost. be less
than the one shown A product cost is charged directly to cost unit, whereas a period cost is
by absorption costing. written-off against the profit of the period.
•Contribution: Marginal costing technique makes use of contribution for marking various
decisions. Contribution is the difference between sales and variable cost. It is on the basis
of the contribution of a product that production and sales policies are designed by a firm.
•The price is determined on the basis of the marginal cost and contribution margin.
•The contribution margin is the basis for deciding profitability of department or product.
•Fixed costs are treated as period cost and debited to profit and loss account and, thus,
9 Advantages of Marginal Costing

The following are the advantages of marginal costing technique:

1.Simplicity

2.Stock Valuation

3.Meaningful Reporting

4.Effect on Fixed Cost

5.Profit Planning

6.Cost Control and Cost Reduction

7.Pricing Policy

8.Helpful to Management
 Simplicity
The statement propounded under marginal costing can be easily followed as it breaks up the cost
as variable and fixed.
10 Stock Valuation
Stock valuation cab be easily done and understood as it includes only the variable cost.
Meaningful Reporting
Marginal costing serves as a good basis for reporting to management. The profits are analyzed
from the point of view of sales rather than production.
Effect on Fixed Cost
The fixed costs are treated as period costs and are charged to Profit and Loss Account directly.
Thus, they have practically no effect on decision making.
Profit Planning
The Cost – Volume Profit relationship is perfectly analysed to reveal efficiency of products,
processes, and departments. Break–even Point and Margin of Safety are the two important
concepts helpful in profit planning.
Cost Control and Cost Reduction
Marginal costing technique is helpful in preparation of flexible budgets as the costs are classified
into fixed and variable. The emphasis is laid on variable cost for control. The constant focus is on
cost and volume and their effect on profit pave the way for cost reduction.
Pricing Policy
Marginal costing is immensely helpful in determination of selling prices under different situations
like recession, depression, introduction of new product, etc. Correct pricing can be developed
under the marginal costs technique with the help of the cost information revealed therein.
Helpful to Management
Marginal costing is helpful to the management in exercising decisions regarding make or buy,
exporting, key factor and numerous other aspects of business operations.
 Limitations of Marginal Costing
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Following are the limitations of marginal costing:

1.Classification of Cost

2.Not Suitable for External Reporting

3.Lack of Long – term Perspective

4.Under Valuation of Stock

5.Automation

6.Production Aspect is Ignored

7.Not Applicable in all Types of Business

8.Misleading Picture

9.Less Scope for Long–term Policy Decision

 Classification of Cost
Break up of cost into fixed and variable portion is a difficult problem. More over clear cost division of
12 semi – variable or semi – fixed cost is complicated and cannot be accurate.
Not Suitable for External Reporting
Since fixed cost is not included in total cost, full cost is not available to outsiders to judge the
efficiency.
Lack of Long–term Perspective
Marginal costing is most suitable for decision making in a short term. It assumes that costs are
classified into fixed and variable. In the long term all the cost are variable. Therefore it ignores time
element and is not suitable for long term decisions.
Under Valuation of Stock
Under marginal costing only variable costs are considered and the output as well as stock are
undervalued and profit is distorted. When there is loss of stock the insurance cover will not meet the
total cost.
Automation
In these days of automation and technical advancement, huge investments are made in heavy
machinery which results in heavy amount of fixed costs. Ignoring fixed cost in this context for
decision making is irrational.
Production Aspect is Ignored
Marginal costing lays too much emphasis on selling function and as such production aspect has
been considered to be less significant. But from the business point of view, both the functions are
equally important.
Not Applicable in all Types of Business
In contract type and job order type of businesses, full cost of the job or the contract is to be charged.
Therefore it is difficult to apply marginal costing in all these types of businesses.
Misleading Picture
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Difference Between Marginal Costing and Absorption Costing:

There are two alternative approaches for the valuation of inventory; they are
Marginal Costing and Absorption Costing. In marginal costing, marginal cost is
determined by bifurcating fixed cost and variable cost. Only variable costs are
charged to operation, whereas the fixed cost are excluded from it and are charged
to profit and loss account for the period.
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 FORMAT OF INCOME STATEMENT
16
(ABSORPTION COSTING)
 FORMAT OF INCOME STATEMENT
17 (MARGINAL COSTING)
18 Problems on Marginal Costing and Absorption Costing:

1. When there is production but no sales:

2. When production is equal to sales

3. When production is more than sales

4. When production is less than sales

19 1. When there is production but no sales:

Under this case, the income under absorption costing may reflect profit through no sales has

been made. This is due to the fact that the manufacturing overheads have been over

absorbed above normal capacity production than its actual fixed manufacturing overheads.

But variable income statement will show loss as there are no sales. Through no sales has

been made but income statement will show gross profit equal to the amount of over

absorption of fixed manufacturing overheads. Thus profit under absorption costing is

influenced by various factors as quantity of production units, units sold, selling price, cost of

production etc…
 Problem No:1
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Following data relate to XYZ company:

Normal Capacity 40,000 units per month

Variable cost @ Rs. 10 per unit

Actual Production 44,000 units

Sales-Nil

Fixed Manufacturing overheads Rs.1,00,000 per month or Rs.2 .50 per unit at normal capacity.

Over fixed Expenses Rs.8000

You are required to prepare income statement under

(a). Absorption Costing

(b). Marginal Costing

 Solution:
Income Statement (Absorption
21
Costing)
Rs. Rs.
Sales
Less: Variable Cost @ Rs. 10 per unit 4,40,000
Fixed Manufacturing overheads for 44,000 units 1,10,000
@ Rs.2.50
Cost of goods manufactured 5,50,000
Less: Closing Inventory 5,50,000
Cost of Goods Sold Nil
Less: Overabsorption of Overheads (4,000 * Rs. - 10,000
2.50)
Gross Profit 10,000
Less: Other Fixed Expenses 8,000
Net Income 2,000

Note: The above income Statement will not show the profit if other fixed expenses are
more than the gross profit
 (b). Income Statement (Marginal Costing)
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Rs. Rs.

Sales Nil

Less: Variable Cost

Cost of goods manufactured for 44,000 units @ Rs. 10 per 4,40,000

unit

Less: Closing Inventory 4,40,000

Cost of Goods Sold Nil

Contribution Nil

Less: Fixed Manufacturing Overhead 1,00,000

Other Fixed Expenses 8,000 1,08,000

Net Income 1,08,000

 2. When Production is equal to sales: When Production and sales are equal i.e., there is no
23 opening or closing stock or when the inventory of finished goods does not fluctuate from
period to period, net income will be the same under absorption costing and marginal costing
techniques.

Problem No:2
Following data relate to XYZ company:
Output and sales 40,000 units. Sales price per unit Rs.15.
Material and Labour cost per unit Rs.8
Production Overheads:
Variable Rs 2 per unit
Fixed Rs.50,000
Other Fixed Overheads Rs. 1,00,000
Prepare Statement under:
(a). Absorption Costing
(b). Marginal Costing
 Solution:
24 (a). Income Statement (Absorption Costing)

Rs. Rs.

Sales (40,000 units @ Rs 15 per unit) 6,00,000

Less: Cost of goods manufactured:

Material and labour cost for 40,000 units @ Rs.8 3,20,000

Variable manufacturing overheads 80,000

Fixed manufacturing overheads 50,000 4,50,000

Gross Profit 1,50,000

Less: Other Fixed Overheads 1,00,000

Net Income 50,000

 (b). Income Statement (Marginal Costing)
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Rs. Rs.

Sales 6,00,000

Less: Variable Cost

Material & Labour Cost (40,000 * Rs 8) 3,20,000

Variable Manufacturing overheads (40,000 * Rs. 2) 80,000 4,00,000

Contribution 2,00,000

Less: Fixed Cost

Manufacturing Overheads 50,000

Other Fixed Cost 1,00,000 1,50,000

Net Income 50,000

 3. When Production is more than sales: When closing stock is more than the opening stock i.e., production exceeds
sales, profit will be higher in absorption costing as compared to marginal costing. It will be more clear from the following
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illustration:
Problem No:3
Following data relates to XYZ Ltd. Which makes and sells toys.
Production 1,00,000 units
Sales 80,000 units
Rs.
Selling Price/Unit 15
Direct Materials 2,50,000
Direct Labour 3,00,000
Factory Overheads:
Variable 1,00,000
Fixed 2,50,000
Selling and Distribution Overheads:
Variable 1,00,000
Fixed 2,00,000
You are required to present income statements using (a) absorption costing and (b) marginal costing. Account
 Solution:
27 (a). Income Statement (Absorption Costing)

Rs. Rs.

Sales (80,000 * Rs 15) 12,00,000

Less: Cost of goods manufactured:

Direct Material 2,50,000

Direct Labour 3,00,000

Factory Overheads: Variable 1,00,000

Fixed 2,50,000

9,00,000

Less: Closing Stock (20,000/1,00,000 * Rs 9,00,000) 1,80,000 7,20,000

Gross Profit 4,80,000

Less: Selling and Distribution Expenses: Fixed 2,00,000

Variable 1,00,000 3,00,000

Net Income 1,80,000

 (b). Income Statement (Marginal Costing)

Rs. Rs.
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Sales (80,000 * Rs 15) 12,00,000

Less: Variable Cost:

Direct Material 2,50,000

Direct Labour 3,00,000

Variable Factory Overheads 1,00,000

6,50,000

Less: Closing Stock (20,000/1,00,000 * Rs 6,50,000) 1,30,000

5,20,000

Add: Variable Selling and Distribution Expenses 1,00,000 6,20,000

Contribution 5,80,000

Less: Fixed Factory Overheads 2,50,000

Fixed Selling and Distribution Expenses 2,00,000 4,50,000

The difference in profits Rs. 50,000 (i.e., Rs.1,80,000-Rs.1,30,000) is due to 1,30,000

Net Income difference in valuation of
closing stock. The value of closing stock in absorption costing is Rs. 1,80,000 whereas this value is Rs.
1,30,000 in marginal costing.
 4. When production is less than sales: When closing stock is less than the opening stock i.e., sales

29 exceeds production for production (or production is less than sales), profit in marginal costing will be
higher as compared to absorption costing. This will be more clear from the following illustration.

Valuation of Stock Under Marginal Costing and Absorption Costing:

Problem 4:
Your company has a production capacity of 2,00,000 units per year. Normal capacity utilization is reckoned
as 90%. Standard variable production costs are Rs.11 per unit. The fixed factory costs are Rs. 3,60,000 per
year. Variable selling costs are Rs.3 per unit and fixed selling costs are Rs. 2,70,000 per year. The unit
selling price is Rs.20. In the year just ended on 30 th June, 2010, the production was 1,60,000 units and sales
were 1,50,000 units. The closing inventory on 30-06-2010 was 20,000 units. The actual variable production
costs for the year were Rs. 35,000 higher than the standard.
(i). Calculate the profit for the year
(a). by the absorption costing method, and
(b). by the marginal costing method.
(ii). Explain the difference in the profits.
 Solution: (i). (a). Profit Statement for the year ended 30th June, 2010 (Absorption Costing)
Rs. Rs.
30
Sales (1,50,000 units @ Rs. 20 per unit) 30,00,000

Less: Cost of Production:

Variable Production Costs 17,60,000

For 1,60,000 units @ Rs.11 per unit

Increase in Variable Cost 35,000

Fixed Costs for 1,60,000 units @ Rs. 2 3,20,000

21,15,000

Add: Opening Stock: 10,000 units 1,30,000

(i.e., sales 1,50,000 units + closing stock 20,000 units – production 1,60,000 units)
@ Rs. 13 (i.e., variable cost Rs11 + Rs.2 fixed cost at normal capacity utilisation
i.e., (Rs.3,60,000 / 90% of 2,00,000 units)

22,45,000

Less: Closing Stock: 20,000 units valued at current cost (Rs. 21,15,000/1,60,000 units * 20,000 units) 2,64,375

19,80,625

Add: Underabsorption of fixed costs (Rs.3,60,000 – Rs 3,20,000) 40,000 20,20,625

Gross Profit 9,79,375

Less: Selling Expense Variable 4,50,000 7,20,000

Fixed 2,70,000

Net Profit 2,59,375

 (i). (b). Profit Statement for the year ended 30th June, 2010 (Marginal Costing)

31 Rs. Rs.

Sales (1,50,000 units @ Rs. 20 per unit) 30,00,000

Less: Marginal Cost:

Variable Production Costs 17,60,000

For 1,60,000 units @ Rs.11 per unit

Additional variable production cost 35,000

17,95,000

Variable cost of opening stock of finished goods (10,000 units @ Rs.11) 1,10,000

19,05,000

Less: Closing Stock of finished goods: units valued at current variable 2,24,375
production cost
( i.e., Rs. 17,95,000 / 1,60,000 units * 20,000 units)

Variable production cost of 1,50,000 units 16,80,625

Add: Variable selling cost of 1,50,000 units sold (1,50,000 * Rs 3) 4,50,000 21,30,625

Contribution 8,69,375

Less: Fixed Cost: Fixed production cost 3,60,000 6,30,000

Fixed Selling Cost 2,70,000
 (ii). The difference in profits Rs. 20,000 (i.e., Rs. 2,59,375 – Rs. 2,39,375), as arrived at under
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absorption costing and marginal costing is due to the element of fixed factory cost included in the
valuation of opening stock and closing stock as shown below:

Opening Closing
Stock Stock
Rs. Rs.
Absorption 1,30,000 2,64,375
Costing
Marginal Costing 1,10,000 2,24,375

20,000 40,000
Net Difference = Rs 40,000 – Rs. 20,000 = Rs. 20,000
 Application of Marginal costing in terms of cost control:

33 1. Cost Control
2. Profit Planning and Maintaining a Desired Level of Profit
3. Fixation of Selling Price
4. Diversification of Products
5. Selection of Most Profitable Product-Mix
6. MAKE OR BUY DECISIONS
7. PRODUCT MIX DECISION UNDER CAPACITY CONSTRAINT
8. CLOSING DOWN OF FACTORY OR SEGMENT
9. Dropping or Adding Product Line
10. Alternative Method of Production
11. Effect of Change in Selling Price
12. . Shut-Down or Continue Decisions
13. Level of Activity Planning
14. Key or Limiting Factor
 1. Cost Control:
34 Marginal costing divides the total cost into fixed and variable cost. Fixed cost can be controlled by
the top management and that to a limited extent. Variable costs can be controlled by the lower level
of management.

2. Profit Planning and Maintaining a Desired Level of Profit:

Marginal costing techniques can be applied for profit planning as well. Profit planning involves the
planning of future operations to achieve maximum profits or to maintain a desired level of profits.
The change in the sales price, variable cost and product mix affect the profitability of a concern.

3.Fixation of Selling Price:

Fixation of selling price of a product is, no doubt, one of the most significant factors in modern
management. It becomes necessary for various purposes, like, under normal circumstances of the
interest; at trade depression, accepting additional order etc.
 Problem on Fixation of Selling Price:
35

You are requested by the directors of the company to advice-them about the minimum price which
may be charged assuming that no production difficulty will arise for the purpose.
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From the above it becomes clear that the minimum price is Rs. 22,500 i.e., the Marginal Cost.
But by quoting so, the company has to sacrifice the recovery of fixed cost and profit. As the
fixed costs are to be increased even if the company does not accept the offer, so any price over
and above Rs. 22,500 may be accepted.
 Problem on Selection of Profitable Product Mix:

37 The directors of a company are considering sales budget for the next budget period. From the
following information you are required to show clearly to management:

(i) The marginal product cost and the contribution per unit;

(ii) The total contribution resulting from each of following sale mixtures;

Sales Mixture:
(a) 100 units of product A and 200 of B

(b) 150 units of product A and 150 of B

(c) 200 units of product A and 100 of B

Recommend which of the sale-mixtures should be adopted.

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(ii) From the above Comparative Contribution statement, it becomes clear that as P/V Ratio of
Product A is higher in comparison with the Product B, Product A is more profitable one. And, as
such, the mixtures which consider the maximum number of Product A would be the most profitable
one which is proved from the following table:

Sales Mixture (C) i.e., 200 units of Product A and 100 units of Product B will yield highest
contribution.
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 Problem on Make or Buy Decision:
40
A radio manufacturing company wants to make component X 273 Q, the same is available in the market
at Rs. 5.75 each, with an assurance of continued supply.

The break-down of cost is:

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(a) Since the Marginal Cost of each component is Rs. 5, which is less than the purchase price of
the open market of Rs. 5.75 each, it is recommended that the component should be manufactured
by the company (if, however, the company is having spare capacity that cannot be filled with more
remunerative jobs).

(b) If the purchase price in the open market is Rs. 4.85, which is less than the marginal cost Rs.
5.00, leaving a saving of Re. 0.15 per unit, it is recommended that the component should be
purchased from the outside market as there is continued supply also. The spare capacity may be
utilised for other purposes.
 Dropping or Adding Product Line
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The following particulars are extracted from the cost records of Hindustan Shoes Ltd.

Capacity utilization 80%

Sales (Rs.) 18,50,000
Direct material (Rs.) 5,00,000
Direct expenses (Rs.) 3,00,000
Variable overhead (Rs.) 1,50,000
Fixed overhead (Rs.) 5,50,000
15,00,000

The company got an order from the UK to export shoes. For meeting this order, the company
requires 50% of its plant capacity. The price is 10% less than the current price. The factory
capacity can be increased by 10% with an extra cost of Rs.1,00,000. You are required to advice
the company with respect to accept or reject the order.
 Solution

43 If the company accepts the order, 50% of the plant capacity will be used for the special order and the
rest of 50% plus the increased 10% capacity will be used for local market. In order to arrive at a
decision, we need to consider the incremental revenue and the differential cost.

Incremental Revenue:
Local sales 60%
Sales revenue at 60% capacity (18,50,000 x 60) x 80

= Rs.13,87,500
The foreign order = 50% @ 10% less than the current
price
= (18,50,000/80) x 50 – 11,56,250 x
(10/100)
= 11,56,250 – 1,15,625
= Rs.10,40,625
Total proposed sale = Rs.13,87,500 + Rs.10,40,625

= Rs.24,28,125
Less: Present sale = Rs.18,50,000
 Differential cost:
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Proposed cost 110%

for
Direct material = (5,00,000/80) x110 = 6,87,500
Direct expenses = (3,00,000/80) x 110 = 4,12,500
Variable = (1,50,000/80) x 110 = 2,06,250
expenses
Fixed cost = 5,50,000
Extra to be = 1,00,000
incurred
As the incremental revenue exceeds the differential cost, the order can be accepted.
19,56,250
Less: Present 15,00,000
cost
Differential cost 4,56,250
 Problem on Level of Activity Planning:
45
A factory engaged in manufacturing plastic buckets is working at 40% capacity and produces
10,000 buckets per annum.

The present cost break-up for one bucket is as under:

The Selling price is Rs. 20 per bucket.

If it is decided to work the factory at 50% capacity, the selling price falls by 3%. At 90%
capacity, the selling price falls by 5% accompanied by a similar fall in the prices of material.

You are required to calculated the profit at 50% and 90% capacities and also calculate break-even
points for the capacity productions.
 Solution:
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 Problem on Effect of change in selling price:
The Income Statement of X Ltd. for the year ended 31st Dec. 1993 is given below from which
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the directors are analysing the results of trading:

The budgeted capacity of sales is Rs. 5,00,000 and sales demand is the limiting factor. Now, the sales
manager of the company proposes, utilising the existing capacity, the selling price should be reduced by 5%.
After considering the following additional information you are asked to prepare a forecast statement which
will show the effect of the proposed reduction in selling price and also to state any changes in costs expected
in the coming year.

Sales Forecast Rs. 4,75,000; Prices of Direct Materials are expected to increase by 2%; . Prices of Direct
Wages are expected to increase by 5% per unit; Variable Overheads are expected to increase by 5% per unit;
Fixed Overhead will increase by Rs. 5,000.
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 Key or Limiting Factor
49
Managers in their decision making process are often confronted with certain
limiting factors that play a pivotal role in arriving at an optimal solution or
may effect profitability. Key or limiting factor is the factor, which limits the
level of activity or the volume of output of a firm at a particular point of
time. Some of the examples of key factors are sales, labor, finance, material,
plant capacity, etc.

If there is a key factor for the undertaking, the profitable position of the
undertaking can be reached by computing the maximum contribution per unit
of key factor. The profitability can be measured by the following formula:

Profitability = Contribution / Key factor

 Problem On key or limiting factor:
50
From the following data, which product would you recommend to be manufactured in a factory,
time, being the key factor?
51

Contribution per hour of product x is more than that of product y by rs.6. Therefore, product x is
more profitable and is recommended to be manufactured.
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 To understand the mathematical relationship between cost, volume and profit, it is
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desirable to understand the following concepts, their calculation and application.

a) Contribution/Sales (C/S)

b) Profit Volume (P/V) Ratio.

c) Break Even Point.

d) Margin of Safety.
 Contribution/Sales Ratio
63
Profit/volume ratio establishes the relationship between contribution and sales. Any increase
in contribution leads to increase in profit because fixed cost is assumed to be constant for all
the levels of production. Mathematically, it is expressed as

Following formulas widely used under marginal costing

Sales = variable cost + fixed cost +

profit
Sales – Variable cost = Contribution
Sales – Variable cost = Fixed cost + profit
Contribution = Fixed cost + profit
Contribution - Fixed = profit
cost
 Problem 1.

64 From the following particulars, calculate:

(i) Break-even point in terms of sales value and in units.

(ii) Number of units that must be sold to earn a profit of Rs. 90,000.
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 Problem # 2.

66
From the following data, you are required to calculate:

(a) P/V ratio

(b) Break-even sales with the help of P/V ratio.

(c) Sales required to earn a profit of Rs. 4,50,000

Fixed Expenses = Rs. 90,000

Variable Cost per unit:

Direct Material = Rs. 5

Direct Labour = Rs. 2

Direct Overheads = 100% of Direct Labour

Selling Price per unit = Rs. 12.

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