The marginal cost technique is not the same as job or batch costing, process costing, contract costing, or operating. All costing methods are used to calculate the cost of products or services. Only variable costs of manufacturing are included in the unit cost in the marginal costing approach. Fixed costs are charged to the Profit and Loss Account in full as period costs. The marginal cost of production is used to determine the change in a product's cost due to creating an extra unit of output. Producing more units after the company has achieved its optimum production level would enhance the cost of production per unit.
Did you Know?
All expenses are divided into fixed and variable costs based on their variability. Fixed and variable expenses are separated from semi-variable costs. This method is used to determine the marginal cost and the influence of variable costs on production volume. The selling price is determined by adding the contribution to the marginal cost. The contribution made available by each department or product determines the relative profitability of items or departments.
Marginal Cost Definition
The additional marginal cost of producing one more unit of an item or service is marginal cost. It is calculated using the variable cost of production, which is the sum of all variable expenses.
Only variable expenses are taken into account in marginal costing. These variable costs will fluctuate in direct proportion to changes in manufacturing volume or output by one unit. The terms marginal cost and variable cost are interchangeable. This is not a new term. The idea of marginal cost as defined by accountants differs from that of marginal cost as defined by economists.
Economists define marginal cost as the incremental cost of manufacturing one more unit. This will also have a fixed cost component. Overproduction beyond a certain point, for example, may need extra pay for workers and higher machinery maintenance expenses.
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Marginal Cost Example
In this case, you maintain manufacturing 750 T-shirts but invest in a new facility. Your fixed expenses will rise by ₹200 per month owing to the new facility. The total cost of your new fixed expenses is ₹2,200 (₹2,000+₹200). Calculate your new unit costs:
(₹2,200 / 750)+₹5.00 = Cost Per Unit
The price per unit is ₹7.93.
Your new per-unit cost is ₹7.93.
Calculate the new cost change:
Costs Change = (₹7.93 X 750) – ₹4,500
Costs Change = ₹1,447.50
Because your quantity did not change, you can compute the new marginal cost of production using the marginal cost formula:
₹1,447.50 / 250 = Marginal Cost
₹5.79 is the marginal cost.
Over 500 units, your marginal cost pricing is ₹5.79 per subsequent item. In this case, it costs ₹0.79 more for each unit (₹5.79 – ₹5.00) than the original 500 units you manufactured.
Marginal Cost in Accounting
Marginal cost in accounting shows us how much more it will cost to make one more product. Put another way, it's the variable cost of producing one additional product after all of the fixed expenses have been taken into account.
Only the direct costs of the marginal change in unit output are considered in marginal cost accounting. Because the marginal cost change in activity has little influence on fixed and overhead expenses, they are ignored. The marginal adjustment is justified by the positive contribution to gross margin, although it does not always result in (a higher) net profit.
Calculating Marginal Cost
Before we go into the marginal cost calculation, it's important to understand what costs should be included. Variable and fixed expenses are included in marginal costs. The labour and resources used to create your final product are variable costs. Expenses like administrative work and overhead are examples of fixed costs. If you increase or reduce production levels, fixed expenses do not vary. As a result, when you raise output (which we'll discuss later), you can spread the fixed expenses across many units.
Let's look at the marginal cost formula and how to get marginal cost now that you know the differences between expenses. The overall change in costs divided by the change in quantity equals your marginal costs:
Change in Costs / Change in Quantity = Marginal Cost
Advantages & Disadvantages of Marginal Cost
Advantages
- The marginal costing approach is straightforward to comprehend and use. This is because fixed expenses are not included in the cost of production, and fixed costs are not apportioned arbitrarily.
- Fixed costs from the current year are not carried forward to the following year. As a result, neither cost nor profit is tainted. Cost comparisons start to make sense.
- The contribution is utilised as a decision-making tool by management. It gives a more trustworthy basis for making decisions.
- Marginal costing depicts the impact of changes in sales volume on profit more clearly.
- Under and excess absorption of overheads is not a concern when using marginal costing.
- Marginal costing can be used in conjunction with normal costing.
- The current connection between cost, selling price, and volume is thoroughly discussed.
- It displays the relative profits contributed by each of some items, as well as where the sales effort should be reduced.
- With marginal costing data, management may make short-term tactical decisions.
For public utility companies, the marginal cost pricing approach is quite beneficial. It aids them in increasing productivity or maximising capacity utilisation. Only when the lowest possible price is charged is this achievable. The product's marginal cost determines the lowest limit. The adoption of marginal cost pricing by public utility companies aids in the maximisation of societal welfare.
Also Read: Know All About Cost Accounting
Disadvantages
- The overall costs are difficult to divide into fixed and variable expenses.
- Furthermore, determining the unpredictability of semi-variable costs is quite challenging.
- Removing fixed costs from the value of completed goods has no validity since fixed costs are incurred for product manufacturing.
- Because the stocks are undervalued, the full amount of the loss cannot be recovered from the insurance company in the event of a fire.
- Tax authorities refuse to recognise stock valuations since the shock does not reflect genuine worth.
- The variable overhead computation does not account for all variable overheads.
- Profit changes per sales volume fluctuations. As a result, preparing periodic operational statements becomes infeasible.
- The absence of fixed expenses makes work cost comparisons difficult.
- Management cannot make a good judgement just based on contributions. If new techniques were used in the manufacturing process, the contribution might change.
- The fixed costs are only consistent for a limited time. All costs are changeable in the long run.
Marginal Cost Pricing
The technique of establishing a product's price at or slightly above the variable cost of production is known as marginal cost pricing. This method is most commonly used when prices are established for a short period. This occurs when a corporation either has a small quantity of residual underutilised production capacity that it wants to use or cannot sell at a higher price. The extra or additional cost of generating one extra output unit is referred to as marginal cost.
Conclusion
Marginal costing is a valuable analysis method that often aids management in making decisions and comprehending the answers to particular revenue problems. The impact of variable costs at various production capacity levels is determined by dividing the total cost into fixed and variable costs, as fixed costs do not affect marginal costs. The marginal cost of the firm, on the other hand, is the change in variable costs in different production capacities. In marginal costing, fixed costs stay constant while variable costs change depending on output level. In reality, fixed costs do not remain constant, and variable costs do not fluctuate depending on the production level.
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