Marginal Costing : Concept, Definition, Features, Advantages, Limitations

Marginal Costing

 

Marginal Costing: Concept

Marginal costing is a method of costing that is concerned with changes in costs resulting from changes in the volume or range of output and sales.

An increase or decrease in total costs that is caused by an increase or decrease in the volume of production and sales is known as marginal cost, differential cost, or incremental cost.

Thus, marginal costs relate to future costs and can be determined by subtracting the total at one level of output or sale from that at another level.

It should be noted that marginal costs refer to the increase or decrease in costs on account of the block of units produced or sold. The marginal costs per unit remain the same.

Marginal costing is a method of costing that is concerned with changes in costs resulting from changes in the volume or range of output and sales.

An increase or decrease in total costs that is caused by an increase or decrease in the volume of production and sales is known as marginal cost, differential cost, or incremental cost.

Thus, marginal costs relate to future costs and can be determined by subtracting the total at one level of output or sale from that at another level.

It should be noted that marginal costs refer to the increase or decrease in costs on account of the block of units produced or sold. The marginal costs per unit remain the same.

Definitions : 

D. Joseph: “Marginal costing is a technique of determining the amount of change in the aggregate cost due to an increase of one unit over the existing level of production.”

Harold J. Wheldon: “Other things being equal, the fixed overhead will, in total remain fix during changes in production achieved and the rate per unit will consequently vary whereas that variable overhead will remain constant per unit of production and vary in total.”

Features/Characteristics of Marginal Costing

The following are the characteristics of marginal costing:

1. Classification of costs: All costs are classified as fixed and variable costs.

2. Focus on variable costs: Fixed costs are constant. They do not fluctuate with output. By contrast, variable costs always go up or down with the output, while the per unit cost remains the same.

3. Treatment of finished and semi-finished goods: The value of finished goods and work-in-progress is included in the marginal cost.

4. Treatment of fixed costs: Fixed expenses are shown on the debit side of the profit and loss account for the period in which they are incurred.

5. Basis of pricing: Prices are based on marginal cost plus contribution. Thus, the contribution is the excess of the selling price over the marginal cost of sales.

6. Determination of profitability: The profitability of a product is determined after a close study of the contribution made available by each unit of output.

Advantages of Marginal Costing

Several advantages are associated with marginal costing, including:

1. Knowledge of cost classification: Fixed costs are more or less uncontrollable and variable cost are always controllable. The cost data needed for decision-making and profit planning are made readily available for the management.

2. Simple operation: Marginal costing is simple to operate because it avoids the complexities of apportionment of fixed costs, which is really arbitrary.

3. No danger of over and under charges of overheads: In this cost control technique, the risk of over- and under-allocating overheads is minimized.

4. Relationship of fixed and variable costs: Fixed costs are related to time with no reference to output, while variable costs are always associated with output. Thus, an increase in output will reflect how much extra funds will be available for additional output.

5. Knowledge of minimum output: Marginal costing can indicate the minimum output required to equate fixed and variable cost. This point is known as the break-even point (BEP), where costs and revenues are always equal.

Limitations of Marginal Costing

Marginal costing suffers from the following limitations:

1. Incorrect assumptions for classification of expenses: It is assumed that the expenses are grouped as fixed and variable, while certain expenses (e.g., employee bonuses) are purely caused by management decisions and have no reference to output or time.

2. Marginal costing does not give due attention to the time factor: There are cases where the marginal cost of two outputs is the same, yet one takes twice the time to produce as the other. However, in reality, jobs that take more time are more costly.

3. Not applicable to all industries: Marginal costing cannot be applied suitably in certain industries, including ship building and contracts.

4. Fixed expenses are controllable: Marginal costing ignores the fact that fixed costs are always controllable. The technique of budgetary control can be helpful in controlling the amount of fixed overheads.

5. Lack of calculation: Marginal costing does not provide any standard for performance evaluation. A system of budgetary control and standard costing gives more effective control compared to marginal costing.

6. Wrong basis of stock and work-in-progress: Under marginal costing, stock and work-in-progress are valued based on the marginal cost, and fixed costs are taken into account. Thus, these expenses are a lesser charge.

7. Limited output: The study of marginal costing is suitable only to a limited extent. There is every possibility that beyond a specific limit of output, fixed expenses will show an unusual jump.

8. Various factors affect production cost: The BEP is affected by fixed and variable costs under marginal costing. However, other factors may affect output, including the efficiency of men and machinery, plant capacity, and technical capabilities.

Example

A company produces 10,000 radios at a fixed cost of $100,000 per annum. The variable cost per radio is $300.

Total variable cost = 10,000 x 300 = $300,000

Add fixed cost = 100,000

Total Cost = $400,000

Extra cost of one radio = $300

Total = $400,300

Thus, the marginal cost per radio is $300. The variable cost and marginal cost are also known as direct costs, activity costs, or volume costs.

Variance Analysis : Material Variances, Labour Variances, Overhead Variences

 

Variance Analysis

Variance analysis is the procedure of computing the differences between standard costs and actual costs and recognizing the causes of those differences. Studies indicated that variance is the difference between standard performance and actual performance. It is the process of scrutinizing variance by subdividing the total variance in such a way that management can assign responsibility for off-Standard Performance.

Variance analysis has four steps:

1. Compute the amount of the variance.
2. Determine the cause of any significant variance.
3. Identify performance measures that will track those activities, analyse the results of the tracking, and determine what is needed to correct the problem.
4. Take corrective action.

Variance Analysis : A Four-Step Approach to Controlling Costs

The variance can be favourable variance or unfavourable variance. When the actual performance is superior to the Standard, it resents "Favourable Variance." Likewise, where actual performance is under the standard it is called as "Unfavourable Variance."

Variance analysis assists to fix the responsibility so that management can determine-

1. The amount of the variance
2. The reasons for the difference between the actual performance and budgeted performance.
3. The person responsible for poor performance
4. Corrective actions to be taken.

Types of Variances :

Variances is categorised into two categories that include Cost Variance and Sales Variance.

Components of Variance Analysis :

Cost Variance :

Total Cost Variance is the difference between Standards Cost for the Actual Output and the Actual Total Cost sustained for manufacturing actual output. The Total Cost Variance consists of:

A. Direct Material Cost Variance

B. Direct Labour Cost Variance

C. Overhead Cost Variance

A. Direct Material Variances: 

Direct Material Variances are also known as Material Cost Variances. The Material Cost Variance is the difference between the Standard cost of materials for the Actual Output and the Actual Cost of materials used for producing actual output. The Material Cost Variance is computed as:

(1) Material Price Variance (MPV) : MPV is the difference between the standard cost of actual quantity and actual cost for actual quantity. 

MPV = (SP - AP) x AQ 

(2) Material Usage Variance (MUV) : MUV is the difference between the standard cost of standard quantity of material for actual output and the Standard cost of the actual material used. 

MUV = SP x (SQ - AQ) 

(3) Material Mix Variance (MMV) : It is the portion of the material usage variance which is due to the difference between the Standard and the actual composition of mix. Material Mix Variance is calculated under two situations as follows : 

(a) When Actual Weight and Standard Weight of Mix are equal : 

(i) The formula is used to calculate the Variance: 

MMV = SP x (SQ - AQ) 

(ii) In case standard quantity is revised due to shortage of a particular categoryof materials, the formula will be changed as follows : 

MMV = SP x (RSQ - AQ) 

Where, RSQ = Revised standard quantity 

(b) When Actual Weight and Standard Weight of Mix are different: 

(i) The formula used to calculate the Variance is : 

MMV = ( Total weight of actual mix/ Total weight of standard mix X standard cost of standard mix) - standard cost of actual mix 

(ii) In case the standard is revised due to the shortage of a particular category of materials, the alternative formula will be as follows: 

MMV = ( Total weight of actual mix/ Total weight of standard mix X standard cost of revised standard mix) - standard cost of actual mix 

(3) Materials Yield Variance (MYV) : It is the portion of Material Usage Variance. This variance arises due to spoilage, low quality of materials and defective production planning etc. Materials Yield Variance may be defined as "the difference between the Standard Yield Specified and the Actual Yield Obtained." This variance may be calculated as under: 

MYV = SR x ( AY - SY) 

Where, AY= Actual Yield, 

SY = Standard Yield and 

Standard Rate is calculated as follows : 

Standard Rate = Standard cost of standard mix / Net standard output. 

Verification: 

1. MCV = MPV + MUV 

2. MUV = MMV + MYV 

Notes- positive means favourable(F) and negative means adverse(A)

B. Labour Cost Variance: 

Labour Cost Variance is the difference between the Standard Cost of labour allowed for the actual output achieved and the actual wages paid. It is also termed as Direct Wage Variance or Wage Variance. Labour Cost Variance is calculated as follow:

1. Labour Cost Variance (LCV): Labour Cost Variance is the difference between the Standard Cost of labour allowed for the actual output achieved and the actual wages paid. 

Labour Cost Variance = Standard Cost of Labour - Actual Cost of Labour (or) Labour Cost Variance = {SR x SH for AO} - { AR x AH} 

Where, 

SR = Standard Rate, 

ST = Standard Hour, 

AO = Actual Output, 

AR = Actual Rate, 

AT = Actual Hour. 

2. Labour Rate Variance (LRV) : It is that part of labour cost variance which is due to the difference between the standard rate specified and the actual rate paid. This variances arise from the following reasons: 

(a) Change in wage rate. 

(b) Faulty recruitment. 

(c) Payment of overtime. 

(d) Employment of casual workers etc. 

It is expressed as follows : 

LRV = AH ( SR - AR) 

3. Labour Efficiency Variance (LEV) : Labour Efficiency Variance otherwise knownasLabour Time Variance. It is that portion of the Labour Cost Variance which arises duetothe difference between standard labour hours specified and the actual labour hours spent. The usual reasons for this variance are 

(a) poor supervision 

(b) poor working condition

(c) increase in labour turnover 

(d) defective materials. 

It may be calculated as following: 

LEV = SR ( SH - effective AH) 

4. Labour Idle Time Variance : Labour Idle Time Variance arises due to abnormal situations like strikes, lockout, breakdown of machinery etc. In other words, idle time occurs due to the difference between the time for which workers are paid and that which they actually expend upon production. 

It is calculated as follows : 

Idle Time Variance = Idle Hours x Standard Rate 

5. Labour Mix Variance (LMV) : It is otherwise known as Gang Composition Variance. This variance arises due to the differences between the actual gang composition than the standard gang composition. Labour Mix Variance is calculated in the same way of Materials Mix Variance. This variance is calculated in two ways: 

(i) When Standard and actual times of the labour mix are same: The formula for its computation may be as follows : 

LMV = Standard cost of standard labour mix - Standard cost of Actual labour mix. 

(ii) When Standard and actual times of the labour mix are different : Changes in the composition of a gang may arise due to shortage of a particular grade of labour. It may be calculated as follows : 

LMV = (RSH - AH) x SR Where, Revised Standard Hour (RSH) = Total Actual Hour/ Total standard hour X actual hour. 

6. Labour Yield Variance (LYV) : 'This variance is calculated in the same way as Material Yield Variance. Labour Yield Variance arises due to the variation in labour cost on account of increase or decrease in yield or output as compared to relative standard. The formula for this purpose is as follows: 

LYV = Standard labour cost per unit of output X (Standard output for actual hour - actual output) 

Verification: 

1. Labour Cost Variance = Labour Rate Variance + Labour Efficiency Variance 

2. Labour Efficiency Variance = Labour Mix Variance + Labour Yield Variance

C. Overhead variance : 

Overhead is explained as the cumulative of indirect material cost, indirect labour cost and indirect expenses. Overhead Variances may occur due to the difference between standard cost of overhead for actual production and the actual overhead cost incurred. The Overhead Cost Variance may be computed as follows:

Classification of Overhead Variance Overhead Variances can be classified as : 

A. Variable Overhead Variances: 

(1) Variable Overhead Cost Variance 

(2) Variable Overhead Expenditure Variance 

(3) Variable Overhead Efficiency Variance 

B. Fixed Overhead Variance: 

(a) Fixed Overhead Cost Variance 

(b) Fixed Overhead Expenditure Variance 

(c) Fixed Overhead Volume Variance 

(d) Fixed Overhead Capacity Variance 

(e) Fixed Overhead Efficiency Variance 

(f) Fixed Overhead Calendar Variance

Sales variance :  

The Variances so far analysis is linked to the cost of goods sold. Quantum of profit is derived from the difference between the cost and sales revenue. Cost Variances affect the amount of profit positively or unfavourably depending upon the cost from materials, labour and overheads. Additionally, it is important to analyse the difference between actual sales and the targeted sales because this difference will have a direct impact on the profit and sales. Therefore the analysis of sales variances is important to study profit variances.

Sales Variances can be calculated by two methods:

A. Sales Value Method.

B. Sales Margin or Profit Method.

Basis of Calculation: Variance analysis emphasizes the causes of the variation in income and expenses during a period compared to the financial plan. In order to make variances significant, the idea of 'flexed budget' is used when calculating variances. Flexed budget acts as a link between the original budget (fixed budget) and the actual results. Flexed budget is prepared in retrospect based on the actual output. Sales volume variance accounts for the difference between budgeted profit and the profit under a flexed budget. All remaining variances are calculated as the difference between actual results and the flexed budget.

To summarize, Variance Analysis, is administrative accounting which denotes to the analysis of deviations in financial performance from the standards definite in organizational budgets. In Variance Analysis, the difference between actual cost and its budgeted or standard cost segregated into price or quality component. It has been shown that favourable variance occurs when output exceeds input or when the price paid for the goods and services is less than anticipated. An unfavourable variance occurs when output is less than input or when the price for goods and services is greater than expected.

Standard Costing Vs Budgetary Control

Standard Costing Vs Budgetary Control 

STANDARD COSTING
Standard costing is a cost accounting technique which compares the results of actual production with the basic standard, as anticipated, in terms of costs so as to determine the reasons for discrepancies between the anticipated and actual costs.

BUDGETARY CONTROL
Budgetary control is the process by which budgets are prepared for the future period and are compared with the actual performance for finding out variances, if any. The comparison of budgeted figures with actual figures will help the management to find out variances and take corrective actions without any delay.

BASIS OF DIFFERENCE	STANDARD COSTING	BUDGETARY CONTROL
MEANING	The costing method in which evaluation of performance and activity is done by making a comparison between actual and standard costs, is Standard Costing.	Budgetary Control is the system in which budgets are prepared and continuous comparisons are made between the actual and budgeted figures to achieve the desired result.
BASIS	Standard costing is determined on the basis of data related to production.	Budgets are prepared on the basis of management’s plans under budgetary control.
RANGE	It is limited to cost details.	It includes cost and financial data.
INTERDEPENDENCE	Budgeting is necessary for standard costing.	Standard costing is not necessary for adopting budgetary control.
CONCEPT	It is a Unit Concept.	It is a Total Concept in itself.
VARIANCES	It deals with the variances of elements of cost i.e. material, labour, overhead and sales separately.	It deals with total variances only.
INCOME/ EXPENSES	Standards are set for expenses only.	Budgets can be prepared for incomes also.
SCOPE	It is Narrow concept.	It is a Wider concept than standard costing.
REPORTING OF VARIANCES	It reports the variances.	It does not report the variances.
FORECASTING	It cannot be used for forecasting.	It can be used for forecasting purpose also.
PROJECTION	It is the projection of cost accounts.	It is projection of financial accounts.
STANDARDIZATION OF PRODUCTS	It requires standardization of products.	It does not necessarily requires standardization of products.
EFFECT OF TEMPORARY CHANGES IN CONDITIONS	The short term changes will not influence the standard costs.	The short term changes will be shown in the budgeted costs.
COMPARISON	It compares Actual costs and standard cost of actual output.	It compares Actual figures and budgeted figures.
APPLICABILITY	It is applicable in Manufacturing concerns only.	It is applicable in All business concerns

CONCLUSION :

Both Standard Costing and Budgetary Control are the techniques which provide a yardstick to judge the performance and analyze disagreement of the actual and estimated figures. Budgetary Control makes side by side comparisons, and that is why periodic revisions are made in the budgets, and that is why there is no need for reporting the variances, which is absent in Standard costing.