Marginal Costing basics

• Marginal costing is a costing technique wherein only variable costs are considered for product costing and inventory valuation

Key Concepts

• Variable costs change in direct proportion with the volume of production or sales
• Fixed costs remain constant regardless of changes in production or sales volume within a relevant range
• Contribution margin is the difference between sales revenue and variable costs
• Break-even point is the level of sales at which total revenues equal total costs
• Profit-volume ratio (P/V ratio) is the ratio of contribution margin to sales revenue
• Marginal cost is the change in the total cost that arises when the quantity produced is incremented by one unit

Cost Classification

• Marginal costing classifies costs into variable and fixed
• Only variable costs are product costs and used for inventory valuation
• Fixed costs are treated as period costs and are charged to the profit and loss statement in the period they are incurred

Contribution Margin

• Contribution margin is calculated as Sales Revenue - Variable Costs
• Represents the amount of revenue available to cover fixed costs and generate profit
• Contribution margin can be expressed in total or per unit

Break-Even Analysis

• Break-even point is calculated as Fixed Costs / Contribution Margin per Unit
• Determines the level of sales required to cover all fixed costs
• At the break-even point, the company neither makes a profit nor incurs a loss

Profit-Volume Ratio (P/V Ratio)

• P/V ratio is calculated as Contribution Margin / Sales Revenue
• Indicates the proportion of each sales rupee that contributes towards covering fixed costs and generating profit
• A higher P/V ratio indicates better profitability

Decision Making

• Marginal costing is useful for various decision-making scenarios
• Pricing decisions help in determining the minimum selling price to cover variable costs and contribute towards fixed costs
• Make-or-buy decisions are useful in deciding whether to manufacture a product internally or outsource it
• Special order decisions provide insights into the profitability of accepting special orders at prices below the normal selling price
• Product mix decisions assist in determining the optimal mix of products to maximize profitability

Advantages

• Simple to understand and apply
• Provides useful information for decision making
• Highlights the relationship between cost, volume, and profit
• Avoids arbitrary allocation of fixed costs

Disadvantages

• Ignores the importance of fixed costs in the long run
• May lead to underpricing in the long run
• Not suitable for all industries
• Inventory may be undervalued

Absorption Costing vs. Marginal Costing

• Absorption costing includes both variable and fixed costs in product costs
• Marginal costing includes only variable costs in product costs
• Absorption costing is required for external reporting purposes
• Marginal costing is primarily used for internal decision making

Applications

• Cost-volume-profit (CVP) analysis
• Budgeting
• Performance evaluation
• Pricing strategies
• Short-term decision making