Concepts Behind Marginal Costing
Every product produced has some cost associated with it. As more and more items are produced, the cost of producing one unit of product keeps changing. At any particular production level, the increase or decrease in the total cost of production for one additional unit of an item is called the marginal cost. In other words, Marginal cost is the change in the total cost when the quantity produced is incremented by one. That is, it is the cost incurred in producing one more unit of a product. Mostly, it is calculated beyond the breakeven point, where the fixed costs have already been recovered, so to speak, by the already produced items and only the direct costs are relevant.
Marginal costs consists of laborcosts and material costs, and a part of fixed costs like administration overheads and selling expenses. For a company, if the average costs are more or less constant, marginal cost is very close to average cost. Conversely, in industries that consume heavy capital investment and have high average costs, like automobile industry, it is relatively very low. The concept of marginal cost is crucially important in resource allocation because, for optimum results, management must put its effort to increase the difference between marginal revenue and marginal cost for maximum profitability.
Example
Let's say the variable cost per unit at 10,000 units = $35
Fixed cost = $150,000
Cost of 10,000(10 batches) units = 35 × 10,000 = $350,000
Total Cost of 10,000 units = Fixed Cost + Variable Cost
= 150,000 + 350,000
= $500,000
variable cost per unit at 11,000(11 batches) units = $36
Total cost of 11000 units = 150,000 + 396,000
= $546,000
Marginal Cost of producing 11 batches = (546,000 - 500,000)/1000
= $46
Marginal costing helps in figuring out the impact of variable cost on the volume of output. It also gives a way to enhance the break-even analysis. It helps managers to perform profitability analysis of a product or department. All costs are categorized into fixed and variable costs and semi-fixed costs are assigned as either fixed cost or variable cost. This concept is also used for valuation of finished stocks and work in progress.
Marginal costing finds use in profit planning; it measures profitability at different level of production and sale. Moreover, it is also used in pricing decisions like fixing a selling price, decision about expert and outsourcing decisions. Marginal costs prevent faulty arbitrary allocation of fixed cost, and thus provide control over variable cost. It also prevents irrational carrying forward of overheads from one accounting period to next.
Difficulties Encountered In Marginal Costing
Many students, owing to a lack of understanding of the concept, calculate the change in the production cost of products over a very large change in production levels. This is erroneous because marginal cost analysis is essentially a concept that is calculated at a particular level of production. By its very definition, it measures the change in costs per unit change in production levels. Hence it is important to keep in mind that this analysis must be done incrementally.
Moreover, many students apply wrong formula while calculating marginal costs. This is because many texts give a rather confusing representation of the formula. At the cost of repeating, it must be reiterated that marginal cost analysis is essentially an incremental analysis and hence must not be calculated over a large change in production levels.
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