Definition of Marginal Costing
Marginal Costing is a cost accounting technique in which only variable costs are considered for decision-making, while fixed costs are treated as period costs and charged directly to the Profit & Loss account. It helps managers analyze how costs behave with changes in production and assists in pricing, profit planning, and decision-making.
Meaning of Marginal Costing
Marginal costing, also known as variable costing or direct costing, separates costs into variable costs (which change with production) and fixed costs (which remain constant). The core principle is that only variable costs should be charged to products, while fixed costs are linked to time and must be written off against revenue of the period.
This method plays a vital role in managerial decision-making. It is not used for external financial reporting but for internal reporting, cost control, break-even analysis, and managerial strategies.
Key Concepts in Marginal Costing
Variable Costs
Costs that vary directly with production (e.g., raw materials, direct labor, power used in production).
Fixed Costs
Costs that remain constant regardless of output (e.g., rent, salaries, depreciation).
Contribution
Contribution = Sales – Variable Cost.
It shows how much revenue contributes toward covering fixed costs and generating profit.
Profit Planning
Once fixed costs are recovered, the contribution contributes to profit.
Formula of Marginal Costing
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Marginal Cost (MC) = Change in Total Cost ÷ Change in Quantity
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Contribution (C) = Sales – Variable Costs
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Profit = Contribution – Fixed Costs
Example Calculation of Marginal Cost
Suppose:
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Total Cost of producing 100 units = ₹10,000
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Total Cost of producing 101 units = ₹10,080
So, the marginal cost of producing one additional unit is ₹80.
Journal Entry in Marginal Costing
Since fixed costs are treated as period costs, only variable costs are recorded against production.
Example:
Company produces 1,000 units at a variable cost of ₹50 per unit.
Journal Entry:
(Fixed costs like rent and salaries are directly debited to Profit & Loss A/c.)
Detailed Illustration – Marginal Costing
Suppose XYZ Ltd. produces and sells 1,000 units at ₹200 each.
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Variable cost per unit = ₹120
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Fixed cost = ₹60,000
Step 1: Calculate Contribution
Contribution = Sales – Variable Costs
= (1,000 × 200) – (1,000 × 120)
= ₹200,000 – ₹120,000 = ₹80,000
Step 2: Deduct Fixed Costs
Profit = Contribution – Fixed Costs
= ₹80,000 – ₹60,000 = ₹20,000
So, profit under marginal costing = ₹20,000.
Key Features of Marginal Costing
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Costs are classified into fixed and variable.
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Fixed costs are treated as period costs.
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Contribution is a key metric.
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Useful for decision-making and break-even analysis.
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Inventory is valued at variable cost only.
Importance of Marginal Costing in Business
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Helps in fixing selling price in competitive markets.
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Facilitates profit planning.
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Essential for make-or-buy decisions.
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Helps in analyzing impact of production level changes.
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Useful for shutdown or continue operations decisions.
Advantages of Marginal Costing
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Simple to understand.
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Provides clarity in decision-making.
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Useful for short-term decisions.
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Helps in cost control.
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Effective for break-even and profit-volume analysis.
Disadvantages
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Not accepted under GAAP or IFRS for external reporting.
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Ignores fixed costs in product cost, which may mislead in the long run.
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Not suitable for industries with high fixed costs.
Usage of Marginal Costing
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Profit-volume analysis.
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Break-even point determination.
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Pricing during competition.
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Evaluation of new projects.
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Optimizing production levels.
Case Studies of Marginal Costing
Automobile Industry
During price wars, car companies like Maruti Suzuki often use marginal costing to set temporary lower prices to cover variable costs and contribute towards fixed costs.
Airline Industry
Airlines frequently use marginal costing for ticket pricing. Even selling at lower prices than average cost helps cover variable costs like fuel and contributes towards fixed expenses.
Practical Example of Marginal Costing
A bakery produces 500 cakes at ₹100 each. Variable cost per cake = ₹60, Fixed cost = ₹15,000.
Contribution = (500 × ₹40) = ₹20,000
Profit = Contribution – Fixed cost = ₹20,000 – ₹15,000 = ₹5,000
Thus, bakery earns ₹5,000 profit using marginal costing analysis.
Common Mistakes or Misunderstandings
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Assuming marginal costing ignores fixed costs completely (they are considered, but treated as period costs).
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Believing marginal costing is suitable for external reporting.
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Confusing contribution with profit.
Real-Life Applications of Marginal Costing
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E-commerce companies like Amazon use marginal costing to decide discounts.
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Manufacturing industries use it for make-or-buy decisions.
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Hospitality industry uses it for seasonal pricing.
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Legal implication: In India, marginal costing is widely used in management accounting but not for statutory financial statements.
FAQs
Q1. Is marginal costing the same as absorption costing?
No. Absorption costing includes both fixed and variable costs, while marginal costing includes only variable costs.
Q2. Can marginal costing be used for tax purposes?
No. It is used only for internal decision-making, not for statutory or tax reporting.
Q3. What industries benefit most from marginal costing?
Airlines, hospitality, retail, and FMCG industries benefit due to fluctuating demand and competitive pricing.
Q4. Why is contribution important in marginal costing?
Because contribution helps cover fixed costs and indicates the profitability of additional sales.
Expert Tip from Learn with Manika
Always use marginal costing alongside absorption costing. While marginal costing helps in short-term decisions, absorption costing ensures a long-term view of profitability. Businesses should integrate both for better strategy.
Related Terms
- Absorption Costing
- Contribution Margin
- Break-even Analysis
- Fixed Cost
- Variable Cost
- Cost-Volume-Profit (CVP) Analysis