PROJECT REPORT ON

“Application of Marginal Costing Technique & its Limitations”

Submitted toUniversity of Mumbai

In Partial Fulfillment of the Requirement

For

M.Com (Accountancy) Semester IIIn the subject

Cost Accounting

By

Name of the student : - Vivek ShriramMahajanRoll No. : - 14 -7288

Name and address of the collegeK. V. Pendharkar College

Of Arts, Science & CommerceDombivli (E), 421203

APRIL 2015

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DECLARATION

I VIVEK SHRIRAM MAHAJAN Roll No. 14 – 7288, the student of

M.Com (Accountancy) Semester II (2015), K. V. Pendharkar College,

Dombivli, Affiliated to University of Mumbai, hereby declare that the project

for the subject Strategic Management of Project report on “Application of

marginal costing Technique & its Limitations” submitted by me to

University of Mumbai, for semester II examination is based on actual work

carried by me.

I further state that this work is original and not submitted anywhere else for any examination.

Place: Dombivli

Date:

Signature of the Student

Name: - Vivek Shriram Mahajan Roll No: - 14 -7288

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ACKNOWLEDGEMENT

It is a pleasure to thank all those who made this project work possible.

I Thank the Almighty God for his blessings in completing this task. The successful completion of this project is possible only due to support and cooperation of my teachers, relatives, friends and well-wishers. I would like to extend my sincere gratitude to all of them.

I am highly indebted to Principal A.K.Ranade, Co-ordinate P.V.Limaye, and my subject teacher Prajakta Karmarkar for their encouragement, guidance and support.

I also take this opportunity to express sense of gratitude to my parents for their support and co-operation in completing this project.

Finally I would express my gratitude to all those who directly and indirectly helped me in completing this project.

Name of the studentVivek Shriram Mahajan

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CHAPTER No Topic Page no

CHAPTER 1 Introduction

Introduction to Subject………………………..Origins...............................................................

56

CHAPTER 2 Objectives & Importance of Cost Accounting Objectives of Cost Accounting..............................Importance of Cost Accounting............................

810

CHAPTER 3 Introduction to Marginal Costing

Marginal Costing as a Costing System...………Features of Marginal Costing.............................

1114

CHAPTER 4 Application of Marginal Costing

Application of Marginal Costing in Managerial Decisions..............................Advantages and Disadvantages of Marginal Costing....

2022

CHAPTER 5 The Limitation of Using the Marginal Costing Technique

Limitations of Marginal Costing Techniques............... 24

Conclusion

Conclusion…………………………………………. 25

Table of Contents:

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CHAPTER 1: Introduction

Introduction of Costing

Definition

System of computing cost of production or of running a business, by allocating expenditure to various stages of production or to different operations of a firm.

Cost Accounting

Cost accounting is a process of collecting, analyzing, summarizing and evaluating various alternative courses of action. Its goal is to advise the management on the most appropriate course of action based on the cost efficiency and capability. Cost accounting provides the detailed cost information that management needs to control current operations and plan for the future.

Since managers are making decisions only for their own organization, there is no need for the information to be comparable to similar information from other organizations. Instead, information must be relevant for a particular environment. Cost accounting information is commonly used in financial accounting information, but its primary function is for use by managers to facilitate making decisions.

Unlike the accounting systems that help in the preparation of financial reports periodically, the cost accounting systems and reports are not subject to rules and standards like the Generally Accepted Accounting Principles. As a result, there is wide variety in the cost accounting systems of the different companies and sometimes even in different parts of the same company or organization.

A method of accounting in which all costs incurred in carrying out an activity or accomplishing a purpose are collected, classified, and recorded. This data is then summarized and analyzed to arrive at a selling price, or to determine where savings are possible.

In contrast to financial accounting (which considers money as the measure of economic performance) cost accounting considers money as the economic factor of production.

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Origins

All types of businesses, whether service, manufacturing or trading, require cost accounting to track their activities. Cost accounting has long been used to help managers understand the costs of running a business. Modern cost accounting originated during the industrial revolution, when the complexities of running a large scale business led to the development of systems for recording and tracking costs to help business owners and managers make decisions.

In the early industrial age, most of the costs incurred by a business were what modern accountants call "variable costs" because they varied directly with the amount of production. Money was spent on labor, raw materials, power to run a factory, etc. in direct proportion to production. Managers could simply total the variable costs for a product and use this as a rough guide for decision-making processes.

Some costs tend to remain the same even during busy periods, unlike variable costs, which rise and fall with volume of work. Over time, these "fixed costs" have become more important to managers. Examples of fixed costs include the depreciation of plant and equipment, and the cost of departments such as maintenance, tooling, production control, purchasing, quality control, storage and handling, plant supervision and engineering. In the early nineteenth century, these costs were of little importance to most businesses. However, with the growth of railroads, steel and large scale manufacturing, by the late nineteenth century these costs were often more important than the variable cost of a product, and allocating them to a broad range of products lead to bad decision making. Managers must understand fixed costs in order to make decisions about products and pricing.

For example: A company produced railway coaches and had only one product. To make each coach, the company needed to purchase $60 of raw materials and components, and pay 6 laborers $40 each. Therefore, total variable cost for each coach was $300. Knowing that making a coach required spending $300; managers knew they couldn't sell below that price without losing money on each coach. Any price above $300 became a contribution to the fixed costs of the company. If the fixed costs were, say, $1000 per month for rent, insurance and owner's salary, the company could therefore sell 5 coaches per month for a total of $3000 (priced at $600 each), or 10 coaches for a total of $4500 (priced at $450 each), and make a profit of $500 in both cases.

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INVESTOPEDIA EXPLAINS 'Cost Accounting'

While cost accounting is often used within a company to aid in decision making, financial accounting is what the outside investor community typically sees. Financial accounting is a different representation of costs and financial performance that includes a company's assets and liabilities. Cost accounting can be most beneficial as a tool for management in budgeting and in setting up cost control programs, which can improve net margins for the company in the future.

Cost accounting is the accounting of the cost. It is made of two words- Cost and Accounting. The term cost denotes the total of all expenditures involved in the process of production. Thus, it covers the costs involved in the production and the cost involved while receiving it. Accounting, on the other hand, collects and maintains financial records of each income and expenditure and make avail of such information to the concerned officials. Thus, cost accounting is a practice and process of cost which determines the profitability of a business concern by controlling the cost with the application of accounting principle, process and rules.

Cost accounting includes the presentation of the information derived there from for purposes of managerial decision making. Thus, cost accounting is a arts as well as science. It is science because it is a body of systematic knowledge having certain principles. It is an art as it requires the ability and skill with which a cost accountant is able to apply the principles of cost accounting in various managerial problems.

According to W.W.Bigg-“ Cost accounting is the provision of such analysis and classification of expenditure as will enable the total cost of any particular unit of production to be ascertained with reasonable degree of accuracy and at the same time to disclose exactly how such total cost is constituted.”

According to R.N. Carter, “Cost accounting is a system of recording in accounts the materials used and labour employed in the manufacture of a certain commodity or on a particular job.”

Thus, cost accounting is considered as an art as well as acinece. It is also a prime part of accounting system which records systematically the cost involved in raw materials and labour used in the process of production and the same time determines the total cost and unit cost of product. The process of recording classifying and analyzing of cost is the cost accounting.

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CHAPTER 2: Objectives & Importance of Cost Accounting

The main objectives of Cost Accounting are as follows:

Ascertainment of Cost

There are two methods of ascertaining costs, viz., Post Costing and Continuous Costing.

Post Costing means, analysis of actual information as recorded in financial books. It is accurate and is useful in the case of "Cost plus Contracts" where price is to be determined finally on the basis of actual cost.

Continuous Costing, aims at collecting information about cost as and when the activity takes place so that as soon as a job is completed the cost of completion would be known. This involves careful estimates being prepared of overheads. In order to be of any use, costing must be a continuous process.

Cost ascertained by the above two methods may be compared with the standard costs which are the target figures already compiled on the basis of experience and experiments.

Determination of selling price

Though the selling price of a product is influenced by market conditions, which are beyond the control of any business, it is still possible to determine the selling price within the market constraints. For this purpose, it is necessary to rely upon cost data supplied by Cost Accountants.

Cost control and cost reduction

"The guidance and regulation, by executive action of the cost of operating an undertaking". The word "guidance" indicates a goal or target to be guided; 'regulation' indicates taking action where there is a deviation from what is laid down; executive action denotes action to "regulate" must be initiated by executives i.e. persons responsible for carrying out the job or the operation; and all this is to be exercised through modern methods of costing in respect of expenses incurred in operating an undertaking.

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Ascertaining the profit of each activity

The profit of any activity can be ascertained by matching cost with the revenue of that activity. The purpose under this step is to determine costing profit or loss of any activity on an objective basis.

Assisting management in decision making

Decision making is defined as a process of selecting a course of action out of two or more alternative courses. For making a choice between different courses of action, it is necessary to make a comparison of the outcomes, which may be arrived under different alternatives. Such a comparison has only been made possible with the help of Cost Accounting information.

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Importance of Cost accounting

Cost accounting has much importance. Specially, the following parties are benefitted from it.

1. Importance to management

Management is highly benefitted with the introduction of cost accounting. It helps to ascertain the cost and selling price of the product. Cost data help management to formulate the business policies. The introduction of budgetary control and standard cost would be an aid to analyze cost. It’s also helps to find out reasons for profit or loss. It provides data to submit tender as well. Thus, cost accounting is an aid to management.

2. Importance to investors

Investors can obtain benefit from the cost accounting. Investors want to know the financial conditions and earning capacity of the business. An investor must gather information about organization before making investment decision and investor can gather such information from cost accounting.

3. Importance of consumers

The ultimate aim of costing is to reduce the cost of production to minimize the profit of business. Reduction in the cost is usually passed on the consumers in the form of lower price. Consumers get quality goods at a lower price.

4. Importance to Employees

Cost accounting helps to fix the wages of the workers. Efficient workers are rewarded for their efficiency. It helps to induce incentive wage plan in business.

5. Importance to Government

Cost accounting is one of the prime sources to provide reliable data to internal as well as external parties. It helps government agencies to determine excise duty and income tax. Government formulates tax policy, industrial policy, export and import policy based on the information provided by the cost accounting.

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CHAPTER 3: Introduction to Marginal Costing

Marginal Costing as a Costing System

Marginal Costing is a type of flexible standard costing that separates fixed costs from proportional costs in relation to the output quantity of the objects. In particular, Marginal Costing is a comprehensive and sophisticated method of planning and monitoring costs based on resource drivers. Selecting the resource drivers and separating the costs into fixed and proportional components ensures that cost fluctuations caused by changes in operating levels, as defined by marginal analysis, are accurately predicted as changes in authorized costs and incorporated into variance analysis.

This form of internal management accounting has become widely accepted in business practice over the last 50 years. During this time, however, the demands placed on costing systems by cost management requirements have changed radically.

Definition

The increase or decrease in the total cost of a production run for making one additional unit of an item. It is computed in situations where the breakeven point has been reached: the fixed costs have already been absorbed by the already produced items and only the direct (variable) costs have to be accounted for.

Marginal costs are variable costs consisting of labor and material costs, plus an estimated portion of fixed costs (such as administration overheads and selling expenses). In companies where average costs are fairly constant, marginal cost is usually equal to average cost. However, in industries that require heavy capital investment (automobile plants, airlines, mines) and have high average costs, it is comparatively very low. The concept of marginal cost is critically important in resource allocation because, for optimum results, management must concentrate its resources where the excess of marginal revenue over the marginal cost is maximum. Also called choice cost, differential cost, or incremental cost.

Marginal cost is the change in the total cost that arises when the quantity produced has an increment by unit. That is, it is the cost of producing one more unit of a good. In general terms, marginal cost at each level of production includes any additional costs required to produce the next unit. For example, if producing additional vehicles requires building a new factory, the marginal cost of the extra vehicles includes the cost of the new factory. In practice, this analysis is segregated into short and long-run cases, so that over the longest run, all costs become marginal.

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If the good being produced is infinitely divisible, so the size of a marginal cost will change with volume, as a non-linear and non-proportional cost function includes the following:

variable terms dependent to volume, constant terms independent to volume and occurring with the respective lot size, Jump fix cost increase or decrease dependent to steps of volume increase.

In practice the above definition of marginal cost as the change in total cost as a result of an increase in output of one unit is inconsistent with the differential definition of marginal cost for virtually all non-linear functions. This is as the definition finds the tangent to the total cost curve at the point q which assumes that costs increase at the same rate as they were at q. A new definition may be useful for marginal unit cost (MUC) using the current definition of the change in total cost as a result of an increase of one unit of output defined as: TC (q+1)-TC(q) and re-defining marginal cost to be the change in total as a result of an infinitesimally small increase in q which is consistent with its use in economic literature and can be calculated differentially.

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Marginal Cost

In economics and finance, marginal cost is the change in total cost that arises when the quantity produced changes by one unit. It is the cost of producing one more unit of a good. [1] Mathematically, the marginal cost (MC) function is expressed as the first derivative of the total cost (TC) function with respect to quantity (Q). Note that the marginal cost may change with volume, and so at each level of production, the marginal cost is the cost of the next unit produced.

Relation between Marginal Cost and Economies of Scale

Production may be subject to economies of scale (or diseconomies of scale). Increasing returns to scale are said to exist if additional units can be produced for less than the previous unit, that is, average cost is falling.

This can only occur if average cost at any given level of production is higher than the marginal cost.

Conversely, there may be levels of production where marginal cost is higher than average cost, and average cost will rise for each unit of production after that point. This type of production function is generally known as diminishing marginal productivity: at low levels of production, productivity gains are easy and marginal costs falling, but productivity gains become smaller as production increases; eventually, marginal costs rise because increasing output (with existing capital, labour or organization) becomes more expensive. For this generic case, minimum average cost occurs at the point where average cost and marginal cost are equal (when plotted, the two curves intersect); this point will not be at the minimum for marginal cost if fixed costs are greater than zero.

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Features of Marginal Costing

It is a method of recording costs and reporting profits;

All operating costs are differentiated into fixed and variable costs;

Variable cost –charged to product and treated as a product cost whilst

Fixed cost treated as period cost and written off to the profit and loss Account

Marginal costing is very helpful in managerial decision making. Management's production and cost and sales decisions may be easily affected from marginal costing. That is the reason; it is the part of cost control method of costing accounting. Before explaining the application of marginal costing in managerial decision making, we are providing little introduction to those who are new for understanding this important concept.

Marginal cost is change in total cost due to increase or decrease one unit or output. It is technique to show the effect on net profit if we classified total cost in variable cost and fixed cost. The ascertainment of marginal costs and of the effect on profit of changes in volume or type of output by differentiating between fixed costs and variable costs. In marginal costing, marginal cost is always equal to variable cost or cost of goods sold. We must know following formulae.

a) Contribution (Per unit) = Sale per unit - Variable Cost per unit

b) Total profit or loss = Total Contribution - Total Fixed Costs

Or Contribution = Fixed Cost + Profit

Or Profit = Contribution - Fixed Cost

c) Profit Volume Ratio = Contribution/ Sale X 100 (It means if we sell Rs. 100 product, what will be our contribution margin, more contribution margin means more profit)

d) Break Even Point is a point where Total sale = Total Cost

e) Break Even Point (In unit) = Total Fixed expenses / Contribution

f) Break Even Point (In Sales Value) = Breakeven point (in units) X Selling price per unit

g) Break Even Point at earning of specific net profit margin

= Total Contribution / Contribution per unit.

Or = fixed cost + profit / selling price - variable cost per unit.

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Direct Costing

The practice of charging all direct costs to operations, processes or products, leaving all indirect costs to be written-off against profit in the period in which they arise is called Direct Costing.

This differs from marginal costing in that some fixed costs could be considered to be direct costs in appropriate circumstances.

Contribution

Contribution is the difference between the sales and the marginal cost of sales. It contributes towards fixed expenses and profit.

The contribution margin is sales minus variable expenses.

Contribution margin = Sales - Variable Expenses

When the contribution margin is expressed as a percentage of sales it is referred to as the contribution margin ratio. The contribution margin per unit is the product’s selling price minus its variable costs and expenses.

Variable Cost

Variable Cost is a cost which tends to vary directly with volume of output. Variable costs are sometimes referred to as direct costs in system of Direct Costing.

Variable Expenses mean the total of the company’s variable costs plus its variable expenses.

Fixed Cost

Fixed Cost is a cost which tends to be unaffected by variations in volume of output. Fixed costs depend mainly on the efflux ion of time and do not vary directly with volume or rate of output.

Fixed costs are sometimes referred to as period costs in system of Direct Costing.

Fixed Expenses

Fixed expenses mean the company’s total amount of fixed costs plus its fixed expenses.

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Fixed costs and Fixed expenses

Fixed costs and fixed expenses are those which do not change as volume changes.

Variable costs and Variable expenses

Variable costs and variable expenses increase as volume increases and they will decrease when volume decreases. The relationship of contribution to Sales will remain constant under different levels of sales only if

1. Variable cost per unit remains constant.2. Fixed costs remain the same.3. Selling price per unit does not change.

The cost per unit of an item is important for

Setting the selling price Valuing stocks Calculating profitability

Terms and Definitions

Basic Equation:

Variable Cost = Direct Materials + Direct Labor + Direct Expenses

Variable cost per unit = Difference in cost / Difference in Activity level

Variable Cost is also called as Marginal Cost.

Marginal Cost Equation:

Sales (S) = Variable Cost (V) + Fixed Expenses (F) + or – Profit (P) / Loss (L)

S = Sales V = Variable Cost F = Fixed Expenses +P = Profit -P = Loss

Sales - Variable Cost = Fixed Expenses + or – Profit / Loss

S - V = F + or – P

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Contribution:

Sales – Variable Cost = Contribution = S - V

Fixed Expenses + or – Profit / Loss = Contribution = F + or – P

In simple form, S – V = F + or – P

Missing Factor:

In the above four factors, if any three factors are known, the remaining one can be easily found out.

Sales = Variable Cost + Fixed Expenses + Profit

Variable Cost = Sales – (Fixed Expenses + Profit)

Fixed Expenses = Sales – Variable Cost – Profit

Profit = Sales – Variable Cost – Fixed Expenses

Units sold:

Units sold = Contribution margin / Contribution margin per unit

Break Even Point:

A business is said to break even when its total sales are equal to its total costs. It is a point where there is no profit or no loss.

Contribution is equal to Fixed Expenses.

Break Even Point (in Units) = Total Fixed Expenses / (Selling Price per Unit – Marginal Cost per Unit)

The answer will be in units and not in value because breakeven point is based on unit cost.

Break Even Sales:

S – V = F + P

At Break Even Point Profit equals zero.

Hence, S – V = F

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For Break Even Point, the equation is S – V = F

Dividing both sides by S – V,

(S – V) / (S – V) = F / (S – V)

i.e. 1 = F / (S – V)

Multiplying both sides by S,

S * 1 = (F * S) / (S – V)

Therefore, the formula for the calculation of break even sales is:

(F * S) / (S – V)

Calculation of Sales for a desired or expected Profit:

(Fixed Expenses + Profit) / (Selling Price per Unit – Marginal Cost per Unit)

Or

(Fixed Expenses + Profit) / Contribution per Unit

The formula for the calculation of Sales to earn an expected or desired profit is:

((F + P) * S) / (S – V)

Profit / Volume Ratio or Contribution / Sales Ratio

(P/V Ratio) or (C/S Ratio)

P/V Ratio

Contribution / Sales i.e. C / S

Or

(Sales – Variable Cost) / Sales i.e. (S – V) / S

Or

(Fixed Expenses + Profit) / Sales i.e. (F + P) / S

Or

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Changes in contribution in two periods / Changes in Sales in two periods

Or

Changes in Profit in two periods / Changes in Sales in two periods

The ratio can be shown in the form of percentage if the formula is multiplied by 100.

This ratio can be used for the calculation of

Break Even Point is Fixed Costs / P/V Ratio = F / P/V Ratio

For the calculation of sales to earn a desired or expected profit is

(Fixed Costs + Profit) / P/V Ratio = F + P / P/V Ratio

Contribution / P/V Ratio

Variable Costs = Sales (1 – P/V Ratio)

Contribution is Sales x P/V Ratio

Margin of Safety (M/S)

It is the difference between the actual sales and the sales at break even point.

Sales or Output beyond break even point is known as margin of safety.

Margin of Safety (M/S) = Present Sales – Break Even Sales

Or

= Profit / P/V Ratio

Break-Even and Target Income

Sales = Total Variable Costs + Total Fixed Costs + Target Income

Where Target Income is zero, then

Sales = Total Variable Costs + Total Fixed Costs

Which is the Break even sales.

Break-Even Point in Units = Total Fixed Costs / Contribution Margin per Unit

Break-Even Point in Sales = Total Fixed Costs / Contribution Margin Ratio

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CHAPTER 4: Application of Marginal Costing

Application of Marginal Costing in Managerial Decisions

By effective use of marginal costing formulae, we can apply marginal costing for managerial decisions with following ways:

1st Application: Managerial Decision Relating to Determination of Optimum Selling Price

To determine the optimum selling price of any product or service is big challenge for a manager of any company because company wants to profit of each unit of any product or service. In marginal costing technique, fixed cost will not be changed at any level of production. Only variable cost is changed for getting optimum selling price where company can achieve expected profit.

2nd Application: To Check the Effect of Reducing of Current Price on profit

We all know, this is the time of competition, customer has become king. He wants product at minimum price. One example, we can see free video on YouTube. Instead of buying costly CDs and DVD, customers of entertainment industry see free films and movies on YouTube. But on the other side, company wants to maintain his current profit. At that time, manager will be in tension because it is not possible to maintain profit even after reducing price. But if manager learns marginal costing techniques and uses it effective way, they can check the effect of reducing of current price on net profit, after this, he can decide to reduce production or increase production. It is the law of economics, variable cost will reduce by reducing units of production in same proportion but when we increase production, fixed cost will fastly decreases due to constant nature.

3rd Application: Choose of Good Product Mix

It may be possible that company is producing more than one product, at that time company has to calculate each product's contribution margin or gross profit margin. After this, manager sees which product is giving high contribution margin. Company manager will give preference to that product whose contribution will high. One more decision can be taken by manger. He can check contribution by producing different quantity of different products. If he see any quantity of products is producing maximum contribution, it will be equilibrium point. Production of units at that quantity will be benefited to company.

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4th Application: Calculation of Margin of Safety

Marginal costing can be utilized for calculating margin of safety. Margin of safety is difference between actual sale and sale at breakeven point. According to marginal costing rules, production will follow sales. Suppose current sale is Rs. 4, 00,000 and BEP is Rs. 3, 00,000, margin of safety is Rs.100000. We can calculate it with following formula

= Profit/ P/V ratio

If company's sale is less than margin of safety, then manager can take step to reduce both fixed and variable cost or increase prices.

5th Application: Decision regarding to sell goods at Different Prices to Different Customers

Sometime, company has to give special discount to special customers. These customers may be govt., foreign companies or wholesaler. At that time manager has to take decision at what limit, we can give discount to special customers. Marginal costing may help in this decision.

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Advantages and Disadvantages of Marginal Costing

Advantages and Benefits of Marginal Costing

Cost control: Marginal costing makes it easier to determine and control costs of production. By avoiding the arbitrary allocation of fixed overhead costs, management can concentrate on achieving and maintaining a uniform and consistent marginal cost.

Simplicity: Marginal costing is simple to understand and operate and it can be combined with other forms of costing (e.g. budgetary costing and standard costing) without much difficulty.

Elimination of cost variance per unit: Since fixed overheads are not charged to the cost of production in marginal costing, units have a standard cost.

Short-term profit planning: Marginal costing can help in short-term profit planning and is easily demonstrated with break-even charts and profit graphs. Comparative profitability can be easily accessed and brought to the notice of the management for decision-making.

Accurate overhead recovery rate: This method of costing eliminates large balances left in overhead control accounts, which makes it easier to ascertain an accurate overhead recovery rate.

Maximum return to the business: With marginal costing, the effects of alternative sales or production policies are more readily appreciated and assessed, ensuring that the decisions taken will yield the maximum return to the business.

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Disadvantages and Limitations of Marginal Costing

Classifying costs: It is very difficult to separate all costs into fixed and variable costs clearly, since all costs are variable in the long run. Hence such classification sometimes may give misleading results. Furthermore, in a firm with many different kinds of products, marginal costing can prove less useful.

Accurately representing profits: Since the closing stock consists only of variable costs and ignores fixed costs (which could be considerable), this gives a distorted picture of profits to shareholders.

Semi-variable costs: Semi-variable costs are either excluded or incorrectly analyzed, leading to distortions.

Recovery of overheads: With marginal costing, there is often the problem of under or over-recovery of overheads, since variable costs are apportioned on an estimated basis and not on actual value.

External reporting: Marginal costing cannot be used in external reports, which must have a complete view of all indirect and overhead costs.

Increasing costs: Since it is based on historical data, marginal costing can give an inaccurate picture in the presence of increasing costs or increasing production.

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CHAPTER 5: The Limitation of Using the Marginal Costing Technique

Marginal costing is defined as the ascertainment of marginal cost and of the effect on profit of changes in volume or type of output by differentiating between fixed costs and variable costs.

Limitations of Marginal Costing Techniques:

1. It is difficult to classify exactly the expenses into fixed and variable category. Most of the expenses are neither totally variable nor wholly fixed.

2. Contribution itself is not a guide unless it is linked with the key factor.

3. Sales staff may mistake marginal cost for total cost and sell at a price; which will result in loss or low profits. Hence, sales staff should be cautioned while giving marginal cost.

4. Overheads of fixed nature cannot altogether be excluded particularly in large contracts, while valuing the work-in-progress. In order to show the correct position fixed overheads have to be included in work-in-progress.

5. Some of the assumptions regarding the behavior of various costs are not necessarily true in a realistic situation. For example, the assumption that fixed cost will remain static throughout is not correct.

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Conclusion

Marginal costing is a useful analysis tool which usually helps management make decisions and understand the answer to specific questions about revenue.

That said, it is not a costing methodology for creating financial statements. In fact, accounting standards explicitly exclude marginal costing from financial statement reporting. Therefore, it does not fill the role of a standard costing, job costing, or process costing system, all of which contribute actual changes in the accounting records.

Still, it can be used to discover relevant information from a variety of sources and aggregate it to help management with a number of tactical decisions. It is most useful in the short-term, and least useful in the long-term, especially where a firm needs to generate sufficient profit to pay for a large amount of overhead.

Furthermore, direct costing can also cause problems in situations where incremental costs may change significantly, or where indirect costs have a bearing on the decision.

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