MARGINAL COST OR VARIABLE COST OR DIRECT COST

Marginal cost is the variable cost of one more unit of a product or service. As such, it arises from additional increments of output. Marginal costing considers only variable cost ( those costs of production that vary with output) in calculating the cost of the product while fixed costs are charged against the revenue (sales) of the product.

Thus, Marginal cost or variable cost = Prime cost (Direct Materials + Direct Labour + Direct expenses )+ Total Variable Overheads

Or

Marginal Cost or variable cost = Total cost - Fixed Cost

MARGINAL COST OR VARIABLE COST OR DIRECT COST

Thus, here variable costs are treated as product cost and fixed costs are not treated as product cost. Fixed manufacturing cost are part of part of period cost.

MARGINAL or VARIABLE or DIRECT COSTING

The revenue arising from the sales over variable costs is technically known as Contribution under marginal costing.

Marginal costing is considered superior to absorption costing so far as managerial decision making is considered. It identifies only such costs with the jobs or products which directly vary with the level of output. Consequently the cost of goods in inventory or cost of goods sold under this method does not contain any fixed overhead cost.

Thus the uncertainty and irrationality associated with apportionment of fixed cost in traditional costing is thus avoided.

MARGINAL COST contd.

A factory produces 500 bicycles per annum. The variable cost per by cycle is US$ 100. the fixed expenses are US$ 10000 per annum.

The cost sheet of bicycle will appear as follows: US $

Variable cost (500 X US$ 100) 50000

Fixed cost 10000___

60000___

If production is increased by one unit i.e. if it becomes 501 bicycles per annum, the cost sheet will appear as follows :

US $

Variable cost (501 X US$ 100) 50100

Fixed cost 10000___

60 100___

The marginal cost is therefore US$ 100

DIFFERENCE BETWEEN ABSORPTION COSTING AND VARIABLE (MARGINAL COSTING)

Recovery of Overheads: In case of absorption costing, both fixed and variable overheads are charged to production while in case of marginal costing only variable overheads are charged to production.

Valuation of stocks: Absorption costing of stocks of work-in-progress and finished goods are valued at work cost and total cost of production respectively. Work cost and cost of production is defined to include fixed overheads too.

While in marginal costing, only variable costs are considered while computing the value of work-in-progress or finished goods. Thus, closing stock is undervalued in marginal costing as compared to absorption costing.

DIFFERENCE BETWEEN ABSORPTION COSTING AND VARIABLE (MARGINAL COSTING)

CONTRIBUTION and PROFIT

Contribution is the difference between selling price and variable cost. It is sum of fixed cost and profit.

Contribution or Gross Margin = Selling Price (total revenue) – Variable Cost (marginal cost)

Contribution= (Variable cost + Fixed cost + Profit) – variable cost

Contribution= Fixed cost + Profit

Or, Profit = Contribution – Fixed cost

Or, Fixed cost = Contribution – profit

Let us take an example.

Variable cost Rs 5000

Fixed cost Rs. 2000

Selling Price Rs 8000

Contribution = Selling price – variable cost

= Rs 8000 – Rs 2000

= Rs 3000

Profit = Contribution – fixed cost

= Rs 3000 – Rs 2000

= Rs 1000

As contribution exceeds fixed cost, there is a profit of Rs. 1000.

If fixed cost is assumed as Rs 4000, the position will change as:

Contribution – fixed cost = Negative Profit (loss)

= Rs 3000 – Rs 4000

= Rs 1000

The sum of Rs 1000 represents the extent of loss since the fixed costs are more than the contribution. At the level of foxed cost of Rs 3000, there shall be no profit and no loss. The concept of break-even analysis arises out of this basic fact.

CONTRIBUTION or GROSS MARGIN contd.

Example 1: Tripura Ltd is manufacturing three product : A, B, C. the cost of manufacture are as follows

A B C

Direct Material per unit

Rs 3 Rs 4 Rs 5

Direct labour per unit Rs 2 Rs 3 Rs 3

Selling price per unit Rs 10 Rs 15 Rs 20

Output 1000 units 1000 units 1000 units

The total overhead costs are Rs.12000 out of which Rs. 9000 are fixed and the rests are variable. It is decided to apportion these costs over different products in the ratio of output. From the above data, prepare a statement of cost and profit according to Marginal Costing.

Example 1: solution

Statement showing Profit And Cost (Marginal Costing )

Product A_____

_____Product _B __ ____Product C _____

Per unit Rs

Total Rs

Per unit Rs

Total Rs

Per unit Rs

Total Rs

Direct material Direct labour

Variable OverheadsTotal Marginal CostContribution (Sales – MC)Selling price

32

1

30002000

1000

43

1

40003000

1000

54

1

50004000

1000

6 4

60004000

87

80001000

1010

1000010000

10 10000 15 15000 20 20000

Example 1: solution contd.

Total profit under marginal costing would be:

Total Contribution Rs.

Product A 4000 Product B 7000 Product C 10000 21000Less: Fixed Cost Product A 3000 Product B 3000 Product C 3000 9000 Profit 12000

Example 2: Tripura Ltd is manufacturing three product : A, B, C. the cost of manufacture are as follows

A B C

Direct Material per unit

Rs 3 Rs 4 Rs 5

Direct labour per unit Rs 2 Rs 3 Rs 3

Selling price per unit Rs 10 Rs 15 Rs 20

Output 1000 units 1000 units 1000 units

The total overhead costs are Rs.12000 out of which Rs. 9000 are fixed and the rests are variable. It is decided to apportion these costs over different products in the ratio of output. Prepare a statement showing the cost and profit of each product according to marginal costing.

Calculate amount of profit and profit and loss made by Tripura Ltd in the first two years of its existence, presuming thati. In the first year, it manufactures 1000 units of each product A, B, C but fails to effect any sales. ii. In the second year, it does not produce anything but sells the entire stock carried forward

from the first year. iii. What fallacious conclusions can be drawn from the results.

Solution : Example2 Tripura Limited

Profit and loss Account of 1st Year (as per marginal costing)

Rs Rs

Direct material ABC

Direct labour ABC

Overhead: variables

A 1000B 1000C 1000

Fixed -----

300040005000___ 12000

200030004000___ 9000

30009000 _12000__ ___33000_

Sales Closing Stock Loss

-----24000 9000

___________33000_

Solution : Example 2 contd.

Tripura Limited Profit and loss Account of 2nd Year (as per marginal costing)

Rs Rs

Opening Stock Fixed overhead Profit

24000 9000 12000

_______45000__

Sales A BC

100001500020000_ 45000

______ 45000_

The above Profit and Loss accounts shows that the company suffered a loss of Rs.9000 in the first year because of non-recovery of fixed overheads while in the second year it makes a profit of Rs. 12000. It may be seen from the profit and loss account that the fixed cost of one year has been carried forward to the next year. Thus, the profit and loss account gives the correct picture according to marginal costing.

Example 3: Tripura Ltd is manufacturing three product : A, B, C. the cost of manufacture are as follows

A B C

Direct Material per unit

Rs 3 Rs 4 Rs 5

Direct labour per unit Rs 2 Rs 3 Rs 3

Selling price per unit Rs 10 Rs 15 Rs 20

Output 1000 units 1000 units 1000 units

The total overhead costs are Rs.12000 out of which Rs. 9000 are fixed and the rests are variable. It is decided to apportion these costs over different products in the ratio of output. From the above data, prepare a statement of cost and profit according to Marginal Costing.

Compute the amount of profit under absorption costing and marginal costing in case units of goods sold of products A, B, C are 900 each.

Example 3: solution

Statement showing Profit And Cost

(Absorption Costing )

Product A_____

_____Product _B _____ ____Product C _____

Total Rs

Total Rs

Total Rs

Direct material Direct labour Variable OverheadsTotal Marginal (variable) CostAdd: Fixed Overheads

Total cost of production Less: Closing Stock Cost of goods sold Profit (sales – cost of goods sold)

300020001000

400030001000

500040001000

60003000

80003000

100003000

9000900

110001100

130001300

8100900

99003600

11700 6300

Sales 9000 13500 18000

Total profit under absorption costing is

Total Profit Rs._______

Product A 900 Product B 3600 Product C 6300 Rs 10800

Example 3: solution contd.

Example 3: solution

Statement showing Profit And Cost (Marginal Costing )

Product A_____

_____Product _B _____

____Product C _____

Total Rs

Total Rs

Total Rs

Direct material Direct labour Variable Overheads

300020001000

400030001000

500040001000

Total Marginal CostLess: Closing Stock Cost of goods sold Contribution (Sales – MC)Sales

6000 600

8000 800

10000 1000

54003600

72006300

90009000

9000 13500 18000

Example 3: solution contd.

Total profit under marginal costing would be:

Total Contribution Rs.

Product A 3600 Product B 6300 Product C 9000 18900Less: Fixed Cost Product A 3000 Product B 3000 Product C 3000 9000 Profit Rs. 9900