Definition
Marginal costing, also known as variable costing, is a management accounting method where only variable costs associated with production are charged to products and fixed costs are treated as period charges. In this method, fixed costs are considered when calculating the profit or loss, and not when calculating the cost per unit. Essentially, it’s a method that helps firms ascertain variable costs per unit, measure cost-volume-profit relationships, and make short-term business decisions.
Key Takeaways
- Marginal costing, also known as cost-variable costing, is a strategy that businesses use to track the marginal cost per unit produced. It considers variable costs as the cost of production and fixed costs as the period costs.
- This costing method is beneficial for decision-making process in management accounting. It helps in providing a clearer picture of variable versus fixed costs, thus allowing businesses to understand what drives their costs and improve budgeting and forecasting activities.
- However, Marginal costing can potentially lead to short-term thinking because fixed costs are not allocated to specific products. Therefore, it may not accurately represent the total production costs when producing multiple products.
Importance
Marginal costing is a key financial tool that plays a pivotal role in managerial decision making.
It is important because it denotes the expense of producing one additional unit of a product or service, providing decision-makers with essential data on how production volume relates to costs.
This information can help management evaluate the economic viability of increasing their production quantities and identify the production scale at which they maximize their profit.
Moreover, marginal costing aids in pricing decisions by revealing the minimum price at which a product ought to be sold to avoid a loss.
It further helps in pinpointing inefficiencies and identifying cost control opportunities, thereby increasing the overall profitability and competitiveness of a business.
Explanation
The primary purpose of marginal costing, also known as variable costing, is to provide an in-depth understanding of business costs and how they react to changes in the production volumes. In essence, it is a managerial accounting tool that bifurcates total costs into fixed and variable costs, thereby helping businesses make informed strategic decisions.
By isolating variable costs that significantly affect the cost per unit as the production number changes, firms can use marginal costing techniques to analyze the impact of different levels of production or sales. Marginal costing is widely used for decision making and profit planning, aiding organizations in cost control, pricing decisions, and profitability analysis.
It clarifies the effect on profit of fluctuations in the volume of output or turnover and assists in the set-up of flexible budgets. With a complex product line, marginal costing can help identify the profitability of each, thereby directing attention towards the most profitable goods or services.
It also plays a critical role in tactical short-term decision-making contexts where it helps in accepting or rejecting a special order, making a decision on the selling price, choosing alternatives that maximize return, etc.
Examples of Marginal Costing
Manufacturing Industries: Marginal costing is commonly used in manufacturing industries. For example, a car manufacturer who has to decide on the production of an additional unit of a particular car model uses this method. The cost of additional raw materials, labor, and other variable direct costs associated with the additional production is calculated as the marginal cost.
Airlines: Airlines might use marginal costing to decide the pricing for additional seats. The fixed costs, including the cost of the aircraft, personnel, and fuel, are incurred regardless of the number of passengers. However, the cost of serving an extra passenger – such as food, beverage, or an in-flight entertainment system – is considered the marginal cost. Based on this they can determine the minimum ticket price.
Restaurant Business: Marginal costing can also be applied in the restaurant business. For a restaurant that is already operational, the fixed costs like rent, salaries, utilities are already being covered. The cost the restaurant incurs when they serve an additional plate of food (cost of ingredients, extra energy used for cooking that dish, etc.) represents the marginal cost. This is often used to make decisions about pricing or introducing new dishes to the menu.
Frequently Asked Questions about Marginal Costing
What is Marginal Costing?
Marginal Costing, also known as variable costing, is an accounting system in which variable costs are charged to cost units and fixed costs of the period are written off in full against the aggregate contribution. It’s a method where the cost of a product is calculated by only considering the costs that change with the volume of production.
What are the main components of Marginal Costing?
The main components of Marginal Costing are variable costs, fixed costs, and selling price. Variable costs are costs that increase or decrease with the level of output, fixed costs are costs that do not change with the level of output, and selling price is the cost at which the product is sold.
How does Marginal Costing benefit businesses?
Marginal Costing is distinguished by its simplicity and by providing management with clear decision making tools. It is beneficial to businesses by offering a straightforward approach to determining a product’s profitability, the optimal production volume, and the impact of changing costs on a product’s selling price.
What is the difference between Marginal Costing and Absorption Costing?
In Marginal Costing, only variable costs are included in product cost while in Absorption Costing, both fixed and variable costs are included in product cost. Marginal Costing is used primarily for internal reporting whereas Absorption Costing is used for both internal and external reporting.
What is the concept behind Marginal Costing?
The concept behind Marginal Costing is that costs can be divided into variable costs and fixed costs. The variable costs, which vary with the level of output, are assigned to the units of output and the fixed costs, which relate to a period of time, are charged in full against the revenue of the same period.
Related Entrepreneurship Terms
- Variable Costs
- Contribution Margin
- Break-Even Point
- Absorption Costing
- Cost-Volume-Profit Analysis
Sources for More Information
- Investopedia – A comprehensive source for financial education. Therefore, you can find detailed information about Marginal Costing.
- AccountingTools – This site provides educational articles and books on finance and accountancy, including topics like Marginal Costing.
- Corporate Finance Institute – This professional training institute provides online courses and articles on financial analysis, modeling, and valuation including detail explanation of Marginal Costing.
- Khan Academy – An online learning resource offering lessons about variety of subjects including finance and capital markets.
