Application of Marginal Costing

Marginal Costing
Marginal costing is a special technique of analysis and presentation of costs, which helps the
management in decision-making. This technique enables the management to understand the
effect of a change in a volume of output on costs and profit.
Marginal costing is also known as variable costing. In marginal costing, the cost of a unit
comprises only variable costs. Fixed costs are treated as period costs and written off to costing
Profit & Loss Account. Consequently, finished goods and work in progress are valued at
marginal cost i.e. Prime cost plus variable overheads.

Under the technique of Marginal costing, cost of production includes variable overheads only
and fixed overheads are, totally, excluded. As a result, cost of production per unit remains the
same up to a particular level of output. Under the technique of Marginal costing, fixed expenses
are not allocated to cost units but charged against a “Fund”, which arises out the excess of selling
price over total variable costs.

Marginal costing is Technique of Costing. Eight areas where marginal costing is applied:

1. Cost control
2. Evaluation of performance
3. Profit planning
4. Decision making: marginal cost helps in short-term decision-making.
a) Effect of change in sale price
b) Key factor
c) Special Order Decision
d) Make or buy decision
e) Selection of a good sales mix
f) Entering new markets
g) Closing down activities
h) Alternative methods of production or distribution

Assumptions of Marginal Costing:

1. All elements of cost–production, administration and selling and distribution can be divided into fixed
and variable components.

2. Variable costs remain constant per unit and so they vary, with the level of production, proportionately.

3. Selling price per unit is constant at all levels. In other words, selling price does not fall, even if more
units are sold.

4. Fixed costs are constant or unchanged for the entire volume of production.

5. Volume of production or output only influences the costs.

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Application of Marginal Costing

I. EFFECT OF CHANGE IN SALE PRICE

1. Quality products Ltd. manufactures and markets a single product. The following data is available in
Rs. per unit

Materials - 16, Conversion Cost - 12, Dealer Margin –4, Selling Price – 40, Fixed Cost Rs. 5 lakh.

Present Sales: 90,000 units, Capacity Utilization 60%.

Due to severe competition in the market, the firm realized concerted efforts are necessary to increase
sales. The following suggestions have been made for increasing sales.

(a) By reducing the sale price by 5%.

(b) By increasing the dealer’s margin by 25% over the existing rates.

Which of these suggestions would you recommend?

II. KEY FACTOR

1. The cost analysis of two products A and B is given below:

Particulars Product A (Rs.) Product B (Rs.)

Material Rs. 2.50 per unit 25 45

Labor @ Rs. 1 per hour 12 --
Labor @ Rs. 1.50 per hour -- 15
Variable overheads 2 5
Selling Price 70 80

On the basis of above information, which product would you recommend to be

manufactured if labor is key factor and if material is key factor?

Particulars Product A (Rs.) Product B (Rs.)

Selling Price 70 80
Material Rs. 2.50 per unit 25 45
Labour 12 15
Variable 2 5
Contribution 31 25
Contribution per unit of M 31/ 10 = 3.1 25/ 18 = 1.39

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Application of Marginal Costing

III. SPECIAL ORDER DECISION

1. A firm, having a capacity of 15,000 units per year, produces 10,000 units, which are
consumed in home market at Rs.25 per unit. The cost per unit (Rs.) is as under:

Material 8.00, Labour 6.00,

Factory Expenses: Fixed 2.00, Variable 1.50
Office Expenses (Fixed) 1.00
Selling Expenses: Fixed 0.50 Variable 1.00
Total Cost 20.00

A foreign consumer is interested in the product and is willing to buy 5,000 units at a price
of Rs. 18 per unit only. Do you advise the firm to accept the order? Justify your
recommendation, with suitable reasoning.

IV. MAKE OR BUY DECISION

1. To manufacture product A it takes 20 hours on machine no. 101. It has a selling price
of Rs.150 and a marginal cost of Rs.110. Component part Y could be made on
machine no. 101 in 4 hours. The marginal cost of component part is Rs.9 and the
supplier’s price is Rs.15.
Should one make or buy component Y?
a) Discuss when Machine no. 101 is working at full capacity
b) There is idle capacity

V. SELECTION OF A GOOD SALES MIX

1. Mitanshi & company manufacture three products. The following is the cost data
relating to products A, B, and C.

Products A B C Total
Sales 1,50,000 90,000 60,000 3,00,000
Variable Cost 1,20,000 63,000 36,000 2,19,000
Contribution 30,000 27,000 24,000 81,000
Fixed Cost 40,500
Profit 40,500

Prove that how knowledge of marginal costing can help management in changing the
sales mix in order to increase profit of the company.

VI. ENTERING NEW MARKETS

1. The following budget has been prepared at 70% level of home market:

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Application of Marginal Costing
Units ‐ 4, 200, Wages ‐ 12, 600, Materials ‐ 21, 000, Fixed cost ‐ 7, 000, Variables cost ‐
2, 100, Total ‐ 42, 700

The selling price in India is Rs. 15. In Sri Lanka about 800 units may be sold only at Rs.
10 and in addition 25 paise per unit will be expenses as freight etc, Do you advise
exploring the market in the Sri Lanka?

VII. CLOSING DOWN ACTIVITIES

1. Asian paints manufacture 1, 000 tins of paints when working at normal capacity. It
incurs the cost of Rs. 16 in manufacturing one unit. The details of this cost are given
below:
Particulars Rs. per unit
Direct Material 7.50
Direct Labour 2.00
Variable Overheads 2.50
Fixed Overheads 4.00
Production Cost 16.00

Each unit of product is sold for Rs. 20 with variable selling and administrative expenses
of Rs. 0.50 per unit of production.

During the next 3 months, only 500 units can be produced and sold. Management plans to
close down the factory estimating that the fixed manufacturing cost can be reduced to Rs.
2, 000 for the quarter.

When the plant is operating, the fixed overhead costs are incurred at a uniform rate
throughout the year. Additional cost of plant shut down for the three month is estimated
at Rs. 2, 800.

Express your view whether the plant should be shut down for three months, and calculate
the shut down point for three months in units of products.

VIII. ALTERNATIVE METHODS OF PRODUCTION OR DISTRIBUTION

1. A company is providing its product to the consumer through the wholesalers. The managing
director of the company thinks that if the company starts selling through retailers or to the
consumers directly, it can increase its sales, charge higher prices and make more profit.

On the basis of the following information, advise the managing director whether the
company should change its channel of distribution or not:

Particulars Wholesaler Retailer Consumer

Rs. Rs. Rs.
Sales per unit 3.60 5.25 6.00

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Application of Marginal Costing
Estimated Sales p.a (units) 1,00,000 1,20,000 1,80,000
Selling and Distribution 0.40 1.00 1.50
overhead (per unit)

Cost of production: Variable cost Rs. 2.50 per unit, Fixed cost Rs. 50, 000.

2. A company has a machine No. 9 which can produce either product A or B. The cost data
relating to machine A and B are as follows:

Particulars Product A Product B

Selling Price Rs.20.00 Rs.30.00
Variable Cost Rs.14.00 Rs.18.00
Contribution Rs.6.00 Rs. 12.00

Additional Information:
a. Capacity of machine No. 9 is 1, 000 hrs.
b. In one hour machine No. 9 can produce 3 units of A and 1 unit of B.
Which product should machine No. 9 produced?

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