Cost and Management Accounting 2010 (Solved)

Margianl Costing is a technique of decision making, which involves:
(a) Ascertainment of total costs
(b) Classification of costs into
                (1) Fixed and (2) Variable
(c) Use of such information for analysis and decision making.

Thus, 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. Marginal costing is mainly concerned with providing information to management to assist in decision making and to exercise control. Marginal costing is also known as ‘variable costing’ or ‘out of pocket costing’

Advantages of Marginal Costing:

Marginal costing technique is frequently used for short-term decision-making. It helps management in the following areas —

a)      Cost control: - Marginal costing divides total cost into fixed and variable cost. Fixed Cost can be controlled by the Top management to a limited extent and Variable costs can be controlled by the lower level of management. Marginal costing by concentrating all efforts on the variable costs can control total cost.
b)      Profit Planning: - It helps in short-term profit planning by making a study of relationship between cost, volume and Profits, both in terms of quantity and graphs. An analysis of contribution made by each product provides a basis for profit-planning in an organisation with wide range of products.
c)       Fixation of selling price: - Generally prices are determined by demand and supply of products and services. But under special market conditions marginal costing is helpful in deciding the prices at which management should sell. When marginal cost is applied to fixation of selling price, it should be remembered that the price cannot be less than marginal cost. But under the following situation , a company shall sell its products below the marginal cost:
                (i) To maintain production and to keep employees occupied during a trade depression.
                (ii) To prevent loss of future orders.
                (iii) To dispose of perishable goods.
                (iv) To eliminate competition of weaker rivals.
                (v) To introduce a new product.
                (vi) To help in selling a co-joined product which is making substantial profit?
                (vii) To explore foreign market

d)      Make or Buy: - Components and spare parts may be made in the factory instead of buying from the market. In such cases, the marginal cost of manufacturing the components or spare parts should be compared with market price while taking decision “to make or buy”. If marginal cost is lower than the market price, it is more profitable to make than purchasing from market.

e)      Evaluation of Performance: - The different products and divisions have different profit earning potentialities. The Performance of each product and division can be brought out by means of Marginal cost analysis, and improvement can be made where necessary.

f)       Limiting Factor: - when a limiting factor restricts the output, a contribution analysis based on the limiting factor can help maximising profit. For example, if machine availability is the limiting factor, then machine hour utilisation by each product shall be ascertained and contribution shall be expressed as so many rupees per machine hour utilized. Then, emphasis is given on the product which gives highest contribution.

g)      Helpful in taking Key Managerial Decisions:- In addition to above, the following are the important areas where managerial problems are simplified by the use of marginal costing :
        a) Selection of Suitable Product mix.
        b) Analysis of Effect of change in Price.
        c) Maintaining a desired level of profit.
        d) Alternative methods of production.
        e) Diversification of products.
        f) Alternative course of action etc.

a)      Misleading Results: It is very difficult to segregate all costs into fixed and variable costs very clearly, since all costs are variable in the long run. Hence such segregation sometimes may give misleading results.
b)      Distorted Picture of Profits: The closing stock consists of variable cost only and ignores fixed costs. This gives Distorted Picture of Profits.
c)       Avoids Semi-Variable Costs: Semi-Variable costs are not considered in the analysis.
d)      Problem of Recovery of Overheads: There is problem of under or over-recovery of overheads, since variable costs are apportioned on estimated basis and not on the actuals.
e)      Ignorance of Time Factor: Since the time factor is completely ignored; comparison of performance between two periods on the basis of contribution alone will give the misleading results.
f)       Under marginal costing, stocks and work in progress are understated. The exclusion of fixed costs from Stock Valuation affects profit, and true and fair view of financial affairs of an organization.
g)      Marginal cost data becomes unrealistic in case of highly fluctuating levels of production, e.g., in case of seasonal factories.
h)      It can correctly assess the profitability on a short-term basis only, but for long term it is not effective.
i)        It does not provide any effective yardstick for evaluation of performance.
j)        Contribution of marginal costing is not a foolproof indicator of profitability.
k)      Marginal cost, if confused with total cost while fixing selling price may lead to a disaster.