UNIT 13: MARGINAL COSTING
Structure
13.0 Objectives
13.1 Introduction
13.2 Segregation of Mixed Costs
13.3 Concept of Marginal Cost and Marginal Costing
13.4 Income Statement under Marginal Costing and Absorption Costing
13.5 Marginal Costing Equation and Contribution Margin
13.6 Profit-Volume Ratio
13.7 Managerial Uses of Marginal Costing
13.8 Limitations of Marginal Costing
13.9 Summary
13.10 Key Words
13.11 Answers to Check Your Progress
13.12 Terminal Questions
13.13 Further Readings
13.0 OBJECTIVES
The aims of this unit are:
●● to introduce you with the concept of marginal costing;
●● to explain the income statement under marginal costing and how it
differs from absorption costing; and
●● to discuss the merits and limitations of marginal costing along with
developing a marginal cost equation uses of marginal costing in
managerial decisions.
13.1 INTRODUCTION
The elements of costs can be divided into fixed and variable costs. You have
learnt these elements of cost in detail under Unit 2. You have also learnt that
there are certain costs which are a combination of fixed and variable costs.
These costs are called semi-variable costs. It is necessary to segregate the
mixed costs into fixed and variable costs for managerial decisions. In this
unit you will study about different methods of segregating mixed costs, the
concept of marginal cost and marginal costing and its managerial uses in
decision making.
13.2 SEGREGATION OF MIXED COSTS
The elements of cost can be divided into two categories. Fixed and
variable costs. Fixed costs are those costs which do not vary but remain
constant within a given period of time in spite of fluctuations in production.
variable costs changes in direct proportion to the change in output. There
253
,Standard Costing and are certain costs, which are a combination of fixed, and variable costs. It
Variance Analysis contains a fixed element as well as a unit cost for variable expenses. Such
costs increase with production but the change is less than the proportionate
change in production. These costs are called semi-variable or semi-fixed or
mixed costs. Example of these costs are depreciation, power, telephone etc.
Rent of the telephone is fixed in a given period and per unit call charges
is a variable component. For decision making, it becomes necessary to
segregate the mixed costs into fixed and variable costs.
Methods of Segregating Mixed Cost
The following methods are applied to segregate the mixed costs into fixed
costs and variable costs:
1) Analytical Method: A careful analysis of mixed cost is done to
determine how far it varies with production. Some semi-variable
costs may have 60 percent variability while other have 40 percent
variability. Accuracy of this method depends upon the knowledge,
experience and judgement of the analyst. This method is simple but
not scientific.
2) High Low Method: This technique was developed by J.H. William.
In this method, the difference in two production levels i.e. highest and
lowest, are compared out of the various levels. Since the fixed cost
component remains constant, any increase or decrease in total semi-
variable cost must be attributed to the variable portion. The variable
cost per unit can be determined by dividing difference in total semi-
variable cost with the difference in production units at two levels.
Illustration 1
From the following information, find out the fixed and variable components.
Production (in units) Semi-Variable Costs
Rs.
100 1500
200 2000
250 2250
300 2500
Highest production is 300 units, then semi-variable costs is Rs. 2500. Lowest
production is 100 units, then semi-variable costs is Rs. 1500.
Difference in Costs
Variable Cost Per unit =
Difference in Volume
Rs. 2500 – Rs. 1500
=
300 – 100
Rs. 1000
= = Rs. 5
200
Total semi-variable costs = Fixed Cost + Variable costs per unit production
2500 = F + Rs. 5 × 300 units
F = Rs. 1000
254
,High-low method is based on observations of extreme data, hence the result Marginal Costing
may not be very accurate as it is based on extreme points and may not be
true for normal situation.
Scatter Diagram Method
In this method, production and semi-variable cost data are plotted on a graph
paper and tentative line of best fit is drawn. The following steps are involved:
●● Volume of production is plotted on x-axis and semi-variable costs on
y-axis.
●● Corresponding semi-variable costs of each volume of production are
plotted on a graph.
●● A line of best fit is drawn through the points plotted. The point where
this line intersects with y-axis, depicts the fixed cost.
●● Variable cost can be determined at any level by subtracting the fixed
cost element. The slope of the total cost curve is the variable cost per
unit
Total Semi-Variable Cost
Semi Variable
Fixed Cost
Cost
Output
The accuracy of line of best fit, depends upon the judgement and experience
of the analyst. One may draw slightly up or slightly down, the intercept on
y-axis will change or two analyst may draw a line having different slopes.
This method involves analyst’s subjectivity and may not give accurate
results.
Method of Least Square:
This method is based on econometric technique, in which line of best fit is
drawn with the help of linear equations.
The equation of a straight line is
y=a+bx
Where ‘a’ is the intercept on y-axis and ‘b’ is the slope of the line. Hence
‘a’ is the fixed cost component and ‘b’ is the slope or tangent of the line or
variable cost per unit. From the above equation, two equation can be drawn.
∑y = na + b ∑ x
∑ xy = a∑ x + b ∑ x2
Solving the equations, will give us the value of ‘a’ (fixed cost) and ‘b’
(variable cost per unit).
255
, Marginal Costing and Cost Illustration 2
Volume Profit Analysis
From the following semi-variable cost information, compute the fixed cost
and variable cost components.
Production Semi-variable
(Units) (Rs.)
100 1200
200 1350
150 1250
190 1380
180 1375
Solution
Month Production Semi-variable
X Y X2 XY
April 100 1200 10000 120000
May 200 1350 40000 270000
June 150 1250 22500 187500
July 190 1380 36100 262200
August 180 1375 32400 247500
Total ∑X = 820 ∑Y = 6555 ∑X2 141000 ∑XY = 1087200
∑y = na + b ∑ x
∑ xy = a∑ x + b ∑ x2
Solving these equations
6555 = 6 a + 820 b
1087200 = 820 a + 141000 b
a = Rs. 1004.632
b = Rs. 1.868
After segregating the mixed costs into fixed cost and variable costs, the
fixed component is added to fixed costs and variable component to variable
costs. Now we have only two costs i.e. fixed costs and variable costs.
13.3 CONCEPT OF MARGINAL COST AND
MARGINAL COSTING
The term ‘Marginal Cost’ is defined as the amount at any given volume of
output by which the aggregate costs are changed if the volume of output
is increased or decreased by one unit. In this context a unit may be single
article, a batch of articles or an order. It is the variable cost of one unit of
a product or a service. For example, the cost of 100 articles is Rs. 50,000
and that of 101 articles is Rs. 50,450, the marginal cost is Rs. 450 (i.e., Rs.
50,450 –50,000).
Thus, the total cost is the aggregate of fixed cost and variable cost and
if production is increased by one more unit, its cost can be computed as
follows:
256
Structure
13.0 Objectives
13.1 Introduction
13.2 Segregation of Mixed Costs
13.3 Concept of Marginal Cost and Marginal Costing
13.4 Income Statement under Marginal Costing and Absorption Costing
13.5 Marginal Costing Equation and Contribution Margin
13.6 Profit-Volume Ratio
13.7 Managerial Uses of Marginal Costing
13.8 Limitations of Marginal Costing
13.9 Summary
13.10 Key Words
13.11 Answers to Check Your Progress
13.12 Terminal Questions
13.13 Further Readings
13.0 OBJECTIVES
The aims of this unit are:
●● to introduce you with the concept of marginal costing;
●● to explain the income statement under marginal costing and how it
differs from absorption costing; and
●● to discuss the merits and limitations of marginal costing along with
developing a marginal cost equation uses of marginal costing in
managerial decisions.
13.1 INTRODUCTION
The elements of costs can be divided into fixed and variable costs. You have
learnt these elements of cost in detail under Unit 2. You have also learnt that
there are certain costs which are a combination of fixed and variable costs.
These costs are called semi-variable costs. It is necessary to segregate the
mixed costs into fixed and variable costs for managerial decisions. In this
unit you will study about different methods of segregating mixed costs, the
concept of marginal cost and marginal costing and its managerial uses in
decision making.
13.2 SEGREGATION OF MIXED COSTS
The elements of cost can be divided into two categories. Fixed and
variable costs. Fixed costs are those costs which do not vary but remain
constant within a given period of time in spite of fluctuations in production.
variable costs changes in direct proportion to the change in output. There
253
,Standard Costing and are certain costs, which are a combination of fixed, and variable costs. It
Variance Analysis contains a fixed element as well as a unit cost for variable expenses. Such
costs increase with production but the change is less than the proportionate
change in production. These costs are called semi-variable or semi-fixed or
mixed costs. Example of these costs are depreciation, power, telephone etc.
Rent of the telephone is fixed in a given period and per unit call charges
is a variable component. For decision making, it becomes necessary to
segregate the mixed costs into fixed and variable costs.
Methods of Segregating Mixed Cost
The following methods are applied to segregate the mixed costs into fixed
costs and variable costs:
1) Analytical Method: A careful analysis of mixed cost is done to
determine how far it varies with production. Some semi-variable
costs may have 60 percent variability while other have 40 percent
variability. Accuracy of this method depends upon the knowledge,
experience and judgement of the analyst. This method is simple but
not scientific.
2) High Low Method: This technique was developed by J.H. William.
In this method, the difference in two production levels i.e. highest and
lowest, are compared out of the various levels. Since the fixed cost
component remains constant, any increase or decrease in total semi-
variable cost must be attributed to the variable portion. The variable
cost per unit can be determined by dividing difference in total semi-
variable cost with the difference in production units at two levels.
Illustration 1
From the following information, find out the fixed and variable components.
Production (in units) Semi-Variable Costs
Rs.
100 1500
200 2000
250 2250
300 2500
Highest production is 300 units, then semi-variable costs is Rs. 2500. Lowest
production is 100 units, then semi-variable costs is Rs. 1500.
Difference in Costs
Variable Cost Per unit =
Difference in Volume
Rs. 2500 – Rs. 1500
=
300 – 100
Rs. 1000
= = Rs. 5
200
Total semi-variable costs = Fixed Cost + Variable costs per unit production
2500 = F + Rs. 5 × 300 units
F = Rs. 1000
254
,High-low method is based on observations of extreme data, hence the result Marginal Costing
may not be very accurate as it is based on extreme points and may not be
true for normal situation.
Scatter Diagram Method
In this method, production and semi-variable cost data are plotted on a graph
paper and tentative line of best fit is drawn. The following steps are involved:
●● Volume of production is plotted on x-axis and semi-variable costs on
y-axis.
●● Corresponding semi-variable costs of each volume of production are
plotted on a graph.
●● A line of best fit is drawn through the points plotted. The point where
this line intersects with y-axis, depicts the fixed cost.
●● Variable cost can be determined at any level by subtracting the fixed
cost element. The slope of the total cost curve is the variable cost per
unit
Total Semi-Variable Cost
Semi Variable
Fixed Cost
Cost
Output
The accuracy of line of best fit, depends upon the judgement and experience
of the analyst. One may draw slightly up or slightly down, the intercept on
y-axis will change or two analyst may draw a line having different slopes.
This method involves analyst’s subjectivity and may not give accurate
results.
Method of Least Square:
This method is based on econometric technique, in which line of best fit is
drawn with the help of linear equations.
The equation of a straight line is
y=a+bx
Where ‘a’ is the intercept on y-axis and ‘b’ is the slope of the line. Hence
‘a’ is the fixed cost component and ‘b’ is the slope or tangent of the line or
variable cost per unit. From the above equation, two equation can be drawn.
∑y = na + b ∑ x
∑ xy = a∑ x + b ∑ x2
Solving the equations, will give us the value of ‘a’ (fixed cost) and ‘b’
(variable cost per unit).
255
, Marginal Costing and Cost Illustration 2
Volume Profit Analysis
From the following semi-variable cost information, compute the fixed cost
and variable cost components.
Production Semi-variable
(Units) (Rs.)
100 1200
200 1350
150 1250
190 1380
180 1375
Solution
Month Production Semi-variable
X Y X2 XY
April 100 1200 10000 120000
May 200 1350 40000 270000
June 150 1250 22500 187500
July 190 1380 36100 262200
August 180 1375 32400 247500
Total ∑X = 820 ∑Y = 6555 ∑X2 141000 ∑XY = 1087200
∑y = na + b ∑ x
∑ xy = a∑ x + b ∑ x2
Solving these equations
6555 = 6 a + 820 b
1087200 = 820 a + 141000 b
a = Rs. 1004.632
b = Rs. 1.868
After segregating the mixed costs into fixed cost and variable costs, the
fixed component is added to fixed costs and variable component to variable
costs. Now we have only two costs i.e. fixed costs and variable costs.
13.3 CONCEPT OF MARGINAL COST AND
MARGINAL COSTING
The term ‘Marginal Cost’ is defined as the amount at any given volume of
output by which the aggregate costs are changed if the volume of output
is increased or decreased by one unit. In this context a unit may be single
article, a batch of articles or an order. It is the variable cost of one unit of
a product or a service. For example, the cost of 100 articles is Rs. 50,000
and that of 101 articles is Rs. 50,450, the marginal cost is Rs. 450 (i.e., Rs.
50,450 –50,000).
Thus, the total cost is the aggregate of fixed cost and variable cost and
if production is increased by one more unit, its cost can be computed as
follows:
256
