MANAGEMENT ACCOUNTING
LECTURE –Three
CONTENTS
1. Definition of marginal cost
2. Determination of marginal cost.
3 METHODS OF SEGREGATION
4 Marginal
COST EQUATIONS
5 ADVANTAGES MARGINAL COSTING.
6. LIMITATIONS OF MARGINAL COSTING
1. Definition of marginal cost
Economists defined marginal cost as ‘the
amount at any given volume of out put by which aggregate costs are changed if
the volume of output is increased or decreased by one unit.
Suppose the cost of production of
10,000 units of product is TK. 1, 00,000
and that of 1, 0001 units TK. 100008.
Therefore, cost of producing an additional
Unit
is = TK. 8 (TK. 10, 00, 8 – 10, 00, 00)
This the marginal cost of one unit and this
marginal cost is the direct cost, comprising the cost of materials; the labor
employed and the variable over head expenses that would not have been incurred
but for producing the additional unit,
The production of additional unit involves
increases in fixed cost along with the variable item as above; such increase
will be included in marginal cost.
But accountants defined marginal cost as “the variable cost of one unit of a
product or a service. I.e. a cost which would be avoided if the unit
was not produced
Thus
marginal cost is the aggregate of variable cost.
For
example,
·
If TK.40, 000 for directs materials,
·
TK. 20,000 for direct labor,
·
TK. 20,000 for variable overhead and
·
TK. 20,000 for fixed overhead are incurred for producing 10,000 units
of a product the marginal cost can be ascertained
as follows:
|
1. Materials
|
TK. 40,000
|
|
2. Direct labor
|
TK. 20,000
|
|
3. Prime cost (1+2)
|
TK.60,000
|
|
4. Variable overhead
|
TK.20,000
|
|
5. Marginal cost (3+4)
|
TK.80,000
|
|
6. Production Unit
|
TK.10,000 units
|
|
7. Marginal cost per unit (5/6)
|
TK.8/-
|
The theory of marginal costing is based upon
the assumption that some elements of cost tend to vary directly with variations
in volume of output while others do not.
That
is why, only variable costs form part of product costs. On the other hand, fixed costs are written off to Marginal Profit
and Loss Account being as period costs inasmuch as cost, such as
·
Supervision,
·
Rent,
·
Rates,
·
Fire insurance,
·
Depreciation, etc, are to be incurred during a period respective of the
volume of production.
Since variable cost are included in product
costs, under stable conditions, such product costs will be a constant ratio, whereas fixed
costs will be a constant amount.
Even if fixed cost increases due to increase
in volume, it will not affect marginal or variable cost.
In the
above example, direct labor costs are included in marginal cost on the assumption
that they are ‘variable.’
If they are
not variable; they should be excluded from marginal cost. It should be noted that
even fixed costs might be directly identifiable with the cost object. While all
variable cost are generally direct; all direct costs need not be variable.
The most important aspect of the direct cost
is the cost object.
A cost item may be direct cost for one cost object, while it may be an indirect cost for another cost
object.
In Bangladesh
labor
costs are not variable, they are almost fixed: only an insignificant portion, say 5 to 10 percentage, is variable
(e.g., casual labor engaged to cope with additions volume, overtime premium,
salesmen’s commission, etc).
Accordingly, cost of labor should be
excluded from the computation of marginal or variable cost: it should be added
to other fixed costs and treated as such.
2. Determination of marginal
cost.
Variable costs, such as direct materials,
direct labor, direct expense etc, can be ascertained without any difficulty and
these costs will tend to be a constant amount per unit.
In determining these costs past actual costs will be the basis for estimate.
Where, budgetary control is in operation, company’s detailed budget will be
guide; Variable overhead can be ascertained from previous ledger posting or the
budget.
Fixed cost can also be picked up individually
without out difficulty. The basic sources of data are the same i.e. Material Requisition
notes for direct and indirect material and Job Cards a wages analysis sheets for labor booking, Expenses
analysis sheet for expenses etc.
Semi variable
items
should be segregated in to variable and fixed elements and be included in the
respective groups group frequently represents a significant portion of the
total costs incurred.
The
accuracy of marginal costs will depend to a large extent upon the accuracy with
which semi- variable costs are segregated into variable and fixed elements.
3 METHODS
OF SEGREGATION OF SEMI- VARIABLE COSTS
The following methods are generally used in
segregating semi- variable costs into their variable and fixed parts:
1. Intelligent estimate of
individual expenses.
2. High and Low points method
3. Equations method
4. Methods of Averages
5. Graphical method
6. Method of Least Squares
1. INTELLIGENT ESTIMATES
In estimating fixed and variable portions of semi- variable overhead, past overhead expenses
at various levels of activity will be analyzed and tabulation will show the
pattern of overhead expenses in relation to volume.
Adjustments are to be made for anticipating
chances in price, rate, etc.
Although this method is not accurate, it is simple to operate.
2. HIGH
& LOW POINTS
This is also known, as Range Method. Segregation
with the help of this method is not difficult in this method; the levels of
highest and lowest expenses are compared with one another and related to output
attained in those periods.
Since fixed portion of the costs is expected
to remain fixed for the two periods, it becomes clear that the change in the
level of the expenses must be due to variable
portion of the overhead.
From this, the variable cost per unit
is easy to ascertain
As follows: Change in expense level
CHANGE ON OUTPUT LEVEL
EXAMPLE: 1.
|
Month
|
Output
(Units)
|
Semi – variable
Overhead TK.
|
||||
|
January
|
 2,500 |
 L 12,500
|
||||
|
February
|
|
14,000
|
||||
|
March
|
3,500
|
15,500
|
||||
|
April
|
4,700
|
H 19,100
|
||||
|
May
|
3,700
|
16,100
|
||||
|
June
|
4,400
|
18,200
|
||||
|
July
|
4,500
|
18,500
|
||||
|
August
|
4,200
|
17,600
|
||||
|
September
|
 4,000 |
 17,000 |
||||
|
October
|
|
|
||||
|
November
|
3,800
|
16,400
|
||||
|
December
|
2,700
|
13,100
|
Now from the above table, taking highest and
lowest output with relative overhead costs: one can segregate the fixed and
variable portions:
|
|
Output
(Units)
|
Semi- variable
Overhead TK.
|
|
Highest (April)
|
4,700
|
19,100
|
|
Lowest (January)
|
2,500
|
12,500
|
|
Change
|
2,200
|
6,600
|
Since variable costs will only change,
variable overhead cost per unit will be
=
TK. 6,600/2,200 = TK. 3/-
=TK.
19,100-(4,700 x TK. 3/-)
Therefore
fixed costs would be: =TK.5, 000/-
This method is not always considered to be
scientific
3. EQUATION
METHOD
Here the straight line equation is used.
The
equation is ---
Y=MX+C
Where
·
Y=Total semi variable cost,
·
C= Fixed cost included in variable cost
·
M= Variable cost per unit
·
X= Output.
It is now possible segregate the fixed and
variable portions with the help of the equations with respect to two periods.
EXAMPLE: 2
Taking the figures for January and February
from Example …. 1.
(January) 12,500=2500M+C
….1
(February) 14,000=3000M+C ….2
Subtracting (1) from (2) 1500=500M
M=TK.
3/-
Putting value of M in (1) 12,500= (2500 X 3) +C
C=TK.
5,000.
4. METHOD
OF AVERAGES
Under this method, average of two selected
groups should be take out for first and
then the method of high and low points or the equation method may be used in
arriving at variable and fixed portions of semi- variable cost.
EXAMPLE: 3.
|
|
Average output
|
Average Semi variable
Overhead
|
|
Last four months
|
3,700 units
|
TK. 16,100
|
|
First four months
|
3,425 units
|
TK. 15,275
|
|
Change
|
275 units
|
TK. 825
|
Variable overhead TK. 825/275=TK. 3 per unit (i.e.
x)
Fixed overhead: TK. 16,100= (3,700 x TK. 3) +
C
C
= 16100 -11100=5000
= 5,000
Where
Y
= MX + C
Y
= 16100
M = 3700
X = 3
4 Marginal COST EQUATION
It has been pointed out earlier that the
difference between sales value and the variable cost of those sales is known as
contribution.
In other words, products sold will provide
a fund to meet first the fixed costs and the balance represents the profits of
the undertaking.
Therefore, contribution may be said to be
equal to fixed costs and profit (or loss).
From this Concept, the following Marginal Cost
Equation is developed:
S- V = F+P [S
– V =; C = F + P]
Where,
· S = Sales;
· V = Variable or marginal
costs:
· F = fixed costs, and
· P = profit.
Thus, if any three factors of the above
equation are known, the fourth can be easily found out. Again, this equation is
used for ascertainment of break – even point.
That is, at break – even point, there will be
no profit or no loss (Total costs = total sales)
So that P = O
5 ADVANTAGES
MARGINAL COSTING.
The possible advantages of marginal costing,
as compared to that of absorption costing. Are
stated below.
1. Greater control over costs is possible. This is to because fixed
costs are excluded from products and management can concentrate on marginal
cost which is a constant ratio.
2. It is an aid to management is taking many valuable
decisions.
Under marginal costing policy decisions in many problems, such as
(i)
Introduction of a product:
(ii)
Quoting selling prices and tendering for contracts in
times of competition:
(iii)
Whether to make or buy:
(iv)
Reduction of prices in times of competition or
depression:
(v)
Selecting the most profitable product or sales – mix :
(vi)
Alternative methods to be employed in manufacturing:
(vii)
Limiting factors
(viii)
Utilization of spare capacity:
(ix)
Profit planning – break – even charts, profit- volume
graphs may be used in profit planning :
(x)
Assessment of capital projects to be undertaken:
(xi)
Selection of the most profitable level of activity,
etc,
3. For all practical purposes, marginal costs will be
the product costs and hence there will be vitiation of costs due to change in level of
performance as marginal costs will tend to be a constant ratio. Under
absorption costing, unit cost will vary depending upon the level of activity
and this may lead to confusion.
4. Closing stocks of finished goods and work – in –
progress are valued at marginal cost. Apart from simplicity in the valuation of
stocks. This will lead to greater accuracy in arriving at profits.
5. The marginal cost statements
are understood by management more
easily than those produced under absorption costing. For instance, the foremen will
be more interested in those costs which are variable and which can be combined
with standard costing.
6. Since fixed costs are
excluded, it eliminates the strenuous task of allocating, apportioning and absorbing
overhead. As a result, there will be no under – or over – recovery of fixed
overhead.
6. LIMITATIONS
OF MARGINAL COSTING:
1. It is difficult to analyze overhead into fixed and
variable elements because many expenses considered to be variable or fixed may not be
exactly the same at various levels of activity. Moreover, in marginal costing,
there is no place of semi – variable or semi – fixed overheads which are to be
segregated into fixed and variable elements. The segregation semi -variable
costs is also a difficult task.
2. There
is the danger of taking policy decisions on the basis of information
presented under marginal costing technique.
For example, in the long run, selling
price should not be fixed simply by looking at contribution as it may result in
losses or low profits. The other important factors such as fixed costs, Capital
employed etc. should also be taken in to consideration in fixing selling
prices.
3. There is also the danger of valuing finished stocks, work – in – progress,
transfer from one process to another etc. at marginal costs only. The arguments
against valuing stocks at marginal costs may be
Summarized
as follows:
(a) In case of loss by fire,
full loss cannot be recovered from the insurance company.
(b) Profits will be lower than
that shown under absorption costing and hence may be objected to by the tax
authorities.
(c) For Balance Sheet purpose,
closing stocks are to be valued at lower of market price and cost. Marginal
costs may not be acceptable to the auditor as true costs for this purpose
(d) Circulating assets will be under
in the Balance sheet and thus the Balance sheet will not exhibit a true and
fair view of the state of affairs.
4. Cost control can also be
achieved with the help of other techniques such as standard costing and budgetary
control. In standard costing volume variance will show the effect of change in
output on fixed costs and bench there will be no vitiation of costs.
REVIEW:
1 Definition of Marginal Cost
Marginal cost means an
additional cost resulting from producing and selling one additional unit.
2 METHODS OF SEGREGATION OF SEMI- VARIABLE COSTS
1.
Intelligent estimate of individual expenses.
2.
High and Low points method
3.
Equations method
4.
Methods of Averages
5.
Graphical method
6.
Method of Least Squares
3 MARGINAL COST Equation
S- V = F+P [S
– V =; C = F + P]
Where,
·
S = Sales;
·
V = Variable or marginal costs:
·
F = fixed costs, and
·
P = profit.
Symbolically: P/V or C/S
Ratio = C/S = (S-V/S)
Where,
C = Contribution
S = Sales
V = Variable Costs.
5. ADVANTAGES MARGINAL COSTING.
1.
Greater control over costs is possible.
2.
It is an aid to management is taking many valuable
decisions.
3.
For all practical purposes, marginal costs will be the
product costs and
4.
Closing stocks of finished goods and work – in –
progress are valued at marginal cost.
5.
understood by management more easily than those
6. LIMITATIONS OF MARGINAL COSTING:
1.
It is difficult to analyze overhead into fixed and
variable elements
2.
There is the danger of taking policy decisions
3.
There is also the danger of valuing finished stocks,
CONCLUSION:
The ultimate target of
Marginal costing and absorption costing is to help the management in taking
proper decision.
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