Application of marginal costing technique & its limitations

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PROJECT REPORT ON
“Application of Marginal Costing Technique & its Limitations”

Submitted to
University of Mumbai
In Partial Fulfillment of the Requirement

For

M.Com (Accountancy) Semester II
In the subject
Cost Accounting

By

Name of the student : - Vivek ShriramMahajan
Roll No. : - 14 -7288



Name and address of the college
K. V. Pendharkar College
Of Arts, Science & Commerce
Dombivli (E), 421203


APRIL 2015

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DECLARATION

I VIVEK SHRIRAM MAHAJAN Roll No. 14 – 7288, the student of
M.Com (Accountancy) Semester II (2015), K. V. Pendharkar College,
Dombivli, Affiliated to University of Mumbai, hereby declare that the project
for the subject Strategic Management of Project report on “Application of
marginal costing Technique & its Limitations” submitted by me to
University of Mumbai, for semester II examination is based on actual work
carried by me.

I further state that this work is original and not submitted anywhere else for
any examination.


Place: Dombivli
Date:

Signature of the Student


Name: - Vivek Shriram Mahajan
Roll No: - 14 -7288

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ACKNOWLEDGEMENT

It is a pleasure to thank all those who made this project work
possible.
I Thank the Almighty God for his blessings in completing this task.
The successful completion of this project is possible only due to
support and cooperation of my teachers, relatives, friends and well-
wishers. I would like to extend my sincere gratitude to all of them.
I am highly indebted to Principal A.K.Ranade, Co-ordinate
P.V.Limaye, and my subject teacher Prajakta Karmarkar for
their encouragement, guidance and support.
I also take this opportunity to express sense of gratitude to my
parents for their support and co-operation in completing this project.
Finally I would express my gratitude to all those who directly and
indirectly helped me in completing this project.



Name of the student
Vivek Shriram Mahajan

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Table of Contents:


CHAPTER No Topic Page no
CHAPTER 1 Introduction

Introduction to Subject………………………..
Origins...............................................................



5
6

CHAPTER 2 Objectives & Importance of Cost Accounting

Objectives of Cost Accounting..............................
Importance of Cost Accounting............................


8
10
CHAPTER 3 Introduction to Marginal Costing

Marginal Costing as a Costing System...………
Features of Marginal Costing.............................


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CHAPTER 4 Application of Marginal Costing

Application of Marginal Costing in Managerial
Decisions..............................
Advantages and Disadvantages of Marginal Costing....




20
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CHAPTER 5 The Limitation of Using the Marginal
Costing Technique

Limitations of Marginal Costing Techniques...............




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Conclusion

Conclusion………………………………………….




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CHAPTER 1: Introduction

Introduction of Costing
Definition
System of computing cost of production or of running a business, by allocating
expenditure to various stages of production or to different operations of a firm.

Cost Accounting
Cost accounting is a process of collecting, analyzing, summarizing and evaluating various
alternative courses of action. Its goal is to advise the management on the most appropriate
course of action based on the cost efficiency and capability. Cost accounting provides the
detailed cost information that management needs to control current operations and plan for
the future.
Since managers are making decisions only for their own organization, there is no need for
the information to be comparable to similar information from other organizations. Instead,
information must be relevant for a particular environment. Cost accounting information is
commonly used in financial accounting information, but its primary function is for use by
managers to facilitate making decisions.
Unlike the accounting systems that help in the preparation of financial reports periodically,
the cost accounting systems and reports are not subject to rules and standards like the
Generally Accepted Accounting Principles. As a result, there is wide variety in the cost
accounting systems of the different companies and sometimes even in different parts of the
same company or organization.
A method of accounting in which all costs incurred in carrying out an activity or
accomplishing a purpose are collected, classified, and recorded. This data is then
summarized and analyzed to arrive at a selling price, or to determine where savings are
possible.
In contrast to financial accounting (which considers money as the measure of economic
performance) cost accounting considers money as the economic factor of production.

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Origins
All types of businesses, whether service, manufacturing or trading, require cost accounting
to track their activities. Cost accounting has long been used to help managers understand
the costs of running a business. Modern cost accounting originated during the industrial
revolution, when the complexities of running a large scale business led to the development
of systems for recording and tracking costs to help business owners and managers make
decisions.
In the early industrial age, most of the costs incurred by a business were what modern
accountants call "variable costs" because they varied directly with the amount of
production. Money was spent on labor, raw materials, power to run a factory, etc. in direct
proportion to production. Managers could simply total the variable costs for a product and
use this as a rough guide for decision-making processes.
Some costs tend to remain the same even during busy periods, unlike variable costs, which
rise and fall with volume of work. Over time, these "fixed costs" have become more
important to managers. Examples of fixed costs include the depreciation of plant and
equipment, and the cost of departments such as maintenance, tooling, production control,
purchasing, quality control, storage and handling, plant supervision and engineering. In the
early nineteenth century, these costs were of little importance to most businesses.
However, with the growth of railroads, steel and large scale manufacturing, by the late
nineteenth century these costs were often more important than the variable cost of a
product, and allocating them to a broad range of products lead to bad decision making.
Managers must understand fixed costs in order to make decisions about products and
pricing.
For example: A company produced railway coaches and had only one product. To make
each coach, the company needed to purchase $60 of raw materials and components, and
pay 6 laborers $40 each. Therefore, total variable cost for each coach was $300. Knowing
that making a coach required spending $300; managers knew they couldn't sell below that
price without losing money on each coach. Any price above $300 became a contribution to
the fixed costs of the company. If the fixed costs were, say, $1000 per month for rent,
insurance and owner's salary, the company could therefore sell 5 coaches per month for a
total of $3000 (priced at $600 each), or 10 coaches for a total of $4500 (priced at $450
each), and make a profit of $500 in both cases.

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INVESTOPEDIA EXPLAINS 'Cost Accounting'
While cost accounting is often used within a company to aid in decision making, financial
accounting is what the outside investor community typically sees. Financial accounting is a
different representation of costs and financial performance that includes a company's assets
and liabilities. Cost accounting can be most beneficial as a tool for management in
budgeting and in setting up cost control programs, which can improve net margins for the
company in the future.
Cost accounting is the accounting of the cost. It is made of two words- Cost and
Accounting. The term cost denotes the total of all expenditures involved in the process of
production. Thus, it covers the costs involved in the production and the cost involved while
receiving it. Accounting, on the other hand, collects and maintains financial records of
each income and expenditure and make avail of such information to the concerned
officials. Thus, cost accounting is a practice and process of cost which determines the
profitability of a business concern by controlling the cost with the application of
accounting principle, process and rules.
Cost accounting includes the presentation of the information derived there from for
purposes of managerial decision making. Thus, cost accounting is a arts as well as science.
It is science because it is a body of systematic knowledge having certain principles. It is an
art as it requires the ability and skill with which a cost accountant is able to apply the
principles of cost accounting in various managerial problems.
According to W.W.Bigg-“ Cost accounting is the provision of such analysis and
classification of expenditure as will enable the total cost of any particular unit of
production to be ascertained with reasonable degree of accuracy and at the same time to
disclose exactly how such total cost is constituted.”
According to R.N. Carter, “Cost accounting is a system of recording in accounts the
materials used and labour employed in the manufacture of a certain commodity or on a
particular job.”
Thus, cost accounting is considered as an art as well as acinece. It is also a prime part of
accounting system which records systematically the cost involved in raw materials and
labour used in the process of production and the same time determines the total cost and
unit cost of product. The process of recording classifying and analyzing of cost is the cost
accounting.

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CHAPTER 2: Objectives & Importance of Cost Accounting

The main objectives of Cost Accounting are as follows:
Ascertainment of Cost
There are two methods of ascertaining costs, viz., Post Costing and Continuous Costing.
Post Costing means, analysis of actual information as recorded in financial books. It is
accurate and is useful in the case of "Cost plus Contracts" where price is to be determined
finally on the basis of actual cost.
Continuous Costing, aims at collecting information about cost as and when the activity
takes place so that as soon as a job is completed the cost of completion would be known.
This involves careful estimates being prepared of overheads. In order to be of any use,
costing must be a continuous process.
Cost ascertained by the above two methods may be compared with the standard costs
which are the target figures already compiled on the basis of experience and experiments.
Determination of selling price
Though the selling price of a product is influenced by market conditions, which are beyond
the control of any business, it is still possible to determine the selling price within the
market constraints. For this purpose, it is necessary to rely upon cost data supplied by Cost
Accountants.
Cost control and cost reduction
"The guidance and regulation, by executive action of the cost of operating an undertaking".
The word "guidance" indicates a goal or target to be guided; 'regulation' indicates taking
action where there is a deviation from what is laid down; executive action denotes action to
"regulate" must be initiated by executives i.e. persons responsible for carrying out the job
or the operation; and all this is to be exercised through modern methods of costing in
respect of expenses incurred in operating an undertaking.

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Ascertaining the profit of each activity
The profit of any activity can be ascertained by matching cost with the revenue of that
activity. The purpose under this step is to determine costing profit or loss of any activity on
an objective basis.
Assisting management in decision making
Decision making is defined as a process of selecting a course of action out of two or more
alternative courses. For making a choice between different courses of action, it is necessary
to make a comparison of the outcomes, which may be arrived under different alternatives.
Such a comparison has only been made possible with the help of Cost Accounting
information.

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Importance of Cost accounting
Cost accounting has much importance. Specially, the following parties are benefitted from
it.
1. Importance to management
Management is highly benefitted with the introduction of cost accounting. It helps to
ascertain the cost and selling price of the product. Cost data help management to formulate
the business policies. The introduction of budgetary control and standard cost would be an
aid to analyze cost. It’s also helps to find out reasons for profit or loss. It provides data to
submit tender as well. Thus, cost accounting is an aid to management.
2. Importance to investors
Investors can obtain benefit from the cost accounting. Investors want to know the financial
conditions and earning capacity of the business. An investor must gather information about
organization before making investment decision and investor can gather such information
from cost accounting.
3. Importance of consumers
The ultimate aim of costing is to reduce the cost of production to minimize the profit of
business. Reduction in the cost is usually passed on the consumers in the form of lower
price. Consumers get quality goods at a lower price.
4. Importance to Employees
Cost accounting helps to fix the wages of the workers. Efficient workers are rewarded for
their efficiency. It helps to induce incentive wage plan in business.
5. Importance to Government
Cost accounting is one of the prime sources to provide reliable data to internal as well as
external parties. It helps government agencies to determine excise duty and income tax.
Government formulates tax policy, industrial policy, export and import policy based on the
information provided by the cost accounting.

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CHAPTER 3: Introduction to Marginal Costing
Marginal Costing as a Costing System
Marginal Costing is a type of flexible standard costing that separates fixed costs from
proportional costs in relation to the output quantity of the objects. In particular, Marginal
Costing is a comprehensive and sophisticated method of planning and monitoring costs
based on resource drivers. Selecting the resource drivers and separating the costs into fixed
and proportional components ensures that cost fluctuations caused by changes in operating
levels, as defined by marginal analysis, are accurately predicted as changes in authorized
costs and incorporated into variance analysis.
This form of internal management accounting has become widely accepted in business
practice over the last 50 years. During this time, however, the demands placed on costing
systems by cost management requirements have changed radically.
Definition
The increase or decrease in the total cost of a production run for making one additional unit
of an item. It is computed in situations where the breakeven point has been reached: the
fixed costs have already been absorbed by the already produced items and only the direct
(variable) costs have to be accounted for.
Marginal costs are variable costs consisting of labor and material costs, plus an estimated
portion of fixed costs (such as administration overheads and selling expenses). In
companies where average costs are fairly constant, marginal cost is usually equal to
average cost. However, in industries that require heavy capital investment (automobile
plants, airlines, mines) and have high average costs, it is comparatively very low. The
concept of marginal cost is critically important in resource allocation because, for optimum
results, management must concentrate its resources where the excess of marginal revenue
over the marginal cost is maximum. Also called choice cost, differential cost, or
incremental cost.
Marginal cost is the change in the total cost that arises when the quantity produced has an
increment by unit. That is, it is the cost of producing one more unit of a good. In general
terms, marginal cost at each level of production includes any additional costs required to
produce the next unit. For example, if producing additional vehicles requires building a
new factory, the marginal cost of the extra vehicles includes the cost of the new factory. In
practice, this analysis is segregated into short and long-run cases, so that over the longest
run, all costs become marginal.

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If the good being produced is infinitely divisible, so the size of a marginal cost will change
with volume, as a non-linear and non-proportional cost function includes the following:
 variable terms dependent to volume,
 constant terms independent to volume and occurring with the respective lot size,
 Jump fix cost increase or decrease dependent to steps of volume increase.
In practice the above definition of marginal cost as the change in total cost as a result of an
increase in output of one unit is inconsistent with the differential definition of marginal
cost for virtually all non-linear functions. This is as the definition finds the tangent to the
total cost curve at the point q which assumes that costs increase at the same rate as they
were at q. A new definition may be useful for marginal unit cost (MUC) using the current
definition of the change in total cost as a result of an increase of one unit of output defined
as: TC (q+1)-TC(q) and re-defining marginal cost to be the change in total as a result of an
infinitesimally small increase in q which is consistent with its use in economic literature
and can be calculated differentially.

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Marginal Cost
In economics and finance, marginal cost is the change in total cost that arises when the
quantity produced changes by one unit. It is the cost of producing one more unit of a good.
[1] Mathematically, the marginal cost (MC) function is expressed as the first derivative of
the total cost (TC) function with respect to quantity (Q). Note that the marginal cost may
change with volume, and so at each level of production, the marginal cost is the cost of the
next unit produced.

Relation between Marginal Cost and Economies of Scale
 Production may be subject to economies of scale (or diseconomies of scale).
Increasing returns to scale are said to exist if additional units can be produced for
less than the previous unit, that is, average cost is falling.

 This can only occur if average cost at any given level of production is higher than
the marginal cost.

 Conversely, there may be levels of production where marginal cost is higher than
average cost, and average cost will rise for each unit of production after that point.
This type of production function is generally known as diminishing marginal
productivity: at low levels of production, productivity gains are easy and marginal
costs falling, but productivity gains become smaller as production increases;
eventually, marginal costs rise because increasing output (with existing capital,
labour or organization) becomes more expensive. For this generic case, minimum
average cost occurs at the point where average cost and marginal cost are equal
(when plotted, the two curves intersect); this point will not be at the minimum for
marginal cost if fixed costs are greater than zero.

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Features of Marginal Costing
It is a method of recording costs and reporting profits;
 All operating costs are differentiated into fixed and variable costs;

 Variable cost –charged to product and treated as a product cost whilst

 Fixed cost treated as period cost and written off to the profit and loss Account
Marginal costing is very helpful in managerial decision making. Management's production
and cost and sales decisions may be easily affected from marginal costing. That is the
reason; it is the part of cost control method of costing accounting. Before explaining the
application of marginal costing in managerial decision making, we are providing little
introduction to those who are new for understanding this important concept.
Marginal cost is change in total cost due to increase or decrease one unit or output. It is
technique to show the effect on net profit if we classified total cost in variable cost and
fixed cost. The ascertainment of marginal costs and of the effect on profit of changes in
volume or type of output by differentiating between fixed costs and variable costs. In
marginal costing, marginal cost is always equal to variable cost or cost of goods sold. We
must know following formulae.
a) Contribution (Per unit) = Sale per unit - Variable Cost per unit
b) Total profit or loss = Total Contribution - Total Fixed Costs
Or Contribution = Fixed Cost + Profit
Or Profit = Contribution - Fixed Cost
c) Profit Volume Ratio = Contribution/ Sale X 100 (It means if we sell Rs. 100 product,
what will be our contribution margin, more contribution margin means more profit)
d) Break Even Point is a point where Total sale = Total Cost
e) Break Even Point (In unit) = Total Fixed expenses / Contribution
f) Break Even Point (In Sales Value) = Breakeven point (in units) X Selling price per unit
g) Break Even Point at earning of specific net profit margin
= Total Contribution / Contribution per unit.
Or = fixed cost + profit / selling price - variable cost per unit.

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Direct Costing
The practice of charging all direct costs to operations, processes or products, leaving all
indirect costs to be written-off against profit in the period in which they arise is called
Direct Costing.
This differs from marginal costing in that some fixed costs could be considered to be direct
costs in appropriate circumstances.
Contribution
Contribution is the difference between the sales and the marginal cost of sales. It
contributes towards fixed expenses and profit.
The contribution margin is sales minus variable expenses.
Contribution margin = Sales - Variable Expenses
When the contribution margin is expressed as a percentage of sales it is referred to as the
contribution margin ratio. The contribution margin per unit is the product’s selling price
minus its variable costs and expenses.
Variable Cost
Variable Cost is a cost which tends to vary directly with volume of output. Variable costs
are sometimes referred to as direct costs in system of Direct Costing.
Variable Expenses mean the total of the company’s variable costs plus its variable
expenses.
Fixed Cost
Fixed Cost is a cost which tends to be unaffected by variations in volume of output. Fixed
costs depend mainly on the efflux ion of time and do not vary directly with volume or rate
of output.
Fixed costs are sometimes referred to as period costs in system of Direct Costing.
Fixed Expenses
Fixed expenses mean the company’s total amount of fixed costs plus its fixed expenses.

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Fixed costs and Fixed expenses
Fixed costs and fixed expenses are those which do not change as volume changes.
Variable costs and Variable expenses
Variable costs and variable expenses increase as volume increases and they will decrease
when volume decreases. The relationship of contribution to Sales will remain constant
under different levels of sales only if
1. Variable cost per unit remains constant.
2. Fixed costs remain the same.
3. Selling price per unit does not change.
The cost per unit of an item is important for
 Setting the selling price
 Valuing stocks
 Calculating profitability
Terms and Definitions
Basic Equation:
Variable Cost = Direct Materials + Direct Labor + Direct Expenses
Variable cost per unit = Difference in cost / Difference in Activity level
Variable Cost is also called as Marginal Cost.
Marginal Cost Equation:
Sales (S) = Variable Cost (V) + Fixed Expenses (F) + or – Profit (P) / Loss (L)
 S = Sales
 V = Variable Cost
 F = Fixed Expenses
 +P = Profit
 -P = Loss
Sales - Variable Cost = Fixed Expenses + or – Profit / Loss
S - V = F + or – P

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Contribution:
Sales – Variable Cost = Contribution = S - V
Fixed Expenses + or – Profit / Loss = Contribution = F + or – P
In simple form, S – V = F + or – P
Missing Factor:
In the above four factors, if any three factors are known, the remaining one can be easily
found out.
Sales = Variable Cost + Fixed Expenses + Profit
Variable Cost = Sales – (Fixed Expenses + Profit)
Fixed Expenses = Sales – Variable Cost – Profit
Profit = Sales – Variable Cost – Fixed Expenses
Units sold:
Units sold = Contribution margin / Contribution margin per unit
Break Even Point:
A business is said to break even when its total sales are equal to its total costs. It is a point
where there is no profit or no loss.
Contribution is equal to Fixed Expenses.
Break Even Point (in Units) = Total Fixed Expenses / (Selling Price per Unit – Marginal
Cost per Unit)
The answer will be in units and not in value because breakeven point is based on unit cost.
Break Even Sales:
S – V = F + P
At Break Even Point Profit equals zero.
Hence, S – V = F

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For Break Even Point, the equation is S – V = F
Dividing both sides by S – V,
(S – V) / (S – V) = F / (S – V)
i.e. 1 = F / (S – V)
Multiplying both sides by S,
S * 1 = (F * S) / (S – V)
Therefore, the formula for the calculation of break even sales is:
(F * S) / (S – V)

Calculation of Sales for a desired or expected Profit:
(Fixed Expenses + Profit) / (Selling Price per Unit – Marginal Cost per Unit)
Or
(Fixed Expenses + Profit) / Contribution per Unit
The formula for the calculation of Sales to earn an expected or desired profit is:
((F + P) * S) / (S – V)
Profit / Volume Ratio or Contribution / Sales Ratio
(P/V Ratio) or (C/S Ratio)
P/V Ratio
Contribution / Sales i.e. C / S
Or
(Sales – Variable Cost) / Sales i.e. (S – V) / S
Or
(Fixed Expenses + Profit) / Sales i.e. (F + P) / S
Or

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Changes in contribution in two periods / Changes in Sales in two periods
Or
Changes in Profit in two periods / Changes in Sales in two periods
The ratio can be shown in the form of percentage if the formula is multiplied by 100.
This ratio can be used for the calculation of
Break Even Point is Fixed Costs / P/V Ratio = F / P/V Ratio
For the calculation of sales to earn a desired or expected profit is
(Fixed Costs + Profit) / P/V Ratio = F + P / P/V Ratio
Contribution / P/V Ratio
Variable Costs = Sales (1 – P/V Ratio)
Contribution is Sales x P/V Ratio
Margin of Safety (M/S)
It is the difference between the actual sales and the sales at break even point.
Sales or Output beyond break even point is known as margin of safety.
Margin of Safety (M/S) = Present Sales – Break Even Sales
Or
= Profit / P/V Ratio
Break-Even and Target Income
Sales = Total Variable Costs + Total Fixed Costs + Target Income
Where Target Income is zero, then
Sales = Total Variable Costs + Total Fixed Costs
Which is the Break even sales.
Break-Even Point in Units = Total Fixed Costs / Contribution Margin per Unit
Break-Even Point in Sales = Total Fixed Costs / Contribution Margin Ratio

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CHAPTER 4: Application of Marginal Costing
Application of Marginal Costing in Managerial Decisions
By effective use of marginal costing formulae, we can apply marginal costing for
managerial decisions with following ways:
1st Application: Managerial Decision Relating to Determination of Optimum Selling
Price
To determine the optimum selling price of any product or service is big challenge for a
manager of any company because company wants to profit of each unit of any product or
service. In marginal costing technique, fixed cost will not be changed at any level of
production. Only variable cost is changed for getting optimum selling price where
company can achieve expected profit.
2nd Application: To Check the Effect of Reducing of Current Price on profit
We all know, this is the time of competition, customer has become king. He wants product
at minimum price. One example, we can see free video on YouTube. Instead of buying
costly CDs and DVD, customers of entertainment industry see free films and movies on
YouTube. But on the other side, company wants to maintain his current profit. At that
time, manager will be in tension because it is not possible to maintain profit even after
reducing price. But if manager learns marginal costing techniques and uses it effective
way, they can check the effect of reducing of current price on net profit, after this, he can
decide to reduce production or increase production. It is the law of economics, variable
cost will reduce by reducing units of production in same proportion but when we increase
production, fixed cost will fastly decreases due to constant nature.
3rd Application: Choose of Good Product Mix
It may be possible that company is producing more than one product, at that time company
has to calculate each product's contribution margin or gross profit margin. After this,
manager sees which product is giving high contribution margin. Company manager will
give preference to that product whose contribution will high. One more decision can be
taken by manger. He can check contribution by producing different quantity of different
products. If he see any quantity of products is producing maximum contribution, it will be
equilibrium point. Production of units at that quantity will be benefited to company.

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4th Application: Calculation of Margin of Safety
Marginal costing can be utilized for calculating margin of safety. Margin of safety is
difference between actual sale and sale at breakeven point. According to marginal costing
rules, production will follow sales. Suppose current sale is Rs. 4, 00,000 and BEP is
Rs. 3, 00,000, margin of safety is Rs.100000. We can calculate it with following formula
= Profit/ P/V ratio
If company's sale is less than margin of safety, then manager can take step to reduce both
fixed and variable cost or increase prices.
5th Application: Decision regarding to sell goods at Different Prices to Different
Customers
Sometime, company has to give special discount to special customers. These customers
may be govt., foreign companies or wholesaler. At that time manager has to take decision
at what limit, we can give discount to special customers. Marginal costing may help in this
decision.

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Advantages and Disadvantages of Marginal Costing
Advantages and Benefits of Marginal Costing
Cost control: Marginal costing makes it easier to determine and control costs of
production. By avoiding the arbitrary allocation of fixed overhead costs, management can
concentrate on achieving and maintaining a uniform and consistent marginal cost.
Simplicity: Marginal costing is simple to understand and operate and it can be combined
with other forms of costing (e.g. budgetary costing and standard costing) without much
difficulty.
Elimination of cost variance per unit: Since fixed overheads are not charged to the cost
of production in marginal costing, units have a standard cost.
Short-term profit planning: Marginal costing can help in short-term profit planning and
is easily demonstrated with break-even charts and profit graphs. Comparative profitability
can be easily accessed and brought to the notice of the management for decision-making.
Accurate overhead recovery rate: This method of costing eliminates large balances left
in overhead control accounts, which makes it easier to ascertain an accurate overhead
recovery rate.
Maximum return to the business: With marginal costing, the effects of alternative sales
or production policies are more readily appreciated and assessed, ensuring that the
decisions taken will yield the maximum return to the business.

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Disadvantages and Limitations of Marginal Costing
Classifying costs: It is very difficult to separate all costs into fixed and variable costs
clearly, since all costs are variable in the long run. Hence such classification sometimes
may give misleading results. Furthermore, in a firm with many different kinds of products,
marginal costing can prove less useful.
Accurately representing profits: Since the closing stock consists only of variable costs
and ignores fixed costs (which could be considerable), this gives a distorted picture of
profits to shareholders.
Semi-variable costs: Semi-variable costs are either excluded or incorrectly analyzed,
leading to distortions.
Recovery of overheads: With marginal costing, there is often the problem of under or
over-recovery of overheads, since variable costs are apportioned on an estimated basis and
not on actual value.
External reporting: Marginal costing cannot be used in external reports, which must have
a complete view of all indirect and overhead costs.
Increasing costs: Since it is based on historical data, marginal costing can give an
inaccurate picture in the presence of increasing costs or increasing production.

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CHAPTER 5: The Limitation of Using the Marginal Costing Technique
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.
Limitations of Marginal Costing Techniques:
1. It is difficult to classify exactly the expenses into fixed and variable category. Most of
the expenses are neither totally variable nor wholly fixed.
2. Contribution itself is not a guide unless it is linked with the key factor.
3. Sales staff may mistake marginal cost for total cost and sell at a price; which will result
in loss or low profits. Hence, sales staff should be cautioned while giving marginal cost.
4. Overheads of fixed nature cannot altogether be excluded particularly in large contracts,
while valuing the work-in-progress. In order to show the correct position fixed overheads
have to be included in work-in-progress.
5. Some of the assumptions regarding the behavior of various costs are not necessarily true
in a realistic situation. For example, the assumption that fixed cost will remain static
throughout is not correct.

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Conclusion
Marginal costing is a useful analysis tool which usually helps management make decisions
and understand the answer to specific questions about revenue.
That said, it is not a costing methodology for creating financial statements. In fact,
accounting standards explicitly exclude marginal costing from financial statement
reporting. Therefore, it does not fill the role of a standard costing, job costing, or process
costing system, all of which contribute actual changes in the accounting records.
Still, it can be used to discover relevant information from a variety of sources and
aggregate it to help management with a number of tactical decisions. It is most useful in
the short-term, and least useful in the long-term, especially where a firm needs to generate
sufficient profit to pay for a large amount of overhead.
Furthermore, direct costing can also cause problems in situations where incremental costs
may change significantly, or where indirect costs have a bearing on the decision.