What is Marginal Cost and Marginal Costing?

Marginal cost is defined as the change in the total cost which takes place when one additional unit of a product is manufactured. The marginal cost is influenced only by the variations which generally occur in the variable costs because the fixed costs remain the same irrespective of the output produced. The concept of marginal cost is used for product pricing when the customers want the lowest possible price for a certain number of orders. There is no accounting entry for marginal cost and it is only used by the management for taking effective decisions.

Marginal costing is an accounting system wherein the variable costs are charged to cost units and the fixed costs that are incurred during the period are written off in full against the contribution for that period. Marginal costing is one of the important costing techniques which is generally used in the decision-making of the organization. The marginal costing classifies costs into fixed cost and variable cost. The marginal costing works on the rationale that costs generally vary with the volume of output, which is the reason why marginal costing is also known as "variable costing". It is not possible to determine the profit per unit of a product in marginal costing, however, it is possible to identify the amount of contribution per product which is generally the difference between the volume of sales and the marginal cost of sales. The profit is thereafter ascertained by deducting the fixed expenses from the contribution.

Example of Marginal Cost

ABC company creates 10,000 widgets at $30,000, so that case the average cost per unit is $3.00. However, if the company creates 10,005 units, the total cost is $30,010, therefore the marginal cost of the five additional units is only $2. This is because there is hardly any additional overhead cost associated with the additional 5 units of output, resulting in a lower marginal cost.

Importance of Marginal Cost in Business Operations

When the financial analysis is performed by the businesses it becomes important to determine the price of each good and services that are being rendered to the customers and in such a scenario marginal cost analysis plays a very important role. In a case where the selling price of a product is more than its marginal in such cases the management should continue the production, however, if the selling price is less than in such cases production should not be continued. This kind of analysis requires an understanding of marginal cost and its impact on the businesses. 

Features of Marginal Costing

The features of marginal costing can be discussed as follows:

• It is a costing technique that is used to evaluate the marginal cost and to identify the impact of variable cost on the output volumes.
• Under marginal costing, the valuation of work in progress and finished goods is done based on marginal cost.
• Under this costing technique, even the selling price is based on the marginal cost-plus contribution.
• The profit under marginal costing is so calculated by deducting marginal cost and fixed cost from sales. 
• The break-even analysis forms an integral part of the marginal costing technique which is a situation where in the business has neither earned any profits nor incurred any losses.

Advantages of Marginal Costing

• This costing technique is very simple to use and easy to understand even for a layman.
• In marginal costing, the valuation of closing stock is done at the marginal cost which helps in preventing unreasonable carrying forward of fixed costs of one accounting period onto the next accounting period as a part of the value of the closing stock.
• The marginal costing keeps in check the control over variable costs by avoiding unpredictable apportionment of fixed costs. 
• This costing technique proves to be very valuable in decision-making.
• Marginal costing helps in cost control by concentrating more on the variable costs as fixed costs generally prove to be uncontrollable in a shorter period.
• It brings out the relationship between the cost, the volume of output, and profit.

Difficulties Which Arise When Using the Marginal Costing Technique

The marginal costing technique also has certain drawbacks which can be identified as follows:

• This costing technique poses a difficulty in segregating all expenses into fixed cost and variable cost since most of the expenses are semi-variable and there is no complete variable cost and no complete fixed cost that can be ascertained from the total volume of output.
• Under the marginal costing technique, the balance sheet so prepared does not represent the true and fair value of the work in progress and finished goods as they are calculated considering marginal cost and ignoring the fixed cost, as a result, the work-in-progress and finished goods remain understated in the balance sheet.
• The Marginal costing technique poses a hurdle in the apportionment of variable costs, while the fixed costs are apportioned appropriately by deducting them from the total cost of contribution.
• This costing technique does not provide any standard for cost control which is generally provided by other costing techniques such as standard costing and budgetary control.

Significance of Contribution in Marginal Costing

The contribution is the difference between the sales and the marginal cost which is utilized to recover the fixed costs that are incurred in the production. In case there is any excess contribution that is left after deducting total cost (fixed) from it, the same is termed as "profits". The concept of contribution helps in determining the break-even point, profit earned from selling of products, etc.

Profit Ascertained Under Marginal Costing Technique

1. Under this costing technique, the profit is ascertained by deducting the Fixed expenses from the Contribution.
2. Contribution is calculated by deducting the marginal cost from the selling price of a product.

So, 

Contribution = Selling Price - Marginal Cost

Profit = Contribution - Fixed Expenses.

Marginal Pricing

Marginal pricing is a concept that takes into the manufacturing costs incurred but not the overhead costs. The marginal pricing requires the presence and use of alternative markets. The marginal pricing generally focuses on what needs to be done to achieve the desired profits. However, the concept of marginal pricing also has a drawback as it makes it difficult to recover the fixed cost that is incurred because the customers might not be interested in buying the products when their prices get increased as they are used to buying them at low prices.

Formulas

Marginal Cost = Change in Total Cost ÷ Change in Quantity

Contribution = Selling Price - Marginal Cost

Profit = Contribution - Fixed Expenses.

Context and Applications

Marginal costing helps in making efficient managerial decision making. It helps in ascertaining the cost of a product, its selling price, optimum level of production that needs to be done to achieve the desired profits. The marginal costing technique also plays a significant role in the expansion of a particular market by providing relevant and adequate data with regards to the amount of expenditure that needs to be incurred. It also helps in taking decisions with regards to the optimum product mix.