Marginal Cost Presentation.

Marginal Costing

When we say that something is marginal we usually mean that it lies near the ‘edge’ ‘edg e’ of some acceptable criteria or concept. We can apply this same idea to product produc t costing and ask ourselves ‘what will the next one cost’ To do this we must consider how we view costs.

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Marginal Costing

We must now ask ourselves the question:

Which of these costs will we incur if we manufacture another unit?

To help us in answering this let us consider running a car

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Marginal Costing

What costs are involved in running a car Tax Fuel

Insurance Maintenance

If we plan to drive 10,000 miles –  what would the 10,001st mile cost?

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Marginal Costing

Fuel

Insurance

Variable

Fixed

Tax

Fixed

Maintenance Semi fixed/variable

Fuel costs are dependant upon the distance we travel Tax and insurance are both fixed –  are independent of distance travelled Maintenance has both fixed and variable elements within it 4

Marginal Costing

If we consider the distance travelled to be the product of owning a car. For each mile travelled we incur additional fuel cost.

Insurance and tax are independent of distance travelled

Maintenance is a mix of costs some determined  by distance travelled and others not

Variable or Product cost

Fixed or Period cost

Semi variable i.e. some elements fixed others not 5

Marginal Costing

For marginal costing what we must consider is cost in relationship to changes in output: Thus for a given volume of output additional units of production can be obtained for less that  proportionate cost. In simpler terms if unit cost is equal to Total Cost divided by the number of units. Then the cost incurred in producing an additional unit will be that portion of the unit cost which is variable (the product cost).

Thus the unit cost falls –  fixed cost is spread over a greater number of units. 6

Marginal Costing

Within limits the total of certain items of cost will remain fixed and the remainder will vary in proportion to the volume of  production If a company were to double its output then the fixed elements of cost would increase for example: Larger premises might be required More equipment More people in non productive roles Etc.

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Marginal Costing

The theory of marginal costing can be summarised as follows: An increase in output will result in a reduced unit cost. Conversely a reduction in output will result in an increase in unit cost For a specified increase in output, if the increase in cost is divided by the number of additional units then the result will be the average marginal cost It is fundamental to the marginal cost approach that costs are segregated into those which tend to remain constant at varying levels of output and those which vary proportionately with the level of output

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Marginal costing

Shown graphically: Cost £

Total cost

Variable cost

Fixed cost

Output 9

Marginal costing

Marginal costing and profit

Marginal costing has developed from a  particular view of the nature and  behaviour of cost and how these affect the  profitability of an enterprise.

The principal assumption is that the difference between the marginal cost of  products (the variable cost) and the selling  price leaves a fund from which to meet fixed cost and provide a profit.

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Marginal costing

In short:

Fixed costs are spread over a given output. Thus:

For increased output the share of fixed cost that any particular unit carries reduces, and conversely

For decreased output the share of fixed costs that any particular unit caries increases. 11

Marginal costing

Variable costs are in direct relationship with the number produced.

Absorption costing does not recognise the distinction between fixed and variable costs  –  fixed costs are charged to each unit even though there is no direct relationship.

Returning to our car:

Although maintenance and depreciation cost will be affected. The principle cost of any  journey is the fuel consumed. Tax and insurance cost remain unaffected. 12

Marginal costing

If absorption costing were to be used all costs of running the car over a year would be taken together and divided by the annual mileage giving the average (or absorbed) cost per mile. This would then be used to calculate the cost of our journey.

In marginal costing –  since tax and insurance, the fixed costs, are unaffected by distance –  we must calculate the marginal or ‘extra’ cost of our journey.

In calculating the marginal cost the fixed costs are irrelevant. 13

Marginal costing

Managers often face similar problems in costing decisions.

Absorbed costs will often cloud the issue when deciding upon the outcome of  particular events.

In making particular decisions it can be assumed that fixed costs will remain fixed in the short term. In the longer term however even fixed costs will alter, for example if the firm were to expand or contract.

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Marginal costing Shown graphically: Cost £

Short term

Total cost

Variable cost

Fixed cost Cost £

Output

Time

Long term Total cost

Variable cost

Fixed cost

Time

Output15