After reading through, you will be familiar with the definition of terms, the Quantitative and Qualitative Factors in Decision Making, Types of Costs, Advantages and Disadvantages of the Marginal Costing Techniques and much more. See also: Absorption Costing Techniques.
What is Marginal Costing Techniques (MCT)
First of all, the marginal costing techniques (MCT) are used by management accountant to present cost information which will be used for decision making. The major characteristics of MCT are the separation of the total cost into its variable and fixed components.
The need for this is to enable the users of such information to distinguish between the costs that are relevant for the decision to be taken.
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What are Period Costs?
Period costs are constant and no matter what the volume of sales and production provided that the operation is within the relevant range. This means that by making and selling an extra unit of a product, the total cost will increase only by the variable cost i.e. the marginal cost of production for that unit. Also, the total cost will fall by the variable cost per unit for each reduction by one unit in the level of activity.
The additional profit earned by making and selling an extra unit of output is the extra revenue from sales minus the variable cost per unit. As the volume of activity increases, there will be an increase in the total profit which is equal to the total extra variable cost.
How to Derive Contribution in Marginal Costing Technique
A contribution is described as a difference between sales and variable costs. Also, contribution to the recovery of fixed cost and profit-making.
TP = TR – TVC – TFC
Where,
TP = Total Profit
TR = Total Revenue
TVC = Total Variable Cost
TFC = Total Fixed Cost
Marginal Costing Technique as a Tool for Decision Making
Decision making is futuristic and involves a choice between alternatives. Many factors both quantitative and qualitative would provide information for many decisions. Financial information is a critical factor. It is important that relevant information on cost and revenue be supplied.
Quantitative Factors in Decision Making
- Quantitative factors can be quantified
- They can be measured
- They are precise and
- They can be expressed in monetary terms.
Qualitative Factors in Decision Making
- Qualitative factors are those factors whose measurement in Naira value are difficult and not precise.
Relevant Cost and Historical Cost
A decision always involves prediction. The function of decision making is to select the causes of action for the future.
The task of an accountant will be made easier in the application of the contribution approach if he or she can identify the cost that is relevant to the decision at hand. For a cost to be relevant, two conditions must be met and they are;
- If a particular action is to be taken by the management which has to do with future cost.
- If the cost makes a difference between alternative decisions.
The identification of relevant costs should help in computing the marginal or incremental cost of a job. Marginal cost includes;
- All variables costs incurred because of the job.
- Any additional cost incurred purposely because of the job.
Relevant Cost for decision is expected future cost that will differ under alternatives. Example: Variable cost, differential fixed cost, replacement cost, opportunity cost etc…
Historical Cost is past cost, Non-futuristic and irrelevant to decisions. However, they may be the best available basis for predicting the future cost.
Difference Between Differential Cost and Incremental Cost
Differential Cost is a difference in the cost of an alternative choice. It is the difference between the relevant costs of each option.
Incremental Cost is the difference in the cost of an extra unit of production i.e. the marginal cost of producing an additional unit of a product.
Therefore, Marginal Costing Techniques are useful decision-making techniques at the disposal of the management of an organization. It involves quantifying and qualifying the cost and benefit associated with alternative causes of action.
Advantages of Marginal Costing Techniques
- It provides a ready source of data for solving decision-making problems.
- It assists in the pricing decision making the process.
- It encourages managers to concentrate on sales volume rather than production volume as surplus production does not add to profit.
- It is simple to operate.
Disadvantages of Marginal Costing Techniques
- It fails to recognize that an upward or downward trend in volume will eventually lead to an increase or decrease in fixed cost.
- A business remains unprofitable unless fixed cost is covered by sufficient contribution.
- It places emphasis on the short-run effect of cost whereas fixed cost will vary in the long run.
- Cost analysis of fixed and variable components may be subjective.
Video Guide on Marginal Costing Techniques
In this video, you’ll learn the four steps to derive NET PROFIT. This video will guide you o the best step to solve all problems under the MCT.