Marginal CostingDefined along with Formula & How to Calculate

Written By:
Lisa Borga

Marginal costing refers to the changes in cost which result from a change in the volume of production or sales.

When a change in total cost occurs due to an increase or decrease in the volume of sales or production, this amount may be referred to as the marginal, differential, or incremental cost.

Marginal costing measures the variable expenses that are incurred in providing additional units of a good or service.

As a result, this measurement can provide valuable information for management to make decisions to optimize production, operations, and resource allocation in order to control costs and maximize profits.

Marginal Costing Explained

Marginal costing is an important concept for any company to optimize its production of goods or services and is particularly useful for the manufacturing industry in order to set an ideal level of production.

Using marginal costing, a company determines the costs associated with adding an additional unit of production.

This does not include fixed costs such as overhead or marketing, which will remain the same regardless of the level of production.

The concept of fixed costs is central to achieving the benefits associated with economies of scale, as a larger number of units produced will mean a lower fixed cost per unit.

Marginal costs include all of the variable expenses associated with producing additional units, such as labor, materials, and equipment.

As additional units are produced, these expenses will increase until the cost is equivalent to marginal revenue, and any further production would result in a loss.

This point where the marginal cost and revenue are equivalent is the point where profit is at its maximum level, and ideally, production should be held at this level.

It is important in calculating the marginal cost of production to include all of the expenses associated with adding an additional unit of production.

For example, adding an additional unit will, up to a point, only involve the addition of materials and labor, but at a point, a company may require an additional factory in order to increase production capacity or additional warehouse space to store units.

These would be marginal costs that should be included in a company’s marginal costing calculation.

Calculating Marginal Cost

In order to calculate marginal cost, a company aims to determine the cost of adding or reducing production.

Often companies will calculate marginal costs beginning at the point where enough units have been produced to cover fixed costs and production has reached a break-even point.

Past this, any expenses would be direct or variable costs.

To calculate marginal cost, the total change in cost is divided by the change in quantity.

For example, if producing 100 units has a cost of $1,000 and producing 101 costs $1,010, the marginal cost of the 101^st unit would be $10.

The formula for calculating marginal cost is:

Marginal Cost = Change in Total Cost / Change in Quantity

In calculating this, a company must determine its total cost, which is the sum of its fixed and variable costs.

Marginal costs will be directly proportional to the variable costs at every level because fixed costs will not change with the quantity of production.

Instead, fixed costs’ effect on per unit cost will simply decline as the number of units produced increases, and it is divided amongst a greater number of units.

Marginal cost can be plotted on a graph and typically will form a U shape.

The marginal cost will generally begin high and then reach the break-even point where fixed expenses are covered.

It will remain at this low point for a time before climbing back up as increased production begins to require a significant investment in additional employees, facilities, equipment, and more.

Components of Marginal Costing

Marginal costing depends on two primary components, which are fixed costs and variable costs.

In every company, the quantity of some required resources will not change with the level of production.

These are fixed costs, and the most common types include overhead costs, administrative costs, and sales costs.

However, for many types of resources, additional inputs must be made in order to increase production.

These are variable costs and often include labor and raw materials.

A good example of this would be a deli. In order to produce sandwiches, it requires a kitchen to prepare the sandwiches and a dining area for customers to purchase and eat them.

However, more of these inputs are not required for virtually any number of sandwiches.

However, the more sandwiches that the deli produces, the more it requires labor to prepare them and raw materials such as meat, bread, and vegetables.

As more of these materials are required, the cost of production will increase.

If production were to increase past a point, even fixed costs might increase as more kitchen and dining space is required, and this would contribute to marginal cost.

However, typically variable costs play the largest role in marginal costing.

Marginal Cost Example

In order to calculate marginal cost, it is necessary to divide the change in production costs by the change in output desired.

Next is an example of how to calculate marginal cost.

Ruby owns a company that manufactures specialty garage doors.

The first year Ruby was in business, she sold 17 doors for $7,000 each for a total of $102,000.

The doors cost $51,000 to make. In Ruby’s second year of business, she sold 25 doors for $7,000 each for a total of $175,000.

It cost Ruby $87,500 to make these doors.

The change in Ruby’s total cost of production follows.

$87,500 – $51,000 = $36,500

Next is the change in quantity.

25 – 17 = 8

Once the change in production costs and change in quantity is determined, it is time to use the marginal costing equation.

MC = ΔTC/ ΔQ

Marginal Cost = $36,500 / 8 = $4,562.50

This means the marginal cost for each door is $4,562.50.

Advantages & Disadvantages of Marginal Costing

Advantages of Marginal Costing

Marginal costing has several advantages, and here are a few of them.

• Overhead pricing is not included.
• It is an easy way to compare costs.
• The cause is easily ascertain
• It helps make decision-making more effective.
• Marginal cost classifies costs as both variable and fixed.

Disadvantages of Marginal Costing

Although marginal costing can be useful for many companies, it does have some disadvantages, such as:

• The marginal cost method does not consider time to be a factor.
• There are some sectors for which marginal costing is not effective.
• The efficiency of resources, as well as some additional factors, may have an effect on marginal cost.

Key Takeaways

• Marginal costing is a key concept in managerial accounting that helps companies to optimize their production process and achieve economies of scale.
• Marginal costing is based upon variable costs, which change according to the level of production, and not fixed costs which remain the same regardless of how many units are produced.
• By utilizing marginal costing, a company can identify its break-even point where the marginal cost is equivalent to marginal revenue. This is crucial for maximizing profit and setting an ideal selling price for a product or service.

FAQs

What Is Marginal Costing?

Marginal costing is a costing method that looks at changes in costing that occurred due to a change in the range or volume of sales and output.

If there is an increase or decrease in total costs that occur due to an increase or decrease in the volume of sales and production, this is a marginal cost.

These costs will include expenses that occur at all of the different stages of production as a result of changes in the resources necessary to produce additional services or products.

How Do Marginal Costing and Absorption Costing Differ?

The marginal costing technique uses variable costs as the production cost.

In contrast, absorption costing uses fixed and variable costs for the production costs.