What is marginal costing and what are the benefits of adopting this method in your Organization? This is something most companies follow inadvertently without actually knowing its pros and cons.
Expenses in a Company can be divided into two:-
1. Fixed cost – Suppose you are running a hotel, there are some basic expenses you incur for the running of the same. Employee cost, electricity, rent etc. This cost you will incur regardless of whether you have customers or not.
2. Variable / Direct cost – This is purely linked to the production volume of a particular product. For preparing 100 Biriyanis we need a particular quantity of rice, meat, spices, oil and other ingredients, the preparation will also need fuel, electricity etc. Assume that by selling this the kitchen is not making any profit or loss, after allocating the fixed expenses. If you get order for another 50 biriyanis, the extra cost will be for the proportionate ingredients only. So the cost of that extra 50 biriyanis will definitely be less that the initial 100 biriyanis where there was no loss / no profit. Hence if you are selling at the same price, you can make good profit off that extra 50 biriyanis.
Both the above expenses are of different kinds. The first one will be fixed and will be the same regardless of any change in volume of customers. The second cost will increase when the business increases. When it reduces it will reduce. When you are able to differentiate a company’s expenses in the methods mentioned above, and you are able to understand how your profit will change if the volume of business goes up or down, beforehand, that is the concept of marginal costing.
Benefits of marginal costing
1. You get to know about the volume of business you need to do to break even.
2. What is the volume of business you need to do, to get your desired profit level.
3. When competition is high, what is the minimum price you can adopt and sell without incurring a loss.
4. Calculated/informed decisions can be made without affecting your bottom line.