MARGINAL AND DIFFERENTIAL COSTING AS A TOOL FOR DECISION MAKING ec pter, you should be able to understand : leaning of relevant costs Relevant costs vs. variable cost and fixed costs Differential costs and relevant costs Marginal and differential costing as a tool for decision making Pricing, make or buy, change of product/sales mix decisions Bone, new markets, export order, depth of processing, and shut-down or continue lecisions Profit planning, evaluation of performance and key or limiting factor etc. m RELEVANT COSTS Relevant costs are the expected future costs which differ under different alternatives. These costs are affected by managerial decisions and hence taken into consideration for taking a particular decision. For example, while taking a decision about whether to retain or replace an old machine, the dismantling cost and the realizable value of old machine are relevant costs but the book value of the old machine is irrelevant cost. Relevant cost analysis is an important technique because it draws attention of the decision-maker to those elements of costs which are relevant for the decision. jm RELEVANT COST VS. VARIABLE COST It must be remembered that all variable costs are not relevant costs as only those variable cost which differ under different alternatives are relevant costs. Variable costs which remain unchange under different alternatives are not relevant costs as these are irrelevant to the decision. i RELEVANT COST VS. FIXED COSTS ed costs are those costs which do not vary with the level of production output. These rema. the level of output. It must, however, be noted that all fixed costs are n Fixe constant irrespective of16.2) Marginat ana wuyeren fant for all times and for all decisions. Fixed costs evant costs but fixed costs which change irrelevant costs as fixed costs do not remain const dered while taking a decisions. which remain constant under different alternatives are irrel t under different alternatives are relevant costs that need to be consi OPPORTUNITY COSTS Opportunity costs refer to the and not the other. For example, if expected rent of the building is the evaluating the profitability of the project. m SUNK COSTS AND SHUT DOWN COSTS be incurred even if productio in reasons such as strike, peen incurred and are irrelev: a result of adopting one course of action ‘an owned building is proposed to be used for a project, the ‘opportunity cost that must be taken into consideration while advantages foregone as wn or operations of an undertaking shortage of raw material, etc. are ant in a particular situation Those fixed costs which have to are discontinued temporarily due to certai called shut down costs. Costs which have are called sunk costs. m DIFFERENTIAL COSTS Differential costs are the increase or decrease in total costs that result from producing, additional or fewer units or from the adoption of an alternative course of action. The alternative course of action may arise due to change in sales volume, alternative method of production, change in product/sales mix, make or buy, refuse or accept decisions, addition of a new product, exploring a new market, decision to drop a product line, etc. Hence, differential cost is the change of cost arising from an alternative course of action, e.g., suppose cost of sales at present level of activity (60% capacity) is % 12,00,000 and expected cost of sales at 80% capacity is % 15,00,000, then differential cost will be %3,00,000, ie., € 15,00,000 — 12,00,000. Differential cost may be referred to as either incremental cost ot decremental cost. When there is an increase in the cost due to increase in the level of production, it is called incremental cost, and when there is decrease in the cost due to decrease in the level oi production, it is called decremental cost. A few definitions of differential cost are given below. oe ding to Pie ‘ Speahgin Management Accountant, London, differential cost may be defined “the increase crease in total cost or th i fi ‘aviation in operations,” e change in specific elements of cost that result from any See ee incon 7 “differential costs, also frequently described as marginal cost and bore are lecrease in total costs that i i " addi result from it tional or fewer units of a product or from a change in method of production or etinuton Ree m DETERMINATION OF DIFFERENTIAL COST Differential cost is the change in cost that results from It can be determined simply by s i y subtracting cos ° i from the cost at one level of activity the i . ost of one alternative from cost of another alternative © y . another avi eifeenta et fom two alematves, fe, rare eleal of activity. In the following illustration ssed : at 70% capacity and 90% capaci bee capacity, has bet adopti 5 . option of an alternative course of actiona 88 @ Tool for Dectston Making Alternative 1 ‘Alternative 1 Differential cost” 70% capacity 90% capacity and revenue @) Sales : % 2 Direct Material 70,000 90,000 20,000 Dirst Labour 28,000 36,000 8,000 vase Overheads ae : ae oo Fixed Costs 7,000 i ,{ (b) Cost of Sates 16,000 16,000 — nant Costs can also be determined with the help of linear equations as follows cls of activity, the equations of costs can be represented as : y'=ma'+F : y =ma’+F ¥' and y* are costs at two levels of activity and m = marginal cost per unit al and a” = levels of activity F = fixed cost. iLe,, yy! = (ma*+ F) - (ma! + F) =m(a*a') where, Hence, Differential Cost, __Thus, in above illustration, where marginal cost at 70% level of activity is % 49,000, the differential cost between 90% and 70% level of activity will be = & 14,000. m_ ESSENTIAL FEATURES OF DIFFERENTIAL COSTING 1. The data used for differential cost analysis are cost, revenue and investments involved in the decision-making problem. 2. Differential costs do not find a place in the accounting records. These can be determined from the analysis of routine accounting records. 3. The total cost figures are considered for differential costing and not the cost per unit. 4. Differential cost analysis determines the choice for future course of action and hence it deal: with the future costs but even then historical or standard costs, adjusted to the futur requirements may be used in differential costing. 5. Differential costing involves the study of difference in costs between two alternatives an hence it is the study of these differences, and not the absolute items of cost, which i important. Moreover, elements of cost which remain the same or identical for th alternatives are not taken into consideration. 6. The differences are measured from a common base~point. 7. The alternative which shows the highest difference between the incremental revenue an the differential cost is the one considered to be the best choice.margins were ae yy a: DIFFERENTIAL COST ANALYSIS VS. MARGINAL COSTING sed as synonymous. But the two are 0 Similarities Most often, marginal costing and differential costing ar° © not exactly the same in all respects: ‘cen the two are summarised as follows: nd difference betws I cost analysis and marginal costing are the techniques of cost analysis The points of similarity a 1, Both the differentia and cost presentation. 2. Both the techniques are used by the management in formulating policies and making. decisions. Differential costs and marginal costs are the same when fixed costs do not change with the change in the output. imilal 1. Fixed costs are excluded fro1 consideration changes in fixe 2. Marginal costs may be incorporated in not find any place in the accounting records of a conce! separately from the analysis of accounting records. Differential cost analysis may be made both in absor costing. 4. Margin of contribution, P/V ratio and contribution per unit of limiting factor are the mai yardsticks for evaluation of managerial decisions in marginal costing. Whereas, ‘ferential costing, differential costs are compared with incremental or decrement revenues for evaluating managerial decisions. MANAGERIAL ‘APPLICATIONS OF MARGINAL AND DIFFERENTIAL COST ANALYSIS (MARGINAL AND DIFFERENTIAL COSTING AS A TOOL FOR DECISION MAKING) Marginal and differential costing technique is a valuable aid to management in taking m: managerial decisions. It is a useful tool for making policy decisions, profit planning and cost cont el igformation supplied by the ‘total cost method’ is usually not sufficient to solve manage problems. The following are some of the important managerial probl inal | differential costing technique can be applied : gan pete m marginal costs whereas differential cost analysis takes into .d costs due to change in the output. the accounting system whereas differential costs d rn. Differential costs are determine xption costing as well as marginz Pricing Decisions. 2. Export Orders and Exploring New Markets. 3. Make or Buy Decisions. 4. Selection of a Suitable or Profitable Product/Sales Mix. 5. Decisions regarding Depth of Processing etc. 6. Shutdown or Continue Decisions. 7. Profit Planning and Maintaining a Desired Level of Profit 8. Problems of Key or Limiting Factor. :