Marginal costingMarginal costing and its uses Marginal costing is a method of costing with marginal costs. It is an alternative to absorption costing as a method of costing. In marginal

Marginal costing

Marginal Cost Definition:

The marginal cost of an item is its variable cost.

Marginal production cost= Direct materials + Direct labour + Variable production overhead.

Marginal cost of sale for a product= Direct materials + Direct labour + Variable production overhead + Other variable overhead (for example, variable selling and distribution overhead).

Marginal cost of sale for a service= Direct materials + Direct labour + Variable overhead.

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Variable overhead costs might be difficult to identify. In practice, variable overheads might be measured using a technique such as high/low analysis or linear regression analysis, to separate total overhead costs into fixed costs and a variable cost per unit of activity.

• For variable production overheads, the unit of activity is often either direct labour hours or machine hours, although another measure of activity might be used.

• For variable selling and distribution costs, the unit of activity might be sales volume or sales revenue.

• Administration overheads are usually considered to be fixed costs, and it is very unusual to come across variable administration overheads.

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Marginal costs and total costs

When marginal costing is used, total costs are the sum of variable costs (marginal costs) and fixed costs. It is important in marginal costing that you should separate variable costs from fixed costs, and identify them separately.

Remember that there might be some variable selling and distribution costs.

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The table below shows how variable and fixed costs might be separated in a marginal costing analysis.

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Marginal costing and its usesMarginal costing is a method of costing with marginal costs. It is an alternative to

absorption costing as a method of costing. In marginal costing, fixed production

overheads are not absorbed into product costs.

There are several reasons for using marginal costing:

• To measure profit (or loss), as an alternative to absorption costing

• To forecast what future profits will be

• To calculate what the minimum sales volume must be in order to make a profit

It can also be used to provide management with information for decision making.

This lesson looks at using marginal costing to measure profit, as an alternative to

absorption costing. Its main uses, however, are for planning (for example, budgeting), forecasting and decision making.

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Assumptions in marginal costing For the purpose of marginal costing, the following assumptions are normally made:

• Every additional unit of output or sale, or every additional unit of activity, has the same variable cost as every other unit. In other words, the variable cost per unit is a constant value.

• Fixed costs are costs that remain the same in total in each period, regardless of how many units are produced and sold.

• Costs are either fixed or variable, or a mixture of fixed and variable costs. Mixed costs can be separated into a variable cost per unit and a fixed cost per period. Techniques such as high/low analysis or linear regression analysis should be used to do this.

• The marginal cost of an item is therefore the extra cost that would be incurred by

making and selling one extra unit of the item.

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Contribution

Contribution is a key concept in marginal costing.

Contribution = Sales – Variable costs

Fixed costs are a constant total amount in each period. To make a profit, an entity must first make enough contribution to cover its fixed costs. Contribution therefore means: ‘contribution towards covering fixed costs and making a profit’.

Total contribution – Fixed costs = Profit

• When fixed costs have been covered, any additional contribution adds directly to profit. If total contribution fails to cover fixed costs, there is a loss

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Reporting profit with marginal costing

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With marginal costing, profit is measured as follows

Total contribution and contribution per unit

In marginal costing, it is assumed that the variable cost per unit of product (or per unit of service) is constant. If the selling price per unit is also constant, this means that the contribution earned from selling each unit of product is the same.

Total contribution can therefore be calculates as:

Units of sale ×Contribution per unit.

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Example

A company manufactures and sells two products, A and B. Product A has a variable cost of $6 and sells for $10, and product B has a variable cost of $8 and sells for $15.

During the period, 20,000 units of Product A and 30,000 units of Product B were sold. Fixed costs were $260,000. What was the profit or loss for the period ?

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Answer

Contribution per unit:

• Product A: $10 – $6 = $4

• Product B: $15 – $8 = $7

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$

Contribution from Product A: (20,000 ×$4) 80,000

Contribution from Product B: (30,000 ×$7) 210,000

Total contribution for the period 290,000

Fixed costs for the period (260,000)

Profit for the period 30,000

A marginal costing income statement with opening and closing inventory

The explanation of marginal costing has so far ignored opening and closing

inventory. In absorption costing, the production cost of sales is calculated as

‘opening inventory value + production costs incurred in the period – closing inventory value’.

The same principle applies in marginal costing. The variable production cost of sales is calculated as ‘opening inventory value + ‘opening inventory value + variable production costs incurred in the period – closing inventory value’.

When marginal costing is used, inventory is valued at its marginal cost of production (= variable production cost), without any absorbed fixed production Overheads.

If an income statement is prepared using marginal costing, the opening and closing

inventory might be shown, as follows:12

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However, when the variable production cost per unit is a constant amount, there is no need to show the opening and closing inventory valuations, and the income

statement could be presented more simply as follows:

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Reporting profit with absorption costing

Absorption costing is the ‘traditional’ way of measuring profit in a manufacturing company. Inventory is valued at the full cost of production, which consists of direct

materials and direct labour cost plus absorbed production overheads (fixed and

variable production overheads).

The absorption rate for variable production overheads should be the same as the

variable overhead rate of expenditure. However in absorption costing variable and

fixed production overheads might not be separated.

In absorption costing, there is some under- or over-absorbed overhead, which

occurs because the absorption rate is a predetermined rate.

The full presentation of an absorption costing income statement might therefore be

as follows (illustrative figures included):

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The difference in profit between marginal costing and absorption costing

The profit for an accounting period calculated with marginal costing is different from the profit calculated with absorption costing. The difference in profit is due entirely to the differences in inventory valuation.

When there is no opening or closing inventory, exactly the same profit will be reported using marginal costing and absorption costing.

The main difference between absorption costing and marginal costing is that:

• in absorption costing, inventory cost includes a share of fixed production overhead costs

• in marginal costing, inventory cost contains no fixed production overhead costs.

The following rules may be applied to calculate the difference in the profit for a

period calculated with marginal costing and with absorption costing.

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Calculating the difference in profit: increase in inventory during a period

Look at the difference between the quantity of opening inventory and closing inventory. Establish whether:

• closing inventory is larger than opening inventory, or

• closing inventory is less than opening inventory.

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Closing inventory is higher than opening inventory when the quantity produced in the period is more than the quantity sold. If the cost per unit is a constant amount, using marginal costing or absorption costing, when the production quantity exceeds the sales quantity:

• There is an increase in inventory during a period

• Closing inventory is therefore higher in value than opening inventory

• The increase in inventory will be greater with absorption costing, by the amount of the increase in fixed production costs in the inventory value

• The production cost of sales is therefore lower with absorption costing than with marginal costing, and the difference is this increase in fixed costs in the inventory value

• Therefore the profit is higher with absorption costing than with marginal costing, by the amount of the increase in fixed costs in the inventory value.

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Example

A company uses marginal costing. In the financial period that has just ended, opening inventory was $8,000 and closing inventory was $15,000. The reported profit for the year was $96,000.

If the company had used absorption costing, opening inventory would have been $16,000 and closing inventory would have been $35,000.

Required

What would have been the profit for the year if absorption costing had been used?

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AnswerThere was an increase in inventory. It was $7,000 using marginal costing (= $15,000 – $8,000). It would have been $19,000 using absorption costing.

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$

Increase in inventory, marginal costing 7,000

Increase in inventory, absorption costing 19,000

Difference (profit higher with absorption costing) 12,000

Profit with marginal costing 96,000

Profit with absorption costing 108,000

The profit is higher with absorption costing because there has been an increase in inventory (production volume has been more than sales volume.)

Example

The following information relates to a manufacturing company for the next costing period.

Production 16,000 units Fixed production costs $80,000

Sales 14,000 units Fixed selling costs $28,000

Using absorption costing, the profit for this period would be $60,000

Required

What would have been the profit for the year if marginal costing had been used?

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Answer

Ignore the fixed selling overheads. These are irrelevant since they do not affect the difference in profit between marginal and absorption costing.

• There is an increase in inventory by 2,000 units, since production volume (16,000 units) is higher than sales volume (14,000 units).

• If absorption costing is used, the fixed production overhead cost per unit is $5 (= $80,000/16,000 units).

• The difference between the absorption costing profit and marginal costing profit is therefore $10,000 (= 2,000 units ×$5).

• Absorption costing profit is higher, because there has been an increase in inventory.

• Marginal costing profit would therefore be $60,000 – $10,000 = $50,000.

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Advantages and disadvantages of absorption costing

Advantages of absorption costing

• Inventory values include an element of fixed production overheads. This is

consistent with the requirement in financial accounting that (for the purpose of

financial reporting) inventory should include production overhead costs.

• Calculating under/over absorption of overheads may be useful in controlling

fixed overhead expenditure.

• By calculating the full cost of sale for a product and comparing it will the selling

price, it should be possible to identify which products are profitable and which

are being sold at a loss.

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Disadvantages of absorption costing

• Absorption costing is a more complex costing system than marginal costing.

• Absorption costing does not provide information that is useful for decision making (like marginal costing does).

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Advantages and disadvantages of marginal costing

Marginal costing has a number of advantages and disadvantages

Advantages of marginal costing

• It is easy to account for fixed overheads using marginal costing. Instead of being apportioned they are treated as period costs and written off in full as an expense the income statement for the period when they occur.

• There is no under/over-absorption of overheads with marginal costing, and therefore no adjustment necessary in the income statement at the end of an accounting period.

• Marginal costing provides useful information for decision making.

• Contribution per unit is constant, unlike profit per unit which varies as the volume of activity varies.

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Disadvantages of marginal costing • Marginal costing does not value inventory in accordance

with the requirements of financial reporting. (However, for the purpose of cost accounting and providing management information, there is no reason why inventory values should include fixed production overhead, other than consistency with the financial accounts.)

• Marginal costing can be used to measure the contribution per unit of product, or the total contribution earned by a product, but this is not sufficient to decide whether the product is profitable enough. Total contribution has to be big enough to cover fixed costs and make a profit.

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•END

• THANK YOU

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