Marginal Costing: Introduction

• We have already looked at absorption costing here
• Now it is time to examine marginal costing which is an alternative way of looking at things
• For while absorption costing treats production overheads as a product cost by assigning a share of these overheads to each units produced
• Marginal costing treats all fixed overheads as period costs which are charged in full against the profit for the period
• Because of this absorption and marginal costing give different value to inventory and cost of sales sold as the later uses an amount which does not have a portion of fixed costs
• The marginal cost of a unit of inventory is the total of variable costs required to produce that unit
• This includes direct materials, direct labour, direct expenses and variable production overheads
• No fixed overheads are included in the inventory valuation
• As they are treated as period costs and deducted in full in the profit and loss statement
• Marginal cost can thus be defined as the cost incurred by producing one extra unit
• That cost could be avoided if that unit is not produced or procured
• Even with its apparent flaws marginal costing is a very useful decision making technique
• This is because marginal costing focuses on avoidable costs that can be changed by the decision under consideration rather than getting distracted by unavoidable fixed overheads

Contribution

• At the heart of marginal costing is the concept of contribution
• \text{Contribution = Sales Price-Variable Costs}
• Contribution can thus be defined as the amount left over after variable costs have been deducted from the selling price
• It represents the amount each unit “contributes” towards fixed overheads
• Unlike the profit of producing each unit contribution per unit is constant in spite of changes in levels of activity
• \text{Total contribution = Contribution per unit x Sales Volume}
• \text{Profit= Total Contribution-Fixed Overheads}

The effect of absorption and marginal costing on inventory valuation and profit determination

• Marginal costing values inventory at the variable cost of production of each product unit
• Absorption costing on the other hand values inventory at the full production cost of each unit including absorbed portions of fixed overheads
• Inventory values will therefore be different at the beginning and end of the year under marginal and absorption costing
• Naturally this means a different profit/loss will be reported in a given period depending on which method is used

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