An introduction to marginal costing

Key terms to understand

• Variable costs are costs which change according to the level of output.  If you think about your kitchen table the two main costs in making it would be the raw materials (say wood) and the labour cost.  We can use this to calculate the cost of making an item.  The more tables a firm makes the higher its variable costs would be.
• Revenue is calculated by multiplying the selling price by the quantity sold
• Fixed costs are those that do not change according to output.  This would include things like rent.  Your landlord will not charge you more if you make one more product in a factory – he just wants his rent!
• Total Contribution is the difference between the total sales revenue and the total variable costs.   It is not the same as profit since we reach a figure for contribution we have only deducted variable costs and not taken away our fixed costs. 
• Contribution per unit is Selling Price per unit – Variable cost per unit .  We can use this to calculate the amount of units we need to sell in order to recover our fixed costs.  This is known as the break-even point.  Each unit sold is contributing towards paying the fixed costs.  After this every unit sold contributes towards profits.

Marginal Costing

Marginal costing is the cost of producing one more item. In other words the marginal cost is the same as variable cost per unit.  The idea behind marginal costing is that fixed costs have to be paid regardless so it is useful for some short term management decisions.  These could include: -

• Whether to make or buy a product
• Special order contract (e.g. supermarket offer to a one off amount)
• Profit maximisation where there is a limiting factor (e.g. raw materials / labour) which means we must maximise profits based on the scarce resources we have.
• Deletion of less profitable products

These are discussed in blogs here

Benefits of Marginal costing

• It is useful in decision making
• It avoids the need for arbitrary division of fixed costs which occurs in Absorption costing
• It provides a flexible basis for pricing decisions which can be done quickly
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• Ignores fixed costs which simplifies matters when making decisions

However

• Some costs are difficult to classify as fixed or variable
• It ignores fixed costs – but these still need to be covered!
• In the longer term, fixed costs can change thus invalidating earlier decisions based on contribution
• When setting a selling price using marginal costing for regular customers a larger percentage may be required (to ensure fixed costs are covered) than with absorption costing.  If the marginal cost is incorrectly calculated it could lead to incorrect pricing being applied.

An example of a marginal costing statement is shown below.