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.

Budgeting definitions

BUDGETS AND BUDGETARY CONTROL

DEFINITIONS:

FORECAST:  A prediction of the results of carrying on business over a future period of time, and of the position of the business at the end of that time if present and, as far as they are known, future conditions and trends are allowed to continue without management intervention.

BUDGET:       A statement in money terms of management’s plans for operating a business over a future period of time and their plans for the position of the business at the end of that time.

MASTER

BUDGET:       A profit and loss account and balance sheet based upon the operating budgets. Often referred to as “forecast income statements and balance sheets”.

BUDGET

PERIODS:      The period for which a budget is prepared, commonly for one year, but it will depend upon the particular business.

BUDGETARY

CONTROL:    The use of budgets to monitor the performance of managers against their functional budgets. The system allows for the continuous comparison of actual with budgeted results at frequent intervals so that corrective action may be taken when necessary. 

SALES

BUDGET:       Based upon the forecast demand for the goods. The forecast will be based upon market research, salesmen’s reports and other trade information sources. It will be expressed in sales volumes.

PRODUCTION

BUDGET:       This is a budget for the production of finished goods.

CASH

BUDGET:       This is a budget for the cash flow of a business. These are prepared on a cash and not accruals basis.

PURCHASES

BUDGETS:     Budgets for the purchases of supplies of materials. The information needed will be compiled from production budgets.

Social Accounting

“Financial data should AID not MAKE decisions for firms”

Accountants have a “social responsibility” to a range of stakeholders; not just those who have a narrow financial interest in the firm’s decision making. This is is also part of business ethics.

Typically such social responsibility extends to considering the side effects and implications of the decisions that may be significantly influenced by financial data.

Considerations could include: -

• The impact of redundancies,
• Is the firm a large local employer with a “community responsibility” too?
• environmental factors (pollution, congestion, destruction of the “natural” environment – brown field development as opposed to green field developments).
• The percentage of waste generated
• Levels of toxic waste
• The number of industrial accidents
• Labour turnover rates
• The percentage of materials that come from sustainable sources
• The amount of waste that is recycled
• The amount of the finished product that can be recycled when it reaches the end of its useful life; this is a big factor in car production – where a tax on the disposal/ scrap value of the vehicle may be charged if much of it isn’t recyclable.
• Will there be “hidden costs”? – Compensation, fines or taxes to pay for the negative externalities generated from firms’ selfish actions?

Summary

Accountants shouldn’t be making decisions that affect the whole business without reference to others Senior Managers in the organisation.  The firm’s Corporate “Mission Statement” should include something about the values and beliefs that they trade under – ETHICS – where profit maximisation doesn’t necessarily always come first.

Indeed cynically many firms now recognise that being “ethical” is good business and this taps into a growing awareness and consciousness in consumers who see ethical practice as one of the factors affecting their purchase choice.  In other words using it to increase profits!