Marginal Costing

 MARGINAL COST AND MARGINAL COSTING 

 Marginal cost 

The marginal cost of an item is its variable cost. 

• Marginal production cost includes direct materials, direct labor, and variable production overheads. 

• Marginal cost of sale for a product includes variable selling and administrative cost in marginal production cost. 

• Marginal cost of sale for a service includes a similar cost as mentioned in marginal production cost, the only difference is that here marginal cost of service is included. 

It is usually assumed that direct labor costs are variable (marginal) costs, but often direct labor costs might be fixed costs, and so would not be included in marginal cost. E.g. If the workers are not being paid on a piece rate basis but rather on a fixed salary. 

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 labor hours or machine hours, although other suitable measures 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. 

Marginal costing is also known as direct costing or variable costing, as in marginal costing, inventory is measured at variable product cost. 

 Marginal costing and its uses 

Marginal costing is a method of costing in which inventories are measured with the variable cost of production. It is an alternative to the absorption costing as a method of costing. In marginal costing, fixed production overheads are treated as period costs and charged as expenses in the year of occurrence. 

There are arguments in support of using marginal costing: 

• Marginal costing provides more useful information for decision-making. The separation of fixed and variable costs helps to provide relevant information for better decision-making. In addition, the estimation of costs at various level helps to judge appropriate level for decision-making as well.  

• Another argument for using variable costing for internal reporting is that the internal profit statements may be used as a basis for measuring the managerial performance. In absorption costing, there might be chances of manipulating performance by enhancing closing inventory, where fixed cost is included in cost of closing inventory. Whereas in marginal costing, it is not possible for managers to manipulate profits, because fixed cost is not a part of inventory. 

• The situation where market demand of product declines, the stock can be end up with surplus stock. In absorption costing, fixed cost proportion is included in the surplus stock. If this surplus stock cannot be sold, then profit calculation for the current period will be misleading. Marginal costing, in this situation, provides true picture of profits, as fixed cost is treated as period cost, not product cost. 

 Marginal costing characteristics 

• All elements of costs are segregated into fixed and variable, whether it is production or non-production cost. 

• Variable cost per unit remains constant irrespective of level of production. However, total variable cost change in accordance with change in volume. 

• Fixed cost is treated as period cost, and is charged to profit & loss in the period of occurrence. 

 

 

• The inventories in marginal costing includes only variable production cost. All fixed costs and variable nonproduction costs are not part of inventory. 

• Marginal costing technique helps to management in decision-making process. For example, large order from customer at discounted price can be judged from marginal costing technique. (Ashok, 2020) 

 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.  

• 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. Therefore, marginal costing is particularly important for decision making as it focuses on what changes as a result of a decision.  

 Contribution margin 

Contribution is a key concept in marginal costing. Gross contribution margin is calculated by deducting the variable production cost from its revenue whereas net contribution margin, mostly known as contribution margin, is derived by deducting total variable costs from its revenue. 

Gross Contribution margin = Sales – Variable Production costs 

Contribution margin = Sales – Variable costs (Both production and non-production)  

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 margin – Fixed costs = Profit 

In simple words… 

Contribution margin is sales minus all Variable costs  


Formate

Sales                                                                         X 

Opening inventory                                                                 X  

Add: variable production cost:  

Direct materials cost (A)                                                         X  

Direct labour cost (B)                                                            X  

Variable production overheads (C)                                                 X  

Less closing inventory (A+B+C)/units produced x closing inventory units (X) 

Gross contribution                                                          X 

Less: variable selling and administrative cost                                 (X) 

Net contribution margin                                                  X 

Less: Fixed cost:  

       Production                                                                  X  

       Non-production                                                         (X) 

Net profit                                                                  X