Marginal Costing – with simple examples

Marginal Costing – with simple examples

Marginal Costing Overview

In marginal costing fixed production overheads are not absorbed into products costs.
The main uses are; planning, forecasting and decision making.

Assumptions in marginal costing:

  • The variable cost per unit is a constant value.
  • Fixed cost are costs that remain same in total in each period.
  • Costs are either fixed or variable costs. Mixed costs can be separated into a variable cost per unit and a fixed cost per period.

Contribution:

  • It is a key concept in marginal costing.
  • Contribution therefore means; contribution towards covering fixed costs and making a profit.
  • If total contribution fails to cover fixed costs there is a loss.

Contribution = Sales – variable costs

Total contribution – fixed costs = Profit

Reporting profit with Marginal Costing

  • In a marginal cost system the opening and closing inventory is measured at its marginal cost. The cost per unit only includes the variable costs of production.
  • Profit is measured by comparing revenue to the cost of goods sold in the period and then deducting other expenses.

Marginal costing

AdvantagesDisadvantages
  • 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 when incurs.
  • No under/over-absorption.
  • Contribution per unit is constant unlike profit per unit which varies as the volume of activity varies.
  • It does not value inventory in accordance with requirements of financial reporting.
  • Marginal costing can be used to measure the contribution per unit of product or total contribution earned by a product, but this is not sufficient to decide whether the product is profitable enough.

Comparison between Absorption costing and Marginal costing

  • The profit calculated with marginal costing is different from the profit calculated with absorption costing.
  • The difference in profit is due to entirely to the differences in the inventory valuation; as in absorption costing inventory cost includes a share of fixed production overheads i,e opening inventory contains fixed production overheads incurred in last period which is written off in the current period and closing inventory contains fixed production overheads that was incurred in this period but carried forward to be written off in the next period.
  • When there is no change in the opening and closing inventory, exactly same profit will be reported using marginal costing and absorption costing.
When there’s an Increase in inventoryWhen there’s a Decrease in inventory

(i,e closing inventory is greater than opening)

  • It reduces cost of sales and increases profit.
  • The absorption profit will be higher.

(i,e closing inventory is greater than opening)

  • It reduces cost of sales and increases profit.
  • The absorption profit will be higher.

Profit Reconciliation: Between Absorption and Marginal costing

To calculate the difference between reported profit using marginal costing and the reported profit using absorption costing make follow simple calculations:

Step I

  • Calculate increase/decrease in inventory during the period in units:(opening inventory absorption & marginal minus closing inventory absorption marginal).

Step II

  • Calculate fixed production overhead cost per unit.

Step III

  • The difference in profit is the increase or decrease in inventory quantity multiplied by the fixed production cost per unit.

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