Marginal Costing

1
Marginal Costing

• Definition
• Marginal cost
• Marginal costing
• Contribution
• Inventory valuation
• Reconciling absorption / marginal costing
• Comparison with absorption costing

2
Definitions

• Marginal cost
• the cost of producing one more unit
• or the cost which could be avoided by
• not producing a unit
• Marginal costing
• an approach in which only variable costs are
  included in cost of sales
• fixed costs are treated as period costs
• and are written off as incurred

3
Contribution

• Sales revenue less variable cost
• May be in total or
• per unit

4
Uses of Marginal Costing

• Break even analysis
• Profit volume (PV) analysis (Profit planning)
• Margin of safety
• Expansion / contraction / divestment decisions
• Utilisation of limiting factor

5
Inventory valuation

• Only variable costs are included in Inventory
• Thus
• closing Inventory value is lower
• fewer costs are carried forward
• profit will be affected by Inventory value

6
Reconciling with absorption

• Difference is due to Inventory valuation
• Only period profit is affected
• In long run, there will be no difference
• In a period if Inventory increases,
• marginal costing will report a lower profit
• Make sure you can think this and the
  alternatives through!

7
Example

• Cost per unit variable 12
• fixed 8
• Inventory value Marginal 12
• Absorption 20
• Opening Inventory 100 units
• Closing Inventory 150 units
• Calculate effect on profit.

8
Example

• Marginal Absorption
• Opening Inventory 1,200 2,000
• Closing Inventory 1,800 3,000
• Movement 600 1,000
• as Inventory has increased, the movement will
  reduce cost of sales
• which will increase profit
• the effect is greater with absorption costing

9
Comparison

• Remember one is no better than the other
• The issue is the prime objective of the approach
• Absorption seeks to ensure that a share of each
  cost is included in each unit produced
• Marginal seeks to highlight the cost of one more
  unit
• However, it is possible to manipulate profits
  using absorption

10
Manipulating profits

• Marginal
• contribution (and therefore profit) changes in
  proportion to volume
• increase in profit increase in contribution
• Absorption
• no direct link between profit and sales volume
• increase in profit increase in gross profit
  
• increase in overhead absorbed
• Thus, by changing output and Inventory volume,
  profit can be manipulated

11
Advantages - Absorption

• Focuses attention on need for full capacity (to
  spread impact of fixed costs)
• Ensures that all costs are recovered
• Selling price will recover all costs
• All costs are variable in the long run
• Consistent with IAS 2

12
Advantages - Marginal

• Useful for short run decision making
• Fixed costs tend to be time based
• Equitable share of fixed costs is difficult
• thus less likely to de-motivate
• Actual volume rarely budgeted volume
• thus under/over absorption