MARGINAL COSTING
In marginal costing, we take ‘Cost behaviour’ into account. Cost behaviour means fixed and variable behaviour of cost. It means we split cost into fixed and variable element of cost. So we focus on Cost behaviour and Changes in the level of activity. When we make decisions, changes in level of activity are considered.
But we do not use information prepared under marginal costing for statutory reporting purpose.
| Variable Cost (VC) | Fixed Cost (FC) |
| VC varies proportionately with activity | FC remains constant in total terms |
| VC/unit is constant | FC in total is a constant |
| VC is a Product Cost | FC is a Period Cost |
| VC incurred due to change in level of activity. It is incurred as the product is produced | FC incurred due to time i.e. Rent, Basic Salary, Insurance |
| Treatment VC is charged to the Cost Unit and to the ‘Income Statement’ as part of cost of sales | FC is charged to the Income Statement in the period in which it is incurred |
USES OF MARGINAL COSTING
1. Decision making
Most of decisions involve the change in the level of activity. We decide whether we should produce more units or less number of units. As a result, we expect that variable cost will also change. There will be no change in fixed cost. It will remain same.
2. Budgeting
Both marginal and absorption costing are used for budgeting. Then they lead to Standard costing.
TERMINOLOGY USED IN MARGINAL COSTING
1. MARGINAL COST
Marginal cost is the Sum of variable costs. Term ‘Variable cost’ and ‘Marginal cost’ are interchangeable in costing purpose here.
2. CONTRIBUTION
When volume of goods goes up or down, the contribution will go up or down. So contribution changes with the change in volume / in level of activity/ in production.
Contribution has special importance in calculation of Marginal Costing. It can be calculated in following two ways.
Contribution = Sales – Variables Cost
Contribution = Fixed Cost + Profit
EXAMPLE FOR CONTRIBUTION
Selling Price = £15/unit
Variable Cost (VC) = £7/unit
Fixed Cost (FC) = £40,000
Budgeted Units =7,000 units
Solution:
| | Per Unit | Budgeted | |
| | | ||
| | £ | | £ |
| Sales | 15 | 15 x 7,000 | 105,000 |
| Less: VC | (7) | 7x 7,000 | (49,000) |
| Contribution | 8 | 8 x 7,000 | 56,000 |
| Less: FC | | | (40,000) |
| Profit | | | 16,000 |
We do not find fixed cost per unit. If the number of units changes, the total contribution will also change.
Marginal Cost Profit Statement includes 5 elements: Sales, Variable Cost, Contribution, Fixed Cost, and Profit
COMPARISON OF MARGINAL AND ABSORPTION COSTING
| | Marginal Costing | Absorption costing | |
| Variable Cost | Charge to Product | Charged to Product | < Treatment is Same for VC |
| Fixed Cost | Charge to Period | Charged to Product | < Treatment is different for FC |
Period = Cost of Sales / Income Statement (as it is prepared for certain period i.e. for a year)
Full Cost = Variable Cost + fixed Cost (as Absorption costing considers the ‘Full cost’)
PROFIT
Profit is calculated on period basis i.e. monthly, quarterly or annually. Overall, the profit will be the same over time but in individual accounting periods, profits may differ.
There will be no difference in Marginal costing and Absorption costing if there are no opening and closing stock in a period or the opening and closing stock are same but if there is increase and decrease in stock during the period, the absorption costing will charge more or less in that period than marginal costing.
To reconcile the difference between Absorption costing and Marginal costing, we need a reconciling item.
Unit Absorption Rate = Fixed Cost / units
Reconciling Item (Difference in profit) = (Fixed Cost / units) x Change in Stock
Change in Stock = Closing stock – Opening stock or Opening stock – Closing stock
| IMPACT ON PROFIT | |
| | |
| CHANGE IN STOCK | |
| Stock is Constant (or does not change) | Absorption Costing Profit = Marginal Costing Profit |
| | ACP = MCP |
| | |
| Increase in Stock | ACP > MCP |
| Closing stock > Opening Stock | |
| Closing stock carry forward more cost to next period than it is receiving as opening stock. Therefore, less cost is charged in current period, hence the profit will increase. So Fixed cost base is lower. | |
| | |
| Decrease in Stock | ACP < MCP |
| Closing stock < Opening Stock | |
| Closing stock carry ward less cost to next period than it is receiving as opening stock. Therefore, more cost is charged in current period, hence the profit will decrease. So Fixed cost base is more. | |
Example (Marginal Costing Profit to Absorption costing Profit)
A company recorded a profit of $12,000 under marginal costing. During the period the company made 4,000 units but sold 4,100. The unit absorption rate is $5 per unit.
The profit under absorption costing is?
Solution:
| Marginal Costing Profit | $12,000 |
| Unit Absorption Rate x Change in stock $5 x 100 | (500) |
| Absorption Costing Profit | $11,500 |
Example
During a period a company had opening stock of 9,200 units and a closing stock of 7,900 units. Profits under absorption costing are $265,000 and under marginal costing $307,250.
If the budgeted fixed overhead was $617,500 what was the budgeted level of production?
Solution:
Change in stock = opening stock – closing stock = 9,200 units – 7,900 units =1,300 units
| Marginal Costing Profit | $307,250 |
| Unit Absorption Rate x Change in stock ? x 1,300 units | 42,250 |
| Absorption Costing Profit | $265,000 |
Difference in profit = Unit Absorption Rate x Change in Stock
42,250 = Unit Absorption Rate x 1,300 units
Unit Absorption Rate = $42,250 / 1,300 units
Unit Absorption Rate = $32.5
Unit Absorption Rate = Fixed Cost / units
Units = Fixed Cost / Unit Absorption Rate
= $617,500 / $32.5 = 19,000 units
OR
Budgeted level of production = Budgeted fixed overheads / Fixed cost per units
Budgeted level of production = $617,500 / $32.5 = 19,000 units
Example
Absorption costing is generally seen as superior to marginal costing in term of short-term decision making?
A) True
B) False
Solution:
B) False (because marginal costing is used for short-term decision making)
