Marginal costing

FOR

Decision making

Lesson 2

Marginal Costing - a technique for short-run decision-making

One of the main functions of management is decision-making. Many of the decisions are of a short-term nature. Only rarely is a manager faced with a decision which has a long term impact eg. buying a new machine, expanding the factory, take-over of another company. Since most of the decisions have a short-term impact it can be assumed that the capacity of the factory will not change. Therefore fixed or periodic costs are not affected by tactical short-run decisions. The only costs which are affected are variable costs ie. those costs which vary directly with the level of activity of the factory. These would include direct materials, direct labour and variable overheads.

Also all the decisions comprise a choice between alternative courses of action. Therefore, past costs can have no relevance for future decisions. Past costs can consist of sunk costs or committed costs.

In marginal costing all costs are classified according to how they behave. They are either variable or fixed. The fixed costs are treated as periodic ie. they are related to time . Examples of fixed costs would be rent, rates, insurance, depreciation etc. These costs stay constant in the short-term regardless of the decision that management takes. Therefore, in making decisions, in choosing between different alternative courses of action management identifies the variable costs and treats the fixed costs as irrelevant.

To summarize the technique of marginal costing:

• Costs are classified as either fixed or variable.

• In the short-run all fixed costs remain unchanged and therefore treated as irrelevant.

• The only relevant costs are variable costs ie. those costs which increase/decrease as output increases/decreases.

Definition: Marginal costing is a costing principle whereby variable costs are charged to cost units and the fixed costs attributable to the relevant period are written off in full against the contribution for that period. (ICMA)

Marginal cost = variable cost = direct materials

direct labour

direct expense

Variable overhead

Contribution = sales revenue - variable(marginal) costs

Contribution is the amount which helps to pay off the fixed costs and any excess represents profit. Contribution is not profit.

Example Format of a Marginal Costing Income Statement

Products	A	B	C	Total
Sales revenue	X	X	X	X
Less Variable costs	(X)	(X)	(X)	(X)
	------	------	------	------
Contribution	X	X	X	X
	------	------	------	------
Fixed costs				(X)
				------
				X
				------

Marginal cost is the amount at any given volume of output by which total costs are changed if the volume of output is increased or decreased. It is the cost of making one extra unit of output. The definition stesses the manner in which costs behave in relation to the volume of activity. It concerns the identification of variable and fixed costs ie. the costs that increase or decrease as output increases or decreases. Only the variable costs both production and non-production change as the output changes.

Example:

A company manufacture units with avaiable cost per unit of £2 and fixed costs of £5,000.

Volume (costs)	0	1	1,000	10,000
	£	£	£	£
Variable costs	---	2	2,000	20,000
Fixed costs	5,000	5,000	5,000	5,000
	-------	-------	-------	-------
Total cost	5,000	5,002	7,000	25,000
	-------	-------	-------	-------

Note £2 is the marginal cost or variable cost per unit.

Applications of marginal costing

(a) Acceptance of a special order.

X Ltd. makes a product which sells for £1.50. The output for the period is 80,000 units of product which represents 80% capacity . Total costs are £90,000 and of these it is estimated that £26.000 are fixed costs. A potential customer offers to buy 20,000 units at £1.10 and this will use up the company’s spare capacity.

Should management accept this special order?

Sales	£120,000
Marginal costs( 80p per unit)	64,000
	--------
Contribution	56,000
Fixed costs	26,000
	--------
Profit	30,000
	--------

Special order:

Sales(20,000 units @ £1.10) £22,000

Less Variable costs(20,000 @ 80p) 16,000

----------

Extra contribution 6,000

----------

Profits can be increased by an additional £6,000 since fixed costs are already covered. However management must consider other relevant factors in arriving at the final decision.

How will existing customers react? They may wish to buy at £1.10 per unit. Could the spare capacity be used more profitably rather than accepting the special order?