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Marginal/Variable Costing

Definition
A marginal cost is The part of the cost of
one unit of product or service which would be avoided if that unit were not produced, or which would increase if one extra unit were produced. system in which variable costs are charged to cost units and fixed costs of the period are written off in full against the aggregate contribution. Its special value is in recognizing cost behavior, and hence assisting in decision-making. 2 (CIMA)

Marginal costing is The accounting

Components of Marginal Cost

The marginal production cost per unit of
an item usually consists of the following: Direct material Direct labor Direct expense Variable production overheads

 Cost of Sales include only variable costs

Closing stock of WIP and Finished Goods

-valued at variable production costs.

Fixed costs treated as a period cost

Contribution
The difference between the sales revenue
and the variable cost of sales.

It is contribution towards covering fixed

overheads and making a profit.

Principles of Marginal Costing

As fixed costs remain the same:(i) revenue will inc. by the sales value (ii) costs will inc. only by the variable cost per unit (iii) inc. in profit will equal to the amount of contribution If sales fall by one unit, profit will fall by the amount of contribution per unit.
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Continue..

Profit measurement should be based on

an analysis of total contribution.

When a unit is made, the extra costs

incurred is the variable production cost.

Fixed costs are unaffected when output is

increased.
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Marginal Cost Statement (Next chapter)

Direct material Direct labor Direct expenses Prime cost Add: variable overheads: Factory Selling Marginal cost

Cost per unit 12 8 3 23

5 7

12 35
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Contribution / Sales ratio (CS ratio)

Also known as profit / volume ratio (PV
ratio) If no change in SP, contribution per unit will be the same at all sales volume. Constant relationship between contribution and sales ie. Contribution earned per $1 of sales will be constant.
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Comparison of Marginal Costing

and Absorption Costing

Marginal Costing
(a) Closing stocks valued at variable production cost. (b)Fixed costs charged in full in period incurred.

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Continue

Absorption Costing
(a) Closing stocks valued at full production cost and include fixed production cost. (b) Cost of sales in a period include some fixed OH incurred in a previous period (opening stock ) and exclude some fixed OH in the current period which is carried forward in closing stock values in the next period.
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Example 1
The variable costs of Product A are $10 per
unit. The company has undertaken some market research which indicates what the likely sales at each of a number of possible selling prices would be: Selling Price $12 $15 $20

Sales (units) 20 10 4.5 The company wants to decide which

selling price it should adopt.

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Answer 1
To determine the optimum price, we need to

ascertain the price at which the contribution is maximized: Selling Price $12 $15 $20 Contribution per unit 2 5 10 Sales 20 10 4.5 Total contribution 40 50 45 Therefore, the company should sell the product at $15 since this will maximize the contribution it makes.

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Example 2
A company manufactures articles for $6
each and normally sells them at $10 each. Fixed costs are $10,000 per month. The firm is currently short of work it is selling only 2,000 units a month. It has the chance of an additional contract for 500 units a month for four months if it will accept a reduced selling price of $8 per unit. Fixed costs will not be increased if the contract is accepted. Should the company accept the contract? 14

Answer 2
Sale of 2,000 units will give a contribution

of $4 per unit Total mthy contribu = 2,000 x $4 = 8,000 Fixed costs, = 10,000 Loss = 2,000
contribution is 500 x $2 = $1,000

If the new contract is accepted, the additional

Therefore, the loss is reduced by $1,000

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Example 3

A company manufactures articles at a

variable cost of $5 each, and usually sells them for $10 each. It has the chance of an additional contract for 600 articles at $9 each but is unsure whether to accept as fixed costs would be increased by $1,500.

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Answer 3
Contribution per unit on the extra sales = $4 Total additional contribution = 600 x $4
= $2,400

Additional fixed costs incurred Additional profit

1,500 900

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The Contribution Format

Sales Revenue Less: Variable costs Contribution margin Less: Fixed costs Net income Total $ 100,000 60,000 $ 40,000 30,000 $ 10,000 Unit $ 50 30 $ 20

The contribution margin format emphasizes cost behavior. Contribution margin covers fixed costs and provides for income.
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The Contribution Format

Used primarily for external reporting.

Used primarily by management.

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The High-Low Method

WiseCo recorded the following production activity and maintenance costs for two months:
High activity level Low activity level Change Units 9,000 5,000 4,000 Cost $ 9,700 6,100 $ 3,600

Using these two levels of activity, compute: the variable cost per unit; the fixed cost; and then express the costs in equation form Y = a + bX.

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The High-Low Method

High activity level Low activity level Change Units 9,000 5,000 4,000 Cost $ 9,700 6,100 $ 3,600

Unit variable cost =

Changein cost Change in units

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The High-Low Method

High activity level Low activity level Change Units 9,000 5,000 4,000 Cost $ 9,700 6,100 $ 3,600

Unit variable cost = $3,600 4,000 units = $0.90 per unit

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The High-Low Method

High activity level Low activity level Change Units 9,000 5,000 4,000 Cost $ 9,700 6,100 $ 3,600

Unit variable cost = $3,600 4,000 units = $0.90 per unit Fixed cost = Total cost Total variable cost
Fixed cost = $9,700 ($0.90 per unit 9,000 units) Fixed cost = $9,700 $8,100 = $1,600

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The High-Low Method

High activity level Low activity level Change Units 9,000 5,000 4,000 Cost $ 9,700 6,100 $ 3,600

Unit variable cost = $3,600 4,000 units = $0.90 per unit Fixed cost = Total cost Total variable cost
Fixed cost = $9,700 ($0.90 per unit 9,000 units) Fixed cost = $9,700 $8,100 = $1,600 Total cost = Fixed cost + Variable cost (Y = a + bX) Y = $1,600 + $0.90X
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Quick Check
If sales salaries and commissions are $10,000 when 80,000 units are sold and $14,000 when 120,000 units are sold, what is the variable portion of sales salaries and commission? a. $0.08 per unit b. $0.10 per unit c. $0.12 per unit d. $0.125 per unit
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Quick Check
If sales salaries and commissions are $10,000 when 80,000 units are sold and $14,000 when 120,000 units are sold, what is the fixed portion of sales salaries and commissions? a. $ 2,000 b. $ 4,000 c. $10,000 d. $12,000
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Note
How does the high-low method work
when you have data for more than two periods? Select the two periods with the lowest March 2,510 $ 15,204 and highest level of activity .
Low month
High month

April May June July

2,550 2,480 2,590 2,670

$ $ $ $

14,976 14,680 15,108 15,060

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Quick Check
April May June July

Using the high-low method, estimate the cost formula Y = a + bX for the patient admitting costs. March 2,510 $ 15,204
Low month High month

2,550 2,480 2,590 2,670

$ $ $ $

14,976 14,680 15,108 15,060

a. b. c. d.

Y = $9,720 + $2.00X Y = $7,050 + $3.00X Y = $8,385 + $2.50X Y = $8,480 + $2.50X

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Quick Check
April May June July

Using the high-low method, estimate the cost formula Y = a + bX for the patient admitting costs. March 2,510 $ 15,204
Low month High month

2,550 2,480 2,590 2,670

$ $ $ $

14,976 14,680 15,108 15,060

a. b. c. d.

Y = $9,720 + $2.00X $15,060 $14,680 $380 = $7,050 + $3.00X = = $2 Yb= 2,670 2,480 190 Ya= $8,385 + $2.50X = $15,060 $2 2,670 = $15,060 $5,340 = $9,720 29 Y = $8,480 + $2.50X

Note
Problems with the high-low method:

Disregards information contained in all of the data

other than the low and the high points. The low and high levels of activity tend to be unusual.

Always plot the data if you have more than two points to make sure it even makes sense to use the high-low method.

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