Marginal costing is a method of costing in which inventory is valued at marginal cost rather than full cost of production. Marginal cost of an item is its variable cost. In marginal costing, value of inventory includes only variable costs whereas fixed costs are charged to profit and loss account in the period in which they are incurred. Costs included in the inventory are:
- Direct material cost
- Direct labor cost
- Variable production overheads
Contribution is one of the key concepts is cost accounting which is very useful in a lot of areas such as forecasting, decision making etc.
Contribution means contribution made by sales towards covering fixed costs and making profit. In order to make a profit, an entity should first aim to earn contribution that is at least equal to fixed costs. Any contribution over and above fixed costs will be the profit of the entity.
Contribution = Sales – Variable costs
The above formula is of total contribution. For detailed analysis, it can be broken into two parts:
- Gross contribution = Sales – Variable production costs ; and
- Net contribution = Gross contribution – other variable costs such as variable selling and admin expenses
Whether an entity earns a profit or incurs a loss will depend on the contribution earned and fixed costs incurred by it. If the contribution earned is more than fixed costs, company will make profit. If the contribution earned is less than fixed costs and the company is not able to cover its fixed costs, company will incur loss.
Profit/ (Loss) = Total contribution – Fixed costs
Example: Marginal costing
The following example will be helpful to understand how marginal costing is applied.
A company is involved in the production and sale of a single product whose selling price is $ 160. Variable production costs per unit consists of material cost of $ 40, labor cost of $ 30 and variable production overheads of $ 15. Variable selling cost per unit is $ 8. Fixed production overheads incurred during the month are $ 104,000 whereas fixed admin expenses are $16,000.
Calculate profit for the month under marginal costing system.
|—-Amount in $—-|
|Sales ($160 x 5,500 units)||880,000|
|Materials used ($40 x 5,500 units)||220,000|
|Direct labor ($30 x 5,500 units)||165,000|
|Variable production overheads ($15 x 5,500 units)||82,500|
|Variable selling expenses ($8 x 5,500 units)||44,000|
|Total variable costs||-511,500|
|Fixed production overheads||104,000|
|Fixed admin expenses||16,000|
|Total fixed costs||-120,000|
|Profit for the month||248,500|