LO 2 : A P P LY A R A N G E O F M A N AG E M E N T

TECHNIQUES

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MARGINAL COSTING SYSTEMS
 Marginal cost is the extra cost arising as a result of
producing one more unit, or the cost saved as a result
of producing one less unit.

 Marginal costing is a costing method which charges

products or services with variable costs alone. The
fixed costs are treated as period costs and are written
off in total against the contribution of the period.

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COST BEHAVIOUR – VARIABLE COSTS
 Variable costs vary in direct proportion to the volume of activity (i.e.
doubling the level of activity will double the total variable cost)

 Examples:
• Direct materials
• Labour cost (i.e. overtime wages and temporary staff wage)
• Commission fees
• Freight out
• Production supplies (i.e. machine oil)

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 VARIABLE COSTS
Total variable costs are linear and unit variable cost is constant

Consider the example of a bicycle manufacturer who purchases component parts. Assume that
the cost of purchasing two wheels for a particular bicycle is £10 per bicycle

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VARIABLE COSTS - MCQ
Which of the following would be a variable cost for a dentist’s office?
A. Depreciation on equipment
B. Cost of renting office space
C. Cost of teeth cleaning material
D. Salary of dentist

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COST BEHAVIOUR – FIXED COSTS
 Fixed costs remain constant over wide ranges of activity for a specified
time period. They are not affected by changes in activity.

 Examples:
o Depreciation of equipment
o Property taxes
o Insurance cost
o Supervisory salaries

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 FIXED COSTS
Total fixed costs are constant and unit fixed cost is variable

Because unit fixed costs are not constant per unit they must be interpreted with caution. For
decision-making, it is better to work with total fixed costs rather than unit costs.

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FIXED COSTS - MCQ
Which of the following would probably be a fixed cost in a fast food
restaurant?
A. Cost of hamburger
B. Cost of french fries
C. Shift manager’s salary
D. Utility cost

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FIXED COSTS - MCQ
Per-unit fixed costs:
A. can be misleading and lead to poor decisions
B. stay the same as output changes
C. decrease as output decreases
D. increase as output increases

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5-10

SUMMARY OF VARIABLE AND FIXED COST

BEHAVIOR
Cost In total Per unit
Variable Is proportional to the activity level remains the same over
within the relevant range. wide ranges
of activity.
Fixed remains the same even when the Goes down as activity
activity level changes within the level goes up.
relevant range.

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VARIABLE COSTS VS. FIXED COSTS
Select the appropriate cost behaviour for the following costs incurred by an
automobile manufacturer.

1. Cost of windshields
2. Cost of assembly line workers
3. Depreciation (straight-line method) on robotic equipment
4. Cost of car stereos
5. Cost of transporting cars to dealerships
6. Cost of inspections
7. Factory supervisor’s salary
8. Cost of rework

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STEP-FIXED COSTS

Within a given time period, they are fixed within specified activity levels, but
they eventually are subject to step increases or decreases by a constant
amount at various critical activity levels

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MIXED COSTS
These include both a fixed and a variable component.
i.e. home phone charge

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MIXED COSTS - MCQ
Which of the following would probably be a mixed cost?
A. Rent on building
B. Raw materials
C. Repairs and maintenance
D. Depreciation

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TYPES OF COSTS

Remains the same in total within the

Variable relevant range
Will increase in total in direct
Fixed proportion to an increase in the cost
driver
Mixed Has an increased fixed component at
specific intervals
Step Has both a variable and a fixed
component

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MARGINAL COSTING SYSTEM
 Marginal costing system is concerned with variable product costs–
direct materials, direct labour, direct expenses, and variable
production overheads – which increase as output increases

 For most decision-making, the marginal cost of a unit of output is,

therefore, the variable cost of producing one more unit.

 Knowing the marginal cost of a unit of output enables the managers

of a business to focus on the contribution provided by each unit.
Selling price – Variable costs = Contribution

Contribution – Total fixed costs = Profit

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5-17

THE CONTRIBUTION FORMAT

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

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5-18

THE CONTRIBUTION FORMAT

Used primarily for Used primarily by

external reporting. management.

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MARGINAL COSTING - MCQ
The term “Contribution” refers to:
A. The difference between selling price and fixed costs
B. The difference between selling price and variable costs
C. Profit
D. None of these

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MARGINAL COSTING - MCQ
The other name of marginal costing is:
A. Direct costing
B. Variable costing
C. Incremental costing
D. All of the above

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 MARGINAL COSTING - EXAMPLE
The Wyvern Bike Company makes 100 bikes each week and its costs are as follows:
Direct materials £4,000
Direct labour £5,000
Production overheads £5,000
Investigations into the behaviour of costs has revealed the following information:
• direct materials are variable costs
• direct labour is a variable cost
• of the production overheads, £2,000 is a fixed cost, and the remainder is a variable
cost
The selling price of each bike is £200.
As an accounts assistant at the Wyvern Bike Company, you are asked to:
• calculate the marginal cost of producing each bike
• show the expected contribution per bike

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MARGINAL COSTING - EXAMPLE

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ABSORPTION COSTING VS. MARGINAL COSTING
When using marginal costing it is the behaviour of the cost – fixed or
variable – that is important, not the origin of the cost.

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ABSORPTION COSTING VS. MARGINAL COSTING
Marginal costing Absorption costing
Main use • Help with short-term • Calculate profit
decision making • Calculate inventory
valuation for financial
statements
How does it work? • Costs are classified as • Overheads are
either fixed or variable charged to output
• Contribution to fixed through an overhead
costs is calculated as absorption rate, often
selling price less on the basis of direct
variable costs labour hours or
machine hours
Main focus • Marginal cost • All overheads charged
• Contribution to output
• Calculate profit
• Calculate inventory
values

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ABSORPTION COSTING VS. MARGINAL COSTING
Marginal costing Absorption costing
Usefulness • Concept of contribution • Acceptable under IAS 2,
is easy to understand Inventories
• Useful for short-term • Appropriate for
decision-making, but no traditional industries
consideration of where overheads are
overheads charged to output on the
basis of direct labour
hours or machine hours
Limitations • Costs have to be • Not as useful in short-
identified as either fixed term decision-making as
or variable marginal costing
• All overheads have to be • May provide less
recovered, otherwise a accurate basis for
loss will be made calculation of selling
• Not acceptable under prices where overheads
IAS 2, Inventories are high and complex in
• Calculation of selling nature
prices may be less
accurate than other
costing methods
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5-26

ABSORPTION COSTING VS. MARGINAL COSTING

Harvey Company produces a single product with the following
information available:
Number of units produced annually 25,000
Variable costs per unit:
Direct materials, direct labor,
and variable production overhead £ 10
Selling & administrative expenses £ 3

Fixed costs per year:

Production overhead £150,000
Selling & administrative expenses £100,000

Calculate unit cost under each costing system?

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5-27

ABSORPTION COSTING VS. MARGINAL COSTING

Unit product cost is determined as follows:
Absorption Variable
Costing Costing
Direct materials, direct labor, £ £
and variable production
overhead 10 10
Fixed production overhead 6 -
(£150,000 ÷ 25,000 units)

Unit product cost 16 10

Fixed selling and administrative expenses are always treated as

period expenses and deducted from revenue as incurred.

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5-28

INCOME STATEMENTS OF
ABSORPTION AND VARIABLE COSTING
Assume the following additional information for Harvey Company:

20,000 units were sold during the year at a price of £30 each.

There is no beginning inventory.

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ABSORPTION COSTING
Sales
Less cost of goods sold:
Beginning inventory
Add COGM
Goods available for sale -
Less: Ending inventory -
Gross margin -
Less selling & admin. exp.
Variable
Fixed
Net profit

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5-30

ABSORPTION COSTING
£ £
Sales (20,000 × £30) 600,000
Less cost of goods sold:
Beginning inventory -
Add COGM (25,000 × £16) 400,000
Goods available for sale 400,000
Less: Ending inventory (5,000 × £16) 80,000 320,000
Gross margin 280,000
Less selling & admin. exp.
Variable (20,000 × £3) 60,000
Fixed 100,000 160,000
Net profit 120,000

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5-31

VARIABLE COSTING
Sales
Less variable expenses:
Beginning inventory
Add COGM
Goods available for sale -
Less ending inventory
Variable cost of goods sold -
Variable selling & administrative expenses
Contribution margin
Less fixed expenses:
Manufacturing overhead
Selling & administrative expenses -
Net operating income

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5-32

VARIABLE COSTING Variable

manufacturing
costs only.

Sales (20,000 × $30) £ £ 600,000

Less variable expenses:
Beginning inventory -
Add COGM (25,000 × £10) 250,000
Goods available for sale 250,000
Less ending inventory (5,000 × £10) 50,000
Variable cost of goods sold 200,000
Variable selling & administrative expenses
60,000 260,000
(20,000 × £3)
Contribution margin 340,000
Less fixed expenses:
Manufacturing overhead 150,000
Selling & administrative expenses 100,000 250,000
Net operating income All fixed 90,000
manufacturing
overhead is
expensed. 32
5-33

EXTENDED COMPARISON OF INCOME STATEMENTS

Here is information about the operation
of Harvey Company for the second year.
Number of units produced 25,000
Number of units sold 30,000
Units in beginning inventory 5,000
Unit sales price £30
Variable costs per unit:
Direct materials, direct labor £10
variable production overhead
Selling & administrative expenses £3
Fixed costs per year:
Manufacturing overhead £150,000
£100,000
Selling & administrative expenses

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5-34

UNIT COST COMPUTATIONS

Absorption Variable
Costing Costing
Direct materials, direct labour and
variable production overhead £ 10 £ 10
Fixed production overhead
(£150,000 ÷ 25,000 units) £ 6 £ -

Unit product cost £ 16 £ 10

Since the variable costs per unit, total fixed costs, and the number of units produced
remained unchanged, the unit cost computations also remain unchanged.

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5-35

ABSORPTION COSTING
£ £
Sales (30,000 × £30) 900,000
Less cost of goods sold:
Beg. inventory (5,000 × £16) 80,000
Add COGM (25,000 × £16) 400,000
Goods available for sale 480,000
Less ending inventory - 480,000
Gross margin 420,000
Less selling & admin. exp.
Variable (30,000 × £3)
90,000
Fixed 100,000 190,000
Net operating income 230,000

These are the 25,000 units

produced in the current period.

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5-36
Variable
VARIABLE COSTING manufacturing
costs only

£ £
Sales (30,000 × £30) 900,000
Less variable expenses:
Beg. inventory (5,000 × £10) 50,000
Add COGM (25,000 × £10) 250,000
Goods available for sale 300,000
Less ending inventory -
Variable cost of goods sold 300,000
Variable selling & administrative
expenses (30,000 × £3) 90,000 390,000
Contribution margin 510,000
Less fixed expenses:
Manufacturing overhead 150,000
Selling & administrative expenses 100,000 250,000
Net operating income 260,000
All fixed
manufacturing
overhead is
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expensed