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)			1,000	10,000
	£	£	£	£
Variable costs	---		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?

Shut-down decisions

Often management wish to analyse the performance of their products, branches, divisions.

Consider the following example.

Example:

Product	A	B	C	Total
	£	£	£	£
Sales	20,000	50,000	25,000	95,000
Less
Direct materials	1,000	15,000	10,000	26,000
Direct labour	3,000	16,000	14,000	33,000
Fixed overheads	2,000	7,000	9,000	18,000
	--------	--------	--------	--------
	6,000	38,000	33,000	77,000
	--------	--------	--------	--------
Profit/(Loss)	14,000	12,000	(8,000)	18,000

With product C making a loss management might consider discontinuing this product. However, using marginal costing principles, with fixed costs treated as irrelevant for short-run decision-making the income statement can be reformatted.

Prtoduct	A	B	C	Total
	£	£	£	£
Sales	20,000	50,000	25,000	95,000
Less
Variable costs	4,000	31,000	24,000	59,000
	--------	--------	--------	--------
Contribution	16,000	29,000	1,000	36,000
Fixed costs				18,000
				--------
Net profit				18,000
				--------

Since product C makes a contribution it may be inadvisable to close it down. If Product C is closed down the company will lose £1,000 contribution and the overall effect would be to reduce profits to £17,000.

Make or Buy

Sometimes management may have to consider whether it is best to manufacture products or components or to sub-contract them out and purchase them externally.

Example:

A company makes product P. A component Q used in the manufacture of P can be purchased from a supplier for £8. The costs to make the component are as follows:

Direct materials £2

Direct wages £3

Variable overheads £2

------

Variable cost of production £7

------

Assume spare capacity and the fixed costs remain unchanged.

Obviously it is cheaper to make than to buy.

However, if the firm is working at full capacity and to make component Q involves moving some of the capacity from product P then the decision is a little more involved.

The following data applies to product P.

Selling price £16

Direct materials £6

Direct labour £4

Variable overhead £2

------

Contribution £4

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