Marginal Costing
Definition
Marginal costing, also known as direct costing or variable costing, is an accounting technique that allocates only variable costs to product costs while treating fixed costs as a lump sum incurred during the period. Only marginal costs—costs that change with the level of output—are charged to cost units. This helps extract the contribution margin, which is the difference between sales revenue and variable costs, and ultimately this margin deducts fixed costs to arrive at the net profit or loss for the period.
Examples
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Example 1: Manufacturing Scenario: A manufacturing firm incurs a variable cost of $10 per unit, which includes materials and labor, and monthly fixed costs of $50,000 for factory rent and salaries. If the company sells 10,000 units in a month at $20 per unit:
- Total Variable Cost = $10 * 10,000 = $100,000
- Sales Revenue = $20 * 10,000 = $200,000
- Contribution Margin = $200,000 - $100,000 = $100,000
- Net Profit = Contribution Margin - Fixed Costs = $100,000 - $50,000 = $50,000
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Example 2: Service Industry: A consulting firm provides billable hours at $150 per hour, incurs variable costs of $40 per hour, and maintains fixed monthly overheads of $30,000. In a given month, they bill 1,000 hours:
- Total Variable Cost = $40 * 1,000 = $40,000
- Sales Revenue = $150 * 1,000 = $150,000
- Contribution Margin = $150,000 - $40,000 = $110,000
- Net Profit = Contribution Margin - Fixed Costs = $110,000 - $30,000 = $80,000
Frequently Asked Questions
Q: What is the primary benefit of marginal costing?
A: The primary benefit of marginal costing is that it provides clarity on the impact of variable costs and helps in making decisions related to pricing, production levels, and other operational choices.
Q: What are the limitations of marginal costing?
A: Marginal costing does not allocate fixed costs to product costs, which can lead to misleading inventory valuations and might not conform to GAAP for external financial reporting.
Q: How does marginal costing differ from absorption costing?
A: Absorption costing allocates both fixed and variable manufacturing costs to product costs, while marginal costing only allocates variable costs, treating fixed costs as period expenses.
Q: Can marginal costing be used for external financial reporting?
A: Typically, no. For external financial reporting, GAAP requires the use of absorption costing. Marginal costing is mostly used for internal management decision-making.
Q: How is inventory valued under marginal costing?
A: Inventory under marginal costing is valued only at its variable cost, excluding fixed overheads.
Related Terms
- Contribution Margin: The difference between sales revenue and variable costs. It contributes towards covering fixed costs and profit.
- Fixed Costs: Costs that do not change with the level of output, such as rent, salaries, and depreciation.
- Variable Costs: Costs that vary directly with the level of production, such as raw materials and direct labor.
- Absorption Costing: A costing method that allocates all manufacturing costs (both fixed and variable) to product costs.
Online References
- Investopedia - Marginal Costing
- AccountingTools - Marginal Costing
- Corporate Finance Institute - Marginal Costing
Suggested Books for Further Studies
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“Managerial Accounting” by Ray H. Garrison and Eric Noreen
This book covers various aspects of cost and managerial accounting, including detailed discussions on marginal costing. -
“Cost Accounting: A Managerial Emphasis” by Charles T. Horngren, Srikant Datar, and Madhav Rajan
This textbook provides an in-depth analysis of cost accounting methodologies, including both absorption and marginal costing. -
“Accounting for Management: Planning and Control” by Robert Anthony and Vijay Govindarajan
This text details strategic decision-making tools in managerial accounting, with a section dedicated to marginal costing.
Accounting Basics: “Marginal Costing” Fundamentals Quiz
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