Definition and Explanation of Marginal Costing (Direct or Variable Costing):
Marginal costing is simply a technique to analyze cost information for decision making process. Different terms are used to describe this costing technique. In UK, this is called marginal costing whereas in US,it is commonly known as direct costing, variable costing or contribution costing.
Marginal costing, unlike absorption costing, requires a clear distinction between variable and fixed cost. In marginal costing, statements costs are separated as variable and fixed costs for decision-making. Variable cost is a product cost and charged to units of output whereas fixed cost is treated as period cost and is fully written off in the income statement. The semi variable costs are divided into their fixed and variable component, for example in telephone costs, fixed line rental of telephone costs is a fixed cost, whereas call charges are categorized as variable costs.
The marginal costing unlike process or job order costing is not a method of costing rather it is simply a technique to analyze cost information for decision making process.
Marginal cost is based on the extra costs incurred and extra revenue generated by the production and sale of an additional unit.
What is Contribution?
The term contribution represents the difference between sales price and variable cost. Contribution means, “contribution towards absorption of fixed costs and profits”. The calculation of contribution may help a business to judge and compare the profitability of different products or business segments.
The following equation is used to calculate the contribution:
Uses of Marginal Costing:
Marginal costing is used for short run decision making, when:
- Business is calculating the break-even level of output.
- Business is making decision about ‘special or one-off’ opportunities.
- Business is considering whether to make or buy a product.
- Business is choosing between two or more alternatives.
- Business is costing a project to determine the minimum possible price to be quoted.
- Business is devising a price strategy.
- Business is abandoning a line of business.
- Business is facing a limiting factor and is deciding about optimum production mix.
- Business is preparing budgets, variance analysis and making capital investment decisions.