Basic principles and guidelines for using marginal costing are as follows:
(1) The sale of an extra unit of product or service results in the following:
- Total revenue increase by the sales price of the item sold.
- Total costs will increase by the variable cost per unit.
- No change will be in fixed costs as for a given time period, fixed costs remain constant for any output level within the ‘relevant range’.
- Profit will increase by the amount of contribution per unit (sales less variable costs) earned from the extra item.
(2) In case of reduction in the sales volume by one unit, the profit will reduce by the amount of contribution related to that unit.
(3) Profit measurement should therefore follows contribution approach, i.e., total fixed cost (remains the same at different output levels) should be subtracted from total contribution (varies with changes in output level).