Uses and Limitations of Marginal Costing

Contribution = selling price − variable cost = 30 − 19 = $11 per unit. Contribution is the amount each unit contributes first towards covering fixed costs, and then towards profit.

Under marginal costing, fixed overhead is treated as a period cost and written off in full against the period's profit; units are charged with variable cost only. Under absorption costing, fixed overhead is absorbed into units and carried in inventory, giving a full cost per unit. The methods therefore value inventory and report profit differently.

Total contribution = 7 × 8,000 = $56,000. Profit = total contribution − fixed costs = 56,000 − 40,000 = $16,000.

Contribution per unit on the order = 33 − 28 = $5. Total extra contribution = 5 × 2,000 = $10,000. As there is spare capacity, fixed costs do not change, so profit rises by $10,000. Advice: accept the order. Although $33 is below the full cost of $38, it exceeds the variable cost of $28 and so adds $10,000 to profit. The business should also check the effect on regular customers and that the price will not be expected on future orders.

The relevant cost of making is the variable cost, $16; the unavoidable $25,000 fixed costs are irrelevant as they continue either way. The buy-in price of $13 is $3 cheaper per unit, a saving of 3 × 4,000 = $12,000. Advice: buy the component to save $12,000, but check the supplier's reliability and quality and whether the freed capacity has a better use.

Contribution per machine hour = contribution ÷ machine hours per unit. P = 24 ÷ 3 = $8 per machine hour. Q = 30 ÷ 5 = $6 per machine hour. P should be prioritised because it earns more contribution per scarce machine hour ($8 vs $6), so it uses the limiting factor more efficiently and maximises total contribution. This is despite Q having the higher contribution per unit — what matters under a limiting factor is contribution per unit of the scarce resource.

Contribution = sales − variable costs = 60,000 − 38,000 = $22,000. The product makes a positive contribution of $22,000 towards the fixed overhead. If it is discontinued, the $26,000 fixed overhead continues (it is apportioned, not avoidable) but the $22,000 contribution is lost, so total profit falls by $22,000. Advice: do not discontinue the product. The reported $4,000 'loss' arises only because of apportioned fixed overhead; the product still helps to cover those costs.

1. It is decision-relevant: it isolates the costs that actually change, giving the right answer for short-term decisions (special orders, make-or-buy).
2. It avoids the arbitrary apportionment of fixed overhead used in absorption costing, so contribution is objective and easy to understand (and underpins break-even/CVP analysis).

1. Inventory valuation. Marginal costing values inventory at variable cost only, which breaches IAS 2 (full production cost) — so it cannot be used for the published accounts. 2. Long-run pricing. Pricing just above variable cost gives only a small contribution; in the long run prices must cover fixed costs too, or the business makes a loss. 3. Capacity. Fixed costs are only fixed within a range; beyond capacity they step up, so the analysis is short-term. 4. Splitting costs. Semi-variable costs must be split into fixed and variable parts, which can be imprecise. Conclusion: marginal costing is excellent for short-term decisions with spare capacity, but it complements rather than replaces absorption costing, which is needed for the accounts and long-run pricing.

1. The effect on regular customers, who may demand the same low price. 2. Setting a precedent for future orders from the customer. 3. Whether accepting it would displace more profitable work or damage the brand/reputation.