The Management Accountant’s Profit Statement – Marginal Costing

CIMA-BA2 · Chapter 6

The Management Accountant’s Profit Statement – Marginal Costing

Marginal costing values each unit at its variable production cost only and charges all fixed costs against the profit of the period in which they are incurred. There is no absorption of fixed overheads, so there is no over- or under-absorption to correct.

The key figure is contribution: selling price less all variable costs. Because the two methods value inventory differently, marginal and absorption costing report different profits whenever inventory levels change – and the difference can be reconciled exactly.

1 Overview

Some businesses only want to know the variable cost of the units they make, regarding fixed costs as period costs. The variable cost is the extra cost each time a unit is made, fixed costs being effectively incurred before any production is started.

The thing we are costing – a product, a service, an activity or a customer – is the cost object (chapter 2). Its marginal cost is the variable cost of producing one more unit of it.

The variable production cost of a unit is made up of:

	$
Direct materials	X
Direct labour	X
Variable production overheads	X
Marginal cost of a unit	X

Marginal costing

Variable production costs are included in cost per unit (i.e. treated as a product cost).

Fixed costs are deducted as a period cost in the profit statement.

Compare absorption costing (chapter 5), where fixed production overheads are also a product cost, absorbed into each unit and carried forward in the value of inventory.

2 Contribution

Contribution is an important concept in marginal costing. Contribution is an abbreviation of “contribution towards fixed costs and profit”.

It is the difference between selling price and all variable costs (including non-production variable costs), usually expressed on a per unit basis.

	$	$
Selling price		X
Less: variable production costs	X
Less: variable non-production costs	X	(X)
Contribution		X

Note: Contribution takes account of all variable costs. Marginal cost takes account of variable production costs only and inventory is valued at marginal cost.

The same ideas apply to a service. A hotel in Sri Lanka charges $50 for a room for one night. Each night a room is let costs $6 for cleaning labour, $4 for laundry and $2 for toiletries, and the hotel pays a booking agent a commission of $5 for every night sold. Rent, reception staff and insurance are fixed costs of the hotel.

Per room-night	$
Cleaning labour	6
Laundry	4
Toiletries	2
Marginal cost of the service	12
Selling price	50
Less: marginal cost	(12)
Less: booking commission (variable, non-production)	(5)
Contribution	33

Every extra room-night sold adds $33 towards the hotel’s fixed costs and profit. The fixed costs are not shared out per night under marginal costing; they are deducted in total from the total contribution.

3 The marginal costing profit statement

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Example 1 uses exactly the same figures as Example 1 in chapter 5, so the two methods can be compared.

X plc produces one product – desks.

Each desk is budgeted to require 4 kg of wood at $3 per kg, 4 hours of labour at $2 per hour, and variable production overheads of $5 per unit.

Fixed production overheads are budgeted at $20,000 per month and average production is estimated to be 10,000 units per month.

The selling price is fixed at $35 per unit.

There is also a variable selling cost of $1 per unit and fixed selling cost of $2,000 per month.

During the first two months, X plc expects the following levels of activity:

	January	February
Production	11,000 units	9,500 units
Sales	9,000 units	11,500 units

All other results were as budgeted.

(a) Prepare a cost card using marginal costing

(b) Set out Profit Statements for the months of January and February.

(a) Cost card (marginal costing)

	$ per unit
Materials (4 kg × $3)	12
Labour (4 hrs × $2)	8
Variable production overheads	5
Marginal cost	25
Selling price	35
Less: marginal cost	(25)
Less: variable selling cost	(1)
Contribution	9

The fixed overheads are not part of the cost card: units are valued at the marginal cost of $25. The $9 left after all variable costs is the contribution per unit.

(b) Budgeted profit statements (marginal costing)

	January	$	February	$
Sales	9,000 × $35	315,000	11,500 × $35	402,500
Less: cost of sales:
Opening inventory		–	2,000 × $25	50,000
Materials	11,000 × $12	132,000	9,500 × $12	114,000
Labour	11,000 × $8	88,000	9,500 × $8	76,000
Variable production overheads	11,000 × $5	55,000	9,500 × $5	47,500
		275,000		287,500
Less: closing inventory	2,000 × $25	(50,000)		–
		225,000		287,500
Sales less variable cost of sales		90,000		115,000
Less: variable selling costs	9,000 × $1	(9,000)	11,500 × $1	(11,500)
Contribution		81,000		103,500
Less: fixed costs – production		(20,000)		(20,000)
Less: fixed costs – selling		(2,000)		(2,000)
Net profit		59,000		81,500

You do not need the full statement to find the profit. Total contribution = units sold × contribution per unit; then deduct the actual fixed costs:

	January $	February $
Contribution (9,000 × $9; 11,500 × $9)	81,000	103,500
Less: fixed costs ($20,000 + $2,000)	(22,000)	(22,000)
Net profit	59,000	81,500

4 Reconciling absorption and marginal profits

With the same figures, absorption costing gave net profits of $63,000 (January) and $77,500 (February) in chapter 5, but marginal costing gives $59,000 and $81,500. Neither is wrong: the difference must be explained.

Using X plc’s figures for January and February (Example 1 above, and Example 1 in chapter 5):

Prepare a reconciliation of absorption and marginal costing profits

	January $	February $
Absorption costing profit (chapter 5)	63,000	77,500
Marginal costing profit (Example 1)	59,000	81,500
Difference	4,000	(4,000)

Fixed production overheads included in the inventory values under absorption costing:

	January $	February $
Opening inventory (2,000 × $2)	–	(4,000)
Closing inventory (2,000 × $2)	4,000	–
	4,000	(4,000)

In January absorption costing carries $4,000 of January’s fixed overheads forward in closing inventory, so it charges $4,000 less than marginal costing and reports $4,000 more profit. In February that $4,000 comes out of opening inventory and is charged, so absorption profit is $4,000 lower. Over the two months the total profit is the same: $140,500 under both methods.

The difference in profit arises from the different inventory valuations which are the result of the difference in treatment of the fixed production overheads.

Difference in profit = change in inventory (units) × fixed production overhead absorbed per unit

Only the fixed production overhead in inventory matters. Everything else – sales, variable costs, fixed selling costs, and the actual fixed production overheads after the over- or under-absorption adjustment – is the same under both methods.

Effects

The delay in charging some production overheads under absorption costing leads to the following situations.

Compare profits under marginal and absorption costing for the following situations

(a) Production > Sales

(b) Production < Sales

(c) Production = Sales

	Inventory	Which profit is higher?
(a) Production > Sales	Increases	Absorption costing – part of this period’s fixed production overheads is carried forward in the higher closing inventory (January in Example 2)
(b) Production < Sales	Decreases	Marginal costing – absorption costing charges this period’s fixed overheads plus those brought forward in the opening inventory that is sold (February in Example 2)
(c) Production = Sales	No change	The profits are the same – no fixed overheads are carried forward or released

In each case the difference is the change in inventory × the fixed production overhead per unit.

Over the long run the total profit is the same under both methods, because one period’s closing inventory is the next period’s opening inventory. The differences are only timing differences from month to month.

5 Absorption or marginal costing?

There is no single ‘right’ profit; there are arguments for each method.

Absorption costing – financial statements must value inventory at full production cost, so many management accountants use absorption costing so that their figures agree with the financial accounts.
Marginal costing – management accounts can use whatever method is most useful. Marginal costing avoids the over- and under-absorption adjustments, the profit is simply units sold × contribution per unit less the fixed costs, and the profit does not change just because inventory levels change.

Whichever method is chosen, it must be used consistently from one month to the next.

6 Test your knowledge

Two quick checks before you move on: work through the flashcards to fix this chapter’s terms and definitions, then sit the objective questions for exam-style practice. Both mark themselves and explain the answers as you go.

Answer the questions one at a time. Your progress is saved so you can leave and come back.

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