Product costs are costs identified with goods produced or purchased for resale. Such costs are initially identified as part of the value of stock and only become expenses when the stock is sold. In contrast, period costs are costs that are deducted as expenses during the current period without ever being included in the value of stock held. We saw how product costs are absorbed into the cost of units of output. Now we describe marginal costing and compare it with absorption costing. Whereas absorption costing recognizes fixed costs (usually fixed production costs) as part of the cost of a unit of output and hence as product costs, marginal costing treats all fixed costs as period costs. Two such different costing methods obviously each have their supporters and we will be looking at the arguments both in favour of and against each method. Each costing method, because of the different stock valuation used, produces a different profit figure and we will be looking at this particular point in detail.
Marginal Cost and Marginal Costing
Marginal Costingis an alternative method of costing to absorption costing
In marginal costing, only variable costs are charged as a cost of sale and a contribution is calculated which is sales revenue minus the variable cost of sales. Closing stocks of work in progress or finished goods are valued at marginal (variable) production cost. Fixed costs are treated as a period cost, and are charged in full to the profit and loss account of the accounting period in which they are incurred.
Marginal Cost is the cost of a unit of a product or service which would be avoided if that unit were not produced or provided.
The marginal production cost per unit of an item usually consists of the following:
- Direct materials,
- Direct labour,
- Variable production overheads.
Contribution is the difference between sales value and the marginal cost of sales.
Contribution is of fundamental in marginal costing, and the term ‘contribution’ is really short for ‘contribution towards covering fixed overheads and making a profit’.
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