The principles of marginal costing are as follows:
- Period fixed costs are the same, for any volume of sales and production (provided that the level of activity is within the ‘relevant range’). Therefore, by selling an extra item of product or service of the following will happen:
- Revenue will increase by the sales value of the item sold,
- Costs will increase by the variable cost per unit,
- Profit will increase by the amount of contribution earned from the extra item.
Similarly, if the volume of sales falls by one item, the profit will fall by the amount of contribution earned from the item.
Profit measurement should therefore be based on an analysis of total contribution. Since fixed costs relate to a period of time, and do not change with increases or decreases in sales volume, it is misleading to charge units of sale with a share of fixed costs from total contribution for the period to derive a profit figure.
When a unit of product is made, the extra costs incurred in its manufacture are the variable production costs. Fixed costs are unaffected, and no extra fixed costs are incurred when output is increased. It is therefore argued that the valuation of closing stocks should be at variable production cost (direct materials, direct labour, direct expenses (if any) and variable production overhead) because these are the only costs properly attributable to the product. Before explaining marginal costing principles any further, it will be helpful to look at a numerical example.
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