One of the main functions of management is decision-making. Many of the decisions are of a short-term nature. Only rarely is a manager faced with a decision which has a long term impact eg. buying a new machine, expanding the factory, take-over of another company. Since most of the decisions have a short-term impact it can be assumed that the capacity of the factory will not change. Therefore fixed or periodic costs are not affected by tactical short-run decisions. The only costs which are affected are variable costs ie. those costs which vary directly with the level of activity of the factory. These would include direct materials, direct labour and variable overheads.
Also all the decisions comprise a choice between alternative courses of action. Therefore, past costs can have no relevance for future decisions. Past costs can consist of sunk costs or committed costs.
In marginal costing all costs are classified according to how they behave. They are either variable or fixed. The fixed costs are treated as periodic ie. they are related to time . Examples of fixed costs would be rent, rates, insurance, depreciation etc. These costs stay constant in the short-term regardless of the decision that management takes. Therefore, in making decisions, in choosing between different alternative courses of action management identifies the variable costs and treats the fixed costs as irrelevant.
To summarize the technique of marginal costing:
• Costs are classified as either fixed or variable.
• In the short-run all fixed costs remain unchanged and therefore treated as irrelevant.
• The only relevant costs are variable costs ie. those costs which increase/decrease as output increases/decreases.
Definition: Marginal costing is a costing principle whereby variable costs are charged to cost units and the fixed costs attributable to the relevant period are written off in full against the contribution for that period. (ICMA)
Marginal cost = variable cost = direct materials
direct labour
direct expense
variable overhead
Contribution = sales revenue – variable(marginal) costs
Contribution is the amount which helps to pay off the fixed costs and any excess represents profit. Contribution is not profit.
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