How to solve marginal costing step by step

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How to solve marginal costing step by step

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Marginal costing, also known as variable costing or direct costing, is a cost accounting technique where only variable costs are charged to cost units, and fixed costs are treated as period costs. This method is particularly useful for decision-making processes such as pricing, output level determination, and financial analysis. Here’s a step-by-step guide on how to solve problems using marginal costing:

Step-by-Step Guide to Marginal Costing

  1. Understand the Concepts:
  • Variable Costs: Costs that vary directly with the level of production (e.g., raw materials, direct labor).
  • Fixed Costs: Costs that remain constant regardless of the level of production (e.g., rent, salaries).
  • Contribution Margin: Sales revenue minus variable costs. It contributes towards covering fixed costs and generating profit.
  • Break-even Point: The level of sales at which total revenue equals total costs (both variable and fixed), resulting in no profit or loss.
  1. Calculate Variable Costs:
  • Identify all variable costs associated with the production of each unit.
  • Sum these costs to determine the total variable cost per unit.
  1. Determine Fixed Costs:
  • List all fixed costs that are incurred during the period.
  • Ensure that these costs are not included in the unit cost calculation.
  1. Compute Contribution Margin:
  • Contribution Margin per Unit:

Contribution Margin per Unit=Selling Price per Unit−Variable Cost per UnitContribution Margin per Unit=Selling Price per Unit−Variable Cost per Unit

  • Total Contribution Margin:

Total Contribution Margin=Contribution Margin per Unit×Number of Units SoldTotal Contribution Margin=Contribution Margin per Unit×Number of Units Sold
5. Break-even Analysis:

  • Break-even Point in Units:

Break-even Point (units)=Total Fixed CostsContribution Margin per UnitBreak-even Point (units)=Contribution Margin per UnitTotal Fixed Costs​

  • Break-even Point in Sales Revenue:

Break-even Point (sales revenue)=Total Fixed CostsContribution Margin RatioBreak-even Point (sales revenue)=Contribution Margin RatioTotal Fixed Costs​

Where Contribution Margin Ratio is:

Contribution Margin Ratio=Contribution Margin per UnitSelling Price per UnitContribution Margin Ratio=Selling Price per UnitContribution Margin per Unit​
6. Target Profit Analysis:

  • To determine the sales volume required to achieve a target profit, use the formula:

Required Sales Volume (units)=Total Fixed Costs+Target ProfitContribution Margin per UnitRequired Sales Volume (units)=Contribution Margin per UnitTotal Fixed Costs+Target Profit​
7. Decision Making:

  • Make or Buy Decision: Compare the contribution margin from producing internally to the cost of buying externally.
  • Special Orders: Assess if accepting a special order (at a different price) would cover its variable costs and contribute to fixed costs/profit.
  • Product Mix Decisions: Allocate resources to products with the highest contribution margin per unit of the constraint (e.g., labor hours, machine hours).

Example Problem

Problem: A company produces a single product. The following information is available:

  • Selling price per unit: $50
  • Variable cost per unit: $30
  • Total fixed costs: $20,000

Steps to Solve:

  1. Contribution Margin per Unit:

Contribution Margin per Unit=Selling Price per Unit−Variable Cost per Unit=50−30=20Contribution Margin per Unit=Selling Price per Unit−Variable Cost per Unit=50−30=20

  1. Break-even Point (units):

Break-even Point (units)=Total Fixed CostsContribution Margin per Unit=20,00020=1,000 unitsBreak-even Point (units)=Contribution Margin per UnitTotal Fixed Costs​=2020,000​=1,000 units

  1. Break-even Point (sales revenue):

Break-even Point (sales revenue)=1,000 units×50 (selling price per unit)=$50,000Break-even Point (sales revenue)=1,000 units×50 (selling price per unit)=$50,000

  1. Target Profit Analysis: Suppose the company wants to achieve a target profit of $10,000.

Required Sales Volume (units)=Total Fixed Costs+Target ProfitContribution Margin per Unit=20,000+10,00020=1,500 unitsRequired Sales Volume (units)=Contribution Margin per UnitTotal Fixed Costs+Target Profit​=2020,000+10,000​=1,500 units

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