Marginal/Variable cost
Introduction
Variable costs or expenses are costs that change in proportion to the activities or
operations of the company or business. For example labor and other overheads or conversion
expenses or cost as they are referred to. Also the prime cost is also a variable cost i.e. direct labor
and direct material. Traditional costing concepts separate and split costs between fixed and
variable. The time scales that are relevant and applicable to most major projects make this
method of costing unsuitable and redundant. Fixed costs are firm’s expenditure that is unrelated
or dependent on the amount of items or services produced by the company. They include
overhead expenditure and other indirect expenses of business. (Kaplan, Robert and Bruns, 2001)
They tend to be related to time such as wages, security, marketing, administrative expenses or
even monthly or quarterly rent payment. Fixed expenses or other costs are used to control and
maintain the prices of items or services to maximize the profits to ensure appropriate income and
profitability for the investment made. Costs are normally classified in terms of short or long run
since most strategic decisions are meant to cover between three to five years during which period
some costs turn and become variable. (Garrison, Noreen, Brewer, 2009) Semi variable costs are
costs that remain fixed for sometime then they become variable costs. For instance, satellite
television costs of acquiring the sets are fixed costs while later the monthly costs payable to get
additional contents are variable costs. . Items whose volumes are smaller take a disproportionate
length of time and material to produce but will only be apportioned and allocated a minor
2 Accounting
proportion of the support cost. (Khan, 1993) Some of the costing methods are founded on
financial costing method and systems and are inappropriate for final decision making purposes.
For purposes of inventory valuation, only overheads related to production may be later absorbed
into the cost of the product while overheads from selling and distribution are ignored.
Marginal costs are costs that a firm incurs in the production of additional or extra unit of a good.
The marginal cost of selling two items instead of one, MC (2 nd item) = TC (2items) – TC (1item)
For example;
The marginal cost obtained in selling 2 nd item is 50 – 30 = 20
Item number 2 calculation of marginal revenue
MC (2 nd item) = TC (2 nd item) – TC (1 st item)
= 50 – 30 = 20
Quantity TR TC MC
0 0 10
1 150 30
2 290 50 20
3 420 80 30
4 540 120 40
5 650 170 50
6 750 230 60
7 840 300 70
8 920 380 80
9 990 470 90
10 1050 570 100
11 1100 680 110
12 1141 800 120
13 1170 930 130
14 1190 1070 140
15 1200 1220 150
3 Accounting
Item number 3 calculation of marginal Cost
MC (3rd item) = TC (3 rd item) – TC (2 nd item)
= 80 – 50 = 30
Item number 4 calculation of marginal cost
MC (4 th item) = TC (4 th item) – TC (3 rd item
= 120 – 80 = 40
The rest of the figures on the table above have been obtained in the same way.
( Sullivan and Sheffrin, 2003)
When the total revenue, quantity and total costs increase the marginal costs also increases at a
constant rate. When the quantity is 4, TR is 540, TC 120 then the marginal cost is 40. ( Sullivan
and Sheffrin, 2003)
Quantity TR TC MC
0 0 10
1 150 30
2 290 50 20
3 420 80 30
4 540 120 40
5 650 170 50
6 750 230 60
7 840 300 70
8 920 380 80
9 990 470 90
10 1050 570 100
11 1100 680 110
12 1141 800 120
13 1170 930 130
14 1190 1070 140
15 1200 1220 150
4 Accounting
Marginal Costs
12345678910111213141516
0
20
40
60
80
100
120
140
160
MC
The marginal cost increases at an increasing trend.
Absorption costing apportions all the overheads to the individual products. In order to achieve
this, the companies must directly apportion and allocate each service overhead to the major
production department. All the direct labor/machine hourly rates are then calculated. All the
costs are allocated to various individual departments and it’s assumed that the overhead costs
relate directly and precisely to the level of production. The major problem with this concept is
that the allocation or the apportionment of the costs is done arbitrary and may not give an
accurate view of the activities which are responsible for the costs. (Hermanson, Ewards, &
Invacevich, 2011). A certain product or an activity may show a big loss just because the method
used to allocate the costs have changed. Absorption costing is time consuming and requires a lot
of concentration and energy to determine and implement an accurate basis of overall overhead
allocation and eventual apportionment. Variable costs are involved in its calculations of the
contribution and the cost of sales and transfer most of the values of the closing stock to later
dates while the absorption income statement involves part of the fixed costs and the variable
5 Accounting
costs in its determination of the closing stock in its cost of sales. (Kieso, Weygandt & Warfield,
2007)
The determination of closing stock under absorption costing.
Materials @ 100 Materials @ 130
Closing stock under absorption costing
Variable cost + part of fixed costs.
200000 + 300000/10000 = 50 per unit 260000 +300000/10000 = 56
Cost of
sales=
2000 @ 50 = 100000 2000 units each 56 =
112000
Add labor 400000 400000
Material 800000 1040000
variable o/h cost 240000 240000
variable cost o/h 80000 80000
Cost of
sales=
1620000 1872000
The net income between the contribution income statement and the absorption income
statement can never be the same. The absorption income statement utilizes both the variable
expenses and the fixed expenses when determining the closing stock while computing the cost
of sales. (Drucker, 1999)
The variable income statement only utilizes the variable cost while calculating its contribution
margin and the cost of sales and it completely ignores the fixed expenses. The need for
companies to create another income statement comes in because of the calculation of the
closing stock on rates that are similar to the current rates of the sales to give a true and fair view
of the cost of sales. (Khan, 1993)
The major advantage of absorption costing is that it’s convenient and simple to apply. The
costing methods may give different results. Absorption costing is reliable as it includes also fixed
6 Accounting
in its allocation of costs. The other two methods are not inclusive. (Vance, 2003) The following
is an example of both the costing methods i.e. variable and absorption costing methods.
Direct materials variable cost increase from 100 to 130
and sales per unit is 250 per unit
Absorption income statement
For the period ending Dec 31st 2011.
Sales 2000000
cost of goods sold 1872000
GP 128000
Selling n adm exp 180000
Net loss -52000
Variable costing
/Contribution method
Sales 2000000
Variable cost
labor 400000
Material 1040000
Variable cost
o/h
240000
variable cost selling n adm 80000
Closing stock 260000
cost of sales 2020000
Contribution -20000
Fixed man o/h 200000
Fixed selling 100000
Net loss -320000
7 Accounting
To conclude, the most important information from the above argument is that a company can
utilize absorption costing as a tool in making decisions in the valuation of closing stock and the
way the different methods of absorption and contribution (variable) income statements affect the
net income. The absorption income statement valuation of the closing stock utilizes most of the
cost in the current income statement by also including the fixed costs together with the variable
costs i.e. it’s very realistic while some methods like the contribution income only uses the
variable cost while determining the closing stock and it excludes the fixed costs
References
Drucker, F. (1999) Management Challenges of the 21st Century. New York: Harper Business,
Garrison, H., Noreen, E., Brewer, C. (2009) Managerial Accounting . McGraw-Hill Irwin.
2009.
Hermanson, R.H., Edwards, J.D., & Invacevich, S.D. (2011). Accounting Principles: A Business
Perspective. First Global Text Edition, Volume 2 Managerial Accounting, 37-73.
Kieso, D. E., Weygandt, J. J., & Warfield, T. D. (2007) Intermediate Accounting (12th Ed.).
Hoboken, NJ: John Wiley & Sons,
Khan, M. Theory & Problems in Financial Management. (1993) Boston: McGraw Hill
Higher Education.
Kaplan, Robert S. and Bruns. (2001) W. Accounting and Management: A Field Study
Perspective (Harvard)
Vance, D. (2003) Financial analysis and decision making: tools and techniques to solve
financial problems and make effective business decisions. New York: McGraw-Hill.
8 Accounting
Sullivan, A. and Sheffrin, S. (2003). Economics: Principles in action. Upper Saddle River, New
Jersey, Pearson Prentice Hall.
