Estimation of variable prime costs

5.1. Marginal costing method or the contribution method

5.2. Comparison of absorption costing and marginal costing methods 5.3. Conclusion

5.4. Questions and exercises

5.1. Marginal costing method or the contribution method

In absorption costing all costs of production or ordering must be taken into account irrespective whether these are variable or fixed costs.

In marginal costing only variable costs are taken into account. Fixed costs are not apportioned among the different types of products or orders, but are recognised as period costs.

Therefore, in application of this method of costing the often complicated apportionment of total costs among departments and individual types of products does not have to be dealt with.

Figure 5.1 Direct costs

Cost object Indirect variable

costs

Indirect fixed costs

Period costs

(fixed, production unrelated costs)

The overhead contribution estimate can be presented as follows:

Direct (variable) material costs

+ Direct salaries

+ Indirect production costs

= Minimum production costs + Variable selling costs

+ Variable administration costs

= Total minimum costs

+ Contribution

= Selling price

Calculation of contribution is the central concept in marginal accounting. The amount of contribution is the difference between the selling price and the total minimum costs and it has to cover the fixed costs and the profit margin required by the enterprise.

In order to better understand the concept of contribution, the above said can be presented as follows:

In marginal costing first of all the variable costs of production or order are estimated, i.e., the minimum allowable costs for the type of product or order. Then in order to establish the selling price, the amount of contribution is added to these costs.

The majority of profitability estimates are related with the marginal costing method. This is because a large part of the enterprises must state the prices of their products based on the existing market prices which are often defined following the information from the leading producers of the products in question. If customers do not wish to pay the price set by the enterprise according to the absorption costing method, the enterprise must assess the profitability of the product or order with the help of the marginal costing method.

The enterprise must find the maximum cost limit where the contribution amount covers for all variable costs; the fixed costs exist in the enterprise in any case regardless of whether the order has been received or not. Minimum costs represent the lowest selling price that can be acceptable to the enterprise. Any price that exceeds this cost level starts to cover for the fixed costs and then start generating the profit.

Also in marginal costing the principles of overhead absorption costing can be used, but the estimates made will only provide information on those overheads that cover the variable costs.

Therefore, contribution made by the enterprise products or orders is an amount that must cover in the current period of time the fixed costs plus the profit margin. The basic principle is displayed in Table 5.1

Table 5.1 Marginal costing method

Marginal costing is practically used by all sales enterprises.

5.2. Comparison of absorption costing and marginal costing methods

Table 5.2 Table of comparison

Absorption costing method Marginal costing method Enterprises using the absorption costing

method believe that the costs in total should be included in the estimates as, for example, the production equipment related costs are as important as variable costs, because it would be impossible to produce goods without these costs, and therefore this production must also cover the pre-defined share of fixed costs.

The followers of marginal costing state that the fixed costs for a period are associated with the enterprise capacity instead of the costs per unit of certain types of products in the relevant period.

There is a belief that all fixed costs (for example, the capitalised costs of buildings and enterprise costs, insurance costs, salaries to management etc.) represent costs associated with the readiness of an enterprise to start producing; and such costs exist irrespective of whether an enterprise produces any output in this period or later, and therefore estimates include only variable costs.

It is usual in enterprises that the selling prices of the products may seldom be identified by the absorption costing method alone. The most significant role in the identification of selling price is played by the market and competition relationship and marginal costing must be performed accordingly. However, for enterprises it is important that they are also aware of the marginal costing method. This method is often necessary for gaining more information on the internal situation of the enterprise as well as such estimates can better explain the flow of undesirable production-related costs. Absorption costing may also help in the improvement of the enterprise profitability. The falling prices of products usually force enterprises to seek for new and more efficient processes of production of current products.

However, it is important to understand that an enterprise cannot exist for a long time if contribution cannot cover its fixed costs plus a larger profit margin.

If the enterprise in its pricing policy is guided solely by the additional unit contribution principle being unaware of how much is needed to fully cover the contribution amount that would cover for all of the enterprise costs, the consequences may be the closure of enterprise.

5.3. Conclusion

Upon performance of costing according to both methods it can be seen that each of the methods has its advantages and each of them is used in some specific circumstances.

The absorption costing method is focuses on the system of output production, but does not provide for any orientation in the business market in the area of services. This method is aimed at past events, because the costs and the profit of the preceding periods do not provide information for the long-term strategic planning.

The information assessed with the help of this method is used for the following purposes:

• assessment of costs and profits in order to take decisions on planning and profit control;

• for elimination of stock of finished and unfinished goods at the end of period;

• for pricing.

Costing is used for profit reporting and in financial accounting.

The variable cost or marginal costing method only takes account of the variable costs, therefore special attention must be paid to covering of fixed costs by contribution.

Contribution is largely related with the profitability estimates. This is because a large group of enterprises must take account of the market price by defining the price for its products. Therefore, the marginal costing method is used in the calculation of such a price that would cover for the variable minimum costs, and if this price exceeds this level of costs, it starts covering the fixed costs.

5.4. Questions and exercises