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Marginal Costing
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The Marginal (incremental) Cost per Unit = Amount by which total costs of production and sales increases when one additional unit of that product is produced and sold.
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Marginal costing is used to determine prices after demand at standard prices has been fulfilled
Most companies base their cost ratios and pricing levels on marking up direct expenses plus full absorption costs.
Full absorption costing ensures full recover of all variable and fixed costs utilising a chosen common productive time resource such as machine hours or labor hours.
An example:
If a firm has fixed annual costs including rent, utilities, management, office expenses plus indirect supervision and maintenance of $3,750,000 per annum, and the firm utilises 250,000 labor hours per annum to meet the normal level of demand, the absorption rate of cost recovery = $15.00 per labor hour.
However, if the firm is operating at less than full capacity, full absorption costing can lead to an overly inflexible approach to setting prices to attract demand that may arise at the last minute, for quantity volume order discount quotations, or other unusual demand patterns.
An alternative approach is to adopt the marginal (incremental) costing method.
If the firm has surplus capacity, calculate only those costs that will increase as each unit of production is manufactured.
Example:
A firm is asked to quote on a large batch order for 50,000 units, for which it has spare labor and machine capacity. The direct material costs are $3.75 per unit, direct labor required will be 2,200 hours at $12.50 per hour, and indirect costs that will increase if the order is accepted will amount to $6,500.
The direct costs of production with surplus capacity
= $187,500 + $27,500 + $6,500 = $221,500.
The break even price = $221,500/50,000 = $4.43 per unit.
Mark up of 25% yields a price = $5.54 per unit.
If the full absorption costing method were to be applied.
Costs of production = $187,500 + $27,500+ $15 x 2,200 = $248,000.
Mark up of 25% yields a price quote = $6.20 per Unit.
Where has the costing difference of $248,000 - $221,500 = $26,500 gone?
The cost difference is the result of under-absorption of fixed costs carried by normal demand sales.
The firm in our example has costed its recovery of fixed expenses of $3,750,000 on a forecast of full production capacity of 250,000 labor hours, at $15.00 per hour. However output in this example is less than full. Therefore the absorption costs for normal demand level sales were incorrect and unrecovered so far.
If the firm actually worked 247,800 man hours per annum to meet standard demand, and it had just 2,200 man house spare capacity, the standard absorption cost to fully recover all fixed expenses should have been $3,750,000/247,800 = $15.13317 per hour worked.
247,800 x $0.13317 = $33,000 less $6,500 costs assigned to make the 50,000 units = $26,500.
Why is this important? Because at the margin, after you have met demand that can be filled at standard prices, you have a decision whether to accept orders to fill temporary available spare capacity at lower prices.
With the Marginal Costing method you can select to recover only those costs that will increase per unit of additional sales. On balance this approach will make you more price competitive and bring more profit contribution.
Real life applications of calculating pricing with unsold capacity using the marginal costing method are > Last minute booking pricing at hotels and airlines to sell surplus room and cabin capacity.
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Software Links
Costing Excel Templates
Download Files
Marginal Costing
Reference Pages
Absorption Costing
Break Even Analysis
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