In simple terms
A friendly intro before the formal notes — no formulas yet.
Costing for decisions
Marginal costing treats fixed costs as period costs — only variable costs go into inventory; contribution covers fixed costs and profit.
- 1
Variable cost — changes with output.
- 2
Fixed cost — period expense, not in unit cost.
- 3
Contribution = sales − variable costs.
- 4
Profit = total contribution − fixed costs.
What this topic covers
The official Cambridge syllabus points this lesson works through.
- 2.2.3.1
How to calculate the contribution of a product
- 2.2.3.2
How to interpret a break-even chart Note: Candidates will not be asked to prepare a break-even chart.
- 2.2.3.3
How to calculate the break-even point, contribution to sales ratio, level of output or sales to achieve a target profit, and margin of safety
- 2.2.3.4
The use and limitations of break-even analysis
- 2.2.3.5
How to prepare costing and profit statements using marginal costing
- 2.2.3.6
How to prepare a statement reconciling the reported profits using marginal costing and absorption costing
- 2.2.3.7
The uses and limitations of marginal costing
- 2.2.3.8
The usefulness of marginal costing data as a support for management decision-making, including make-or-buy, special orders, closure of business unit, limiting factors, target profit
- 2.2.3.9
Non-financial factors and their significance
Explore the concept
Use the live diagram and synced steps — play it or tap a step card to walk through.
At a glance — side by side
Compare key properties side by side — ideal for exam contrasts.
Comparison: Marginal Costing vs. Absorption Costing
| Feature | Marginal Costing | Absorption Costing |
|---|---|---|
| Cost Classification | Costs are classified by behaviour (variable and fixed). | Costs are classified by function (production and non-production). |
| Inventory Valuation | Valued at variable production cost only. | Valued at full production cost (variable + fixed production overheads). |
| Treatment of Fixed Production Overheads | Treated as a period cost and written off in the period incurred. | Absorbed into the cost of units produced and carried in inventory. |
| Reported Profit | Profit varies with sales volume. | Profit is affected by both sales and production volume. |
| Primary Purpose | Internal decision-making (e.g., CVP analysis, special orders). | External financial reporting (required by IFRS) and internal use. |
Cost Classification
Marginal Costing
Absorption Costing
Inventory Valuation
Marginal Costing
Absorption Costing
Treatment of Fixed Production Overheads
Marginal Costing
Absorption Costing
Reported Profit
Marginal Costing
Absorption Costing
Primary Purpose
Marginal Costing
Absorption Costing
Full topic notes
Formal explanation with the rigour you need for the exam.
Understanding Cost Behaviour: Variable and Fixed Costs
The foundation of marginal costing lies in the clear distinction between variable and fixed costs. Variable costs are costs that change in total, in direct proportion to the level of activity or output. For instance, the cost of direct materials increases for every additional unit produced. In contrast, fixed costs remain constant in total over a specific period and within a relevant range of activity, regardless of the number of units produced. A classic example is factory rent, which is paid monthly irrespective of production volume. Understanding this behavioural difference is paramount, as marginal costing separates these two cost types to provide insights for decision-making, which is not as clear under other costing methods.
Variable costs per unit are constant, but the total variable cost changes with output.
Fixed costs in total are constant within a relevant range, but the fixed cost per unit decreases as output increases.
Marginal costing classifies costs by their behaviour (variable or fixed), not by their function (production or non-production).
Semi-variable costs (e.g., a telephone bill with a fixed line rental and variable call charges) must be split into their fixed and variable components.
The Concept of Contribution
Contribution is the cornerstone of marginal costing. It represents the amount of money generated from sales that is available to 'contribute' towards covering a business's fixed costs and, once these are covered, generating profit. It is calculated by subtracting all variable costs from sales revenue. This can be expressed on a per-unit basis (Selling Price per unit – Variable Cost per unit) or in total (Total Sales Revenue – Total Variable Costs). Each unit sold provides a fixed amount of contribution. This simple but powerful metric allows managers to quickly assess the profitability of products and the financial impact of changes in sales volume, making it indispensable for short-term decision-making.
Formula (per unit): Contribution = Selling Price – Variable Cost.
Formula (total): Contribution = Sales Revenue – Total Variable Costs.
Contribution is not profit. Profit is only earned after total contribution has covered all total fixed costs for the period.
A product with a positive contribution should be continued in the short term, as it helps to cover fixed costs.
In exam questions, always calculate contribution before deducting any fixed costs. A common mistake is to deduct some fixed costs too early. The structure is rigid: Sales - Variable Costs = Contribution. Then, Contribution - Fixed Costs = Profit.
The Marginal Costing Statement of Profit or Loss
A marginal costing statement presents profit in a format that highlights contribution. The layout is fundamentally different from an absorption costing statement. It begins with sales revenue, from which all variable costs (both production and non-production) are deducted to arrive at the total contribution. Subsequently, all fixed costs for the period (both production and non-production) are subtracted from the total contribution to determine the net profit. A key feature is the valuation of closing inventory, which is valued at its marginal (variable) production cost only. This statement format is not used for external financial reporting but is a vital internal tool for management accounting, particularly for CVP analysis.
Pro-forma: Sales less Variable Costs of Sales = Contribution.
From Contribution, deduct all Fixed Costs (production and non-production) to find Net Profit.
Closing inventory is valued at variable production cost per unit.
This format clearly separates costs by behaviour, aiding short-term decision-making.
Reconciling Marginal and Absorption Costing Profits
The profit figures calculated under marginal and absorption costing will differ if inventory levels change during a period. This difference is due solely to the treatment of fixed production overheads. Under absorption costing, fixed overheads are included in the inventory valuation. Therefore, if inventory increases, some of the period's fixed overheads are carried forward in closing inventory, leading to a higher profit than marginal costing. If inventory decreases, fixed overheads from a previous period are released from opening inventory, leading to a lower profit. The difference in profit can be reconciled by calculating the change in inventory (in units) and multiplying it by the fixed overhead absorption rate per unit.
If production = sales, inventory levels are constant, and both methods give the same profit.
If production > sales, inventory levels increase, and absorption profit > marginal profit.
If production < sales, inventory levels decrease, and absorption profit < marginal profit.
Reconciliation formula: Difference in profit = Change in inventory (units) × Fixed overhead absorption rate per unit.
When asked to reconcile profits, start with the profit from one method, then adjust for the fixed overhead in inventory. The adjustment is: 'add fixed overhead in closing inventory' and 'deduct fixed overhead in opening inventory' to move from marginal to absorption profit.
Worked examples
See the formulas applied — reveal one step at a time, like the exam.
Sales 2,000 units @ $40. Variable cost $22 per unit. Fixed costs $24,000. Prepare marginal costing profit statement.
- 1
Sales = 2,000 × 80,000** Variable costs = 2,000 × 44,000)** Contribution = ** Fixed costs = **( Profit = **
Absorption profit $12,000. Opening inventory 100 units; closing 300 units. Fixed overhead absorption rate $6 per unit. Reconcile to marginal profit.
- 1
Inventory increase = 300 − 100 = 200 units Fixed overhead in inventory = 200 × 1,200**
How it all connects
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Glossary
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Quick check
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Revision flashcards
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Contribution?
Sales revenue − Variable costs (per unit or total).
Key takeaways
Review these before you close the topic — retrieval beats re-reading.
- ✓
Variable costs per unit are constant, but the total variable cost changes with output.
- ✓
Fixed costs in total are constant within a relevant range, but the fixed cost per unit decreases as output increases.
- ✓
Marginal costing classifies costs by their behaviour (variable or fixed), not by their function (production or non-production).
- ✓
Semi-variable costs (e.g., a telephone bill with a fixed line rental and variable call charges) must be split into their fixed and variable components.
Practice — then mark it
The whole point: a real Cambridge question, marked mark-by-mark.
9706/22 · Q4(d)
Prepare a marginal costing statement for Option A to show the total monthly profit being made.
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Frequently asked
Checkpoint
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