Relevant Costs and Marginal Costing Explained

Knowing how to produce the information is one part of the ‘process’, interpreting and using it is the remainder. We should adopt a sense of perspective and focus when using financial information. We should avoid getting bogged down with an abundance of (meaningless) financial data, we must always bear in mind

  • What is the decision all about?
  • What information and techniques will help us in making that decision?
  • How do we apply those techniques?
  • What does it all mean?

We must remember that financial techniques supplement management; they are not a replacement for it. Responsibility and ownership for the decisions should remain ours; they should not be abrogated away and become an automatic process.

Marginal Costing and Contribution Analysis

Our knowledge of cost distinctions and behaviour helps us apply marginal costing. Marginal costing is a technique, which presents us with information enabling us to consider the profitability of an undertaking by considering the behaviour of costs.
Marginal costing depends on:

  • Cost identification and separation
  • Calculation of contribution
  • Identification and separation

We need to be able to separate our costs into the various elements as described above. Our variable costs are also referred to as marginal costs, which can be defined as “every expense (whether of production, selling or distribution) incurred by the taking of a particular decision”.

Contribution

Once we have identified our marginal costs we can calculate the respective contribution. The calculated contribution will be the sales of those products or services, minus the respective marginal costs. The contribution can be expressed as:

  • An amount per unit
  • A percentage of sales revenue