Accounting For Profit With Marginal Costing

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Business costs and expenses as expressed as a unit cost of a product can vary significantly as purchase or production volumes change. The first stage in using marginal costing to generate higher levels of profit is to identify the variability of all the individual cost elements.

Costs which are a component part of the product would normally be classified as variable costs since each component would require to be bought in specifically for that product. The cost of items bought for resale would also be classified as variable costs.

Fixed costs would be items not relating to the volume of goods manufactured or sold. Examples would be the premises costs, machinery costs.

A number of business expenses would be semi variable in that they can in some circumstances be viewed as a fixed expense but in other circumstances could also be viewed as variable expenses. Advertising expenses might be regarded as almost fixed expenses to promote the business or products whereas promoting the business name would be largely a fixed cost while specific product related advertising might be viewed as a variable product cost.

Wages and salaries are an important cost to most businesses and would normally be classified as semi variable. Administration salaries are more likely to be fixed while direct labour costs will contain both a fixed and variable element.

To operate a marginal costing program identify the variability of each cost item and evaluate that marginal cost and the fixed overheads of the business. To use the marginal costing as part of an accounting for profit program apply different volumes to the marginal costs.

At the lowest volume the fixed costs might well exceed the marginal profit, which in accounting terms is called the contribution, being the difference between the selling price and the marginal cost. The point at which the overall volume produces neither a loss nor a profit is called the break even point.

Break even analysis is important to ensure there is sufficient market demand to be able to exceed the break even point and the marketing effort will ensure that break even point is not just reached but easily achievable.

A further stage in accounting for profit would be to plan various volumes, the effect those volumes have on variable costs and occasionally on fixed costs too. Determine what is achievable and what is not achievable, the effect on the volume of profit and set business plans accordingly.

In addition to higher volumes producing higher marginal profits the variable costs also reduce when volumes increase and these changes require to be accounted for. Even if goods are being bought in purely for resale the variable costs will vary with volumes.

Buying in 100 items of a product will be cheaper than buying in 2 or 3. Selling and delivering the items individually is likely to cost more in distribution co0sts than selling in parcels of 10 or 20.

By analysing costs and their variability in relation to actual and potential volumes gives the accountant a real voice to influence management decisions in the way the business plans are constructed and by routine checks on progress using marginal costing as part of the budgeting and reporting process maximum profits can be achieved by accounting for profit.
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Terry Cartwright, CEO DIY Accounting, a qualified accountant in the UK, designs Accounting Software on excel spreadsheets and Payroll Software for small to medium sized business providing a complete accounting solution and also supplies Company Formation packages for new limited liability companies