The different methods of costing used in a manufacturing business, result in variations in the format of income statements. If you understand the differences between the various methods of cost, you will understand that these variations are necessary because each method of costing, brings slight changes to the cost of production of the finished goods.

Now, we are going to discuss the income statement under marginal costing. Before we look at the income statement, let us have a look at what is marginal costing.

Marginal Costing

In very simple terms, marginal cost is the cost of producing one extra unit. The formula for finding out the marginal cost can be written as

Marginal cost = (Change in the total cost of production)/(Change in total quantity)

The discussion below will help you to understand it better.

Suppose Gilded ltd produces 10,000 units for the total cost of $5 million. There has however been a huge increase in the demand for the units produced by Gilded ltd and the year-end data shows that Gilded produced 15000 units for the total cost of $7 million.

We can see that the initial average cost was $500 but as the demand spiked up, the increase in produced units resulted in the average cost falling down to $466.6.

Meanwhile, the marginal cost of Gilded ltd was $400 (2000,000/5000).

The main impact of costing methods is upon the cost of finished goods and by extension on opening and closing inventory. Marginal costs include only the variable costs of production and not the fixed costs because the assumption is that fixed costs do not change with the change in the quantity of production in the short run. This means that the cost of production only has the variable cost element. By extension, the stock of opening and closing inventory under marginal costing also includes only the variable cost element and not the absorbed fixed costs.

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This is why income statements prepared on marginal cost and absorption cost basis end up having different figures for profit.

Format of Income statement under Marginal Costing

Now, let us look at the format of income statements under marginal costing.

Income Statement under Marginal Costing

 USDUSD
Sales Revenue XXX
The less marginal cost of sales  
Opening inventory(valued at marginal cost)xxx 
Cost of manufactured goods (valued at marginal cost)xxx 
Closing inventory (valued at marginal cost)(xxx) 
  (xxx)
Less variable costs  
Variable selling costxxx 
Variable administration costxxx 
Variable distribution costxxx(xxx)
Contribution Margin XXX
Less fixed costs  
Fixed selling costxxx 
Fixed administration costxxx 
Fixed production costxxx(xxx)
Profit XXX

It is seen that variable costs are deducted first from the sales revenue to arrive at the contribution margin. The contribution margin shows how much money is left to cover the fixed costs.

The contribution margin also shows us the philosophy of the marginal costing system. Since the marginal costing system focuses on variable costs, it has a short-term outlook. The element of contribution margin shows that the marginal costing system allows the business to look at the short-term viability of production while separating out the fixed costs that impact the long-term outlook of the business.

This is why as long as the marginal cost of the business is lower than its selling price, it will leave something for the business to cover the fixed costs, if however, the marginal cost is higher than the selling price, then it shows that the production of that good or product is no longer viable because the product cannot even cover the short term variable costs.

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Let see a worked example.

Gilded limited has presented the following data

Unit Selling Price$10
Unit Variable Cost$6
Fixed cost$400,000
Budgeted activity150,000 units
Sold units180,000 units
Opening inventory for the period30,000 units

Using this information we can make the income statement under marginal costing

Income Statement under Marginal Costing

 USDUSD
Sales Revenue 1800,000
The less marginal cost of sales  
Opening inventory(valued at marginal cost)180,000 
Cost of manufactured goods (valued at marginal cost)900,000 
Closing inventory (valued at marginal cost)NIL 
  (1080,000)
Less variable costs  
Variable selling costNIL 
Variable administration costNIL 
Variable distribution costNIL(NIL)
Contribution Margin 720,000
Less fixed costs  
Fixed selling costNIL 
Fixed administration costNIL 
Fixed production cost400,000(400,000)
Profit 320,000

See a few important figures in this calculation.

Sales Revenue

Sales revenue was calculated by multiplying sold units (180,000) by the selling price ($10) to arrive at $1800,000.

Opening Inventory

The question only gave us the 30,000 units of opening inventory. To arrive at the cost of opening inventory, we simply have to multiply the number of units with the variable cost i-e $6 to arrive at $180,000.

Cost of manufactured goods.

The question gave us the number of budgeted goods at 150,000 units. We simply had to multiply this by $6 to arrive at $900,000.

Closing inventory

Closing inventory is NIL because our opening inventory was 30,000 and manufactured units were 150,000 which equals 180,000. This was also the number of sold units, which means that there was no closing inventory.

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If there was any closing inventory, then the units would simply have been multiplied by the variable cost to arrive at the cost of closing inventory.

Contribution Margin

The contribution margin, as we can see, is $720,000. We can also find out the contribution ratio by dividing the contribution margin by the sales revenue. This gives a contribution ratio of 40%. This means that after accounting for the variable costs, 40% of the sales revenue is left to cover the fixed costs of production.

This example clearly shows how to use marginal costing to create an income statement. The only point to remember is that in marginal costing, variable costs are included in the cost of production and not the fixed costs. This is why marginal costing income statements give us a higher net profit as compared to absorption costing.