Use marginal costing for profit and decisions
Prepare a marginal-costing profit statement, reconcile it to absorption profit, and use relevant contribution data in short-run decisions.
Exam scope and assessment notes
Cambridge International AS & A Level Accounting 9706, 2026–2028 syllabus, Version 2. These original lessons cover Topic 2.2.1–2.2.4: unit, job and batch costing; absorption costing and overheads; marginal costing, contribution and break-even analysis; and cost–volume–profit decisions. Practice is self-checked, not an official Cambridge grade; full timed Papers 1–4 and human subject-teacher review remain outstanding.
Before you begin
- Know the difference between direct and indirect costs and between fixed and variable cost behaviour. Keep units, production volume, overhead rates and relevant ranges visible in calculations.
Work on paper. Try each question before revealing help, and explain why your method works.
Quick readiness check
What is the treatment of fixed production overhead in marginal-costing inventory?
What you will learn
- Prepare a marginal-costing statement and reconcile profit with absorption costing
- Use relevant costs and contribution for specified decisions
- Evaluate financial and non-financial factors before recommending action
Report contribution after variable costs
A marginal-costing statement deducts variable production costs from revenue to show contribution, then deducts fixed costs for the period to find profit. Fixed production overhead is a period cost in this statement; closing inventory is valued at variable production cost under the model.
Absorption costing includes fixed production overhead in inventory cost. If production exceeds sales and inventory rises, absorption profit is higher than marginal profit by the fixed production overhead carried in closing rather than opening inventory. If inventory falls, the direction reverses. Reconcile using the change in inventory units × fixed production overhead per unit, when the unit rate is constant.
Use relevant contribution, not an arbitrary average
For a special order with spare capacity, compare incremental revenue with incremental costs and any avoidable fixed or setup cost. For make-or-buy, compare costs that change and consider how released capacity could be used. For closure, compare lost contribution with avoidable fixed costs; allocated common costs may continue after closure.
When one resource limits output, compare contribution per unit of the limiting factor, subject to demand and other constraints. Consider product quality, customer relationships, staff, reliability, legal obligations and long-term strategy. A favourable short-term contribution does not guarantee the best overall decision.
Pause and explain
Production is greater than sales and closing inventory increases. Which profit is usually higher, assuming a constant fixed overhead rate?
Worked example
A company makes 5,000 units and sells 4,400. Fixed production overhead is $30,000, variable manufacturing cost $12 per unit, selling price $30, variable selling cost $2 per unit, fixed selling cost $8,000 and administration $20,000. There is no opening inventory. Calculate marginal profit and reconcile it to the absorption profit.
Show the worked solution
- Contribution = 4,400 × ($30 − $12 − $2) = $70,400.
- Marginal profit = 70,400 − 30,000 − 8,000 − 20,000 = $12,400.
- Fixed production overhead per unit = 30,000 ÷ 5,000 = $6. Closing inventory is 600 units; 600 × $6 = $3,600. Absorption profit = 12,400 + 3,600 = $16,000.
Answer Marginal profit $12,400; absorption profit $16,000, higher by $3,600 because fixed production overhead is carried in closing inventory.
Try a topic test
Choose Easy, Normal or Difficult. Save your answers and open worked review after finishing.
Test this topic →From guided practice to a new situation
Write your answer and reasoning first. Use a hint only if you are stuck. The model solution is for self-checking; your written work is not automatically marked.
A supplier offers to make 500 units for $17 each. The business can make them for variable cost $14 each, and doing so would require an extra setup cost of $900. Spare capacity exists and no regular sales would be lost. Compare the relevant financial effects and one non-financial check.
Give me a hint
Compare the supplier's total price with internal variable cost plus the avoidable setup cost.
Compare my reasoning
- Buy cost = 500 × $17 = $8,500.
- Make relevant cost = 500 × $14 + $900 = $7,900; making saves $600 on the stated figures.
- Check supplier quality and reliability, internal staff capacity and whether the setup cost is truly avoidable before recommending.
Making is $600 cheaper on the stated relevant costs. Confirm quality, delivery reliability, capacity and the avoidability of the setup cost before deciding.
Look for these in your work
- Relevant costs included
- Saving calculated
- Non-financial check added
A division earns contribution of $22,000 and is charged $28,000 of fixed costs. Only $12,000 of those costs would be avoided if it closes. Assess closure on the stated financial evidence.
Give me a hint
Separate avoidable costs from allocated costs that remain.
Compare my reasoning
- The division's reported result is a $6,000 loss after the $28,000 charge.
- Closing loses $22,000 contribution but saves only $12,000 avoidable fixed cost.
- Total business profit would fall by $10,000, before non-financial or redeployment effects; the remaining $16,000 fixed cost continues.
Do not close on the reported segment loss alone. On these figures, closure reduces total profit by $10,000 because lost contribution exceeds avoidable cost; review capacity redeployment and service or strategic effects.
Look for these in your work
- Segment loss calculated
- Avoidable cost isolated
- Business-wide effect stated
A factory can make either Product A or Product B with its 1,000 limiting machine hours. A contributes $30 per unit and uses 3 machine hours; B contributes $24 and uses 2 hours. Demand is at least 500 units for each. Recommend a production mix and state what else to check.
Give me a hint
Compare contribution per scarce machine hour, then use the 1,000 hours without exceeding demand.
Compare my reasoning
- A contributes $30 ÷ 3 = $10 per machine hour; B contributes $24 ÷ 2 = $12 per machine hour.
- Make 500 units of B first, using all 1,000 hours; this gives contribution $12,000.
- Check whether the machine-time estimate is reliable and consider quality, delivery commitments, other limiting resources and customer effects.
Under the stated single constraint, produce 500 units of B for contribution $12,000. Recheck demand and all other constraints and non-financial commitments before applying the recommendation.
Look for these in your work
- Limiting-factor contribution compared
- Demand constraint applied
- Other factors checked
Common mistakes
- Treating a contribution as profit before deducting fixed costs
- Including fixed production overhead in marginal closing inventory
- Using allocated fixed costs as avoidable without checking whether they will actually cease
What can you explain now?
A company has contribution $42,000 and fixed costs $35,000. What is its profit under the marginal model?
Compare with the explanation
$7,000
Profit equals contribution less fixed costs.
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Make it stick
How does a change in inventory create a difference between absorption and marginal profit?
If you needed the solution, close it and solve the problem again from a blank page. A correct answer is stronger when you can explain the reason for each step.