What is the difference between marginal and absorption costing, and how is contribution used to make short-term decisions?
The distinction between marginal and absorption costing, the calculation and use of contribution, and the application of marginal costing to short-term decisions such as accepting a special order, making or buying, and discontinuing a product.
A focused answer to the SQA Higher Accounting marginal and absorption costing content, covering fixed and variable costs, contribution, how the two costing methods treat fixed overhead, and using marginal costing for special order, make or buy and discontinuance decisions.
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What this dot point is asking
The SQA wants you to distinguish marginal costing from absorption costing, calculate contribution, and use marginal costing to make short-term decisions. You must know how each method treats fixed overhead and why marginal costing, by focusing on contribution, gives clearer guidance for decisions such as a special order, make or buy, or discontinuing a product.
Two ways to cost a unit
The methods differ in one thing: how they treat fixed production overhead. This difference changes the cost of a unit, the value of closing inventory and, in the short term, the reported profit.
Contribution
Contribution is the heart of marginal costing. Each unit sold contributes its selling price less its variable cost towards the fixed costs; once fixed costs are covered, every further unit's contribution is profit.
Marginal costing for decisions
Because fixed costs often do not change with a short-term decision, the relevant comparison is usually contribution. The SQA tests three classic decisions.
- Special order
- Accept extra units if the offered price is above variable cost, so each unit adds contribution, provided fixed costs and normal-price sales are not harmed.
- Make or buy
- Compare the variable cost of making in-house with the price of buying in; if the bought-in price is below the marginal cost of making and capacity is free, buying may be cheaper, but consider quality, reliability and any fixed costs that would remain.
- Discontinue a product
- Keep a product while it makes a positive contribution, even if it shows a loss after fixed overhead, because dropping it loses the contribution while the unavoidable fixed costs remain.
Why the methods give different profit
When inventory levels change, the two methods report different profits because absorption costing carries fixed overhead into closing inventory while marginal costing writes it all off in the period. Over the long run the totals reconcile, but in a single period the difference can matter, which is why decisions should focus on contribution and avoid being distorted by absorbed fixed costs.
Try this
Q1. Selling price £60, variable cost £45. Calculate the contribution per unit. [1 mark]
- Cue. £60 - £45 = £15.
Q2. Contribution per unit is £15 and 5,000 units are sold. Fixed costs are £50,000. Calculate the profit. [2 marks]
- Cue. (£15 x 5,000) - £50,000 = £75,000 - £50,000 = £25,000.
Q3. State the relevant cost to compare against a bought-in price in a make or buy decision when there is spare capacity. [1 mark]
- Cue. The variable (marginal) cost of making the unit in-house.
Exam-style practice questions
Practice questions written in the style of SQA exam questions on this dot point, with worked answer explainers. The year tag is the paper they imitate, not the source.
SQA Higher style5 marksA product sells for £40. Variable cost per unit is £25 and fixed costs are £90,000 per year. The business currently sells 8,000 units. A customer offers to buy 1,000 extra units at £30 each, which would not affect fixed costs or normal sales. Calculate the contribution from the special order and advise whether to accept it.Show worked answer →
Contribution per unit on the special order = special price - variable cost = £30 - £25 = £5 (2 marks).
Total extra contribution = 1,000 units x £5 = £5,000 (1 mark).
Because fixed costs are unchanged and normal sales are not affected, the £5,000 extra contribution increases profit by £5,000 (1 mark).
Advice: accept the order, since it makes a positive contribution and adds to profit even though £30 is below the normal £40 price (1 mark). Markers reward the contribution per unit, the total, the effect on profit and a justified recommendation.
SQA Higher style4 marksExplain the difference between how marginal costing and absorption costing treat fixed production overhead, and state which method is generally preferred for short-term decision making.Show worked answer →
Under marginal costing, fixed production overhead is treated as a period cost and charged in full against the period's contribution; only variable costs are included in the cost of a unit (2 marks).
Under absorption costing, fixed production overhead is absorbed into the cost of each unit using an absorption rate, so each unit carries a share of fixed cost (1 mark).
Marginal costing is generally preferred for short-term decisions because it focuses on contribution and avoids fixed costs that do not change with the decision (1 mark). Markers reward the treatment of fixed overhead under each method and the reason marginal costing suits decisions.
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Sources & how we know this
- SQA Higher Accounting Course Specification — SQA (2023)