Mid Term Assignment on

Marginal &
Absorption
Costing
Subject:

Management
and Cost Accounting
Submitted to:
Prof. Hafiz Javed Iqbal
5th Semester
By
Fezan Akhtar
MBAP-F13-19
Faisal Saeed
MBAP-F13-07
Hina Shaheen
MBAP-F13-10
Ammara Ch
MBAP-F13-24

MASTERS IN BUSINESS ADMINISTRATION

Faculty of Management Sciences

THE SUPERIOR UNIVERSITY LAHORE

Campus, Okara, Pakistan
Date of Submission: 00-12-2015

Marginal Costing
Introduction
The costs that vary with a decision should only be included in decision analysis. For many decisions that involve
relatively small variations from existing practice and/or are for relatively limited periods of time, fixed costs are
not relevant to the decision. This is because either fixed costs tend to be impossible to alter in the short term or
managers are reluctant to alter them in the short term.
Marginal costing - definition
Marginal costing distinguishes between fixed costs and variable costs as conventionally classified.
The marginal cost of a product

is its variable cost. This is normally taken to be; direct labour, direct material, direct expenses and the variable
part of overheads.
Marginal costing is formally defined as:
the accounting system in which variable costs are charged to cost units and the fixed costs of the period are

Features of Marginal Costing

The main features of marginal costing are as follows:
Cost Classification
The marginal costing technique makes a sharp distinction between variable costs and fixed costs. It is the variable
cost on the basis of which production and sales policies are designed by a firm following the marginal costing
technique.
Stock/Inventory Valuation
Under marginal costing, inventory/stock for profit measurement is valued at marginal cost. It is in sharp contrast
to the total unit cost under absorption costing method.
Marginal Contribution
Marginal costing technique makes use of marginal contribution for marking various decisions. Marginal
contribution is the difference between sales and marginal cost. It forms the basis for judging the profitability of
different products or department.

Common Use Cases for Marginal Costing

Marginal costing can be a useful tool for evaluating some types of decisions. Here are some of the most common
scenarios where marginal costing can provide the most benefit:

Automation investments: Marginal costing is useful to determine how much a firm stands to gain or lose by
automating some function. The key costs to take into consideration are the incremental labor cost of any
employees who will be terminated versus the new costs incurred from equipment purchase and subsequent
maintenance.

Cost reporting: Marginal costing is very useful for controlling variable costs, because you can create a variance
analysis report that compares the actual variable cost to what the variable cost per unit should have been.

Customer profitability: Marginal costing can help determine which customers are worth keeping and which
are worth eliminating.

Internal inventory reporting: Since a firm must include indirect costs in its inventory in external reports, and
these can take a long time to complete, marginal costing is useful for internal inventory reporting.

Profit-volume relationship: Marginal costing is useful for plotting changes in profit levels as sales volumes
change. It is relatively simple to create a marginal costing table that points out the volume levels at which
additional marginal costs will be incurred, so that management can estimate the amount of profit at different
levels of corporate activity.

Outsourcing: Marginal costing is useful for deciding whether to manufacture an item in-house or maintain a
capability in-house, or whether to outsource it.

Advantages and Benefits of Marginal Costing

Cost control: Marginal costing makes it easier to determine and control costs of production. By avoiding the
arbitrary allocation of fixed overhead costs, management can concentrate on achieving and maintaining a uniform
and consistent marginal cost.
Simplicity: Marginal costing is simple to understand and operate and it can be combined with other forms of
costing (e.g. budgetary costing and standard costing) without much difficulty.
Elimination of cost variance per unit: Since fixed overheads are not charged to the cost of production in
marginal costing, units have a standard cost.
Short-term profit planning: Marginal costing can help in short-term profit planning and is easily demonstrated
with break-even charts and profit graphs. Comparative profitability can be easily assessed and brought to the
notice of the management for decision-making.
Accurate overhead recovery rate: This method of costing eliminates large balances left in overhead control
accounts, which makes it easier to ascertain an accurate overhead recovery rate.
Maximum return to the business: With marginal costing, the effects of alternative sales or production policies
are more readily appreciated and assessed, ensuring that the decisions taken will yield the maximum return to the
business.

Disadvantages and Limitations of Marginal Costing

Classifying costs: It is very difficult to separate all costs into fixed and variable costs clearly, since all costs are
variable in the long run. Hence such classification sometimes may give misleading results. Furthermore, in a firm
with many different kinds of products, marginal costing can prove less useful.
Accurately representing profits: Since the closing stock consists only of variable costs and ignores fixed costs
(which could be considerable), this gives a distorted picture of profits to shareholders.
Semi-variable costs: Semi-variable costs are either excluded or incorrectly analyzed, leading to distortions.
Recovery of overheads: With marginal costing, there is often the problem of under or over-recovery of
overheads, since variable costs are apportioned on an estimated basis and not on actual value.
External reporting: Marginal costing cannot be used in external reports, which must have a complete view of all
indirect and overhead costs.
Increasing costs: Since it is based on historical data, marginal costing can give an inaccurate picture in the
presence of increasing costs or increasing production.

Advantages and Disadvantages of Marginal Costing

Advantages
1 . M a r gi n a l c o s t i n g i s s i m p l e t o u n d e r s t a n d .
2 . By not charging fixed overhead to cost of production, the effect of varying charges per unit is
avoided.
3 . It prevents the illogical carry forward in stock valuation of some proportion of current years
fixed overhead.
4 . The effects of alternative sales or production policies can be more readily available and assessed,
and decisions taken would yield the maximum return to business.
5 . It eliminates large balances left in overhead control accounts which indicate the difficulty of
ascertaining an accurate overhead recovery rate.
6 . Practical cost control is greatly facilitated. By avoiding arbitrary allocation of fixed overhead,
efforts can be concentrated on maintaining a uniform and consistent marginal cost. It is useful to various
levels of management.
7 . It helps in short-term profit planning by breakeven and profitability analysis, both in terms of
quantity and graphs. Comparative profitability and performance between two or more products and
divisions can easily be assessed and brought to the notice of management for decision making.
Disadvantages
1. The separation of costs into fixed and variable is difficult and sometimes gives misleading
results.
2. Normal costing systems also apply overhead under normal operating volume and this shows that
no advantage is gained by marginal costing.
3. Under marginal costing, stocks and work in progress are understated. The exclusion of fixed costs
from inventories affect profit, and true and fair view of financial affairs of an organization may not be
clearly transparent.
4. Volume variance in standard costing also discloses the effect of fluctuating output on fixed
overhead. Marginal cost data becomes unrealistic in case of highly fluctuating levels of production, e.g.,
in case of seasonal factories.
5. Application of fixed overhead depends on estimates and not on the actual and as such there may
be under or over absorption of the same.
6. Control affected by means of budgetary control is also accepted by many. In order to know the net
profit, we should not be satisfied with contribution and hence, fixed overhead is also a valuable item. A
system which ignores fixed costs is less effective since a major portion of fixed cost is not taken care
of under marginal costing.
7. In practice, sales price, fixed cost and variable cost per unit may vary. Thus, the assumptions
underlying the theory of marginal costing sometimes becomes unrealistic. For long term profit planning,
absorption costing is the only answer.

Rs.
Sales Revenue
Less Marginal Cost of Sales
Opening Stock (Valued @ marginal cost)
Add Production Cost (Valued @ marginal cost)
Total Production Cost
Less Closing Stock (Valued @ marginal cost)
Marginal Cost of Production
Add Selling, Admin & Distribution Cost
Marginal Cost of Sales
Contribution
Less Fixed Cost
Marginal Costing Profit

Rs.
xxxxx

xxxx
xxxx
xxxx
(xxx)
xxxx
xxxx
(xxxx)
xxxxx
(xxxx)
xxxxx

MARGINAL COSTING PRO-FORMA

ABSORPTION COSTING PRO-FORMA

Rs.
Sales Revenue
Less Absorption Cost of Sales
Opening Stock (Valued @ absorption cost)
Add Production Cost (Valued @ absorption cost)
Total Production Cost
Less Closing Stock (Valued @ absorption cost)
Absorption Cost of Production
Add Selling, Admin & Distribution Cost
Absorption Cost of Sales
Un-Adjusted Profit
Fixed Production O/H absorbed
Fixed Production O/H incurred
(Under)/Over Absorption
Adjusted Profit

Rs.
xxxxx

xxxx
xxxx
xxxx
(xxx)
xxxx
xxxx
(xxxx)
xxxxx
xxxx
(xxxx)
xxxxx
xxxxx

Absorption Costing Definition:

Absorption costing is defined as a method for accumulating the costs associated with a production process and
apportioning them to individual products. This type of costing is required by the accounting standards to create an
inventory valuation that is stated in an organization's balance sheet.
A product may absorb a broad range of fixed and variable costs. These costs are not recognized as expenses in the
month when an entity pays for them. Instead, they remain in inventory as an asset until such time as the inventory
is sold; at that point, they are charged to the cost of goods sold.

Types of Absorption Costing systems

There are three different types of Absorption Costing systems:

1. Job Order Costing:

The cost calculation is assigned to the product in batches (a nonrecurring collection of several production
units) and lots (production unit, linked to the serial numbers of a product).

2. Process Costing:
The cost calculation is systematically assigned to the product because there are not batches or lots.

3. Activity Based Costing: (ABC)

Activity-based costing (ABC) is a costing methodology that identifies activities in an organization and
assigns the cost of each activity with resources to all products and services according to the actual
consumption by each.

Absorption Costing Components

The key costs assigned to products under an absorption costing system are:
1. Direct materials: Those materials that are included in a finished product.
2. Direct labor: The factory labor costs required to construct a product.
3. Variable manufacturing overhead: The costs to operate a manufacturing facility which vary with
production volume. Examples are supplies and electricity for production equipment.
4. Fixed manufacturing overhead: The costs to operate a manufacturing facility, which do not vary with
production volume. Examples are rent and insurance.

Absorption Costing Steps

The steps required to complete a periodic assignment of costs to produced goods is:
1. Assign costs to cost pools. This is comprised of a standard set of accounts that are always included in cost
pools, and which should rarely be changed.
2. Calculate usage. Determine the amount of usage of whatever activity measure is used to assign overhead
costs, such as machine hours or direct labor hours used.
3. Assign costs. Divide the usage measure into the total costs in the cost pools to arrive at the allocation rate
per unit of activity, and assign overhead costs to produced goods based on this usage rate.

Overhead Absorption
Absorbed overhead is manufacturing overhead that has been applied to products or other cost objects. Overhead
is usually applied based on a predetermined overhead allocation rate. Overhead is over absorbed when the
amount allocated to a product or other cost object is higher than the actual amount of overhead, while the amount
is under absorbed when the amount allocated is lower than the actual amount of overhead.

Advantages and disadvantages of Absorption Costing

Advantages:
The key advantages of absorption costing include:
1. It identifies the importance of fixed costs involved in production.
2. The absorption costing method is accepted by Inland Revenue as stock is not undervalued.
3. The absorption costing method is always used for preparing financial accounts.
4. The absorption costing method shows less fluctuation in net profits in case of constant production but
fluctuating sales.
5. Contrasting marginal costing which involves fixed cost changing into variable cost, it is cost into the
stock value thus distorting the stock valuation.

Disadvantages:
The main drawbacks of Absorption Costing include:
1. Since absorption costing emphasized on total cost that is to say both variable as well as fixed, it is not
useful for management to use to make decision, control, and planning.
2. Besides, since the manager emphasizes on the total cost, the cost volume profit relationship is ignored.
The manager, therefore, needs to use his intuition for decision making.

References:
http://www.toolshero.com/financial-management/absorption-costing/
http://www.readyratios.com/reference/accounting/absorption_costing.html
http://hubpages.com/education/Advantages-and-Disadvantages-of-Marginal-Costing
http://cptcwa.blogspot.com/2012/01/marginal-costing-formulas.html

Introduction: What is Marginal Costing?

Marginal costing is a method of cost accounting and decision-making used for internal reporting in which only
marginal costs are charged to cost units and fixed costs are treated as a lump sum. It is also known as direct,
variable, and contribution costing.
In marginal costing, only variable costs are used to make decisions. I
t does not consider fixed costs, which are assumed to be associated with the time periods in which they were
incurred.
Marginal costs include:

The costs actually consumed when you manufacture a product

The incremental increase in costs when you ramp up production

The costs that disappear when you shut down a production line

The costs that disappear when you shut down an entire subsidiary

In this technique, cost data is presented with variable costs and fixed costs shown separately for the purpose of
managerial decision-making.
Marginal costing is not a method of costing like process costing or job costing. Rather, it is simply a way to analyze
cost data for the guidance of management, usually for the purpose of understanding the effect of profit changes due
to the volume of output.

The direct costing concept is extremely useful for short-term decisions, but can lead to harmful results if used for longterm decision-making, since it does not include all costs that may apply to a longer-term decision. Furthermore,
marginal costing does not comply with external reporting standards.