MARGINAL COSTING

INTRODUCTION:

Like process costing or job costing, marginal costing is not a distinct method of ascertainment of

cost but is a technique which applies existing methods in a particular manner so that the

relationship between profit & the volume of output can be clearly brought out. Marginal costing

ascertains marginal or variable costs & the effect on profit, of the changes in volume or type of

output, by differentiating between variable costs & fixed costs. To any type of costing such as

historical, standard, process or job; the marginal costing technique may be applied.

Under the process of marginal costing, from the cost components, fixed costs are excluded. The

difference which arises between the variable costs incurred for activities & the revenue earned

from those activities is defined as the gross margin or contribution. It may relate to total sales or

may relate to one unit.

The calculation of contribution for a specific product or group of products is done as follows:

Sales Revenue XXX

Less Variable cost of production XXX

Contribution XX

For the business as a whole, contributions earned by specific products or group of products, are

added so as to calculate the pool of total contribution. The fixed costs of the business are paid

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from this pool & then the part of the total contribution which remains becomes the profit of the

business as a whole.

A typical format for marginal costing statement is as below:

Product types or departments A B C Total

Sales Revenue XXXX

Less Variable cost of production XXXX

Contribution XXXX

Less: Fixed Costs XX

Total Profit XX

Under marginal costing, for the calculation of profits for individual products or departments, no

attempt is made- only calculation of individual contributions is done. The fixed cost does not

allocated to or gets absorbed by the individual products or departments. Thus, accounting

techniques relating to the treatment of fixed costs will not influence the decisions which are

based on marginal costing system.

Examples of typical problems which require executive decisions are:

a. At a lower price should a particular order be accepted or declined?

b. Should purchase of a particular component be made from an outside supplier or

manufactured within the factory?

c. Concentration should be given on which products?

d. By which profit-mix, profit will be maximized?

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e. What should be the effect on the business when an existing department is being closed or

a new department is being opened?

f. To make up for wage rise, what should be the additional volume of business?

g. How by change in sales volumes or sales prices, the level of profit of business be

influenced?

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MEANING:

The increase or decrease in the total cost of a production run for making one additional unit of an

item. It is computed in situations where the breakeven point has been reached: the fixed costs

have already been absorbed by the already produced items and only the direct (variable) costs

have to be accounted for.

Marginal costs are variable costs consisting of labor and material costs, plus an estimated portion

of fixed costs (such as administration overheads and selling expenses). In companies where

average costs are fairly constant, marginal cost is usually equal to average cost. However, in

industries that require heavy capital investment (automobile plants, airlines, mines) and have

high average costs, it is comparatively very low. The concept of marginal cost is critically

important in resource allocation because, for optimum results, management must concentrate its

resources where the excess of marginal revenue over the marginal cost is maximum. Also called

choice cost, differential cost, or incremental cost.

Marginal costing distinguishes between fixed costs and variable costs as convention ally

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 written-off in full against the aggregate

contribution. Its special value is in decision making. (Terminology.)

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The term contribution mentioned in the formal definition is the term given to the difference

between Sales and Marginal cost. Thus:

MARGINAL COST = VARIABLE COST DIRECT LABOUR

DIRECT MATERIAL

DIRECT EXPENSE

VARIABLE OVERHEADS

CONTRIBUTION = SALES - MARGINAL COST

The term marginal cost sometimes refers to the marginal cost per unit and sometimes to the total

marginal costs of a department or batch or operation. The meaning is usually clear from the

context.

Note:

Alternative names for marginal costing are the contribution approach and direct costing In this

lesson, we will study marginal costing as a technique quite distinct from absorption costing.

Marginal cost is the cost to create one more unit of a product. In a highly automated

environment, this incremental change is likely to be solely the material cost of a product; in a

less automated environment, it may also include the cost of the labor needed to create the

product.

For example, it costs $20,000 to produce 50 units of a green widget, with most of the cost

associated incurred during the setup of the production equipment at the beginning of the

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production run. It costs $20,100 to produce 51 units of the green widget, which means that the

marginal cost of the next unit of production is $100. The average cost of producing 51 units of

the green widget is $394 ($20,100 divided by 51 units). Given the large disparity between the

marginal cost and the average cost of the green widget, you must be very careful about the uses

to which you put these numbers.

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Features of Marginal Costing:

a. Classification of costs into fixed costs & variable costs is done under marginal costing

system. Also semi-fixed or semi-variable cots get further classified into fixed & variable

elements.

b. To the product, only variable elements of cost, which constitute marginal cost, are

attached.

c. After the marginal cost & marginal contribution are taken into consideration; price is

fixed.

d. From the total contribution for any period, fixed cost for the period are deducted.

e. The profitability of a department or product is decided by the marginal contribution.

f. At variable production cost, the valuation of work-in-progress & finished product is

made.

But the main features of marginal costing are as follows:

1. 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.

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2. 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.

3. 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

departments.

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Advantages of Marginal Costing:

Components and spare parts may be made in the factory instead of buying from the market. In

such cases, the marginal cost of manufacturing the components or spare parts should be

compared with market price while taking decision to make or buy. If marginal cost is lower than

the market price, it is more profitable to make than purchasing from market. Additional or

specific fixed cost may be a relevant cost. Following are the advantages of Marginal Costing:

Variable cost remains constant per unit of output and fixed costs remain constant in total

during short period. Thus control over costs becomes more effective and easier.

Standards can be set for variable costs, while Budgets can be established for fixed cost in

order to exercise full control over the total activities.

Marginal costing brings out contribution or profit margin per unit of output, and clearly

brings out the effect of change in activity. It facilitates making policy decisions in a

number of management problems, such as determining profitability of products,

introducing a new product, discontinuing a product, fixing selling price, deciding whether

to make or buy, utilizing spare capacity, profit-planning, etc.

The distinction between product cost and period cost helps easy understanding of

marginal cost statements.

Closing inventory of work-in-progress and finished goods are valued at marginal or

variable cost only. This method leads to greater accuracy in arriving at profit as it

eliminates any carryover of fixed costs of the previous period through inventory

valuation.

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As a corollary to above, since fixed costs do not enter into product-cost, it eliminates the

process of allocating, apportioning and absorbing overheads and adjusting under and

over-absorbed overheads. Therefore, the method is simpler to operate.

As there is involvement of computation of variable costs only in marginal costing, it is

easy to understand & operate the same.

Among different products or departments, arbitrary apportionment of fixed costs is

avoided & the under-recovery or over-recovery problems are eliminated.

Any attempt of measurement of relative profitability of different products or different

departments becomes complicated due to the arbitrary apportionment of fixed costs.

Analysis of contribution, break even charts & analysis of cost-volume-profit-analysis are

resulted out of a marginal costing system; for making short term decisions all of these are

important.

More uniform & realistic figures are resulted out of marginal costing system because

fixed overhead costs are excluded from valuation of stock & work-in-progress.

Apportionment of responsibility of control can be more easily done since to each level of

management only variable costs are presented over which they have control.

The effects of their decisions can be more readily seen by all levels of management-

sometimes even before taking of an action.

Marginal costing is simple to understand.

By not charging fixed overhead to cost of production, the effect of varying charges per

unit is avoided.

It prevents the illogical carry forward in stock valuation of some proportion of current

year's fixed overhead.

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 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.

It eliminates large balances left in overhead control accounts which indicate the difficulty

of ascertaining an accurate overhead recovery rate.

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.

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.

Main advantages of Marginal Costing are as follows:

Ø Cost Control: 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 useful to the various levels of management.

Ø Simplicity: Marginal Costing is simple to understand and operate; it can be combined with

other forms of costing, such as, budgetary costing, standard costing without much difficulty.

Ø Elimination of varying charge per unit: In marginal Costing fixed overheads are not

charged to the cost of production due to this the effect of varying charges per unit is avoided.

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Ø Short-Term Profit Planning: It helps in short-term profit planning by break-even charts and

profit graphs. Comparative profitability can be easily assessed and brought to the notice of the

management for decision-making.

Ø Prevents Illogical Carry forwards: It prevents the illogical carry-forwards in stock-valuation

of some proportion of current years fixed overhead.

Ø Accurate Overhead Recovery Rate: It eliminates large balances left in overhead control

accounts, which indicate the difficulty of ascertaining an accurate overhead recovery rate.

Ø Maximum return to the business: The effects of alternative sales or production policies can

be more readily appreciated and assessed, and decisions taken will yield the maximum return to

the business.

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Disadvantages of Marginal Costing:

The technique is based on the segregation of costs into fixed and variable ones, while

many expenses are neither totally fixed nor totally variable at various levels of activity.

Thus, classifying all expenses into two categories of either fixed or variable is a difficult

task.

The assumptions regarding behaviour of costs, such as, fixed cost remains static, are

often not realistic.

Contribution is not the only index to take decisions. For example, where fixed cost is very

high, selling price should not be fixed on the basis of contribution alone without

considering other key factors such as capital employed.

Marginal cost, if confused with total cost while fixing selling price may lead to a disaster.

Inventory valuation at marginal cost will understate profits and may not be acceptable by

tax-authorities. Any claim based on cost will be very low, as it will not have a share of

fixed cost.

The process of separating semi-variable or semi-fixed costs into their variable & fixed

elements is an arbitrary exercise which at different levels of output may be subject to

fluctuations & inaccuracy. Consequently, a substantial degree of error may be contained

in the basic cost information which is used in decision making process.

When selling prices are based on marginal costs, great care need to be exercised, as in the

long run, all fixed overheads should be covered by the prices & a reasonable margin over

& above the total costs should be left.

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Under many circumstances, the deduction of contribution made by some production units

may be difficult. Thereby the effectiveness of the system is lost.

Since on the basis of variable costs only the valuation of stock of finished goods & work-

in-progress is done, they are always understated. As result profit is also understated.

More effective utilization of present resources or by expansion of resources or by

mechanization, increased production & sales may be effected. The disclosure of this fact

cannot be done by marginal costing.

The separation of costs into fixed and variable is difficult and sometimes gives

misleading results.

Normal costing systems also apply overhead under normal operating volume and this

shows that no advantage is gained by marginal costing.

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.

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.

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.

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.

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 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.

Main Disadvantages of Marginal Costing are as follows:

Ø Misleading Results: It is very difficult to segregate all costs into fixed and variable costs very

clearly, since all costs are variable in the long run. Hence such segregation sometimes may give

misleading results.

Ø Distorted Picture of Profits: The closing stock consists of variable cost only and ignores

fixed costs. This gives Distorted Picture of Profits.

Ø Avoids Semi-Variable Costs: Semi-Variable costs are not considered in the analysis.

Ø Problem of Recovery of Overheads: There is problem of under or over-recovery of

overheads, since variable costs are apportioned on estimated basis and not on the actual.

Ø Ignorance of Time Factor: Since the time factor is completely ignored; comparison of

performance between two periods on the basis of contribution alone will give the misleading

results.

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Formulas of Marginal Costing:

Marginal cost = prime cost + total variable overheads

Or

Marginal cost = total variable cost.

Contribution = selling price – variable (marginal) cost

Or Contribution = fixed cost + profit (or-loss)

Or Contribution – fixed cost = profit (or loss)

Thus,

Sales = Variable cost + fixed cost + profit (or – loss)

Sales = Variable cost = fixed cost + profit (or – loss)

P/V = contribution/sales = S/C

Or = [Fixed Costs + Profit/sales] = [F+P/S]

Or = [Sales-Variable Cost/Sales] = [S-V/S]

Break-even Point (units) = Total fixed costs/Contribution per unit [F/C per unit]

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Break-even Sales = Total Fixed Costs x selling price per unit / contribution per unit

[F/C*S]

Fixed Cost/P/V Ratio [F/P/V]

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Break Even Analysis:

Break-even analysis is an analytical technique that is used to determine the probable profit at any

level of production. It is basically an extension of marginal costing.

Break-even point is that point at which there is neither profit nor loss. It is at point costs are

equal to sales. It is otherwise called as balancing point, neutral point, equilibrium point, loss

ending point, profit beginning point etc. After BEP is achieved, all the further sales will

contribute to profit.

At BEP, Sales – Variable cost = Fixed costs. OR Contribution = Fixed costs.

Break-even Point is the representation position of that volume of sales or production which has

no profit no loss. It means total sales are just equal to total cost.

Advantages of Break-even analysis:

1. Profit planning

2. Product planning

3. Activity Planning

4. Lease Decisions

5. Make or buy decisions

6. Capital profit decisions

7. Distribution channel decisions

8. Price decisions

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9. Choosing Promotion Mix

10. Decision regarding profitability of products or department.

Break-even chart shows the graphical representation of cost and revenue of inter-relation at

different volumes of output.

No doubt about the advantages of Break-even chart that it helps to determine the selling price to

give a desired volume of profit.

It shows costs and profits and different volumes of productions. But along with, there are

limitations of break-even chart also. People also say that break even chart does not always show

a true chart.

At last we can analyse about break-even and can say that it is the level of operations which is the

position of cost and revenue equilibrium.

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ABSORPTION COSTING
INTRODUCTION:

The objective of absorption costing is to include in the total cost of a product an appropriate

share of the organization's total overheads. Overhead is the cost incurred in the course of making

a product, providing a service or running a department, but which cannot be traced directly and

fully to the product, service or department.

Overheads are actually the total of the following:-

Indirect materials

Indirect labour

Indirect expenses

In cost accounting there are two schools of thoughts as to the correct method of dealing with

overheads:-

Absorption costing

Marginal costing.

An appropriate share is generally taken to mean an amount which reflects the amount of time and

effort which has gone into producing a unit or completing a job. The theoretical justification for

using absorption costing is that all production overhead are incurred in production of output so

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each unit of the product receives some benefits from these cost. Therefore each unit of output

should be charged with some of the overhead costs.

Practical reasons for using absorption costing- Inventory valuations

• Inventory in hand must be valued for two reasons:-

• For the closing inventory figure in the statement of financial position

• For the cost of sales figure in the statement of comprehensive income

• In absorption costing, closing inventory is valued at fully absorbed factory costs.

Practical reasons for using absorption costing- Pricing decisions

• Many companies attempt to fix selling prices by calculating the full cost of production or

sales of each product, and then adding a margin for profit.

• Without using absorption costing, a full cost is difficult to ascertain.

Practical reasons for using absorption costing- Establishing profitability of different products

• If a company sells more than one product, it will be difficult to judge how profitable each

individual product is, unless overhead costs are shared on a fair basis and charged to the

cost of sales of each product

Absorption of overheads

• Absorption of overheads is charging of overheads from cost centre’s to products or

services by means of absorption rates for each cost center which is calculated as follows:

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Overhead absorption Rate = total overheads of cost centre
total quantum of base

• The base (denominator) is selected on the basis of type of the cost centre and its

contribution to the products or services, for example, machine hours, labour hours,

quantity produced etc.

Overhead absorption

• Overhead absorption is the process whereby overhead costs allocated and apportioned to

production cost centre’s are added to unit, job or batch costs.

• Overhead absorption is sometimes known as overhead recovery

• Therefore having allocated and/or apportioned all overheads, the next stage is to add

them to, or absorb them into, cost units

• Overheads are usually added to costs units using a predetermined overhead absorption

rate, which is calculated using figures from the budget.

Calculation of overhead absorption rate

• Estimate the overhead likely to be incurred during the period

• Estimate the activity level for the period

• Divide the estimated overhead by the budgeted activity level

• Absorb the overhead into the cost unit by applying the calculated absorption rate

Choosing the appropriate absorption base:

• A percentage of direct materials cost

• A percentage of direct labour cost

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 • A percentage of prime cost

• A rate per machine hour

• A rate per direct labour hour

• A rate per unit

• A percentage of factory cost (for admin overhead)

• A percentage of sales or factory cost (for selling and distribution overhead)

Blanket absorption rate and departmental absorption rate:

• A blanket overhead absorption rate is an absorption rate used throughout a factory and for

all jobs and units of output irrespective of the department in which they are produced

• If a separate absorption rate is used for each department, charging of overheads will be

fair and the full cost of production of items will represent the amount of effort and

resources put in making them

• Blanket overhead rates are not appropriate in the following circumstances:-

– There is more than one department

– Jobs do not spend an equal amount of time in each department

Over and under absorption of overheads:

• The rate of overhead absorption is based on estimates (of both numerator and

denominator) and it is quite likely that either one or both of the estimates will nit agree

with what actually occurs

– Over absorption means that the overheads charged to the cost of sales is more

than the overheads actually incurred.

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 – Under absorption means that insufficient overheads have been included in the cost

of sales

The reasons for over/under absorbed overheads:

• The overhead absorption rate is predetermined from budget estimates of overhead cost

and the expected volume of activity.

• Over or under recovery of overhead will occur in the following circumstances:-

– Actual overhead costs are different from budgeted overhead

– The actual activity level is different from the budgeted activity level

– Actual overhead costs and actual activity level differ from the budgeted costs and

levels.

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MEANING:

A managerial accounting cost method of expensing all costs associated with manufacturing a

particular product. Absorption costing uses the total direct costs and overhead costs associated

with manufacturing a product as the cost base. Generally accepted accounting principles (GAAP)

require absorption costing for external reporting.

Absorption costing is also known as full absorption costing.

Some of the direct costs associated with manufacturing a product include wages for workers

physically manufacturing a product, the raw materials used in producing a product, and all of the

overhead costs, such as all utility costs, used in producing a good.

Absorption costing includes anything that is a direct cost in producing a good as the cost base.

This is contrasted with variable costing, in which fixed manufacturing costs are not absorbed by

the product. Advocates promote absorption costing because fixed manufacturing costs provide

future benefits.

It is a costing technique where all normal costs whether it is variable or fixed costs are charged to

cost units produced.

Unlike marginal costing which take the fixed cost as period cost.

Absorption costing means that all of the manufacturing costs are absorbed by the units produced.

In other words, the cost of a finished unit in inventory will include direct materials, direct labor,

and both variable and fixed manufacturing overhead. As a result, absorption costing is also

referred to as full costing or the full absorption method.

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Absorption costing is often contrasted with variable costing or direct costing. Under variable or

direct costing, the fixed manufacturing overhead costs are not allocated or assigned to (not

absorbed by) the products manufactured. Variable costing is often useful for management’s

decision-making. However, absorption costing is required for external financial reporting and for

income tax reporting.

A method of costing a product in which all fixed and variable costs are apportioned to cost

centers where they are accounted for using absorption rates. This method ensures that all

incurred costs are recovered from the selling price of a good or service. Also called full

absorption costing. See also direct costing, marginal costing.

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Advantages of Absorption Costing:

It recognizes the importance of fixed costs in production

This method is accepted by Inland Revenue as stock is not undervalued

This method is always used to prepare financial accounts

When production remains constant but sales fluctuate absorption costing will show less

fluctuation in net profit and

Unlike marginal costing where fixed costs are agreed to change into variable cost, it is

cost into the stock value hence distorting stock valuation.

Absorption costing recognizes fixed costs in product cost. As it is suitable for

determining price of the product. The pricing based on absorption costing ensures that all

costs are covered.

Absorption costing will show correct profit calculation than variable costing in a situation

where production is done to have sales in future ( e.g. seasonal production and seasonal

sales).

Absorption costing conforms with accrual and matching accounting concepts which

requires matching costs with revenue for a particular accounting period.

Absorption costing has been recognized for the purpose of preparing external reports and

for stock valuation purposes.

Absorption costing avoids the separating of costs into fixed and variable elements.

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The allocation and apportionment of fixed factory overheads to cost centers makes

manager more aware and responsible for the cost and services provided to others.

It identifies the importance of fixed costs involved in production.

The absorption costing method is accepted by Inland Revenue as stock is not

undervalued.

The absorption costing method is always used for preparing financial accounts.

The absorption costing method shows less fluctuation in net profits in case of constant

production but fluctuating sales.

Contrasting marginal costing which involves fixed cost changing into variable cost, it is

cost into the stock value thus distorting the stock valuation

Absorption costing offers an advantage when you do not sell all of your manufactured

products during the accounting period. You may have finished goods in inventory.

Because you assign a per-unit amount for fixed expenses, each product in inventory has a

value that includes part of the fixed overhead. You do not show the expense until you

actually sell the items in inventory. This can improve your profits for the period.

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Disadvantages of Absorption Costing:

Absorption costing, also known as full costing is an accounting method that includes fixed

overhead costs in the cost of goods sold by allocating an equal portion of the overhead cost to

each finished unit of inventory. Absorption costing is the Generally Accepted Accounting

Practices, or GAAP, method and publicly held companies must use this method on their income

statements. While this system has some advantages, particularly for outside analysts, it also has a

number of disadvantages, such as:

As absorption costing emphasized on total cost namely both variable and fixed, it is not

so useful for management to use to make decision, planning and control;

As the manager’s emphasis is on total cost, the cost volume profit relationship is ignored.

The manager needs to use his intuition to make the decision

Absorption costing is not useful for decision making. It considers fixed manufacturing

overhead as product cost which increase the cost of output. As a result, it does not help in

accepting specially offered price for the product. Various types of managerial problems

relating to decision making can be solved only with the help of variable costing system.

Absorption costing is not helpful in control of cost and planning and control functions. It

is not useful in fixing the responsibility for incurrence of costs. It is not practical to hold a

manager accountable for costs over which he/she has not control.

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 Some current product costs can be removed from the income statement by producing for

inventory. As such, managers who are evaluated on the basis of operating income can

temporarily improve profitability by increasing production

Since absorption costing emphasized on total cost that is to say both variables as well as

fixed, it is not useful for management to use to make decision, control, and planning.

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

Absorption costing can artificially inflate your profit figures in any given accounting

period. Because you will not deduct your entire fixed overhead if you haven't sold all of

your manufactured products, your profit-and-loss statement does not show the full

expenses you had for the period. This can mislead you when you are analyzing your

profitability.

Some of the important disadvantages of absorption costing are as follows:

1) Inadequate for Managerial Decision Making

Because absorption costing allocates fixed overhead costs to the unit level, it makes it appear as

though additional units produced add overhead cost, when in fact they are revenue opportunities.

If a company makes 100 baseballs per month for a variable cost of $4 and fixed overhead costs

are $100 per month, absorption costing allocates $1 to each baseball for a total cost of $5 per

baseball. If the company has an opportunity to sell another 10 baseballs at $4.50 each, absorption

costing makes it look as if the company is taking a loss of $.50 each, when in fact it is making

$.50 each because it is not adding fixed cost by producing 10 more units, only variable cost.

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2) Costs Hides in Inventory

Inventory shows as an asset on a company's balance sheet. Since the company allocates fixed

overhead to the finished unit level in absorption costing, until the company sells a unit, the cost

does not show up as an expense, or Cost of Goods Sold. This means that if a company builds

10,000 units of a finished good in a period, with $1 fixed overhead allocated to each unit, and

sells only 1,000 of those units, $9,000 of the fixed overhead incurred in that period will show on

the balance sheet as an asset, rolled into the cost of inventory, instead of as a cost.

3) Unsuitable for Irregular Volume

In theory, if a company using absorption costing produces and sells an equal, steady amount of

units each period, absorption costing will accurately reflect the true cost of goods sold. However,

if production or sales are irregular, this method of costing will make it appear that fixed overhead

and variable costs fluctuate with sales. In fact, the level of production or sales does not affect

fixed overhead costs, and only the level of production affects variable costs. For irregular

production and sales patterns, variable costing gives a much clearer picture of the costs of

running the business.

4) Considerations

Absorption costing has its benefits, particularly for external reporting. The fact that absorption

costing combines variable and fixed costs allows a company to report its profits to shareholders

without disclosing too much detail to competitors. In addition, since the business includes costs

as an inventory asset on the balance sheet until it sells the inventory, this method sometimes

benefits a slow quarter's metrics. The alternative to absorption costing, known as variable

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costing, presents costs in a way that internal decision makers find useful. A well-informed

manager will look at costs using both methods.

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What is the Difference between
Marginal Costing and Absorption
Costing?
Distinguish between marginal costing and absorption costing :-

Theory of Marginal Costing :-The theory of marginal costing as set out in A report on Marginal

Costing published by CIMA, London is as follows: -

In relation to a given volume of output, additional output can normally be obtained at less than

proportionate cost because within limits, the aggregate of certain items of cost will tend to

remain fixed and only the aggregate of the remainder will tend to rise proportionately with an

increase in output. Conversely, a decrease in the volume of output will normally be accompanied

by less than proportionate fall in the aggregate cost.

The theory of marginal costing may, therefore, by understood in the following two steps: -

1. If the volume of output increases, the cost per unit in normal circumstances reduces.

Conversely, if an output reduces, the cost per unit increases. If a factory produces 1000 units at a

total cost of $3,000 and if by increasing the output by one unit the cost goes up to $3,002, the

marginal cost of additional output will be $.2.

2. If an increase in output is more than one, the total increase in cost divided by the total increase

in output will give the average marginal cost per unit. If, for example, the output is increased to

1020 units from 1000 units and the total cost to produce these units is $1,045, the average

marginal cost per unit is $2.25. It can be described as follows:

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Additional cost =
Additional units

$ 45 = $2.25
20

The ascertainment of marginal cost is based on the classification and segregation of cost into

fixed and variable cost. In order to understand the marginal costing technique, it is essential to

understand the meaning of marginal cost.

Marginal cost means the cost of the marginal or last unit produced. It is also defined as the cost

of one more or one less unit produced besides existing level of production. In this connection, a

unit may mean a single commodity, a dozen, a gross or any other measure of goods.

For example, if a manufacturing firm produces X unit at a cost of $ 300 and X+1 units at a cost

of $ 320, the cost of an additional unit will be $ 20 which is marginal cost. Similarly if the

production of X-1 units comes down to $ 280, the cost of marginal unit will be $ 20 (300-280).

The marginal cost varies directly with the volume of production and marginal cost per unit

remains the same. It consists of prime cost, i.e. cost of direct materials, direct labor and all

variable overheads. It does not contain any element of fixed cost which is kept separate under

marginal cost technique.

Marginal costing may be defined as the technique of presenting cost data wherein variable costs

and fixed costs are shown separately for managerial decision-making. It should be clearly

understood that marginal costing is not a method of costing like process costing or job costing.

Rather it is simply a method or technique of the analysis of cost information for the guidance of

management which tries to find out an effect on profit due to changes in the volume of output.

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There are different phrases being used for this technique of costing. In UK, marginal costing is a

popular phrase whereas in US, it is known as direct costing and is used in place of marginal

costing. Variable costing is another name of marginal costing.

Marginal costing technique has given birth to a very useful concept of contribution where

contribution is given by: Sales revenue less variable cost (marginal cost)

Contribution may be defined as the profit before the recovery of fixed costs. Thus, contribution

goes toward the recovery of fixed cost and profit, and is equal to fixed cost plus profit (C = F +

P).

In case a firm neither makes profit nor suffers loss, contribution will be just equal to fixed cost

(C = F). this is known as break-even point.

The concept of contribution is very useful in marginal costing. It has a fixed relation with sales.

The proportion of contribution to sales is known as P/V ratio which remains the same under

given conditions of production and sales.

The principles of marginal costing are as follows:

a. For any given period of time, fixed costs will be the same, for any volume of sales and

production (provided that the level of activity is within the 'relevant range'). Therefore, by selling

an extra item of product or service the following will happen.

§ Revenue will increase by the sales value of the item sold.

§ Costs will increase by the variable cost per unit.

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§ Profit will increase by the amount of contribution earned from the extra item.

b. Similarly, if the volume of sales falls by one item, the profit will fall by the amount of

contribution earned from the item.

c. Profit measurement should therefore be based on an analysis of total contribution. Since fixed

costs relate to a period of time, and do not change with increases or decreases in sales volume, it

is misleading to charge units of sale with a share of fixed costs.

d. When a unit of product is made, the extra costs incurred in its manufacture are the variable

production costs. Fixed costs are unaffected, and no extra fixed costs are incurred when output is

increased.

Reconciliation Statement for Marginal Costing and Absorption Costing Profit

Marginal Costing Profit xx

ADD:

(Closing stock - opening Stock) x OAR xx

= Absorption Costing Profit xx

Where OAR( overhead absorption rate) = Budgeted fixed production overhead

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Marginal Costing versus Absorption Costing :-

After knowing the two techniques of marginal costing and absorption costing, we have seen that

the net profits are not the same because of the following reasons:

1. Over and Under Absorbed Overheads :-

In absorption costing, fixed overheads can never be absorbed exactly because of difficulty in

forecasting costs and volume of output. If these balances of under or over absorbed/recovery are

not written off to costing profit and loss account, the actual amount incurred is not shown in it. In

marginal costing, however, the actual fixed overhead incurred is wholly charged against

contribution and hence, there will be some difference in net profits.

2. Difference in Stock Valuation: - In marginal costing, work in progress and finished stocks

are valued at marginal cost, but in absorption costing, they are valued at total production cost.

Hence, profit will differ as different amounts of fixed overheads are considered in two accounts.

The profit difference due to difference in stock valuation is summarized as follows:

a. When there is no opening and closing stocks, there will be no difference in profit.

b. When opening and closing stocks are same, there will be no difference in profit, provided the

fixed cost element in opening and closing stocks are of the same amount.

c. When closing stock is more than opening stock, the profit under absorption costing will be

higher as comparatively a greater portion of fixed cost is included in closing stock and carried

over to next period.

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d. When closing stock is less than opening stock, the profit under absorption costing will be less

as comparatively a higher amount of fixed cost contained in opening stock is debited during the

current period.

The features which distinguish marginal costing from absorption costing are as follows. :-

a.) In absorption costing, items of stock are costed to include a fair share of fixed production

overhead, whereas in marginal costing, stocks are valued at variable production cost only. The

value of closing stock will be higher in absorption costing than in marginal costing.

b.) As a consequence of carrying forward an element of fixed production overheads in closing

stock values, the cost of sales used to determine profit in absorption costing will:

i. Include some fixed production overhead costs incurred in a previous period but carried forward

into opening stock values of the current period;

ii. Exclude some fixed production overhead costs incurred in the current period by including

them in closing stock values.

In contrast marginal costing charges the actual fixed costs of a period in full into the profit and

loss account of the period. (Marginal costing is therefore sometimes known as period costing.)

c.) In absorption costing, actual fully absorbed unit costs are reduced by producing in greater

quantities, whereas in marginal costing, unit variable costs are unaffected by the volume of

production (that is, provided that variable costs per unit remain unaltered at the changed level of

production activity). Profit per unit in any period can be affected by the actual volume of

production in absorption costing; this is not the case in marginal costing.

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d.) In marginal costing, the identification of variable costs and of contribution enables

management to use cost information more easily for decision-making purposes (such as in

budget decision making). It is easy to decide by how much contribution (and therefore profit)

will be affected by changes in sales volume. (Profit would be unaffected by changes in

production volume).

In absorption costing, however, the effect on profit in a period of changes in both:

i. production volume; and

ii. sales volume; is not easily seen, because behaviour is not analyzed and incremental costs are

not used in the calculation of actual profit.

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CONCLUSION:

Marginal cost is the cost management technique for the analysis of cost and revenue information

and for the guidance of management. The presentation of information through marginal costing

statement is easily understood by all managers, even those who do not have preliminary

knowledge and implications of the subjects of cost and management accounting.

Absorption costing and marginal costing are two different techniques of cost accounting.

Absorption costing is widely used for cost control purpose whereas marginal costing is used for

managerial decision-making and control.

The following are the criticisms towards absorption costing:

1. You might have observed that in absorption costing, a portion of fixed cost is carried over to

the subsequent accounting period as part of closing stock. This is an unsound practice because

costs pertaining to a period should not be allowed to be vitiated by the inclusion of costs

pertaining to the previous period and vice versa.

2. Further, absorption costing is dependent on the levels of output which may vary from period to

period, and consequently cost per unit changes due to the existence of fixed overhead. Unless

fixed overhead rate is based on normal capacity, such changed costs are not helpful for the

purposes of comparison and control.

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The cost to produce an extra unit is variable production cost. It is realistic to the value of closing

stock items as this is a directly attributable cost. The size of total contribution varies directly with

sales volume at a constant rate per unit. For the decision-making purpose of management, better

information about expected profit is obtained from the use of variable costs and contribution

approach in the accounting system.

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BIBLIOGRAPHY:
 www.businessdictionary.com

 costaccounting.blogspot.com

 www.accountingtools.com

 ahmadladhani.files.wordpress.com

 uombusiness.webs.com

 www.investopedia.com

 basiccollegeaccounting.com

 accountlearning.blogspot.com

 smallbusiness.chron.com

 mortgageprocess.wordpress.com

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