Marginal costing


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Marginal costing

  1. 1. 1 | P a g eMARGINAL COSTINGINTRODUCTION:Like process costing or job costing, marginal costing is not a distinct method of ascertainment ofcost but is a technique which applies existing methods in a particular manner so that therelationship between profit & the volume of output can be clearly brought out. Marginal costingascertains marginal or variable costs & the effect on profit, of the changes in volume or type ofoutput, by differentiating between variable costs & fixed costs. To any type of costing such ashistorical, 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. Thedifference which arises between the variable costs incurred for activities & the revenue earnedfrom those activities is defined as the gross margin or contribution. It may relate to total sales ormay relate to one unit.The calculation of contribution for a specific product or group of products is done as follows:Sales Revenue XXXLess Variable cost of production XXXContribution XXFor the business as a whole, contributions earned by specific products or group of products, areadded so as to calculate the pool of total contribution. The fixed costs of the business are paid
  2. 2. 2 | P a g efrom this pool & then the part of the total contribution which remains becomes the profit of thebusiness as a whole.A typical format for marginal costing statement is as below:Product types or departments A B C TotalSales Revenue X X X XLess Variable cost of production X X X XContribution X X X XLess: Fixed Costs XXTotal Profit XXUnder marginal costing, for the calculation of profits for individual products or departments, noattempt is made- only calculation of individual contributions is done. The fixed cost does notallocated to or gets absorbed by the individual products or departments. Thus, accountingtechniques relating to the treatment of fixed costs will not influence the decisions which arebased 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 ormanufactured within the factory?c. Concentration should be given on which products?d. By which profit-mix, profit will be maximized?
  3. 3. 3 | P a g ee. What should be the effect on the business when an existing department is being closed ora 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 beinfluenced?
  4. 4. 4 | P a g eMEANING:The increase or decrease in the total cost of a production run for making one additional unit of anitem. It is computed in situations where the breakeven point has been reached: the fixed costshave already been absorbed by the already produced items and only the direct (variable) costshave to be accounted for.Marginal costs are variable costs consisting of labor and material costs, plus an estimated portionof fixed costs (such as administration overheads and selling expenses). In companies whereaverage costs are fairly constant, marginal cost is usually equal to average cost. However, inindustries that require heavy capital investment (automobile plants, airlines, mines) and havehigh average costs, it is comparatively very low. The concept of marginal cost is criticallyimportant in resource allocation because, for optimum results, management must concentrate itsresources where the excess of marginal revenue over the marginal cost is maximum. Also calledchoice cost, differential cost, or incremental cost.Marginal costing distinguishes between fixed costs and variable costs as convention allyclassified.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 arecharged to cost units and the fixed costs of the period are written-off in full against the aggregatecontribution. Its special value is in decision making. (Terminology.)
  5. 5. 5 | P a g eThe term contribution mentioned in the formal definition is the term given to the differencebetween Sales and Marginal cost. Thus:MARGINAL COST = VARIABLE COST DIRECT LABOUR+DIRECT MATERIAL+DIRECT EXPENSE+VARIABLE OVERHEADSCONTRIBUTION = SALES - MARGINAL COSTThe term marginal cost sometimes refers to the marginal cost per unit and sometimes to the totalmarginal costs of a department or batch or operation. The meaning is usually clear from thecontext.Note:Alternative names for marginal costing are the contribution approach and direct costing In thislesson, 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 automatedenvironment, this incremental change is likely to be solely the material cost of a product; in aless automated environment, it may also include the cost of the labor needed to create theproduct.For example, it costs $20,000 to produce 50 units of a green widget, with most of the costassociated incurred during the setup of the production equipment at the beginning of the
  6. 6. 6 | P a g eproduction run. It costs $20,100 to produce 51 units of the green widget, which means that themarginal cost of the next unit of production is $100. The average cost of producing 51 units ofthe green widget is $394 ($20,100 divided by 51 units). Given the large disparity between themarginal cost and the average cost of the green widget, you must be very careful about the usesto which you put these numbers.
  7. 7. 7 | P a g eFeatures of Marginal Costing:a. Classification of costs into fixed costs & variable costs is done under marginal costingsystem. Also semi-fixed or semi-variable cots get further classified into fixed & variableelements.b. To the product, only variable elements of cost, which constitute marginal cost, areattached.c. After the marginal cost & marginal contribution are taken into consideration; price isfixed.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 ismade.But the main features of marginal costing are as follows:1. Cost Classification:-The marginal costing technique makes a sharp distinction betweenvariable costs and fixed costs. It is the variable cost on the basis of which production andsales policies are designed by a firm following the marginal costing technique.
  8. 8. 8 | P a g e2. Stock/Inventory Valuation:-Under marginal costing, inventory/stock for profitmeasurement is valued at marginal cost. It is in sharp contrast to the total unit cost underabsorption costing method.3. Marginal Contribution: - Marginal costing technique makes use of marginal contributionfor marking various decisions. Marginal contribution is the difference between sales andmarginal cost. It forms the basis for judging the profitability of different products ordepartments.
  9. 9. 9 | P a g eAdvantages of Marginal Costing:Components and spare parts may be made in the factory instead of buying from the market. Insuch cases, the marginal cost of manufacturing the components or spare parts should becompared with market price while taking decision to make or buy. If marginal cost is lower thanthe market price, it is more profitable to make than purchasing from market. Additional orspecific 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 totalduring 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 inorder to exercise full control over the total activities.Marginal costing brings out contribution or profit margin per unit of output, and clearlybrings out the effect of change in activity. It facilitates making policy decisions in anumber of management problems, such as determining profitability of products,introducing a new product, discontinuing a product, fixing selling price, deciding whetherto make or buy, utilizing spare capacity, profit-planning, etc.The distinction between product cost and period cost helps easy understanding ofmarginal cost statements.Closing inventory of work-in-progress and finished goods are valued at marginal orvariable cost only. This method leads to greater accuracy in arriving at profit as iteliminates any carryover of fixed costs of the previous period through inventoryvaluation.
  10. 10. 10 | P a g eAs a corollary to above, since fixed costs do not enter into product-cost, it eliminates theprocess of allocating, apportioning and absorbing overheads and adjusting under andover-absorbed overheads. Therefore, the method is simpler to operate.As there is involvement of computation of variable costs only in marginal costing, it iseasy to understand & operate the same.Among different products or departments, arbitrary apportionment of fixed costs isavoided & the under-recovery or over-recovery problems are eliminated.Any attempt of measurement of relative profitability of different products or differentdepartments becomes complicated due to the arbitrary apportionment of fixed costs.Analysis of contribution, break even charts & analysis of cost-volume-profit-analysis areresulted out of a marginal costing system; for making short term decisions all of these areimportant.More uniform & realistic figures are resulted out of marginal costing system becausefixed 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 ofmanagement 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 perunit is avoided.It prevents the illogical carry forward in stock valuation of some proportion of currentyears fixed overhead.
  11. 11. 11 | P a g eThe effects of alternative sales or production policies can be more readily available andassessed, and decisions taken would yield the maximum return to business.It eliminates large balances left in overhead control accounts which indicate the difficultyof ascertaining an accurate overhead recovery rate.Practical cost control is greatly facilitated. By avoiding arbitrary allocation of fixedoverhead, efforts can be concentrated on maintaining a uniform and consistent marginalcost. It is useful to various levels of management.It helps in short-term profit planning by breakeven and profitability analysis, both interms of quantity and graphs. Comparative profitability and performance between two ormore products and divisions can easily be assessed and brought to the notice ofmanagement for decision making.Main advantages of Marginal Costing are as follows:Ø Cost Control: Practical cost control is greatly facilitated. By avoiding arbitrary allocation offixed overhead, efforts can be concentrated on maintaining a uniform and consistent marginalcost useful to the various levels of management.Ø Simplicity: Marginal Costing is simple to understand and operate; it can be combined withother 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 notcharged to the cost of production due to this the effect of varying charges per unit is avoided.
  12. 12. 12 | P a g eØ Short-Term Profit Planning: It helps in short-term profit planning by break-even charts andprofit graphs. Comparative profitability can be easily assessed and brought to the notice of themanagement for decision-making.Ø Prevents Illogical Carry forwards: It prevents the illogical carry-forwards in stock-valuationof some proportion of current years fixed overhead.Ø Accurate Overhead Recovery Rate: It eliminates large balances left in overhead controlaccounts, 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 canbe more readily appreciated and assessed, and decisions taken will yield the maximum return tothe business.
  13. 13. 13 | P a g eDisadvantages of Marginal Costing:The technique is based on the segregation of costs into fixed and variable ones, whilemany 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 difficulttask.The assumptions regarding behaviour of costs, such as, fixed cost remains static, areoften not realistic.Contribution is not the only index to take decisions. For example, where fixed cost is veryhigh, selling price should not be fixed on the basis of contribution alone withoutconsidering 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 bytax-authorities. Any claim based on cost will be very low, as it will not have a share offixed cost.The process of separating semi-variable or semi-fixed costs into their variable & fixedelements is an arbitrary exercise which at different levels of output may be subject tofluctuations & inaccuracy. Consequently, a substantial degree of error may be containedin 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 thelong run, all fixed overheads should be covered by the prices & a reasonable margin over& above the total costs should be left.
  14. 14. 14 | P a g eUnder many circumstances, the deduction of contribution made by some production unitsmay 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 bymechanization, increased production & sales may be effected. The disclosure of this factcannot be done by marginal costing.The separation of costs into fixed and variable is difficult and sometimes givesmisleading results.Normal costing systems also apply overhead under normal operating volume and thisshows that no advantage is gained by marginal costing.Under marginal costing, stocks and work in progress are understated. The exclusion offixed costs from inventories affect profit, and true and fair view of financial affairs of anorganization may not be clearly transparent.Volume variance in standard costing also discloses the effect of fluctuating output onfixed overhead. Marginal cost data becomes unrealistic in case of highly fluctuatinglevels of production, e.g., in case of seasonal factories.Application of fixed overhead depends on estimates and not on the actual and as suchthere may be under or over absorption of the same.Control affected by means of budgetary control is also accepted by many. In order toknow the net profit, we should not be satisfied with contribution and hence, fixedoverhead is also a valuable item. A system which ignores fixed costs is less effectivesince a major portion of fixed cost is not taken care of under marginal costing.
  15. 15. 15 | P a g eIn practice, sales price, fixed cost and variable cost per unit may vary. Thus, theassumptions 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 veryclearly, since all costs are variable in the long run. Hence such segregation sometimes may givemisleading results.Ø Distorted Picture of Profits: The closing stock consists of variable cost only and ignoresfixed 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 ofoverheads, 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 ofperformance between two periods on the basis of contribution alone will give the misleadingresults.
  16. 16. 16 | P a g eFormulas of Marginal Costing:Marginal cost = prime cost + total variable overheadsOrMarginal cost = total variable cost.Contribution = selling price – variable (marginal) costOr 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/COr = [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]
  17. 17. 17 | P a g eBreak-even Sales = Total Fixed Costs x selling price per unit / contribution per unit[F/C*S]Fixed Cost/P/V Ratio [F/P/V]
  18. 18. 18 | P a g eBreak Even Analysis:Break-even analysis is an analytical technique that is used to determine the probable profit at anylevel 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 areequal to sales. It is otherwise called as balancing point, neutral point, equilibrium point, lossending point, profit beginning point etc. After BEP is achieved, all the further sales willcontribute 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 hasno profit no loss. It means total sales are just equal to total cost.Advantages of Break-even analysis:1. Profit planning2. Product planning3. Activity Planning4. Lease Decisions5. Make or buy decisions6. Capital profit decisions7. Distribution channel decisions8. Price decisions
  19. 19. 19 | P a g e9. Choosing Promotion Mix10. Decision regarding profitability of products or department.Break-even chart shows the graphical representation of cost and revenue of inter-relation atdifferent volumes of output.No doubt about the advantages of Break-even chart that it helps to determine the selling price togive a desired volume of profit.It shows costs and profits and different volumes of productions. But along with, there arelimitations of break-even chart also. People also say that break even chart does not always showa true chart.At last we can analyse about break-even and can say that it is the level of operations which is theposition of cost and revenue equilibrium.
  20. 20. 20 | P a g eABSORPTION COSTINGINTRODUCTION:The objective of absorption costing is to include in the total cost of a product an appropriateshare of the organizations total overheads. Overhead is the cost incurred in the course of makinga product, providing a service or running a department, but which cannot be traced directly andfully to the product, service or department.Overheads are actually the total of the following:-Indirect materialsIndirect labourIndirect expensesIn cost accounting there are two schools of thoughts as to the correct method of dealing withoverheads:-Absorption costingMarginal costing.An appropriate share is generally taken to mean an amount which reflects the amount of time andeffort which has gone into producing a unit or completing a job. The theoretical justification forusing absorption costing is that all production overhead are incurred in production of output so
  21. 21. 21 | P a g eeach unit of the product receives some benefits from these cost. Therefore each unit of outputshould 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 orsales 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 eachindividual product is, unless overhead costs are shared on a fair basis and charged to thecost of sales of each productAbsorption of overheads• Absorption of overheads is charging of overheads from cost centre’s to products orservices by means of absorption rates for each cost center which is calculated as follows:
  22. 22. 22 | P a g eOverhead absorption Rate = total overheads of cost centretotal quantum of base• The base (denominator) is selected on the basis of type of the cost centre and itscontribution 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 toproduction 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 addthem to, or absorb them into, cost units• Overheads are usually added to costs units using a predetermined overhead absorptionrate, 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 rateChoosing the appropriate absorption base:• A percentage of direct materials cost• A percentage of direct labour cost
  23. 23. 23 | P a g e• 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 forall 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 befair and the full cost of production of items will represent the amount of effort andresources 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 departmentOver and under absorption of overheads:• The rate of overhead absorption is based on estimates (of both numerator anddenominator) and it is quite likely that either one or both of the estimates will nit agreewith what actually occurs– Over absorption means that the overheads charged to the cost of sales is morethan the overheads actually incurred.
  24. 24. 24 | P a g e– Under absorption means that insufficient overheads have been included in the costof salesThe reasons for over/under absorbed overheads:• The overhead absorption rate is predetermined from budget estimates of overhead costand 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 andlevels.
  25. 25. 25 | P a g eMEANING:A managerial accounting cost method of expensing all costs associated with manufacturing aparticular product. Absorption costing uses the total direct costs and overhead costs associatedwith 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 workersphysically manufacturing a product, the raw materials used in producing a product, and all of theoverhead 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 bythe product. Advocates promote absorption costing because fixed manufacturing costs providefuture benefits.It is a costing technique where all normal costs whether it is variable or fixed costs are charged tocost 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 alsoreferred to as full costing or the full absorption method.
  26. 26. 26 | P a g eAbsorption costing is often contrasted with variable costing or direct costing. Under variable ordirect costing, the fixed manufacturing overhead costs are not allocated or assigned to (notabsorbed by) the products manufactured. Variable costing is often useful for management’sdecision-making. However, absorption costing is required for external financial reporting and forincome tax reporting.A method of costing a product in which all fixed and variable costs are apportioned to costcenters where they are accounted for using absorption rates. This method ensures that allincurred costs are recovered from the selling price of a good or service. Also called fullabsorption costing. See also direct costing, marginal costing.
  27. 27. 27 | P a g eAdvantages of Absorption Costing:It recognizes the importance of fixed costs in productionThis method is accepted by Inland Revenue as stock is not undervaluedThis method is always used to prepare financial accountsWhen production remains constant but sales fluctuate absorption costing will show lessfluctuation in net profit andUnlike marginal costing where fixed costs are agreed to change into variable cost, it iscost into the stock value hence distorting stock valuation.Absorption costing recognizes fixed costs in product cost. As it is suitable fordetermining price of the product. The pricing based on absorption costing ensures that allcosts are covered.Absorption costing will show correct profit calculation than variable costing in a situationwhere production is done to have sales in future ( e.g. seasonal production and seasonalsales).Absorption costing conforms with accrual and matching accounting concepts whichrequires matching costs with revenue for a particular accounting period.Absorption costing has been recognized for the purpose of preparing external reports andfor stock valuation purposes.Absorption costing avoids the separating of costs into fixed and variable elements.
  28. 28. 28 | P a g eThe allocation and apportionment of fixed factory overheads to cost centers makesmanager 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 notundervalued.The absorption costing method is always used for preparing financial accounts.The absorption costing method shows less fluctuation in net profits in case of constantproduction but fluctuating sales.Contrasting marginal costing which involves fixed cost changing into variable cost, it iscost into the stock value thus distorting the stock valuationAbsorption costing offers an advantage when you do not sell all of your manufacturedproducts 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 avalue that includes part of the fixed overhead. You do not show the expense until youactually sell the items in inventory. This can improve your profits for the period.
  29. 29. 29 | P a g eDisadvantages of Absorption Costing:Absorption costing, also known as full costing is an accounting method that includes fixedoverhead costs in the cost of goods sold by allocating an equal portion of the overhead cost toeach finished unit of inventory. Absorption costing is the Generally Accepted AccountingPractices, or GAAP, method and publicly held companies must use this method on their incomestatements. While this system has some advantages, particularly for outside analysts, it also has anumber of disadvantages, such as:As absorption costing emphasized on total cost namely both variable and fixed, it is notso 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 decisionAbsorption costing is not useful for decision making. It considers fixed manufacturingoverhead as product cost which increase the cost of output. As a result, it does not help inaccepting specially offered price for the product. Various types of managerial problemsrelating 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. Itis not useful in fixing the responsibility for incurrence of costs. It is not practical to hold amanager accountable for costs over which he/she has not control.
  30. 30. 30 | P a g eSome current product costs can be removed from the income statement by producing forinventory. As such, managers who are evaluated on the basis of operating income cantemporarily improve profitability by increasing productionSince absorption costing emphasized on total cost that is to say both variables as well asfixed, 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 profitrelationship is ignored. The manager, therefore, needs to use his intuition for decisionmakingAbsorption costing can artificially inflate your profit figures in any given accountingperiod. Because you will not deduct your entire fixed overhead if you havent sold all ofyour manufactured products, your profit-and-loss statement does not show the fullexpenses you had for the period. This can mislead you when you are analyzing yourprofitability.Some of the important disadvantages of absorption costing are as follows:1) Inadequate for Managerial Decision MakingBecause absorption costing allocates fixed overhead costs to the unit level, it makes it appear asthough 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 costsare $100 per month, absorption costing allocates $1 to each baseball for a total cost of $5 perbaseball. If the company has an opportunity to sell another 10 baseballs at $4.50 each, absorptioncosting 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.
  31. 31. 31 | P a g e2) Costs Hides in InventoryInventory shows as an asset on a companys balance sheet. Since the company allocates fixedoverhead to the finished unit level in absorption costing, until the company sells a unit, the costdoes not show up as an expense, or Cost of Goods Sold. This means that if a company builds10,000 units of a finished good in a period, with $1 fixed overhead allocated to each unit, andsells only 1,000 of those units, $9,000 of the fixed overhead incurred in that period will show onthe balance sheet as an asset, rolled into the cost of inventory, instead of as a cost.3) Unsuitable for Irregular VolumeIn theory, if a company using absorption costing produces and sells an equal, steady amount ofunits 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 overheadand variable costs fluctuate with sales. In fact, the level of production or sales does not affectfixed overhead costs, and only the level of production affects variable costs. For irregularproduction and sales patterns, variable costing gives a much clearer picture of the costs ofrunning the business.4) ConsiderationsAbsorption costing has its benefits, particularly for external reporting. The fact that absorptioncosting combines variable and fixed costs allows a company to report its profits to shareholderswithout disclosing too much detail to competitors. In addition, since the business includes costsas an inventory asset on the balance sheet until it sells the inventory, this method sometimesbenefits a slow quarters metrics. The alternative to absorption costing, known as variable
  32. 32. 32 | P a g ecosting, presents costs in a way that internal decision makers find useful. A well-informedmanager will look at costs using both methods.
  33. 33. 33 | P a g eWhat is the Difference betweenMarginal Costing and AbsorptionCosting?Distinguish between marginal costing and absorption costing :-Theory of Marginal Costing :-The theory of marginal costing as set out in A report on MarginalCosting published by CIMA, London is as follows: -In relation to a given volume of output, additional output can normally be obtained at less thanproportionate cost because within limits, the aggregate of certain items of cost will tend toremain fixed and only the aggregate of the remainder will tend to rise proportionately with anincrease in output. Conversely, a decrease in the volume of output will normally be accompaniedby 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 atotal cost of $3,000 and if by increasing the output by one unit the cost goes up to $3,002, themarginal 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 increasein output will give the average marginal cost per unit. If, for example, the output is increased to1020 units from 1000 units and the total cost to produce these units is $1,045, the averagemarginal cost per unit is $2.25. It can be described as follows:
  34. 34. 34 | P a g eAdditional cost =Additional units$ 45 = $2.2520The ascertainment of marginal cost is based on the classification and segregation of cost intofixed and variable cost. In order to understand the marginal costing technique, it is essential tounderstand the meaning of marginal cost.Marginal cost means the cost of the marginal or last unit produced. It is also defined as the costof one more or one less unit produced besides existing level of production. In this connection, aunit 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 costof $ 320, the cost of an additional unit will be $ 20 which is marginal cost. Similarly if theproduction 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 unitremains the same. It consists of prime cost, i.e. cost of direct materials, direct labor and allvariable overheads. It does not contain any element of fixed cost which is kept separate undermarginal cost technique.Marginal costing may be defined as the technique of presenting cost data wherein variable costsand fixed costs are shown separately for managerial decision-making. It should be clearlyunderstood 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 ofmanagement which tries to find out an effect on profit due to changes in the volume of output.
  35. 35. 35 | P a g eThere are different phrases being used for this technique of costing. In UK, marginal costing is apopular phrase whereas in US, it is known as direct costing and is used in place of marginalcosting. Variable costing is another name of marginal costing.Marginal costing technique has given birth to a very useful concept of contribution wherecontribution is given by: Sales revenue less variable cost (marginal cost)Contribution may be defined as the profit before the recovery of fixed costs. Thus, contributiongoes 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 undergiven 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 andproduction (provided that the level of activity is within the relevant range). Therefore, by sellingan 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.
  36. 36. 36 | P a g e§ 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 ofcontribution earned from the item.c. Profit measurement should therefore be based on an analysis of total contribution. Since fixedcosts relate to a period of time, and do not change with increases or decreases in sales volume, itis 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 variableproduction costs. Fixed costs are unaffected, and no extra fixed costs are incurred when output isincreased.Reconciliation Statement for Marginal Costing and Absorption Costing ProfitMarginal Costing Profit xxADD:(Closing stock - opening Stock) x OAR xx= Absorption Costing Profit xxWhere OAR( overhead absorption rate) = Budgeted fixed production overheadBudgeted levels of activities
  37. 37. 37 | P a g eMarginal Costing versus Absorption Costing :-After knowing the two techniques of marginal costing and absorption costing, we have seen thatthe 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 inforecasting costs and volume of output. If these balances of under or over absorbed/recovery arenot written off to costing profit and loss account, the actual amount incurred is not shown in it. Inmarginal costing, however, the actual fixed overhead incurred is wholly charged againstcontribution and hence, there will be some difference in net profits.2. Difference in Stock Valuation: - In marginal costing, work in progress and finished stocksare 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 thefixed 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 behigher as comparatively a greater portion of fixed cost is included in closing stock and carriedover to next period.
  38. 38. 38 | P a g ed. When closing stock is less than opening stock, the profit under absorption costing will be lessas comparatively a higher amount of fixed cost contained in opening stock is debited during thecurrent 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 productionoverhead, whereas in marginal costing, stocks are valued at variable production cost only. Thevalue 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 closingstock 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 forwardinto opening stock values of the current period;ii. Exclude some fixed production overhead costs incurred in the current period by includingthem in closing stock values.In contrast marginal costing charges the actual fixed costs of a period in full into the profit andloss 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 greaterquantities, whereas in marginal costing, unit variable costs are unaffected by the volume ofproduction (that is, provided that variable costs per unit remain unaltered at the changed level ofproduction activity). Profit per unit in any period can be affected by the actual volume ofproduction in absorption costing; this is not the case in marginal costing.
  39. 39. 39 | P a g ed.) In marginal costing, the identification of variable costs and of contribution enablesmanagement to use cost information more easily for decision-making purposes (such as inbudget 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 inproduction volume).In absorption costing, however, the effect on profit in a period of changes in both:i. production volume; andii. sales volume; is not easily seen, because behaviour is not analyzed and incremental costs arenot used in the calculation of actual profit.
  40. 40. 40 | P a g eCONCLUSION:Marginal cost is the cost management technique for the analysis of cost and revenue informationand for the guidance of management. The presentation of information through marginal costingstatement is easily understood by all managers, even those who do not have preliminaryknowledge 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 formanagerial 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 tothe subsequent accounting period as part of closing stock. This is an unsound practice becausecosts pertaining to a period should not be allowed to be vitiated by the inclusion of costspertaining to the previous period and vice versa.2. Further, absorption costing is dependent on the levels of output which may vary from period toperiod, and consequently cost per unit changes due to the existence of fixed overhead. Unlessfixed overhead rate is based on normal capacity, such changed costs are not helpful for thepurposes of comparison and control.
  41. 41. 41 | P a g eThe cost to produce an extra unit is variable production cost. It is realistic to the value of closingstock items as this is a directly attributable cost. The size of total contribution varies directly withsales volume at a constant rate per unit. For the decision-making purpose of management, betterinformation about expected profit is obtained from the use of variable costs and contributionapproach in the accounting system.
  42. 42. 42 | P a g eBIBLIOGRAPHY: