Marginal Costing and Absorption Costing

http://www.globusz.com/ebooks/Costing/00000012.htm
Learning Objectives
o un!erstan! the meanings o" marginal cost an! marginal costing
o !istinguish between marginal costing an! absorption costing
o ascertain income un!er both marginal costing an! absorption costing
Introduction
he costs that var# with a !ecision shoul! onl# be inclu!e! in !ecision anal#sis. $or
man# !ecisions that involve relativel# small variations "rom e%isting practice an!/or are
"or relativel# limite! perio!s o" time& "i%e! costs are not relevant to the !ecision. his is
because either "i%e! costs ten! to be impossible to alter in the short term or managers are
reluctant to alter them in the short term.
Marginal costing - definition
'arginal costing !istinguishes between "i%e! costs an! variable costs as convention all#
classi"ie!.
The marginal cost of a product () is its variable cost*. his is normall# taken to be+
!irect labour& !irect material& !irect e%penses an! the variable part o" overhea!s.
Marginal costing is formally defined as:
,the accounting s#stem in which variable costs are charge! to cost units an! the "i%e!
costs o" the perio! are written-o"" in "ull against the aggregate contribution. .ts special
value is in !ecision making/. 0erminolog#.1
he term ,contribution/ mentione! in the "ormal !e"inition is the term given to the
!i""erence between 2ales an! 'arginal cost. hus
'345.63L CO2 7 834.39L: CO2 ;.4:C L39O<4
=
;.4:C '3:4.3L
=
;.4:C :>?:62:
=
834.39L: O8:4@:3;2
CO64.9<.O6 23L:2 - '345.63L CO2
he term marginal cost sometimes re"ers to the marginal cost per unit an! sometimes to
the total marginal costs o" a !epartment or batch or operation. he meaning is usuall#
clear "rom the conte%t.
Note
3lternative names "or marginal costing are the contribution approach an! !irect costing
.n this lesson& we will stu!# marginal costing as a techniAue Auite !istinct "rom
absorption costing.
Theory of Marginal Costing
he theor# o" marginal costing as set out in )3 report on 'arginal Costing* publishe! b#
C.'3& Lon!on is as "ollows:
.n relation to a given volume o" output& a!!itional output can normall# be obtaine! at less
than proportionate cost because within limits& the aggregate o" certain items o" cost will
ten! to remain "i%e! an! onl# the aggregate o" the remain!er will ten! to rise
proportionatel# with an increase in output. Conversel#& a !ecrease in the volume o"
output will normall# be accompanie! b# less than proportionate "all in the aggregate cost.
he theor# o" marginal costing ma#& there"ore& b# un!erstoo! in the "ollowing two steps:
1. ." the volume o" output increases& the cost per unit in normal circumstances
re!uces. Conversel#& i" an output re!uces& the cost per unit increases. ." a "actor#
pro!uces 1000 units at a total cost o" BC&000 an! i" b# increasing the output b#
one unit the cost goes up to BC&002& the marginal cost o" a!!itional output will be
B.2.
2. ." an increase in output is more than one& the total increase in cost !ivi!e! b# the
total increase in output will give the average marginal cost per unit. ."& "or
e%ample& the output is increase! to 1020 units "rom 1000 units an! the total cost
to pro!uce these units is B1&0DE& the average marginal cost per unit is B2.2E. .t can
be !escribe! as "ollows:
3!!itional cost 7
3!!itional units
B DE 7 B2.2E
20
he ascertainment o" marginal cost is base! on the classi"ication an! segregation o" cost
into "i%e! an! variable cost. .n or!er to un!erstan! the marginal costing techniAue& it is
essential to un!erstan! the meaning o" marginal cost.
Marginal cost means the cost o" the marginal or last unit pro!uce!. .t is also !e"ine! as
the cost o" one more or one less unit pro!uce! besi!es e%isting level o" pro!uction. .n this
connection& a unit ma# mean a single commo!it#& a !ozen& a gross or an# other measure
o" goo!s.
$or e%ample& i" a manu"acturing "irm pro!uces > unit at a cost o" B C00 an! >=1 units at
a cost o" B C20& the cost o" an a!!itional unit will be B 20 which is marginal cost.
2imilarl# i" the pro!uction o" >-1 units comes !own to B 2F0& the cost o" marginal unit
will be B 20 0C00(2F01.
he marginal cost varies !irectl# with the volume o" pro!uction an! marginal cost per
unit remains the same. .t consists o" prime cost& i.e. cost o" !irect materials& !irect labor
an! all variable overhea!s. .t !oes not contain an# element o" "i%e! cost which is kept
separate un!er marginal cost techniAue.
Marginal costing ma# be !e"ine! as the techniAue o" presenting cost !ata wherein
variable costs an! "i%e! costs are shown separatel# "or managerial !ecision-making. .t
shoul! be clearl# un!erstoo! that marginal costing is not a metho! o" costing like process
costing or job costing. 4ather it is simpl# a metho! or techniAue o" the anal#sis o" cost
in"ormation "or the gui!ance o" management which tries to "in! out an e""ect on pro"it
!ue to changes in the volume o" output.
here are !i""erent phrases being use! "or this techniAue o" costing. .n <G& marginal
costing is a popular phrase whereas in <2& it is known as !irect costing an! is use! in
place o" marginal costing. 8ariable costing is another name o" marginal costing.
'arginal costing techniAue has given birth to a ver# use"ul concept o" contribution where
contribution is given b#: 2ales revenue less variable cost 0marginal cost1
Contribution ma# be !e"ine! as the pro"it be"ore the recover# o" "i%e! costs. hus&
contribution goes towar! the recover# o" "i%e! cost an! pro"it& an! is eAual to "i%e! cost
plus pro"it 0C 7 $ = ?1.
.n case a "irm neither makes pro"it nor su""ers loss& contribution will be just eAual to "i%e!
cost 0C 7 $1. this is known as break even point.
he concept o" contribution is ver# use"ul in marginal costing. .t has a "i%e! relation with
sales. he proportion o" contribution to sales is known as ?/8 ratio which remains the
same un!er given con!itions o" pro!uction an! sales.
The principles of marginal costing
he principles o" marginal costing are as "ollows.
a. $or an# given perio! o" time& "i%e! costs will be the same& "or an# volume o" sales
an! pro!uction 0provi!e! that the level o" activit# is within the ,relevant range/1.
here"ore& b# selling an e%tra item o" pro!uct or service the "ollowing will
happen.
4evenue will increase b# the sales value o" the item sol!.
Costs will increase b# the variable cost per unit.
?ro"it will increase b# the amount o" contribution earne! "rom the e%tra
item.
b. 2imilarl#& i" the volume o" sales "alls b# one item& the pro"it will "all b# the
amount o" contribution earne! "rom the item.
c. ?ro"it measurement shoul! there"ore be base! on an anal#sis o" total contribution.
2ince "i%e! costs relate to a perio! o" time& an! !o not change with increases or
!ecreases in sales volume& it is mislea!ing to charge units o" sale with a share o"
"i%e! costs.
!. Hhen a unit o" pro!uct is ma!e& the e%tra costs incurre! in its manu"acture are the
variable pro!uction costs. $i%e! costs are una""ecte!& an! no e%tra "i%e! costs are
incurre! when output is increase!.
Features of Marginal Costing
he main "eatures o" marginal costing are as "ollows:
1. Cost Classification
he marginal costing techniAue makes a sharp !istinction between variable costs
an! "i%e! costs. .t is the variable cost on the basis o" which pro!uction an! sales
policies are !esigne! b# a "irm "ollowing the marginal costing techniAue.
2. Stock/Inventory Valuation
<n!er marginal costing& inventor#/stock "or pro"it measurement is value! at
marginal cost. .t is in sharp contrast to the total unit cost un!er absorption costing
metho!.
C. Marginal Contribution
'arginal costing techniAue makes use o" marginal contribution "or marking
various !ecisions. 'arginal contribution is the !i""erence between sales an!
marginal cost. .t "orms the basis "or ju!ging the pro"itabilit# o" !i""erent pro!ucts
or !epartments.
Advantages and Disadvantages of Marginal Costing Technique
Advantages
1. 'arginal costing is simple to un!erstan!.
2. 9# not charging "i%e! overhea! to cost o" pro!uction& the e""ect o" var#ing
charges per unit is avoi!e!.
C. .t prevents the illogical carr# "orwar! in stock valuation o" some proportion o"
current #ear/s "i%e! overhea!.
D. he e""ects o" alternative sales or pro!uction policies can be more rea!il#
available an! assesse!& an! !ecisions taken woul! #iel! the ma%imum return to
business.
E. .t eliminates large balances le"t in overhea! control accounts which in!icate the
!i""icult# o" ascertaining an accurate overhea! recover# rate.
I. ?ractical cost control is greatl# "acilitate!. 9# avoi!ing arbitrar# allocation o"
"i%e! overhea!& e""orts can be concentrate! on maintaining a uni"orm an!
consistent marginal cost. .t is use"ul to various levels o" management.
J. .t helps in short-term pro"it planning b# breakeven an! pro"itabilit# anal#sis& both
in terms o" Auantit# an! graphs. Comparative pro"itabilit# an! per"ormance
between two or more pro!ucts an! !ivisions can easil# be assesse! an! brought to
the notice o" management "or !ecision making.
Disadvantages
1. he separation o" costs into "i%e! an! variable is !i""icult an! sometimes gives
mislea!ing results.
2. 6ormal costing s#stems also appl# overhea! un!er normal operating volume an!
this shows that no a!vantage is gaine! b# marginal costing.
C. <n!er marginal costing& stocks an! work in progress are un!erstate!. he
e%clusion o" "i%e! costs "rom inventories a""ect pro"it& an! true an! "air view o"
"inancial a""airs o" an organization ma# not be clearl# transparent.
D. 8olume variance in stan!ar! costing also !iscloses the e""ect o" "luctuating output
on "i%e! overhea!. 'arginal cost !ata becomes unrealistic in case o" highl#
"luctuating levels o" pro!uction& e.g.& in case o" seasonal "actories.
E. 3pplication o" "i%e! overhea! !epen!s on estimates an! not on the actuals an! as
such there ma# be un!er or over absorption o" the same.
I. Control a""ecte! b# means o" bu!getar# control is also accepte! b# man#. .n or!er
to know the net pro"it& we shoul! not be satis"ie! with contribution an! hence&
"i%e! overhea! is also a valuable item. 3 s#stem which ignores "i%e! costs is less
e""ective since a major portion o" "i%e! cost is not taken care o" un!er marginal
costing.
J. .n practice& sales price& "i%e! cost an! variable cost per unit ma# var#. hus& the
assumptions un!erl#ing the theor# o" marginal costing sometimes becomes
unrealistic. $or long term pro"it planning& absorption costing is the onl# answer.
resentation of Cost Data under Marginal Costing and Absorption Costing
'arginal costing is not a metho! o" costing but a techniAue o" presentation o" sales an!
cost !ata with a view to gui!e management in !ecision-making.
he tra!itional techniAue popularl# known as total cost or absorption costing techniAue
!oes not make an# !i""erence between variable an! "i%e! cost in the calculation o" pro"its.
9ut marginal cost statement ver# clearl# in!icates this !i""erence in arriving at the net
operational results o" a "irm.
$ollowing presentation o" two ?er"orma shows the !i""erence between the presentation o"
in"ormation accor!ing to absorption an! marginal costing techniAues:
MA!"INA# C$%TIN" !$-F$!MA
K K
2ales 4evenue %%%%%
Less 'arginal Cost o" 2ales
Opening 2tock 08alue! L marginal cost1 %%%%
3!! ?ro!uction Cost 08alue! L marginal cost1 %%%%
otal ?ro!uction Cost %%%%
Less Closing 2tock 08alue! L marginal cost1 0%%%1
'arginal Cost o" ?ro!uction %%%%
3!! 2elling& 3!min M ;istribution Cost %%%%
'arginal Cost o" 2ales 0%%%%1
Contribution %%%%%
Less $i%e! Cost 0%%%%1
'arginal Costing ?ro"it %%%%%
A&%$!TI$N C$%TIN" !$-F$!MA
K K
2ales 4evenue %%%%%
Less 3bsorption Cost o" 2ales
Opening 2tock 08alue! L absorption cost1 %%%%
3!! ?ro!uction Cost 08alue! L absorption cost1 %%%%
otal ?ro!uction Cost %%%%
Less Closing 2tock 08alue! L absorption cost1 0%%%1
3bsorption Cost o" ?ro!uction %%%%
3!! 2elling& 3!min M ;istribution Cost %%%%
3bsorption Cost o" 2ales 0%%%%1
<n-3!juste! ?ro"it %%%%%
$i%e! ?ro!uction O/@ absorbe! %%%%
$i%e! ?ro!uction O/@ incurre! 0%%%%1
0<n!er1/Over 3bsorption %%%%%
3!juste! ?ro"it %%%%%
!econciliation %tatement for Marginal Costing and Absorption Costing rofit
B

'arginal Costing ?ro"it %%
3;;
0Closing stock ( opening 2tock1 % O34
%%
7 3bsorption Costing ?ro"it %%
Hhere O340 overhea! absorption rate1 7
9u!gete! "i%e! pro!uction overhea!
9u!gete! levels o" activities
Marginal Costing versus Absorption Costing
3"ter knowing the two techniAues o" marginal costing an! absorption costing& we have
seen that the net pro"its are not the same because o" the "ollowing reasons:
'( $ver and )nder Absorbed $verheads
.n absorption costing& "i%e! overhea!s can never be absorbe! e%actl# because o"
!i""icult# in "orecasting costs an! volume o" output. ." these balances o" un!er or over
absorbe!/recover# are not written o"" to costing pro"it an! loss account& the actual amount
incurre! is not shown in it. .n marginal costing& however& the actual "i%e! overhea!
incurre! is wholl# charge! against contribution an! hence& there will be some !i""erence
in net pro"its.
*( Difference in %toc+ ,aluation
.n marginal costing& work in progress an! "inishe! stocks are value! at marginal cost& but
in absorption costing& the# are value! at total pro!uction cost. @ence& pro"it will !i""er as
!i""erent amounts o" "i%e! overhea!s are consi!ere! in two accounts.
he pro"it !i""erence !ue to !i""erence in stock valuation is summarize! as "ollows:
a. Hhen there is no opening an! closing stocks& there will be no !i""erence in pro"it.
b. Hhen opening an! closing stocks are same& there will be no !i""erence in pro"it&
provi!e! the "i%e! cost element in opening an! closing stocks are o" the same
amount.
c. Hhen closing stock is more than opening stock& the pro"it un!er absorption
costing will be higher as comparativel# a greater portion o" "i%e! cost is inclu!e!
in closing stock an! carrie! over to ne%t perio!.
!. Hhen closing stock is less than opening stock& the pro"it un!er absorption costing
will be less as comparativel# a higher amount o" "i%e! cost containe! in opening
stock is !ebite! !uring the current perio!.
The features -hich distinguish marginal costing from absorption costing
are as follo-s(
a. .n absorption costing& items o" stock are coste! to inclu!e a ,"air share/ o" "i%e!
pro!uction overhea!& whereas in marginal costing& stocks are value! at variable
pro!uction cost onl#. he value o" closing stock will be higher in absorption
costing than in marginal costing.
b. 3s a conseAuence o" carr#ing "orwar! an element o" "i%e! pro!uction overhea!s
in closing stock values& the cost o" sales use! to !etermine pro"it in absorption
costing will:
i. inclu!e some "i%e! pro!uction overhea! costs incurre! in a previous
perio! but carrie! "orwar! into opening stock values o" the current perio!+
ii. e%clu!e some "i%e! pro!uction overhea! costs incurre! in the current
perio! b# inclu!ing them in closing stock values.
.n contrast marginal costing charges the actual "i%e! costs o" a perio! in "ull into
the pro"it an! loss account o" the perio!. 0'arginal costing is there"ore sometimes
known as perio! costing.1
c. .n absorption costing& ,actual/ "ull# absorbe! unit costs are re!uce! b# pro!ucing
in greater Auantities& whereas in marginal costing& unit variable costs are
una""ecte! b# the volume o" pro!uction 0that is& provi!e! that variable costs per
unit remain unaltere! at the change! level o" pro!uction activit#1. ?ro"it per unit
in an# perio! can be a""ecte! b# the actual volume o" pro!uction in absorption
costing+ this is not the case in marginal costing.
!. .n marginal costing& the i!enti"ication o" variable costs an! o" contribution
enables management to use cost in"ormation more easil# "or !ecision-making
purposes 0such as in bu!get !ecision making1. .t is eas# to !eci!e b# how much
contribution 0an! there"ore pro"it1 will be a""ecte! b# changes in sales volume.
0?ro"it woul! be una""ecte! b# changes in pro!uction volume1.
.n absorption costing& however& the e""ect on pro"it in a perio! o" changes in both:
i. pro!uction volume+ an!
ii. sales volume+
is not easil# seen& because behaviour is not anal#se! an! incremental costs
are not use! in the calculation o" actual pro"it.
#imitations of Absorption Costing
he "ollowing are the criticisms against absorption costing:
1. Nou might have observe! that in absorption costing& a portion o" "i%e! cost is
carrie! over to the subseAuent accounting perio! as part o" closing stock. his is
an unsoun! practice because costs pertaining to a perio! shoul! not be allowe! to
be vitiate! b# the inclusion o" costs pertaining to the previous perio! an! vice
versa.
2. $urther& absorption costing is !epen!ent on the levels o" output which ma# var#
"rom perio! to perio!& an! conseAuentl# cost per unit changes !ue to the e%istence
o" "i%e! overhea!. <nless "i%e! overhea! rate is base! on normal capacit#& such
change! costs are not help"ul "or the purposes o" comparison an! control.
he cost to pro!uce an e%tra unit is variable pro!uction cost. .t is realistic to the value o"
closing stock items as this is a !irectl# attributable cost. he size o" total contribution
varies !irectl# with sales volume at a constant rate per unit. $or the !ecision-making
purpose o" management& better in"ormation about e%pecte! pro"it is obtaine! "rom the use
o" variable costs an! contribution approach in the accounting s#stem.
%ummary
'arginal cost is the cost management techniAue "or the anal#sis o" cost an! revenue
in"ormation an! "or the gui!ance o" management. he presentation o" in"ormation
through marginal costing statement is easil# un!erstoo! b# all mangers& even those who
!o not have preliminar# knowle!ge an! implications o" the subjects o" cost an!
management accounting.
3bsorption costing an! marginal costing are two !i""erent techniAues o" cost accounting.
3bsorption costing is wi!el# use! "or cost control purpose whereas marginal costing is
use! "or managerial !ecision-making an! control.
.uestions
1. .s marginal costing an! absorption costing sameO
2. Hhat is presentation o" cost !ataO 3nswer with suitable e%ample.