Shah Coaching Classes

Mudholkar Peth, Rajapeth, Amravati

M.B.A. First Semester
Accounting for Managers

Marginal costing and Absorption Costing

Que 1: - What is Costing? What are its objectives?

 Costing is any system for assigning costs to an element of a business. Costing is typically used to
develop costs for any or all of the following:

 Customers
 Distribution channels
 Employees
 Geographic regions
 Products
 Product lines
 Processes
 Subsidiaries
 Entire companies
 Costing may involve only the assignment of variable costs, which are those costs that vary with some
form of activity (such as sales or the number of employees). This type of costing is called direct
costing. For example, the cost of materials varies with the number of units produced, and so is a
variable cost.
 Costing can also include the assignment of fixed costs, which are those costs that stay the same,
irrespective of the level of activity. This type of costing is called absorption costing. Examples of fixed
costs are rent, insurance, and property taxes.

Costing is used for two purposes/ Objectives of costing:

 Internal reporting. Management uses costing to learn about the cost of operations, so that it can
work on refining operations to improve profitability. This information can also be used as the basis
for developing product prices.

 External reporting. The various accounting frameworks require that costs be allocated to the
inventory recorded in a company's balance sheet at the end of a reporting period. This calls for the
use of a cost allocation system, consistently applied.

Within the areas of both internal and external reporting, costing is most heavily utilitized in the
area of assigning costs to products. This can be done with job costing, which requires the detailed
assignment of individual costs to production jobs (which are small product batches). Another alternative
is to use process costing, where costs are aggregated and charged to a large number of uniform products,
such as are found on a production line. An efficiency improvement on either concept is to use standard
costing, where costs are estimated in advance and then assigned to products, followed by variance
analysis to determine the differences between actual and standard costs.

Que 2: - What is Marginal Costing?

Meaning of the Term Marginal Costing: -

 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.
 It is a costing technique where only variable cost or direct cost will be charged to the cost unit
produced.
 Marginal costing also shows the effect on profit of changes in volume/type of output by differentiating
between fixed and variable costs.
 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 breakeven 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.

Salient Points:

 Marginal costing involves ascertaining marginal costs. Since marginal costs are direct cost, this
costing technique is also known as direct costing;
 In marginal costing, fixed costs are never charged to production. They are treated as period charge
and is written off to the profit and loss account in the period incurred;
 Once marginal cost is ascertained contribution can be computed. Contribution is the excess of revenue
over marginal costs.
 The marginal cost statement is the basic document/format to capture the marginal costs.

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.

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.

Que 3: - State the Advantages and Disadvantages of Marginal Costing.

Advantages of Marginal Costing: -

1. Marginal costing is simple to understand.

2. By not charging fixed overhead to cost of production, the effect of varying charges per unit is avoided.
3. It prevents the illogical carry forward in stock valuation of some proportion of current years fixed
overhead.
4. The effects of alternative sales or production policies can be more readily available and assessed, and
decisions taken would yield the maximum return to business.
5. It eliminates large balances left in overhead control accounts which indicate the difficulty of
ascertaining an accurate overhead recovery rate.
6. Practical cost control is greatly facilitated. By avoiding arbitrary allocation of fixed overhead, efforts
can be concentrated on maintaining a uniform and consistent marginal cost. It is useful to various levels
of management.
7. It helps in short-term profit planning by breakeven and profitability analysis, both in terms of
quantity and graphs. Comparative profitability and performance between two or more products and
divisions can easily be assessed and brought to the notice of management for decision making.

Disadvantages of marginal Costing:

1. Marginal cost has its limitation since it makes use of historical data while decisions by management
relates to future events.
2. It ignores fixed costs to products as if they are not important to production.
3. Stock valuation under this type of costing is not accepted by the Inland Revenue as it ignores the fixed
cost element.
4. It fails to recognize that in the long run, fixed costs may become variable.
5. Its oversimplified costs into fixed and variable as if it is so simply to demarcate them.
6. It is not a good costing technique in the long run for pricing decision as it ignores fixed cost. In the
long run, management must consider the total costs not only the variable portion.
7. Difficulty to classify properly variable and fixed cost perfectly, hence stock valuation can be distorted
if fixed cost is classified as variable.
Que 4: - What do you understand by Absorption Costing? State its Advantages and
Disadvantages.
Absorption Costing: -

 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.
 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.

Absorption Costing Components

The key costs assigned to products under an absorption costing system are:

 Direct materials. Those materials that is included in a finished product.

 Direct labor. The factory labor costs required to construct a product.
 Variable manufacturing overhead. The costs to operate a manufacturing facility, which vary with
production volume. Examples are supplies and electricity for production equipment.
 Fixed manufacturing overhead. The costs to operate a manufacturing facility, which do not vary with
production volume. Examples are rent and insurance.

Advantages of Absorption Costing System

Following are the main advantages of absorption costing system:

1. 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.

2. 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).

3. Absorption costing conforms to accrual and matching accounting concepts which requires matching
costs with revenue for a particular accounting period.

4. Absorption costing has been recognized for the purpose of preparing external reports and for stock
valuation purposes.

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

6. 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.
Disadvantages of Absorption Costing System

1. 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.

2. 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.

3. 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.

Que 5: - Difference between Marginal Costing and Absorption Costing.

Though, marginal costing and absorption costing are two traditional costing techniques, they have
their own unique principles that draw a fine line that separates one from another.

1. In marginal costing, contribution is calculated, whereas this is not calculated under absorption
costing.
2. When valuing the stocks under marginal costing, only the variable costs are considered, whereas
valuation of stock under absorption costing includes costs incurred for the production function
also.
3. Generally, the value of inventory is higher under absorption costing than marginal costing.
4. Marginal costing is often used for internal reporting purposes (facilitate the decision making of
managers), while absorption costing is required for external reporting purposes, such as income
tax reporting.
5. Contribution must be calculated under marginal costing system, whereas gross profit will be
calculated under absorption costing method.

 Summary
 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 mangers, 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.