MARGINAL COSTING

UNIT 3
 ABSORPTION COSTING
• It is a conventional technique of ascertaining cost. It is also known as
‘Conventional Costing’ or ‘Full Costing’.

• Total cost (Fixed as well as variable cost) is charged as production cost.

• In this system, fixed factory overheads are absorbed on the basis of a

predetermined overhead rates, based on normal capacity.

• Under/over absorbed overheads are adjusted before computing profit for a

particular period.

• Closing Stock is also valued at total cost which includes all direct costs and fixed
factory overheads (and sometimes administrative overheads also).
 ADVANTAGES OF ABSORPTION COSTING
• Price based on absorption costing ensures that all costs are covered. Prices
are well regulated where full cost is the basis.
• It shows correct calculation in case where production is done to have sales
in future (e.g. seasonal sales) as compared to variable costing.
• It conforms with accrual and matching concepts which requires matching
cost with revenue for a particular period.
• It is recognised by various bodies as FASB (USA), ASC (UK), ASB (India)
for the purpose of preparing external reports and for valuation of
inventory.
• It avoids separation of costs into fixed and variable elements which cannot
be done easily and accurately.
• It discloses inefficient and efficient utilisation of production resources by
indicating under absorption or over absorption of factory overheads.
 LIMITATION OF ABSORPTION COSTING
1. Difficulty in comparison and control of cost.

2. Not helpful in managerial decision making.

3. Cost is vitiated because of fixed cost included in inventory valuation.

4. Fixed cost inclusion in cost not justified.

5. Apportionment of fixed overheads on arbitrary methods.

6. Not helpful in preparation of flexible budget.

Illustration 1: Following data relate to XYZ company:
Direct material cost Rs. 48,000
Direct wages Rs. 22,000
Variable overheads – Factory Rs. 13,000
- Adm. and selling Rs. 2,000
Fixed overheads – Factory Rs. 20,000
- Adm. And selling Rs. 8,000
Sales Rs. 1,25,000

Prepare Income statement under absorption costing.

 MARGINAL COSTING
• It is also known as ‘variable costing’ or ‘direct costing’.
• In this technique, only variable costs are charged as product costs and
included in inventory valuation.
• Fixed manufacturing costs are not allocated to products but are considered
as period costs and thus charged directly to profit and loss account of that
year. Fixed costs also do not enter in stock valuation.
• Both, absorption costing and marginal costing treat non-manufacturing costs
(i.e. administration, selling and distribution overheads) as period costs.
• It is the additional cost of producing an additional unit of product. It is the
total of all variable costs. It is composed of all direct cost and variable
overheads.
• It is defined as ‘the amount at any given volume of output by which aggregate
costs are changed, if volume of output is increased or decreased by one unit.’
 CHARACTERISTICS OF MARGINAL COSTING
1. Segregation of costs into fixed and variable elements

2. Marginal costs as product costs: Only marginal (variable) costs are charged to product produced during the
period.

3. Fixed costs as period costs: Fixed costs are treated as period costs and charged to costing profit and loss
account of the period in which they are incurred.

4. Valuation of inventory: The work-in-progress and finished stocks are valued at marginal costs only.

5. Contribution: Contribution is the difference between the sales value and marginal cost of sales. The relative
profitability of products or departments is based on a study of ‘contribution’ made by each of the products or
departments.

6. Pricing: Prices are based on marginal cost plus contribution.

7. Marginal costing and profit: It is calculated by two-staged approach. Firstly, contribution for each product or
department is determined for each product or department. Then contributions of various products or
 Absorption Costing
1. All costs fixed & variable are included for ascertaining the costs.
2. Different unit cost are obtained at different levels of output
because fixed expenses remains same.
3. Difference between sales and total cost is profit.
4. A portion of fixed cost is carried forward to next period because
closing stock of WIP & finished goods is valued at cost of
production which is inclusive of fixed cost.
5. Apportionment of fixed expenses on an arbitrary basis gives
rises to over or under absorption of overheads which ultimately
makes the product cost inaccurate and unreliable.
6. Absorption costing is not very helpful in taking managerial
decisions such as whether to accept an order or not, whether to
buy or manufacture, minimum price to be charged during
depreciation.
7.Costs are classified according to function such as production cost,
office and administration cost etc.
8. Absorption costing fails to establish relationship of cost, volume
and profit as costs are seldom classified as fixed and variable costs.
Marginal Costing
1. Only variable costs are included. Fixed costs are recovered
from contribution.
2. Marginal cost per unit will remain same at different levels of
output because variable expenses vary in same proportion in
which output varies.
3. Difference between sales and marginal cost is contribution and
difference between contribution and fixed cost is profit or loss.
4. Stock of WIP and finished goods are valued at marginal cost
which does not include fixed cost.
5. Only variable costs are charged to products, therefore, marginal
cost technique does not lead to over or under absorption of fixed
overheads.
6. Techniques of marginal costing is very helpful in taking
managerial decisions because it takes into consideration the
additional cost involved only assuming fixed expenses remain
constant.
7. Costs are classified on the basis of behaviour of costs i.e. fixed
costs and variable costs.
8. Cost, volume and profit relationship is an integral part of
marginal cost studies as costs are classified into fixed and variable
costs.
Illustration 2: Following data relate to XYZ company:
Direct material cost Rs. 48,000
Direct wages Rs. 22,000
Variable overheads – Factory Rs. 13,000
- Adm. and selling Rs. 2,000
Fixed overheads – Factory Rs. 20,000
- Adm. And selling Rs. 8,000
Sales Rs. 1,25,000

Prepare Income statement under marginal costing.

 DIFFERENCE IN PROFIT UNDER MARGINAL COSTING AND
ABSORPTION COSTING
Profit under the two systems may be different because of difference in the
stock valuation.
(a) Production is equal to sales
i. When there are no opening and closing stock, profit/loss under absorption and
marginal costing are equal.
ii. When opening stock is equal to closing stock then also profit/loss under the
two systems will be equal provided the fixed cost element in opening and
closing stocks is the same amount.
(b) Production is more than sales
When closing stock is more than opening stock, the profit as per absorption
costing will be more than that shown by marginal costing. This is because in
absorption costing a part of fixed overheads in closing stock value is carried
forward to next accounting period in the form of closing stock.
 DIFFERENCE IN PROFIT UNDER MARGINAL COSTING AND
ABSORPTION COSTING (CONTD.)
c) Production is less than sales
When opening stock is more than closing stock, the profit as per marginal
costing will be more than that shown by absorption costing. This is because in
absorption costing a part of fixed cost from the preceding period is added to
the current year’s cost of good sold in the form of opening stock.
Effect of Profit in Marginal Costing Profit in Absorption Costing
1. Production = Sales Equal Equal
2. Production > Sales Lower Higher
3. Production < Sales Higher Lower
 ADVANTAGES OF MARGINAL COSTING
1. Help in managerial decisions
2. Cost control
3. Simple technique
4. No under and over absorption of overheads
5. Constant cost per unit
6. Realistic valuation of stocks
7. Aid to profit planning
8. Valuable supplement to other techniques
 DISADVANTAGES OF MARGINAL COSTING
1. Difficult analysis
2. Ignores time factor
3. Difficulty in application
4. Less effective in capital-intensive industry
5. Improper basis of pricing
Illustration 3: The following cost data are available from the records of M/S ZP ltd. With regards to their product
“Millenium”.
Selling price per unit Rs. 60
Variable cost per unit Rs. 36
Fixed cost per unit Rs. 12
Normal output 1,00,000 units
Other additional data is available for four consecutive periods are as under:
Period I Period II Period III Period IV Total units
Opening stock - - 30,000 20,000 -
Production 1,00,000 1,20,000 1,10,000 90,000 4,20,000
Sales 1,00,000 90,000 1,20,000 1,10,000 4,20,000
Closing stock - 30,000 20,000 - -

You are required to prepare a statement showing profit for different periods, under both Marginal Costing and
Absorption Costing methods, showing under/over absorption of overheads, if any, and also give your comments.
Illustration 4: XYZ supplies you the following data, for the year ended 31 December
2023.
Production – 1,100 units,
Sales – 1,000 units
There is no opening stock.
Variable manufacturing cost per unit 7
Fixed manufacturing overheads (total) 2,200
Variable selling and administration overheads per unit 0.50
Fixed selling and administration overheads (total) 400
Selling price per unit 15
Prepare
(a) Income statement under marginal costing
(b) Income statement under absorption costing
(c) Explain the difference in profit under marginal and absorption costing, if any.
 COST-VOLUME-PROFIT ANALYSIS(CVP
ANALYSIS)
• It is an extension of the principles of marginal costing.
• It studies the interrelationship of three basic factors of business operations:
a) Cost of Production
b) Volume of production/sales
c) Profit
• It is “the study of the effects on future profits of changes in fixed cost,
variable cost, sale price, quantity and mix.”
• It explains the impact of the following on the net profit:
a) Changes in Selling Price
b) Changes in volume of sales
c) Changes in variable cost
d) Changes in fixed cost
 CONTRIBUTION
• It is also known as contribution margin or gross margin
• It is the difference between sales and the marginal (variable) cost of sales.
Formula:
Contribution = Sales – Variable cost (C = S - V)

Also, Contribution = Fixed cost + Profit (C = F + P)

or Contribution = Fixed cost - Loss (C = F - L)

 PROFIT-VOLUME RATIO (P/V RATIO)
• It is also known as contribution/sales ratio (C/S ratio)
Formula:
P/V ratio = = =

Also,
P/V ratio = =

• It is an indicator of the rate at which profit is being earned.

• High P/V ratio – indicates – High profit; Low P/V ratio – indicates – Low profit.
 BREAK-EVEN ANALYSIS
• In narrow sense, it is concerned with determining break-even point, i.e. that level
of production and sales where there is no profit and no loss. At this point total
cost is equal to total sales revenue.
• In board sense, it is used to determine probable profit/loss at any given level of
production /sales. It is also used to determine the amount of sales to earn a
desired amount of profit.
• Formula:
Break-even point (in units)=

Break-even point (in Rupees)=

Break-even point (in Rupees)=

or
FORMULA FOR DESIRED PROFITS

Unit for desired profit =

Sales for desired profits =

 MARGIN OF SAFETY (M/S)
• It is defined as the difference between actual sales and sales at break-
even point
• It may be expressed in absolute money terms:

Margin of safety = Actual Sales – Break-even point

• Or, as a percentage of sales:

Margin of Safety as a % of sales = x 100

• Also
Margin of Safety =
Illustration 5: Given:
Fixed cost = Rs. 8,000
Profit earned = Rs. 2,000
Break-even sales = Rs. 40,000
What is actual sales?

Illustration 6: Selling price- Rs 150 per unit

Variable cost – Rs. 90 per unit
Fixed cost – Rs. 6,00,000 (total)
What is the break-even point(in terms of units)?
What is the selling price per unit if break-even point is 12,000
Illustration 6: From the following data, calculate:
(i) Break-even point expressed in amount of sales in rupees.
(ii) No. of units that must be sold to earn a profit of Rs. 1,20,000.
Selling price per unit = Rs 40
Variable manufacturing cost per unit = Rs 22
Variable selling cost per unit = Rs 3
Fixed Factory overheads = Rs. 1,60,000
Fixed Selling cost = Rs. 20,000
Illustration 7: A company has fixed expenses of Rs. 90,000 with sales at Rs.
3,00,000 and a profit of Rs. 60,000 during first half year. If in the next half
year, the company suffered a loss of Rs. 30,000. Calculate:
(a) The P/V ratio, break-even point (in Rs.) and margin of safety for the first
half year.
(b) Expected sales volume for next half year assuming that selling price and
fixed expenses remain unchanged.
(c) The break even point in rupees and margin of safety for the whole year.