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.
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.
Marginal Cost Statement
| Particulars | Per unit | Amount(Rs.) |
| Sales | XXX | XXX |
| Less: Variable Cost | XXX | XXX |
| Contribution | XXX | XXX |
| Less:Fixed Cost | ------ | XXX |
| Profit | ------ | XXX |
Absorption Costing
It is a managerial accounting cost method of expensing all costs associated with manufacturing a particular product. ". Absorption costing means that all of the manufacturing costs are absorbed by the units produced. Absorption costing uses the total direct costs and overhead costs associated with manufacturing a product as the cost base. In other words, the cost of a finished unit in inventory will include direct materials, direct labor, and both variable and fixed manufacturing overhead. Generally accepted accounting principles (GAAP) require absorption costing for external reporting. Absorption costing is also known as "full absorption costing
Presentation of Cost Data under Marginal Costing and Absorption Costing
Marginal costing is not a method of costing but a technique of presentation of sales and cost data with a view to guide management in decision-making.
The traditional technique popularly known as total cost or absorption costing technique does not make any difference between variable and fixed cost in the calculation of profits. But marginal cost statement very clearly indicates this difference in arriving at the net operational results of a firm.
Following presentation of two Performa shows the difference between the presentation of information according to absorption and marginal costing techniques:
MARGINAL COSTING PRO-FORMA
| | Rs. | Rs. |
| Sales Revenue | | xxxxx |
| Less Marginal Cost of Sales | | |
| Opening Stock (Valued @ marginal cost) | xxxx | |
| Add Production Cost (Valued @ marginal cost) | xxxx | |
| Total Production Cost | xxxx | |
| Less Closing Stock (Valued @ marginal cost) | (xxx) | |
| Marginal Cost of Production | xxxx | |
| Add Selling, Admin & Distribution Cost | xxxx | |
| Marginal Cost of Sales | | (xxxx) |
| Contribution | | xxxxx |
| Less Fixed Cost | | (xxxx) |
| Marginal Costing Profit | | xxxxx |
ABSORPTION COSTING PRO-FORMA
| | Rs. | Rs. |
| Sales Revenue | | xxxxx |
| Less Absorption Cost of Sales | | |
| Opening Stock (Valued @ absorption cost) | xxxx | |
| Add Production Cost (Valued @ absorption cost) | xxxx | |
| Total Production Cost | xxxx | |
| Less Closing Stock (Valued @ absorption cost) | (xxx) | |
| Absorption Cost of Production | xxxx | |
| Add Selling, Admin & Distribution Cost | xxxx | |
| Absorption Cost of Sales | | (xxxx) |
| Un-Adjusted Profit | | xxxxx |
| Fixed Production O/H absorbed | xxxx | |
| Fixed Production O/H incurred | (xxxx) | |
| (Under)/Over Absorption | | xxxxx |
| Adjusted Profit | | xxxxx |
| Particulars | Rs. |
| 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 Budgeted levels of activities |
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:
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.
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:
- When there is no opening and closing stocks, there will be no difference in profit.
- 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.
- 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.
- 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.
- 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.
- 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:
- include some fixed production overhead costs incurred in a previous period but carried forward into opening stock values of the current period;
- 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.)
- 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.
- 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:
- production volume; and
- sales volume; is not easily seen, because behaviour is not analysed and incremental costs are not used in the calculation of actual profit.
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