Absorption Costing and Marginal Costing ( Introduction - Meaning and Definition of Marginal Costing )

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        The costs that vary with a decision should only be included in the decision analysis. For many decisions that involve relatively small variations from existing practice and/or are for relatively limited periods of time, fixed costs are not relevant to the decision. This is because either fixed costs tend to be impossible to alter in the short term or managers are reluctant to alter them in the short term. This is a technique where only the variable costs are considered while computing the cost of a product.

The perception of marginal cost has been borrowed from economic theory. In economics, marginal cost is an incremental cost; it is considered as the addition to the total cost, which results from the production of one more unit of output. According to the perception of marginal cost, it requires a thorough understanding of various classes of costs and their relation with the change in the level of activity.

Thus, Marginal Costing is a costing method in which only variable costs are accumulated and cost per unit is ascertained only on the basis of variable costs. Prime Costs and Variable Factory Overheads are used to determine the value of stock lying with the enterprise.

For decision‐making, it is more important to the management for taking further steps for the improvement of the business. It can be called direct costing, differential costing, incremental costing, and comparative costing.

Meaning and Definition:

Marginal costing distinguishes between fixed costs and variable costs as conventionally classified.

The marginal cost of a product –is its variable cost. This normally includes direct labor, direct material, direct expenses, and the variable part of overheads.

According to CIMA Terminology, Marginal Costing is defined as the “Ascertainment of marginal costs and the effect on profit of changes in volume or type of output by differentiating between Fixed Costs and Variable Costs.”

Marginal Costing can be formally defined as,

‘The accounting system in which variable costs are charged to cost units and the fixed costs of the period are written‐off in full against the aggregate contribution. Its special value is in decision-making".

The theory of marginal costing as set out in a report on Marginal Costing published by CIMA, London is as follows:

In relation to a given volume of output, the additional output can normally be obtained at less than proportionate cost because within limits, the aggregate of certain items of cost will tend to remain fixed and only the aggregate of the remainder will tend to rise proportionately with an increase in output. Conversely, a decrease in the volume of output will normally be accompanied by a less than proportionate fall in the aggregate cost.

The theory of marginal costing may, therefore, be 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 100 units at a total cost of Rs. 5,000 and if by increasing the output by one unit the cost goes up to Rs. 5,030, the marginal cost of additional output will be Rs. 30.
  2. If an increase in output is more than one, the total increase in the cost divided by the total increase in output will give the average marginal cost per unit. If, for example, the output is increased to 1020 units from 1000 units and the total cost to produce these units is Rs. 1,045, the average marginal cost per unit is Rs. 2.25.
 It can be described as follows:

The ascertainment of marginal cost is based on the classification and segregation of cost into fixed and variable costs. In order to understand the marginal costing technique, it is essential to understand the meaning of marginal cost.

Marginal cost means the cost of the marginal or last unit produced. It is also defined as the cost of one more or one less unit produced besides the existing level of production. In this connection, a unit may mean a single commodity, a dozen, gross, or any other measure of goods.

For example, if a manufacturing firm produces X unit at a cost of Rs. 500 and X+1 units at a cost of Rs. 540, the cost of an additional unit will be Rs. 40 which is a marginal cost. Similarly, if the production of X‐1 units comes down to Rs. 460, the cost of the marginal unit will be Rs. 40 (500–460).

The marginal cost varies directly with the volume of production and marginal cost per unit remains the same. It consists of prime cost, i.e. cost of direct materials, direct labor, and all variable overheads. It does not contain any element of fixed cost which is kept separate under the marginal cost technique.

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 cost. In the UK, marginal costing is a popular phrase whereas, in the USA, it is known as direct costing and is used in place of marginal costing. Variable costing is another name for marginal costing.

The marginal costing technique has given birth to a very useful concept of contribution where the 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, the 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 a profit nor suffers a loss, the contribution will be just equal to the fixed cost (C = F). This is known as the 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 the P/V ratio which remains the same under given conditions of production and sales.

Absorption Costing and Marginal Costing (Absorption Costing )

Absorption Costing:

              Absorption Costing is a conventional technique of ascertaining cost. It is the practice of charging all costs, both variable and fixed to operations, processes, or products and is also known as 'Full Costing Technique.'  In this technique of costing, cost is made up of direct costs plus overhead costs absorbed on some suitable basis. Here, cost per unit remains the same only when the level of output remains the same for some duration. None the less, the level of output cannot remain the same forever and so does the cost per unit because the fixed cost remains the same despite the changes in the level of output. The change in the cost per unit with a change in the level of output in Absorption Costing Technique poses a problem to the management in taking managerial decisions. Absorption Costing is useful if there is only one product; when there is no inventory and overhead recovery rate is based on normal capacity instead of actual level of activity. Two distinguishing features of Absorption Costing are that fixed factory expenses are included in unit cost as well as inventory value.