Marginal Costing and Absorption Costing

There are two alternative approaches for the valuation of inventory; they are Marginal Costing
and Absorption Costing. Marginal Costing excludes fixed cost of production, whereas
Absorption Costing includes the same
Basis for
Comparison

Marginal Costing

A decision making technique for

ascertaining the total cost of
Meaning
production is known as Marginal
Costing.
The variable cost is considered as
Cost Recognition product cost while fixed cost is
considered as period costs.
Classification of
Fixed and Variable
Overheads
Profitability is measured by Profit
Profitability
Volume Ratio.
Variances in the opening and
Cost per unit
closing stock does not influence
the cost per unit of output.
Highlights
Contribution per unit

Absorption Costing
Apportionment of total costs to the cost
center in order to determine the total cost
of production is known as Absorption
Costing.
Both fixed and variable cost is considered
as product cost.
Production, Administration and Selling &
Distribution
Due to the inclusion of fixed cost,
profitability gets affected.
Variances in the opening and closing stock
affects the cost per unit.
Net Profit per unit

Definition of Marginal Costing

Marginal Costing, also known as Variable Costing, is a costing method whereby decisions can be
taken regarding the ascertainment of total cost or the determination of fixed and variable cost to
find out the best process and product for production, etc.
It identifies the Marginal Cost of production and shows its impact on profit for the change in the
output units. Marginal cost refers to the movement in the total cost, due to the production of an
additional unit of output.
In marginal costing, all the variable costs are regarded as product related costs while fixed costs
are assumed as period costs. Therefore, fixed cost of production is posted to the Profit & Loss
Account. Moreover, fixed cost is also not given relevance while determining the selling price of
the product or at the time of valuation of closing stock (whether it is finished goods or Work in
Progress).

Definition of Absorption Costing

Absorption Costing is a method for inventory valuation whereby all the manufacturing expenses
are allocated to the cost centers to recognize the total cost of production. These manufacturing

expenses include all fixed as well as variable costs. It is the traditional method for cost
ascertainment, also known by the name Full Absorption Costing.
In an absorption costing system, both the fixed and variable costs are regarded as
product related cost. In this method, the objective of the assignment of the total cost to cost
center is to recover it from the selling price of the product.On the basis of function, the expenses
are divided into Production, Administration and Selling & Distribution. The following are the
types of Absorption Costing:

Activity Based Costing

Job Costing

Process Costing

Committed cost

A committed cost is an investment that a business entity has already made

and cannot recover by any means, as well as obligations already made that the business
cannot get out of. You should be aware of which costs are committed costs when you are
reviewing company expenditures for possible cutbacks or asset sales.

For example, if a company buys a machine for $40,000 and also issues a
purchase order to pay for a maintenance contract for $2,000 in each of the next three
years, all $46,000 is a committed cost, because the company has already bought the
machine, and has a legal obligation to pay for the maintenance. A multi-year property
lease agreement is also a committed cost for the full term of the lease, since it is
extremely difficult to terminate a lease agreement.

There is usually a long-term legal agreement associated with a committed cost. If not, it
is much easier to negotiate the termination of an expense.

Similar Terms

A committed cost has some similarity to the term sunk cost

Semi-fixed cost
A semi-fixed cost is a cost that contains both fixed and variable elements. As a result, the
minimum cost level that will be experienced will be greater than zero; once a certain
activity level is surpassed, the cost will begin to increase beyond the base level, since the
variable component of the cost has been triggered.

As an example of a semi-fixed cost, a company must pay a certain amount to maintain

minimum operations for a production line, in the form of machinery depreciation,
staffing, and facility rent. If the volume of production exceeds a certain amount, then the
company must hire additional staff or pay overtime, which is the variable component of
the semi-fixed cost of the production line.

Another example of a semi-fixed cost is a salaried salesperson. This person earns a fixed
amount of compensation (in the form of a salary), as well as a variable amount (in the
form of a commission). In total, the cost of the salesperson is semi-fixed.

A third example is the monthly bill for a cell phone, where the recipient pays a fixed fee
for phone usage, as well as a variable fee if the user exceeds a certain amount of data
usage, calls, or texts.

A cost that is classified as semi-fixed does not have to contain a certain proportion of
fixed or variable costs to be classified as such. Instead, any material mix of the two cost
types qualifies a cost as semi-fixed.

A semi-fixed cost tends to also be a step cost. That is, the cost remains the same until a
certain activity threshold is exceeded, after which the cost increases. The same approach
works in reverse, where the variable component of the cost will be eliminated when the
activity level declines below a certain amount.

'Variable Cost'
A variable cost is a corporate expense that varies with production output. Variable costs are those
costs that vary depending on a company's production volume; they rise as production increases
and fall as production decreases. Variable costs differ from fixed costs such as rent, advertising,
insurance and office supplies, which tend to remain the same regardless of production output.
Fixed costs and variable costs comprise total cost.
Variable costs can include direct material costs or direct labor costs necessary to complete a
certain project. For example, a company may have variable costs associated with the packaging

of one of its products. As the company moves more of this product, the costs for packaging will
increase. Conversely, when fewer of these products are sold the costs for packaging will
consequently decrease.

'Fixed Cost'
A fixed cost is a cost that does not change with an increase or decrease in the amount of goods or
services produced or sold. Fixed costs are expenses that have to be paid by a company,
independent of any business activity. It is one of the two components of the total cost of running
a business, along with variable cost.
A fixed cost is an operating expense of a business that cannot be avoided regardless of the level
of production. Fixed costs are usually used in breakeven analysis to determine pricing and the
level of production and sales under which a company generates neither profit nor loss. Fixed
costs and variable costs form the total cost structure of a company, which plays a crucial role in
ensuring its profitability.

Total cost
(TC) describes the total economic cost of production and is made up of variable costs, which
vary according to the quantity of a good produced and include inputs such as labor and raw
materials, plus fixed costs, which are independent of the quantity of a good produced and include
inputs (capital) that cannot be varied in the short term, such as buildings and machinery.
Total cost in economics includes the total opportunity cost of each factor of production as part of
its fixed or variable costs.

Uncontrollable costs
Uncontrollable costs are business expenses that the manager doesn't have direct power over. In
other words, the business manager doesn't have control over how these costs are incurred. A
good example of an uncontrollable cost is insurance. A manager who runs a department on the
factory floor does not have control over the liability insurance that the company buys. If several
accidents happen within the company and the liability issuance increases, the manager shouldn't
be penalized for the increased cost. Upper level executives usually set this insurance policy, so
the factory floor manager doesn't have control over it.
Depreciation is another example of an uncontrollable cost. Even though a factory floor manager
has control over the machines, maintenance costs, and upkeep, depreciation and accelerated
depreciation is rarely set at the manager level. Depending on how much equipment was
purchased for the year, depreciation can also eliminate all profits from the department. Managers'

profit performance evaluations usually do not include depreciation for this reason. It won't be fair
to count these costs against a manager who has no control over them. Instead managers'
performance is only judged based on controllable costs.

Cost concept
Economic efficiency of any firm operating in the market is determined by the ability of the firm
to minimize its costs and maximize its profits. WE also need to understand that cost is a function
of Output. As the output of a firm changes the cost pattern of a firm also undergoes change.
Study of cost and its behavior as production pattern changes in the short run and the long run.
In this module various cost concepts are:

Opportunity Cost

Money Cost and Real Cost

Accounting Cost and Economic Cost

Private Cost and Social Cost

Fixed Cost, Variable Cost, Average Cost and Marginal Cost

Opportunity Cost
The resources of any firm operating in the market are limited and investment options are many.
The firm therefore has to decide or select only those investment opportunities/options which
provide the firm with the best return or best income on investment. This means that if a firm can
invest money/ resources only in one investment option then the firm will select that investment
option which promises best return on investment to the firm. In other words while doing so the
firm gives up/rejects the next best option for investing the funds. The opportunity cost of a
company is thus this income/ return which the firm could have earned on the next best
investment alternative. Opportunity Cost is also termed as Implicit Cost.
Money Cost and Real Cost
Money Cost of production is the actual monetary expenditure made by company in the
production process. Money cost thus includes all the business expenses which involve outlay of
money to support business operations. For example the monetary expenditure on purchase of raw

material, payment of wages and salaries, payment of rent and other charges of business etc can
be termed as Money Cost.
Real Cost of production or business operation on the other hand includes all such expenses/costs
of business which may or may not involve actual monetary expenditure. For example if owner

of a business venture uses his personal land and building for running the business
venture and he/she does not charge any rent for the same then such head will not
be considered/included while computing the Money Cost but this head will be part of
Real Cost computation. Here the cost involved is the Opportunity Cost of the land
and building. If the promoter of the company had not used the land and building for
the business venture then the land and building could have been used elsewhere for
some other enture and could have generated some income for the promoter. This
income/rent which could have been earned under the next best investment option is
the opportunity cost which needs to be considered while calculating the Real Cost
for the firm.

Accounting Cost and Economic Cost

Accounting Cost includes all such business expenses that are recorded in the book of accounts
of a business firm as acceptable business expenses. Such expenses include expenses like Cost of
Raw Material, Wages and Salaries, Various Direct and Indirect business Overheads,
Depreciation, Taxes etc. When such business expenses or accounting expenses are deducted from
the Sales income of any firm the accounting profit is obtained. Such Accounting/Business
expenses or costs are also termed as Explicit Costs.

Accounting Cost: Various allowed business expenses. Such as Cost of Raw Material,
Salaries and Wages, Electricity Bill, Telephone Charges, Various Administrative
Expenses, Selling and Distribution Expenses, Production Overhead Expenses, Other
Indirect Overhead Expenses etc.

Accounting Profit = Sales Income - Accounting Cost

Economic Cost on the other hand includes all the accounting expenses as well as the
Opportunity cost of a business firm. Economic Cost and Economic Profit is thus calculated as
follows:

Economic Cost = Accounting Cost (Explicit Costs) + Opportunity Cost

Economic Profit = Total Revenues - (Accounting Cost + Opportunity Cost)

Private Cost and Social Cost

The actual expenses of individuals/ firms which are borne or paid out by the individual or a firm
can be termed as Private Cost. Thus for a business firm this may include expenses like Cost of
Raw Material, Salaries and Wages, Rent, Various Overhead Expenses etc.
On the other hand Private Cost for an individual will be his or her private expenses such as
expense on food, rent of house, expenses on clothing, expenses on travel, expenses on
entertainment etc.
Social Cost on the other hand includes Private Cost and also such costs which are not borne by
the firm but by the society at large. For example the cost of damage or disutility caused by the
operations of a firm in an economy
Fixed Cost, Variable Cost, Average Cost and Marginal Cost
Fixed Cost is that cost which does not change (that is either goes up or goes down) irrespective
of whether the firm is operating or not.
Variable Cost on the Other hand is directly proportional to the production operations. As the size
of production at any business grows, along with that grow the variable expenses.
Average Cost is the cost that is obtained after dividing Total Cost with the number of units
produced.

Total Cost = Fixed Cost + Variable Cost

Average Cost = Total Cost / Units of Good produced

Marginal Cost is the change in the Total cost when an additional unit of good is produced. In
other words Marginal Cost is difference between total Cost of producing N + 1 units of good
and N units of good.

Marginal Cost = TC (n+1) - TC(n)

Various cost concepts help in understanding the business operations and cost
involved in business operation of the firms better. For example opportunity cost is
the return involved in the next best alternative. Social cost is the cost of damage
caused by a business firm/individual to society at large. Private cost are the varied
business expenses which a firm/individual has to bear on account of its
business/personal operations pertaining to the business of the firm.
Direct Cost

The cost that can be directly attributable to/identified with/ associated with the specific cost
center or cost object like a product, function, activity, project and so on is known as Direct Cost.
Based on elements, the direct costs are classified into the following parts:

Direct Material: The cost of material that can be allocable to production.

Example: Raw material consumed during production of the unit.

Direct Labor: Wages to the laborers that can be identified with a cost object.
Example: The term wages include bonus, gratuity, provident fund,
perquisites, incentives, etc.

Direct Expenses: It includes all the other expenses that are directly linked
to the production of a product.
Example: Job processing charges, hire charges for tools and equipment,
subcontracting expenses.

When all these three costs are taken together, they are known as Prime Cost
Indirect Cost

Indirect cost is those costs that cannot be directly assigned to/related to/identified with a
particular cost center or cost object, but they benefit multiple cost objects. It is not possible to
calculate them for a single cost object. However, it needs to be apportioned over various products
as well as among the different departments of the organization. It includes production, office &
administration, selling & distribution costs. The indirect cost is divided into the following
categories:

Indirect Material: Material Cost which cannot be identified with a particular

product or project.
Example: Lubricants

Indirect Labor: Salary to the employees that cannot be allocable to a

particular cost object.
Example: Salary to the management team and employees of the accounts
department.

Indirect Expenses: All the expenses other than indirect material and labor
are included in this category.
Example: Interest, Rent, Tax, Duty, etc.

Basis for
Comparison
Meaning

Direct Cost

Indirect Cost

A cost that is easily attributable Indirect Cost is defined as the cost

to a cost object is known as
that cannot be allocated to a
Direct Cost.
particular cost object.

Basis for
Comparison

Direct Cost

Indirect Cost

Benefits

Specific projects

Multiple projects

Aggregate

When all the direct costs are

taken together they are known
as prime costs.

Total of all the indirect costs is

called as overheads or oncost.

Traceable

Yes

No

Classification

Direct material, direct labor,

direct expenses

Indirect material, indirect labor,

indirect overheads