School of Finance & Commerce

Course Code: MCOM1004 Course Name: Management Accounting

Unit 3
Marginal costing and
Absorption costing

Faculty Name: Dr. Mohd Shamshad Program

 Prerequisites

Basics of Management Accounting.

Basic concepts of types of costs
 Objectives

 This Presentation explains the basic concepts of Marginal Costing

& Absorption Costing.
 You will also get to know their practical applications and
difference between both these techniques of costing.
 Contents

Meaning of Marginal Costing

Contribution & Profit
Contribution Sales Ratio
Features, Advantages & Limitations of
Marginal Costing
Meaning of Absorption Costing
Features, Advantages & Limitations of
Absorption Costing
 Marginal Cost

“The change in aggregate costs due to per unit

change in the volume of production.”
The marginal cost of a product is its “Variable Cost”.
Marginal cost per unit of a product consists of
Direct Material, Direct Labour, Direct Expenses &
Variable portion of other overheads.
 Marginal Costing

 Marginal costing is a very useful technique of

costing for decision making.

 In marginal costing, costs are segregated into

Fixed Costs and Variable Costs.
 Marginal Costing Definition
 The ascertainment by differentiating between fixed costs, and
variable costs, of marginal costs and of the effect on profit of changes
in volume or type of output.
- ICMA
 Marginal costing is a technique of determining the amount of change
in the aggregate costs due to an increase of one unit over the existing
level of production. As such, it arises from the production of
additional increments of output.
-Dr. Joseph
 Marginal costing is a technique of cost accounting, which pays
special attention to the behavior of costs with changes in the volume
of output.
-Batty
 Formulas of Marginal Costing
Main Formulas

Sales = Fixed Cost + Variable Cost + Profit

Sales – Variable Cost = Fixed Cost + Profit = Contribution

Contribution – Fixed Cost = Profit

 Contribution

Contribution is the difference between

the total sales value and the marginal cost
of sales.
Total Contribution = Sales - Variable
Cost OR Fixed Cost + Profit.
It is one of the central concepts of
marginal costing.
 Contribution & Profit
Contribution Profit
It includes fixed cost and It does not include fixed cost.
profit.
Marginal costing technique Profit is the accounting concept
uses the concept of to determine profit or loss of a
contribution. business concern.
At break-even point, Only the sales in excess of
contribution equals to fixed break-even point results in
cost. profit.
Contribution concept is used in Profit is computed to determine
managerial decision making. the profitability of product and
the concern.
 Contribution Sales Ratio

This ratio shows the relationship between sales and

contribution.
The contribution margin per unit expressed as a
percentage of the selling price per unit.
Contribution to sales ratio (C/S Ratio, P/V Ratio)
(Contribution/Sales) X 100
OR
(Change in Contribution/Change in Sales) X 100
 Features of Marginal Costing

Costs are categorized into fixed and variable costs.

Fixed costs are considered period costs and variable costs
are considered as product costs.
Stock of work-in-progress and finished goods are valued at
marginal cost of production.
Products transferred from one process to another are valued
at marginal costs only.
Prices are determined with reference to marginal cost and
contribution margin.
 Features Contd…

Profitability of departments, products etc. is determined

with reference to their contribution margin.
The overhead control account in the cost ledger
represents only the variable overhead.
Presentation of data is oriented to highlight the total
contribution and contribution from each product.
The difference in the magnitude of opening stock and
closing stock does not affect the unit cost of production
since all the product costs are variable costs.
 Advantages of Marginal Costing
 Fixed costs are period costs in nature and it should be
charged to the concerned period.
 Inclusion of fixed costs in the product cost distorts the
comparability of products at different volumes and
disturbs control actions.
 The difficulty in apportionment and absorption of fixed
costs to product cost will not exist in contribution
approach.
 Marginal cost method is simple in application and is easy
for exercise of cost control.
 It helps the management with more appropriate
information in taking vital business decisions.
 Advantages contd…
 Profit-volume analysis is facilitated by the use of break-even
charts and profit-volume graphs.
 The analysis of contribution per key factor or limiting resource
is a useful aid in budgeting and production planning.
 Pricing decisions can be based on the contribution levels of
individual products.
 The profit and loss statement is not distorted by changes in
stock levels.
 Responsibility accounting is more effective when based on
marginal costing because managers can identify their
responsibilities more clearly when fixed overhead is not
charged arbitrarily to their departments or divisions.
 Limitations of Marginal Costing
 Difficulty may be experienced in trying to separate fixed
and variable elements of overhead costs.
 The misuse of marginal costing approach may result in
setting selling prices which do not allow for the full
recovery of overhead.
 The main assumption of marginal costing is that variable
cost per unit will be same at any level of activity.
 The assumption that fixed costs remain constant in total
regardless of changes in volume will be correct up to a
certain level of output.
 Limitations contd…

Increased automation and mechanization has resulted the

reduction in labour costs and increased fixed costs.
Exclusion of fixed overheads from costs may lead to
erroneous conclusions.
Adherence to marginal costing will involve deviation from
accepted accounting practices.
The income-tax authorities do not recognize the marginal
cost for inventory valuation.
 Meaning of Absorption Costing

Ascertainment of costs after they have been incurred.

It is a costing technique in which all manufacturing
cost are considered as cost of production and are used
in determining the cost of goods manufactured and
inventories.
The fixed production costs are treated as part of the
actual production costs.
“The process of charging all costs, both variable and
fixed to operations, process or products.” -CIMA
 Objectives of Absorption Costing

To know direct and indirect cost separately.

To know department wise participation in cost.
To know the overall cost of the product.
To analyse the data related to production and to
confirm that the resources are properly used or not.
To find out and fixing the sale price to be quoted in
the market.
 Absorption Costing – Main Features

 Period Costs
 Classification on Functional Basis
 Treatment As Product costs
 Advantages of Absorption Costing

Based on Accrual Concepts

More Consciousness about Costs and Services
Revelation of Inefficient Use of Production
Resources
Covering All Costs
No requirement of Separation of Costs
Compliance With Accounting Standards
 Limitations of Absorption Costing

 Of little Use for Decision-making

 Reduction in Practical Utility
 Unsound Practice
 Costs not highlighted
 Absorption & Marginal Costing
Basis Absorption Costing Marginal Costing
Product All costs are treated as product Only variable costs are treated
costing costs. as product costs.
Under/over- Fixed manufacturing overheads Fixed overheads are charged on
absorption are charged to the production actual basis.
of overheads on the basis of estimated
overhead rate.
Inventory Inventory is valued at full Inventories are valued at
valuation manufacturing cost. marginal cost.
Profit Profit is the key to decision Contribution is the key to
concept making. decision making.
 Self Assessment Questions

 Define Marginal Costing, also discuss its advantages

and limitations.
 Differentiate between Contribution and Profit.
 Discuss in detail the features of Marginal Costing.
 Define Absorption Costing, also discuss its advantages
and limitations.
 Discuss in detail the objectives of Absorption Costing.
 Differentiate between Marginal Costing & Absorption
Costing.
 References

D. T. Decoster and E. L. Schafer, Management Accounting,

New York: John Willey and Sons, 1979.
R. K. Sharma and Shashi K. Gupta, Management Accounting-
Principles and Practice (7th.), New Delhi: Kalyani Publishers,
1996.
https://www.accountingnotes.net/cost-accounting/marginal-
costing/marginal-costing-meaning-and-features-cost-
accounting/10533
Thank You