Marginal Costing and Absorption Costing

Learning Objectives

 To understand the meanings of marginal cost and marginal costing

 To distinguish between marginal costing and absorption costing

 To ascertain income under both marginal costing and absorption costing

 To reconcile profit under the two alternative costing methods.

Introduction

The costs that vary with a decision should only be included in 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.

Marginal costing - definition

Marginal costing distinguishes between fixed costs and variable costs as convention ally
classified.

The marginal cost of a product –“ is its variable cost”. This is normally taken to be; direct
labour, direct material, direct expenses and the variable part of overheads.

Marginal costing is 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 term ‘contribution’ mentioned in the formal definition is the term given to the
difference between Sales and Marginal cost. Thus

MARGINAL COST = VARIABLE COST = DIRECT LABOUR

DIRECT MATERIAL

DIRECT EXPENSE
 +

VARIABLE OVERHEAD
CONTRIBUTION MARGIN = SALES - MARGINAL COST

The term marginal cost sometimes refers to the marginal cost per unit and sometimes to the
total marginal costs of a department or batch or operation. The meaning is usually clear
from the context.

Note

Alternative names for marginal costing are the contribution approach and direct costing. In
this lesson, we will study marginal costing as a technique quite distinct from absorption
costing.

Theory of Marginal Costing

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, additional output can normally be obtained at less
than proportionate cost because within limits, the aggregate of cekrtain 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 less than proportionate fall in the aggregate cost.

The theory of marginal costing may, therefore, by 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 1000 units
at a total cost of Tshs.3,000 and if by increasing the output by one unit the cost goes up to
Tshs. 3,002, the marginal cost of additional output will be Tshs 2.

2. If an increase in output is more than one, the total increase in 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 Tshs
3,045, the average marginal cost per unit is Tshs 2.25. It can be described as follows:

Additional cost = Tshs 45 = Tshs 2.25

Additional units 20

The ascertainment of marginal cost is based on the classification and segregation of cost
into fixed and variable cost. 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 existing level of production. In this
connection, a unit may mean a single commodity, a dozen, a gross or any other measure of
goods.
For example, if a manufacturing firm produces X unit at a cost of Tshs 300 and X+1 units at a
cost of Tshs 320, the cost of an additional unit will be Tshs 20 which is marginal cost.
Similarly if the production of X-1 units comes down to Tshs 280, the cost of marginal unit will
be Tshs 20 (300–280).

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 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 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.

The principles of marginal costing

The principles of marginal costing are as follows.

a. For any given period of time, fixed costs will be the same, for any volume of sales and
production (provided that the level of activity is within the ‘relevant range’). Therefore, by
selling an extra item of product or service the following will happen.

 Revenue will increase by the sales value of the item sold.

 Costs will increase by the variable cost per unit.

 Profit will increase by the amount of contribution earned from the extra item.

b. Similarly, if the volume of sales falls by one item, the profit will fall by the amount of
contribution earned from the item.
c. Profit measurement should therefore be based on an analysis of total contribution.
Since fixed costs relate to a period of time, and do not change with increases or decreases in
sales volume, it is misleading to charge units of sale with a share of fixed costs.

d. When a unit of product is made, the extra costs incurred in its manufacture are the
variable production costs. Fixed costs are unaffected, and no extra fixed costs are incurred
when output is increased.
Features of Marginal Costing

The main features of marginal costing are as follows:

1. Cost Classification
The marginal costing technique makes a sharp distinction between variable costs and fixed
costs. It is the variable cost on the basis of which production and sales policies are designed
by a firm following the marginal costing technique.

2. Stock/Inventory Valuation
Under marginal costing, inventory/stock for profit measurement is valued at marginal cost. It
is in sharp contrast to the total unit cost under absorption costing method.

3. Marginal Contribution
Marginal costing technique makes use of marginal contribution for making various decisions.
Marginal contribution is the difference between sales and marginal cost. It forms the basis
for judging the profitability of different products or departments.

Advantages of Marginal Costing Technique.

1. Marginal costing is simple to understand.

2. By not charging fixed overhead to cost of production, the effect of varying charges per
unit is avoided.

3. It prevents the illogical carry forward in stock valuation of some proportion of current
year’s fixed overhead.

4. The effects of alternative sales or production policies can be more readily available and
assessed, and decisions taken would yield the maximum return to business.

5. It eliminates large balances left in overhead control accounts which indicate the
difficulty of ascertaining an accurate overhead recovery rate.

6. Practical cost control is greatly facilitated. By avoiding arbitrary allocation of fixed

overhead, efforts can be concentrated on maintaining a uniform and consistent marginal
cost. It is useful to various levels of management.

7. It helps in short-term profit planning by breakeven and profitability analysis, both in

terms of quantity and graphs. Comparative profitability and performance between two or
more products and divisions can easily be assessed and brought to the notice of
management for decision making.

Disadvantages

1. The separation of costs into fixed and variable is difficult and sometimes gives
misleading results.

2. Normal costing systems also apply overhead under normal operating volume and this
shows that no advantage is gained by marginal costing.
3. Under marginal costing, stocks and work in progress are understated. The exclusion of
fixed costs from inventories affect profit, and true and fair view of financial affairs of an
organization may not be clearly transparent.

4. Volume variance in standard costing also discloses the effect of fluctuating output on
fixed overhead. Marginal cost data becomes unrealistic in case of highly fluctuating levels of
production, e.g., in case of seasonal factories.

5. Application of fixed overhead depends on estimates and not on the actuals and as such
there may be under or over absorption of the same.

6. Control affected by means of budgetary control is also accepted by many. In order to

know the net profit, we should not be satisfied with contribution and hence, fixed overhead
is also a valuable item. A system which ignores fixed costs is less effective since a major
portion of fixed cost is not taken care of under marginal costing.

7. In practice, sales price, fixed cost and variable cost per unit may vary. Thus, the
assumptions underlying the theory of marginal costing sometimes becomes unrealistic. For
long term profit planning, absorption costing is the only answer.

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

Tshs Tshs

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)

Profit xxxxx
ABSORPTION COSTING PRO-FORMA

Tshs Tshs

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

Reconciliation Statement for Marginal Costing and Absorption Costing Profit

Marginal Costing Profit xx

ADD xx

(Closing stock – opening Stock) x OAR

= Absorption Costing Profit xx

Budgeted fixed production overhead

Where OAR( overhead absorption rate) =
Budgeted levels of activities
Marginal Costing versus Absorption Costing

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:1. Over and Under
Absorbed Overheads

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.

2. Difference in Stock Valuation

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:

a. When there is no opening and closing stocks, there will be no difference in profit.

b. 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.

c. 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.

d. 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.

The features which distinguish marginal costing from absorption costing are as follows.

a. 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.

b. 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:

i. include some fixed production overhead costs incurred in a previous

period but carried forward into opening stock values of the current period;

ii. 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.)
c. 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.

d. 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:

i. production volume; and

ii. sales volume;

is not easily seen, because behaviour is not analysed and incremental costs are not used in
the calculation of actual profit.

Limitations of Absorption CostingThe following are the criticisms against absorption costing:

1. You might have observed that in absorption costing, a portion of fixed cost is carried
over to the subsequent accounting period as part of closing stock. This is an unsound
practice because costs pertaining to a period should not be allowed to be vitiated by the
inclusion of costs pertaining to the previous period and vice versa.

2. Further, absorption costing is dependent on the levels of output which may vary from
period to period, and consequently cost per unit changes due to the existence of fixed
overhead. Unless fixed overhead rate is based on normal capacity, such changed costs are
not helpful for the purposes of comparison and control.

The cost to produce an extra unit is variable production cost. It is realistic to the value of
closing stock items as this is a directly attributable cost. The size of total contribution varies
directly with sales volume at a constant rate per unit. For the decision-making purpose of
management, better information about expected profit is obtained from the use of variable
costs and contribution approach in the accounting system. Summary

Marginal cost is the cost management technique for the analysis of cost and revenue
information and for the guidance of management. The presentation of information through
marginal costing statement is easily understood by all mangers, even those who do not have
preliminary knowledge and implications of the subjects of cost and management accounting.

Absorption costing and marginal costing are two different techniques of cost accounting.
Absorption costing is widely used for cost control purpose whereas marginal costing is used
for managerial decision-making and control.

Review questions

Mbeya motors Ltd assembles and sells motor vehicles. It uses an actual costing system, in
which unit costs are calculated on a monthly basis. Data relating to the month of march,
2012 is as given below:-
Particulars: units Tshs.

Opening inventory 150

Production 400

Sales 520

Variable cost Data

Manufacturing cost per unit produced 10,000

Distribution cost per unit sold 3,000

Fixed cost data

Manufacturing costs 2,000,000

Marketing costs 600,000

The selling price per motor vehicle is shs. 24,000

Required

(a) Prepare an income statement for Mbeya Motors Ltd under:-

i. Direct costing ( 4 marks)

ii. Full costing ( 4 marks)

(b) Clearly explain the difference between (a) (i) and (ii) above for the month of
march. ( 2 marks )