For recovery of overheads, the following two methods are generally used in practice:
1. Absorption Costing
2. Marginal Costing
Absorption Costing:
Absorption Costing is a principle whereby fixed well as variable costs are allotted to cost units and total overheads are absorbed according to activity level. It is the practice of charging all costs, both variable and fixed, and both direct and indirect to operations, products or processes. Conceptually,absorption costing is a simple and fundamental method of ascertaining the cost of a product or service.
Marginal Costing:
The term ‘Marginal Cost’ is defined as the amount at any given volume of output by which aggregate costs are changed if the volume of output is increased or decreased by one unit. It is a variable cost of one unit of a product or a service i.e., a cost that would be avoided if that unit was not produced or provided.
Marginal costing is a principle whereby variable costs are charged to cost units and the fixed costs attributable to the relevant period is written off in full against the contribution for that period. Marginal Costing is the ascertainment of marginal cost and the effect on profit of changes in volume or type of output by differentiating between fixed costs and variable cost.
In marginal costing, costs are classified into fixed and variable costs. The concept of marginal costing based on the behaviour of costs that vary with the volume of output. Marginal costing is known as variable costing in which only variable costs are accumulated and cost per unit is ascertained only as of variable costs. Sometimes, Marginal Costing and Direct Costing are treated as interchangeable terms. The major difference between these two is that,Marginal Cost covers only those expenses that are of variable nature whereas direct cost may also include cost that besides being fixed in nature identified with cost objective.
Features of Marginal Costing
The main features of marginal costing are as follows:
•All costs are categorised into fixed and variable costs. Variable cost per unit is same at any level of activity. Fixed costs remain constant in total regardless of changes in volume.
• Fixed costs are considered period costs and are not included in product cost, only variable costs are considered as product costs.
• Stock of work-in-progress and finished goods are valued at marginal cost of production.
• In marginal process costing, products are transferred from one process to another are valued at marginal costs only.
• Prices are determined with reference to marginal cost and contribution margin.
• Profitability of departments, products, etc. is determined with reference to their contribution margin.
• In accounting marginal cost, the overhead control account in the cost ledger represents only the variable overhead. Fixed costs are taken as expenses in the profit and loss account and thus excluded from costs.
• Presentation of data is oriented to highlight the total contribution from each and contribution 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.
Marginal Costing vs. Absorption Costing
The following generalization to be made on the impact on profit of these two different methods of costing:
• Where sales and production levels are constant through time, profit is the same under the two methods.
• Where production remains constant but sales fluctuate, profit rises or falls with the level of sales, assuming that costs and prices remain constant, but the fluctuations in net profit figures are greater with marginal costing than with absorption costing.
• Where sales are constant but production fluctuates, marginal costing provides for constant profit whereas under absorption costing, profit fluctuates.
• Where production exceeds sales, profit is higher under absorption costing than under marginal costing for the reason that absorption of fixed overheads into closing stock increases their value thereby reducing the cost of goods sold.
• Where sales exceed production, profit is higher under Marginal costing.The fixed cost, which previously were part of stock values, are now charged against revenue under absorption. Therefore, under absorption costing the value of fixed costs charged against revenue is greater than incurred for the period. The choice between using absorption costing and marginal cost be determined by the following factors:
Cost Management
The system of financial control in use e.g. responsibility accounting is inconsistent with an absorption costing.The production methods in use e.g. marginal costing is favoured in simple processing situations in which all products receive similar attention; but when different products receive widely amounts differing attention, the absorption costing may be more realistic.The significance of prevailing level of fixed overhead costs.The marginal cost is considered to be linear in function and marginal cost is assumed to be constant per Cost per unit. The fixed cost per unit will decrease with the increase in activity level and vice versa.
Practical Applications of Marginal Costing Technique
Marginal costing technique is useful in managerial decision making in the following situations:
• Key or limiting factory analysis
• Price fixation
• Profit Planning
• Discontinuance or diversification of product line
• Optimising product mix accept or reject special offer and sub-contracting
• Break-even analysis
• Make or buy decisions
• Cost-volume-profit analysis
A proforma of income statement under absorption costing and marginal costing is given in Table.
1. Absorption Costing
2. Marginal Costing
Absorption Costing:
Absorption Costing is a principle whereby fixed well as variable costs are allotted to cost units and total overheads are absorbed according to activity level. It is the practice of charging all costs, both variable and fixed, and both direct and indirect to operations, products or processes. Conceptually,absorption costing is a simple and fundamental method of ascertaining the cost of a product or service.
Marginal Costing:
The term ‘Marginal Cost’ is defined as the amount at any given volume of output by which aggregate costs are changed if the volume of output is increased or decreased by one unit. It is a variable cost of one unit of a product or a service i.e., a cost that would be avoided if that unit was not produced or provided.
Marginal costing is a principle whereby variable costs are charged to cost units and the fixed costs attributable to the relevant period is written off in full against the contribution for that period. Marginal Costing is the ascertainment of marginal cost and the effect on profit of changes in volume or type of output by differentiating between fixed costs and variable cost.
In marginal costing, costs are classified into fixed and variable costs. The concept of marginal costing based on the behaviour of costs that vary with the volume of output. Marginal costing is known as variable costing in which only variable costs are accumulated and cost per unit is ascertained only as of variable costs. Sometimes, Marginal Costing and Direct Costing are treated as interchangeable terms. The major difference between these two is that,Marginal Cost covers only those expenses that are of variable nature whereas direct cost may also include cost that besides being fixed in nature identified with cost objective.
Features of Marginal Costing
The main features of marginal costing are as follows:
•All costs are categorised into fixed and variable costs. Variable cost per unit is same at any level of activity. Fixed costs remain constant in total regardless of changes in volume.
• Fixed costs are considered period costs and are not included in product cost, only variable costs are considered as product costs.
• Stock of work-in-progress and finished goods are valued at marginal cost of production.
• In marginal process costing, products are transferred from one process to another are valued at marginal costs only.
• Prices are determined with reference to marginal cost and contribution margin.
• Profitability of departments, products, etc. is determined with reference to their contribution margin.
• In accounting marginal cost, the overhead control account in the cost ledger represents only the variable overhead. Fixed costs are taken as expenses in the profit and loss account and thus excluded from costs.
• Presentation of data is oriented to highlight the total contribution from each and contribution 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.
Marginal Costing vs. Absorption Costing
The following generalization to be made on the impact on profit of these two different methods of costing:
• Where sales and production levels are constant through time, profit is the same under the two methods.
• Where production remains constant but sales fluctuate, profit rises or falls with the level of sales, assuming that costs and prices remain constant, but the fluctuations in net profit figures are greater with marginal costing than with absorption costing.
• Where sales are constant but production fluctuates, marginal costing provides for constant profit whereas under absorption costing, profit fluctuates.
• Where production exceeds sales, profit is higher under absorption costing than under marginal costing for the reason that absorption of fixed overheads into closing stock increases their value thereby reducing the cost of goods sold.
• Where sales exceed production, profit is higher under Marginal costing.The fixed cost, which previously were part of stock values, are now charged against revenue under absorption. Therefore, under absorption costing the value of fixed costs charged against revenue is greater than incurred for the period. The choice between using absorption costing and marginal cost be determined by the following factors:
Cost Management
The system of financial control in use e.g. responsibility accounting is inconsistent with an absorption costing.The production methods in use e.g. marginal costing is favoured in simple processing situations in which all products receive similar attention; but when different products receive widely amounts differing attention, the absorption costing may be more realistic.The significance of prevailing level of fixed overhead costs.The marginal cost is considered to be linear in function and marginal cost is assumed to be constant per Cost per unit. The fixed cost per unit will decrease with the increase in activity level and vice versa.
Practical Applications of Marginal Costing Technique
Marginal costing technique is useful in managerial decision making in the following situations:
• Key or limiting factory analysis
• Price fixation
• Profit Planning
• Discontinuance or diversification of product line
• Optimising product mix accept or reject special offer and sub-contracting
• Break-even analysis
• Make or buy decisions
• Cost-volume-profit analysis
A proforma of income statement under absorption costing and marginal costing is given in Table.
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| Income Statement (Absorption Costing) |
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