Marginal Costing & Absorption costing

Marginal Costing

Marginal Costing is the process of ascertaining marginal cost, by differentiating between fixed cost and variable cost, and of the effect on profit of changes in volume or type of output.

In marginal costing, fixed costs are never charged to production. They are treated as period charge and is written off to the profit and loss account in the period incurred.

Features of Marginal Costing

The main features of marginal costing are as follows-

• This technique is used to ascertain the marginal cost and to know the impact of variable cost on the value of output.
• All the costs are classified into fixed cost and variable costs. Semi-variable costs are segregated into fixed and variable costs.
• The stock of finished goods and work-in-progress are valued on the basis of variable costs.
• Two integral parts of this analysis are break-even analysis and cost-volume-profit analysis.
• The relative profitability of products or departments is based on the contribution made available by each department or product.

Advantages of Marginal Costing

• The technique is simple to understand and easy to operate because it avoids the complexities of apportionment of fixed costs.
• Marginal cost provides all the related and useful data for managerial decision making.
• There is no problem of over or under absorption of overheads.
• This technique can be used along with other techniques such as budgetary control and standard costing.
• It establishes a clear relationship between cost, sales, output, and break-even analysis.
• It shows the relative contribution to profit and where the sales effort should be concentrated.

Disadvantages of Marginal Costing

•  The separation of costs into fixed and variable elements includes considerable technical difficulty.
• It ignores fixed costs to products as if they are not important to production.
• The value of a stock cannot be accepted by taxation authorities since it deflates profit.
• The distinction between fixed and variable costs holds good only in the short run. In the long run, however, all costs are variable.
• This technique is less effective when there is an increase in the use of automatic machinery because it will increase the fixed costs but marginal costing increase the fixed costs.
• Pricing decisions cannot be based on contribution alone.

Absorption Costing

Absorption costing is the oldest and widely used method of ascertaining cost. Under this technique of costing, the cost is made up of direct costs plus overhead costs absorbed on some suitable basis.

It is the practice of charging both variable and fixed costs to operations, processes, and products. Under this technique cost per unit remains the same only when the level of output remains the same.

Absorption coating is useful if there is only one product, there is no inventory and overhead recovery rate is based on normal capacity instead of the actual level of activity.

Advantages of Absorption Costing

• It suitably recognizes the importance of including fixed manufacturing costs in product cost determination and framing a suitable policy.
• It shows correct profit calculation in a case where a product is manufactured to have sales in the future as compared to variable costing.
• It avoids the separation of costs into fixed and variable elements which cannot be done easily.
• It helps to calculate the net profit and gross profit separately in the income statement.
• It helps to make the managers more responsible for the costs and services provided to their departments.

Limitations of Absorption Costing

• Absorption costing makes comparison and control of cost difficult because it is dependent on the level of output; so different unit costs are obtained for different levels of output. An increase in the output normally results in reduced unit cost and a reduction in the output result in an increased cost per unit due to the existence of fixed expenses.
• Absorption costing is not very helpful in taking managerial decisions such as a selection of suitable product mix, choice of alternatives, and the number of units to be sold to earn the desired profit, etc.
• In absorption costing no distinction is made between the fixed and variable costs. It is not possible to prepare a flexible budget without making this distinction.
• In absorption costing, costs are vitiated because of fixed costs included in inventory valuation.

Difference between Marginal Costing and Absorption Costing

ABSORPTION COSTING	MARGINAL COSTING
Cost split is based on function, production, or non-production.	Cost splits are based on the behavior of variable or fixed costs
Inventory is valued at the full production cost (fixed and variable)	Inventory is valued at the variable production cost only.
Sales – Cost of sales = Gross Profit	Sales – Variable Cost = Contribution
Non-production overhead are deducted after gross profit	Non-production overheads are deducted before contribution.