You are on page 1of 26

INDEX

S.N O
1. 2. 3. 4. 5. 6. 7. 8. 9. 10.

PARTICULARS
Introduction Absorption Costing Marginal Costing Theory of Marginal Costing Principles of Marginal Costing Advantages of Marginal Costing Disadvantages of Marginal Costing Contribution Presentation of Cost Data under Marginal Costing and Absorption Costing

PAGE NO.
2 3 4-5 5-6 6

Features of Marginal Costing 7 8 9 9 10-11

11.

Marginal Costing versus Absorption Costing


1

12-13

12. 13.

Utility of Marginal costing Applications of Marginal Costing Breakeven analysis Margin of Safety Make or Buy Decision

14-15

15-19 19 20-22 22 23

1. 2.

Conclusion Bibliography

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. The cost is furthermore diversified and classified into PRODUCT COST and PERIOD COST. Product costs are the cost which are necessary for production and which will not be incurred if there is no production. These are absorbed by the units produced. These are also called INVENTORIABLE COSTS as these are included in the cost of inventory, for e.g.:- direct materials, direct labour etc.Period costs are those costs which are not necessary for production and are incurred even if there is no production. These are written off as expenses in the period in
2

which these are incurred. For e.g. administrative expenses, selling expenses etc. MARGINAL COSTING is a costing method in which only variable costs are accumulated and cost per unit is ascertained only on the basis of variable costs. Prime costs and variable overheads are included in the value of inventories and fixed costs are not taken into account while ascertaining cost per unit, but they are not ignored. ABSORPTION COSTING is a technique of costing in which all manufacturing costs are absorbed, in the cost of the products produced. In absorption costing, fixed factory overheads are absorbed on actual cost basis or on the basis of a predetermined overhead rate based on normal capacity.

ABSORPTION COSTING:
Absorption costing technique is also termed as Traditional or Full Cost Method. According to this method, the cost of a product is determined after considering both fixed and variable costs. The variable costs, such as those of direct materials, direct labour, etc. are directly charged to the products, while the fixed costs are apportioned on a suitable basis over different product manufactured during a period. Thus, in case of Absorption Costing all costs are identified with the manufactured products. This system of costing has a number of disadvantages: i. It assumes prices are simply a function of costs. ii. It does not take account of demand. iii. It includes past costs that may not be relevant to the pricing decision at hand. iv.It does not provide information that aids decision making in a rapidly changing market environment.
3

Thus, the technique of Absorption Costing may lead to rather odd results particularly for seasonal businesses in which the stock level fluctuate widely from one period to another. The transfer of overheads in and out of stock will influence their profits for the two periods, showing falling profits when the sales are high and increasing profits when the sales are low. The technique of Absorption Costing may also lead to the rejection of profitable business. The total unit cost will tend to be regarded as the lowest possible selling price. An order at a price, which is less than the total unit cost, may be refused though this order may actually be profitable.

MARGINAL COSTING
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, COST = MARGINAL VARIABLE COST DIRECT LABOUR + DIRECT MATERIAL + DIRECT EXPENSE
4

+ VARIABLE OVERHEADS Marginal cost thus 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 $ 300 and X+1 units at a cost of $ 320, the cost of an additional unit will be $ 20 which is marginal cost. Similarly if the production of X-1 units comes down to $ 280, the cost of marginal unit will be $ 20 (300280). 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 labour 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.

THEORY OF MARGINAL COSTING


The theory of marginal costing given 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 certain 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.
5

The theory of marginal costing may, therefore, is given as: 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 $3,000 and if by increasing the output by one unit the cost goes up to $3,002, the marginal cost of additional output will be $.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 $1,045, the average marginal cost per unit is $2.25. It can be described as follows: Additional cost = Additional units $ 45 = $2.25 20

The ascertainment of marginal cost is based on the classification and segregation of cost into fixed and variable cost. 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.

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.
6

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. Stock/Inventory Valuation Under marginal costing, inventory/stock for profit measurement is valued at marginal cost. It is in sharp
7

2.

contrast to the total unit cost under absorption costing method.


3.

Marginal Contribution Marginal costing technique makes use of marginal contribution for marking 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. Fixed costs as period costs- fixed costs are treated as period costs and are charged to costing profit and loss account of the period in which they are incurred. Variable costs are product costs- only marginal or variable costs are charged to products produced during the period. Marginal costing and profit- in marginal costing profit is calculated by two stage approach. First of all, contribution is determined for each product or department. The contributions of various products or departments are pooled together and such a total of contributions from all products is called FUND. Then from this fund is deducted the total fixed cost to arrive at a profit or loss.

4.

5.

6.

ADVANTAGES OF MARGINAL COSTING


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 years fixed overhead.
8

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 OF MARGINAL COSTING


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 actual 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.

CONTRIBUTION
Contribution is the difference between selling price and variable cost of sales. It is a fund or pool out of which all fixed costs irrespective of their nature is met, and to each product has to contribute its share. the excess of profit over fixed cost is the profit. if the total contribution does not meet the entire fixed cost, there will be loss. In normal circumstances, selling prices contain an element of profit but there may be circumstances, when products have to be sold at cost or even at loss. Therefore, the character of contributions is given as:CONTRIBUTION= FIXED COST+ PROFIT Or, CONTRIBUTION= SALES VARIABLE COST

10

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 Rs Sales Revenue Less Marginal Cost of Sales Opening Stock (Valued @ marginal cost) Add Production Cost (Valued @ marginal cost) Total Production Cost Less Closing Stock (Valued @ marginal cost) Marginal Cost of Production Add Selling, Admin & Distribution Cost Marginal Cost of Sales Contribution Less Fixed Cost Marginal Costing Profit
11

Rs xxxx x

xxxx xxxx xxxx (xxx) xxxx xxxx (xxxx ) xxxx x (xxxx ) xxxx

ABSORPTION COSTING PRO-FORMA Rs Sales Revenue Less Absorption Cost of Sales Opening Stock (Valued @ absorption cost) Add Production Cost (Valued @ absorption cost) Total Production Cost Less Closing Stock (Valued @ absorption cost) Absorption Cost of Production Add Selling, Admin & Distribution Cost Absorption Cost of Sales Un-Adjusted Profit Fixed Production O/H absorbed Fixed Production O/H incurred (Under)/Over Absorption Adjusted Profit xxxx (xxxx) xxxx x xxxx x Rs xxxx x

xxxx xxxx xxxx (xxx) xxxx xxxx (xxx x) xxxx x

Reconciliation Statement for Marginal Costing and Absorption Costing Profit


12

PARTICULARS

R s x x x x x x

Marginal Costing Profit ADD (Closing stock opening Stock) x OAR = Absorption Costing Profit

Budgeted fixed production Where OAR( overhead absorption overhead 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

13

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;

14

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.

UTILITY OF MARGINAL COSTING:


Marginal costing is a special technique used for managerial decision making. The technique of marginal costing is used to provide a basis for the interpretation of cost data to measure the profitability of different products, processes and cost centres in the course of decision making. It can, therefore, be used in conjunction with the different methods of costing such as job costing, process costing etc., or even with other
15

techniques such as standard costing or budgetary control. The technique of marginal costing has become more relevant and useful in todays business environment of globalization. This is because in marginal costing the cost of a product or a service is computed only on the basis of variable costs. Global companies want to take advantage of cheap labour in developing or backward countries. Marginal costing techniques help management in several ways in the present day context of global business environment. These are listed below:

Volume of production: Marginal costing helps in determining the level of output which is most profitable for running concern. The production capacity, therefore, can be utilized to the maximum possible extent. It helps in determining the most profitable relationship between cost, price, and volume in the business which helps the management in fixing best selling prices for its products. Selecting product lines: The marginal costing technique helps in determining the most profitable production line by comparing the profitability of different products. Produce or procure: The decision whether a particular product should be manufactured in the factory or procured from outside source can be taken comparing the price at which it can be had from outside. In case the procurement price is lower than the marginal cost of production, it will be advisable to procure the product from outside source. Method of manufacturing: If a product can be manufactured by two or more methods, ascertaining the marginal cost of manufacturing the product by each method will be helpful in deciding as to which method should be adopted. Shut down or continue: marginal costing, particularly in the times of depression, helps in deciding whether the production in the plant should be suspended temporarily or continued in spite of low demand for the firms products. Accepting an offer or exporting below normal price: volume of output and sales may be increased by reducing
16

the normal prices of additional sales. The company should be cautious that the sales below normal prices in additional markets should not affect the normal market.

Maintaining a desired level of profit- a company has to cut prices of its products from time to time because of competition, Government regulations and other compelling reasons. The contribution per unit on account of such cutting is reduced while the industry is interested in maintaining a minimum level of its profits. In case the demand for the companys product is elastic, the maximum level of profits can be maintained by pushing up the sales. The volume of such sales can be found by marginal costing techniques.

COST-PROFIT-VOLUME ANALYSIS, BREAK EVEN CHART, MARGIN OF SAFETY AND PRICING DECISIONS ALSO TAKE INTO ACCOUNTS THE MARGINAL COSTING.

17

APPLICATIONS OF MARGINAL COSTING

A)BREAK EVEN ANALYSIS


The break-even point is the point or state of a business at which there is neither a profit nor a loss. In other words, it is at this point where the contribution is equal to fixed expenses. At this point or level, the sales revenue is just equal to the costs incurred. Below this level the firm will make losses, while above this level the firm will make profits. Below break even point fixed costs will eat up all excess sales over variable cost leaving a loss. Above BEP, excess of sales over variable costs is much more than the fixed costs of the activities and it leads to profits. There are different types of breakeven point are:2)

Cash break-even point: While computing the breakeven point if only cash fixed costs is considered, the breakeven point so computed is called cash break-even point. The computation of cash break-even-point excludes depreciation and other non-cash fixed expenses. Cash break-even point thus will give such a level of output or sales at which the sales revenue will be equal to cash outflow.

Cash break-even point = Cash fixed costs / Contribution per unit


3)

Composite break-even point: It is a single breakeven point in the case of firms manufacturing two or more products. Composite break-even point is determined by dividing the total fixed costs by composite P/V ratio.

The composite P/V ratio can be calculated by dividing the total


18

Contribution by total sales and multiplying by 100. Composite break-even point. = Total fixed costs/Composite P/V ratio Composite P/V ratio = (Total contribution/Total Sales) x 100
4)

Cost-break-even point: It is a situation under which the costs of operating two alternative plants are equal. Though both the plants may have the same total costs, their total fixed costs and variable costs per unit may be different. In such a case, the firm may like to determine that point at which the total costs (fixed and variable) of operating both the plants are same. Such a point may be called cost breakeven point.

ASSUMPTIONS OF BREAK EVEN ANALYSIS


The break even analysis is based on following assumptions 1) All costs can be separated into fixed and variable components. 2) Variable cost per unit remains constant and total variable costs varies in direct proportion to the volume of production. 3) Total fixed cost remains constant. 4) Selling price per unit does not change as volume changes. 5) There is only one product or in the case of multiple products, the sales mix does not change. When several products are being sold, the sale of various products will always be in some predetermined proportion. 6) There is synchronisation between production and sales. In other words, volume of production equals volume of sales.
19

7) Productivity per worker does not change. 8) There will be no change in general price level.

BREAK EVEN CHART

COMPUTATION OF BREAK EVEN POINT

1)
20

2)

BREAK EVEN = TOTAL REVENUE-TOTAL COST

LIMITATIONS OF BREAK EVEN POINT

Break-even analysis is only a supply side (i.e. costs only) analysis, as it tells you nothing about what sales are actually likely to be for the product at these various prices.

It assumes that fixed costs (FC) are constant. Although this is true in the short run, an increase in the scale of production is likely to cause fixed costs to rise.

It assumes average variable costs are constant per unit of output, at least in the range of likely quantities of sales. (i.e. linearity)

It assumes that the quantity of goods produced is equal to the quantity of goods sold (i.e., there is no change in the quantity of goods held in inventory at the beginning of the period and the quantity of goods held in inventory at the end of the period).

In multi-product companies, it assumes that the relative proportions of each product sold and produced are constant (i.e., the sales mix is constant).

B) MARGIN OF SAFETY
Margin of safety represents the strength of the business. It enables a business to know what the exact amount it has gained or lost is and whether they are over or below the
21

breakeven point. Margin of safety is the difference between the actual sales and sales at breakeven point. Sales beyond break even volume bring in profits. Such sale is margin of safety. Margin of safety is calculated as:Margin of safety = (current output breakeven output) Margin of safety% = (current output breakeven output)/current Output x 100 When dealing with budgets you would instead replace "Current output" with "Budgeted output". Break Even (in units) = FC / (SP VC) Where, FC is Fixed Cost, SP is Selling Price and VC is Variable Cost

C) MAKE OR BUY DECISION


When a company has unused capacity and wants to manufacture some components, it has two alternatives: (A) To make within the organization or (B) To buy from the market. Often, firms face the question whether to outsource production of a component or continue to make it in the factory.
22

Comparison of the relevant costs of both the alternatives in such cases will show whether to continue the existing arrangement or change to buying it, discontinuing the current production. The answer depends upon whether the firm has the option to use the freed capacity, profitably, or not.

The decision to buy, discontinuing present production, depends on whether the capacity that is released by the nonmanufacture of the component can be profitably utilized, elsewhere, or not. Role of Fixed Costs: Fixed costs are sunk costs. Fixed costs cannot be reversed, without loss. Machinery purchased, already, cannot be sold, without loss, in terms of money. Fixed costs that are incurred are not relevant in decision-making. Costs that will be incurred, in any event, should not be considered in the decision-making. In other words, the existing fixed costs, which cannot be saved, do not influence the decision as those costs are already incurred and cannot be reversed, whether the firms makes or buys. Decision-making between purchase and continuation of production: Decision depends on whether the machinery that is freed would remain idle or can be utilized profitably, elsewhere. Machinery turns idle: If the machinery remains idle, existing fixed costs related to that machinery is not to be considered for decision-making. Variable costs only with the market price of the material are compared. If one is stopped making the component in the factory and buy it from the market, he can save is only future variable costs, but not the fixed costs, already incurred. The firm would continue to incur costs on the idle machine. In other words, we consider those costs that can be saved or avoided.
23

Compare the Saved costs with the corresponding market price for decision-making to buy or continue to produce. Costs that can be saved are only Variable Costs. So, compare variable costs with market price for decision making, when the machinery turns to be idle. Machinery would be utilized profitably, elsewhere: The second situation is that the existing machinery can be utilized, elsewhere, profitably. Where the capacity freed can be utilized in an alternative profitable way, the fixed costs can be considered as saved. As the machinery is utilized in a profitable way, the existing component does not bear the burden of fixed costs, as the machinery is not utilized in producing that component and not remaining idle too. In such an event, costs saved are both variable costs and fixed costs. So, comparison is to be made between the aggregate costs saved with the corresponding market price. When the machine is not idle and can be profitably utilized, elsewhere, compare total costs saved, both variable and fixed costs, with the market price for decision making. If saved costs are more than the market price, buying is cheaper rather than producing. Produce, if market price is more than saved costs.

24

Following figure shows the buy or produce decision chart specifically:

CONCLUSION
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
25

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.

BIBLIOGRAPHY

BOOKS REFERRED: COMPANY SECRETARIES MODULESCompany accounts,cost management accounting Management Accounting, M.N.Arora SITES REFFERED:

and

www.scribd.com www.google.com

26