by Marginal Costing
Marginal costing is a cost accounting method that focuses on analyzing the impact of changes in production volume on a company’s profit. It distinguishes between fixed costs and variable costs, with the latter being the cost of producing one additional unit of output.
In marginal costing, only variable costs are considered when determining the cost of a product or service. Fixed costs are treated as period costs and are deducted from revenue in the period they are incurred, rather than being allocated to individual products or services. The contribution margin, which is the difference between the sales revenue and variable costs, is used to cover the fixed costs and provide a profit.
The marginal costing approach is particularly useful for short-term decision making, such as whether to accept a special order or whether to produce more or less of a particular product. By focusing on the marginal cost of production, managers can determine the most profitable course of action without being influenced by irrelevant fixed costs that do not change with production volume.
However, marginal costing has its limitations, particularly for long-term decision making. It does not take into account the full cost of production, including the fixed costs that must be paid regardless of production volume. As such, it may not provide an accurate picture of a company’s profitability over the long term.
Marginal Costing Methods
There are several methods used in marginal costing, including:
- Direct costing:
This method considers only the direct costs of producing a product, such as materials, labour, and variable overheads. Fixed overheads are treated as period costs and are not included in the cost of goods sold.
Direct cost per unit = Direct materials + Direct labour + Direct expenses
Total variable cost = Direct cost per unit x Units produced
Contribution margin = Sales – Total variable cost
Net profit = Contribution margin – Fixed costs
- Absorption costing:
This method includes both variable and fixed costs in the cost of a product. This means that fixed costs are absorbed into the cost of goods sold and allocated to individual products based on a predetermined overhead rate.
Cost per unit = Direct materials + Direct labor + Direct expenses + (Fixed overheads/Units produced)
Total cost = Cost per unit x Units produced
Contribution margin = Sales – Total cost
Net profit = Contribution margin – Fixed costs
- Contribution margin:
This method calculates the contribution margin, which is the difference between the selling price and variable cost per unit. The contribution margin is then used to cover fixed costs and provide a profit.
Contribution margin per unit = Selling price per unit – Variable cost per unit
Contribution margin ratio = (Contribution margin per unit / Selling price per unit) x 100
Contribution margin = Sales x Contribution margin ratio / 100
Net profit = Contribution margin – Fixed costs
- Break-even analysis:
This method determines the level of sales required to cover all of the company’s costs, including fixed costs. This helps managers to determine the minimum sales volume required to break even and make a profit.
Break-even point in units = Fixed costs / (Selling price per unit – Variable cost per unit)
Break-even point in dollars = Break-even point in units x Selling price per unit
Margin of safety = Actual sales – Break-even sales
- Cost-volume-profit (CVP) analysis:
This method is used to determine the relationship between costs, volume, and profit. It helps managers to understand how changes in volume, price, and cost affect the company’s profitability.
Profit = (Sales – Variable costs) – Fixed costs
Break-even point in units = Fixed costs / Contribution margin per unit
Break-even point in dollars = Fixed costs / Contribution margin ratio
Margin of safety = Actual sales – Break-even sales
Absorption Costing
Absorption costing is a method of accounting that assigns both variable and fixed costs to products. This method is also known as full costing because it includes all costs associated with the production of a product, including direct materials, direct labour, variable overhead, and fixed overhead.
In absorption costing, fixed costs are absorbed into the cost of goods sold and are allocated to individual products based on a predetermined overhead rate. This means that the cost of a product includes both variable and fixed costs, which are spread across all units produced.
The absorption costing approach is useful because it provides a more accurate picture of a company’s profitability over the long term. By including fixed costs in the cost of goods sold, managers can determine the true cost of producing a product and make better decisions about pricing and production volume.
However, absorption costing has its limitations. It can make it difficult to determine the true profitability of a product if there are significant variations in production volume or if fixed costs change over time. In addition, absorption costing can make it difficult to compare the profitability of different products or production processes because fixed costs are spread across all units produced.
Despite these limitations, absorption costing is still widely used in many industries, particularly in manufacturing, where fixed costs can be a significant portion of the total cost of production.
Absorption costing is a method of costing in which all direct costs (such as direct materials, direct labour, and direct expenses) and all indirect costs (such as overheads) are absorbed into the cost of a product. This method of costing is also known as full costing.
The formula for absorption costing is as follows:
Total cost per unit = Direct materials + Direct labor + Direct expenses + Manufacturing overheads/Number of units produced
The formula for calculating manufacturing overheads is:
Manufacturing overheads = Fixed overheads + Variable overheads
Fixed overheads are those overheads that do not vary with changes in the level of production, such as rent, depreciation, salaries of permanent employees, etc. Variable overheads are those overheads that vary with changes in the level of production, such as utilities, maintenance, etc.
Absorption costing is used to determine the total cost of a product, which is important for pricing decisions, inventory valuation, and financial reporting. However, it has some limitations, such as the potential for overestimating profits in periods of low production, and the fact that it does not account for the opportunity cost of using capacity.
Key Differences Between Marginal Costing and Absorption Costing
| Factors | Marginal Costing | Absorption Costing |
| Cost classification | Only variable costs are considered. | Both variable and fixed costs are considered. |
| Treatment of fixed costs | Fixed costs are treated as period costs and are not considered while calculating the cost of production. | Fixed costs are included in the cost of production and are absorbed using a predetermined overhead rate. |
| Profitability analysis | The contribution margin is used to determine the profitability of a product or service. | The net profit or loss is used to determine the profitability of a product or service. |
| Application | More suited for short-term decision making. | More suited for long-term decision making. |
| Compliance with GAAP | Not compliant with GAAP as it ignores fixed costs. | Compliant with GAAP as it considers both variable and fixed costs. |
Important Differences Between Marginal Costing and Absorption Costing
- Cost classification: Marginal costing considers only variable costs and segregates fixed costs as period costs, while absorption costing considers both variable and fixed costs in the cost of production.
- Treatment of fixed costs: Marginal costing treats fixed costs as period costs and excludes them from the cost of production. In contrast, absorption costing absorbs fixed costs into the cost of production using a predetermined overhead rate.
- Profitability analysis: Marginal costing uses the contribution margin to determine the profitability of individual products or services, while absorption costing uses the net profit or loss to determine the profitability of a product or service.
- Application: Marginal costing is more suited for short-term decision making, such as pricing decisions, product mix decisions, and make-or-buy decisions. Absorption costing is more suited for long-term decision making, such as capital budgeting and product development.
- Compliance with GAAP: Marginal costing is not compliant with Generally Accepted Accounting Principles (GAAP) as it ignores fixed costs, while absorption costing is compliant with GAAP as it considers both variable and fixed costs.
Similarities Between Marginal Costing and Absorption Costing
Marginal costing and absorption costing are two methods of cost accounting used to determine the cost of a product or service. While they differ in their approach, there are some similarities between the two methods, including:
- Both methods aim to determine the cost of a product or service.
- Both methods take into account direct costs such as materials, labor, and variable overheads.
- Both methods are used for decision making, including pricing decisions, product mix decisions, and make-or-buy decisions.
- Both methods are used to determine the profitability of a product or service.
Laws governing Marginal Costing and Absorption Costing
Marginal Costing and Absorption Costing are two methods used for cost accounting and management. The laws governing these methods are typically defined by the accounting and tax regulations of the country in which they are applied. However, there are some general principles that apply to both methods.
Marginal Costing:
- Direct costs are separated from indirect costs, and only direct costs are considered in the calculation of marginal cost.
- Fixed costs are not included in the calculation of marginal cost and are treated as period costs.
- The contribution margin is used to determine the profitability of individual products or services.
- Marginal Costing is more suited to short-term decision making.
Absorption Costing:
- Both direct and indirect costs are included in the calculation of the cost of a product or service.
- Fixed costs are allocated to the products or services based on a predetermined overhead absorption rate.
- Absorption costing is used to determine the full cost of production, including fixed costs.
- Absorption costing is more suited to long-term decision making.
