[Marginal Costing & Absorption Costing Notes, Management Accounting Notes, Notes For B.Com, M.Com, BBA and MBA Students, Applications of Marginal Costing]
Marginal Costing Notes for B.Com, M.Com BBA and MBA
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In the post
I have given a brief explanation of Marginal
Costing and Absorption costing. These notes are useful for the students of
B.Com, BBA and MBA of various universities. For more notes visit our website
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Table of Contents
1. Meaning of Marginal Cost and Marginal Costing
2. Features of Marginal Costing
3. Assumptions in Marginal Costing
4. Advantages and Disadvantages of Marginal Costing
5. Marginal Costing is a valuable aid to Management/Applications of Marginal Costing
6. Short notes:
a) Contribution
b) Marginal Cost Equation
c) PV Ratio and its uses
d) Break Even Analysis
e) C-V-P or Break Even Analysis
f) Break Even Point (BEP) and Margin of Safety (MOS)
g) Break even chart and PV Chart
h) Angle of Incidence
7. Introduction to Absorption Costing
8. Advantages and Disadvantages of Absorption Costing
9. Difference between Marginal Costing and Absorption
Costing
10. Difference between Marginal Costing and Differential
Costing
Table of Contents
1. Meaning of Marginal Cost and Marginal Costing
2. Features of Marginal Costing
3. Assumptions in Marginal Costing
4. Advantages and Disadvantages of Marginal Costing
5. Marginal Costing is a valuable aid to Management/Applications of Marginal Costing
6. Short notes:
a) Contribution
b) Marginal Cost Equation
c) PV Ratio and its uses
d) Break Even Analysis
e) C-V-P or Break Even Analysis
f) Break Even Point (BEP) and Margin of Safety (MOS)
g) Break even chart and PV Chart
h) Angle of Incidence
7. Introduction to Absorption Costing
8. Advantages and Disadvantages of Absorption Costing
9. Difference between Marginal Costing and Absorption Costing
10. Difference between Marginal Costing and Differential Costing
2. Features of Marginal Costing
3. Assumptions in Marginal Costing
4. Advantages and Disadvantages of Marginal Costing
5. Marginal Costing is a valuable aid to Management/Applications of Marginal Costing
6. Short notes:
a) Contribution
b) Marginal Cost Equation
c) PV Ratio and its uses
d) Break Even Analysis
e) C-V-P or Break Even Analysis
f) Break Even Point (BEP) and Margin of Safety (MOS)
g) Break even chart and PV Chart
h) Angle of Incidence
7. Introduction to Absorption Costing
8. Advantages and Disadvantages of Absorption Costing
9. Difference between Marginal Costing and Absorption Costing
10. Difference between Marginal Costing and Differential Costing
Meaning of Marginal Cost and Marginal Costing
Marginal Cost: The term Marginal
cost means the additional cost incurred for producing an additional unit of
output. It is the addition made to total cost when the output is increased by
one unit. Marginal cost of nth unit = Total cost of nth unit- total cost of n-1
unit. E.g. When 100 units are produced, the total cost is Rs. 5000.When the
output is increased by one unit, i.e, 101 units, total cost is Rs.5040.Then
marginal cost of 101th unit is Rs. 40[5040-5000]
Marginal cost is
also equal to the total variable cost of production or it is the aggregate of
prime cost and variable overheads. The chartered Institute of Management
Accountants [CIMA] England defines Marginal 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.
Marginal Costing: It is the
technique of costing in which only marginal costs or variable are charged to
output or production. The cost of the output includes only variable costs
.Fixed costs are not charged to output. These are regarded as ‘Period Costs’.
These are incurred for a period. Therefore, these fixed costs are directly
transferred to Costing Profit and Loss Account.
According to
CIMA, marginal costing is “the ascertainment, by differentiating between fixed
and variable costs, of marginal costs and of the effect on profit of changes in
volume or type of output. Under marginal costing, it is assumed that all costs
can be classified into fixed and variable costs. Fixed costs remain constant
irrespective of the volume of output. Variable costs change in direct proportion
with the volume of output. The variable or marginal cost per unit remains
constant at all levels of output.”
Thus, Marginal costing is defined as the ascertainment of marginal cost
and of the ‘effect on profit of changes in volume or type of output by
differentiating between fixed costs and variable costs. Marginal costing is
mainly concerned with providing information to management to assist in decision
making and to exercise control. Marginal costing is also known as ‘variable
costing’ or ‘out of pocket costing’.
The main Features (Characteristics) 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.
2. Managerial
Decisions: It is a technique of analysis and presentation of costs which help
management in taking many managerial decisions such as make or buy decision,
selling price decisions etc.
3. Inventory
Valuation: Under marginal costing, inventory for profit measurement is valued
at marginal cost only.
4. Price
Determination: Prices are determined on the basis of marginal cost by adding
contribution which is the excess of selling price over variable costs of sales.
5. Contribution:
Marginal costing technique makes use of Contribution for taking various
decisions. Contribution is the difference between sales and marginal cost. It
forms the basis for judging the profitability of different products or
departments.
Management Accounting | |
Chapter Wise Notes | Chapter Wise MCQs |
1. Introduction to Management Accounting 4. Marginal Costing 5. Budget and Budgetary Control Also Read: | |
Management Accounting Important Questions for Upcoming Exams (Dibrugarh University) | |
Management Accounting Solved Papers: 2013 2014 2015 2016 2017 2018 2019 | |
Management Accounting Question Papers: 2013 2014 2015 2016 2017 2018 2019 | |
Assumptions in Marginal Costing
1. All costs can
be classified into fixed and variable elements. Semi variable costs are also
segregated into fixed and variable elements.
2. The total
variable costs change in direct proportion with units of output. It follows a
linear relation with volume of output and sales.
3. The total
fixed costs remain constant at all levels of output. These are incurred for a
period and have no relation with output.
4. Only variable
costs are treated as product costs and are charged to output, product, process
or operation
5. Fixed costs
are treated as ‘Period costs’ and are directly transferred to Costing Profit
and Loss Account.
6. The closing
stock is also valued at marginal cost and not at total cost.
7. The relative profitability
of product or department is based on the contribution it gives and not based on
the profit.
8. It is also
assumed that the selling price per unit remains the same i.e, any number of
units can be sold at the current market price.
9. The product or
sales mix remains constant over a period of time.
Advantages of Marginal
Costing
a)
Simple and Easy: It is very simple to understand
and easy to operate.
b)
Helpful in Cost control: Marginal costing
divides total cost into fixed and variable cost. Marginal costing by
concentrating all efforts on the variable costs can control total cost.
c)
Profit Planning: It helps in short-term profit
planning by making a study of relationship between cost, volume and Profits,
both in terms of quantity and graphs.
d)
Evaluation of Performance: The different
products and divisions have different profit earning potentialities. Marginal
cost analysis is very useful for evaluating the performance of each sector.
e)
Helpful in Decision Making: It is a technique of
analysis and presentation of costs which help management in taking many
managerial decisions such as make or buy decision, selling price decisions, Key
or limiting factor, Selection of suitable Product mix etc.
f)
Production Planning: It helps the management in
Production planning. The effect of alternative production policy can be readily
available and decision can be taken that would yield the maximum return to
Business.
g)
It removes the complexities of under-absorption
of overheads.
h)
The distinction between product cost and period
cost helps easy understanding of marginal cost statements.
Disadvantages of Marginal Costing
a)
It is based on an unrealistic assumption that
all costs can be segregated into fixed and variable costs. In the long term
sales price, fixed cost and variable cost per unit may vary.
b)
All costs are not divisible into fixed and
variable. There are certain costs which are semi-variable in nature. The
separation of costs into fixed and variable is difficult and sometimes gives
misleading results.
c)
Under marginal costing, stocks and work in
progress are understated. The exclusion of fixed costs from Stock Valuation
affects profit, and true and fair view of financial affairs of an organization.
d) Marginal cost
data becomes unrealistic in case of highly fluctuating levels of production,
e.g., in case of seasonal factories.
e) It can
correctly assess the profitability on a short-term basis only, but for long
term it is not effective.
f) It does
not provide any effective yardstick for evaluation of performance.
g) Contribution
of marginal costing is not a foolproof indicator of profitability.
h)
Marginal cost, if confused with total cost
while fixing selling price may lead to a disaster.
“Marginal Costing” is a valuable aid to Management
Marginal costing and Beak even analysis are
very useful to management. The important uses of marginal costing and Break
Even analysis are the following:
1)
Cost
control: Marginal
costing divides total cost into fixed and variable cost. Fixed Cost can be
controlled by the Top management to a limited extent and Variable costs can be
controlled by the lower level of management. Marginal costing by concentrating
all efforts on the variable costs can control total cost.
2)
Profit
Planning: It helps
in short-term profit planning by making a study of relationship between cost,
volume and Profits, both in terms of quantity and graphs. An analysis of
contribution made by each product provides a basis for profit-planning in an
organisation with wide range of products.
3)
Fixation
of selling price: Generally
prices are determined by demand and supply of products and services. But under
special market conditions marginal costing is helpful in deciding the prices at
which management should sell. When marginal cost is applied to fixation of
selling price, it should be remembered that the price cannot be less than
marginal cost. But under the following situation, a company shall sell its
products below the marginal cost:
Ø To
maintain production and to keep employees occupied during a trade depression.
Ø To prevent
loss of future orders.
Ø To dispose
of perishable goods.
Ø To
eliminate competition of weaker rivals.
Ø To
introduce a new product.
Ø To help in
selling a co-joined product which is making substantial profit?
Ø To explore
foreign market
4)
Make or Buy: Marginal costing helps the management in deciding whether to make
a component part within the factory or to buy it from an outside supplier.
Here, the decision is taken by comparing the marginal cost of producing the
component part with the price quoted by the supplier. If the marginal cost is
below the supplier’s price, it is profitable to produce the component within
the factory. Whereas if the supplier’s price is less than the marginal cost of
producing the component, then it is profitable to buy the component from
outside.
5)
Closing down of a department or discontinuing
a product: The firm that has
several departments or products may be faced with this situation, where
one department or product shows a net loss. Should this product or
department be eliminated? In marginal costing, so far as a department or
product is giving a positive contribution then that department or product shall
not be discontinued. If that department or product is discontinued the
overall profit is decreased.
6)
Selection of a Product/ sales mix: The
marginal costing technique is useful for deciding the optimum product/sales mix. The product which
shows higher P/V ratio is more profitable. Therefore, the company should produce maximum units of that
product which shows the highest
P/V ratio so as to maximize profits.
7)
Evaluation
of Performance: The
different products and divisions have different profit earning potentialities.
The Performance of each product and division can be brought out by means of
Marginal cost analysis, and improvement can be made where necessary.
8)
Limiting Factor: When a limiting factor restricts the output, a
contribution analysis based on the limiting factor can help maximizing profit.
For example, if machine availability is the limiting factor, then machine hour
utilisation by each product shall be ascertained and contribution shall be
expressed as so many rupees per machine hour utilized. Then, emphasis is given on
the product which gives highest contribution.
9)
Helpful in taking Key Managerial Decisions: In addition to
above, the following are the important areas where managerial problems are
simplified by the use of marginal costing :
Ø Analysis of Effect of change in Price.
Ø Maintaining a desired level of profit.
Ø Alternative methods of production.
Ø Diversification of products.
Ø Alternative course of action etc.
Cost-Volume-Profit
analysis is analysis of three variables i.e., cost, volume and profit
which explores the relationship existing
amongst costs, revenue, activity levels and the resulting profit. It aims at measuring variations of
profits and costs with volume, which is significant for business profit
planning.
CVP
analysis makes use of principles of marginal costing. It is an important tool
of planning for making short term decisions.
The following are the basic decision making indicators in Marginal Costing:
(a)
Profit Volume Ratio (PV Ratio) / Contribution Margin ratio
(b)
Break Even Point (BEP)
(c)
Margin of Safety (MOS)
(d)
Indifference Point or Cost Break Even Point
(e)
Shut-down Point
Assumptions in CVP analysis
The assumptions
in CVP analysis are the same as that under marginal costing.
a)
Cost can be classified into fixed and variable components.
b)
Total fixed cost remain constant at all levels of output
c)
The variable cost change in direct proportion with the volume of
output
d)
The product mix remains constant
e)
The selling price per unit remains the same at all the levels of
sales
f)
There is synchronization of output and sales, i.e, what ever
output is produced , the same is sold during that period.
Contribution
Contribution
is the excess of sales over marginal cost. It is not purely profit. It is the
profit before recovery of fixed assets. Fixed costs are first met out of
contribution and only the remaining amount is regarded as profit. Contribution
is an index of profitability. It has a fixed relationship with sales. Larger
the sales more will be the contribution and vice versa. Contribution = Sales –
Marginal cost.
Profit/Volume Ratio:
Profit-Volume
Ratio expresses the relationship between contribution and sales. It indicates
the relative profitability of diff products, processes and departments. Higher
the P/V ratio, more will be the profit and lower the P/V ratio lesser will be
the profit. Hence, it should be the aim of every concern to improve the P/V
ratio which can be done by increasing selling price, reducing variable cost
etc.
It
can be calculated as follows:
P/V ratio = (S – VC)/ S X 100
=
Cont / Sales X 100
=
Change in profit or loss / Change in sales
Uses of P/V Ratio:
1. To compute the variable costs
for any volume of sales.
2. To measure the efficiency or to
choose a most profitable line. The overall profitability of the firm can be
improved by increasing the sales/output of a product giving a higher PV ratio.
3. To determine break-even point
and the level of output required to earn a desired profit.
4. To decide more profitable
sales-mix.
Break-even Point:
Break Even Point is the level of
sales required to reach a position of no profit, no loss. At Break Even Point,
the contribution is just sufficient to cover the fixed cost. The organisation starts earning profit when
the sales cross the Break Even Point.
Break Even Point can be calculated either in terms of units or in terms
of cash or in terms of capacity utilization. It can be calculated as follows:
BEP in units = Fixed Cost /
Contribution per unit
BEP in cash = Fixed Cost / P.V.
Ratio
BEP in terms of capacity
utilization = (BEP in units / Total capacity) x 100
Margin of Safety:
The positive difference between the sales
volume and the break even volume is known as the margin of safety. The larger
the difference, the safer the organization is from a loss making situation. It
can be calculated either in cash or in units.
Margin of Safety can be derived as
follows:
Margin
of Safety = Actual Sales – Break even Sales or,
Margin
of Safety (in cash) = Profit / P/V Ratio
Break-even chart:
The break-even chart is a graphical
representation of cost-volume profit relationship. It depicts the following:
a)
Profitability of the firm at different levels of
output.
b)
Break-even point - No profit no loss situation.
c)
Angle of Incidence: This is the angle at which
the total sales line cuts the total cost line.
It is shows as angle Θ (theta). If the angle is large, the firm is said
to make profits at a high rate and vice versa.
d)
Relationship between variable cost, fixed
expenses and the contribution.
e)
Margin of safety representing the difference
between the total sales and the sales at breakeven point.
Different types of Break-even charts
a)
Contribution Breakeven Chart: This chart shows
contribution earned by, the firm at different levels of activity.
b)
Cash Breakeven Chart: In this chart variable
costs are assumed to be payable in cash. Besides this the fixed expenses are
divided into two groups, viz. (a) those expenses which involve cash outflow
e.g. rent, insurance, salaries, etc. and (b) those which do not involve cash
outflow. e.g. depreciation.
c)
Control Breakeven Chart: Both budgeted and
actual cost data are depicted in this chart. This chart is useful in comparing
the actual performance of the firm with the budgeted performance for exercising
control.
d)
Analytical break even chart: This chart shows
the break-up of variable expenses into important elements of cost. Viz. direct
materials, direct labour, variable overheads, etc. Also the appropriations of
profit such as ordinary dividends, preference dividend, reserves, etc. are
depicted in this chart.
e)
Product wise break even chart: Separate
break-even charts for different products can also be prepared to compare the
profitability of the products or their contribution.
f)
Profit graph: Profit graph is a special type of
break-even chart, which shows the profits or loss at different levels of
output.
Limitations of break-even chart
a)
The variable cost line need not necessarily be a
straight line because of the possibility of operation of law of increasing
returns or decreasing returns.
b)
Similarly the selling price will not be a
constant factor. Any increase or decrease in output is likely to have all
influence on the selling price.
c)
When a number of products are produced separate
break-even charts will have to be calculated. This poses a problem of
apportionment of fixed expenses to each product.
d)
Break-even charts ignore the capital employed in
business, which is one of the important guiding factors the determination of
profitability.
Angle of Incidence:
Angle of incidence is an indicator of
profit earning capacity above the break-even point. A wider angle will indicate
higher profitability, while a narrow angle will indicate very low
profitability.
If margin of safety and angle of incidence
are considered together, they will provide significant information to
management regarding profit earning position of the undertaking. A high margin
of safety with a wider angle of incidence will indicate the most favourable
condition of the business.
PROFIT VOLUME CHART OR [P/V CHART]
It shows the amount of profit or loss at
different levels of output. When the output is zero, total loss will be equal
to fixed costs. The fixed costs are recovered gradually when the volume of
output is increased. When the output reaches the Break even point, the whole
fixed costs are recovered. The firm incurs no loss or earns no profit.
Thereafter, the firm makes a profit and the amount of profit increases with the
increase in sales volume.
CONSTRUCTION OF P/V CHART
The same data used for drawing a Break even
chart may be used for constructing a
P/V chart. The following steps may be followed for constructing a P/V chart.
1. Sales or units of output are plotted along
the X axis
2. The Y axis is used for marking fixed costs
losses and profits
3. Points of Profits or losses are marked at
different levels of sales and these points
are joined to get the profit or loss line.
4. The point where the profit or loss line
intersects the X axis is marked as the Break even point.
5. The angle at the BEP measures the angle of
incidence.
6. The distance between BEP and actual sales
on the X axis measures the margin of
safety.
Difference Between Marginal Costing and Differential Costing
a)
Marginal cost is a unit concept and applies to
output per unit basis. Whereas Differential cost is a total concept and applies
to a fixed additional quantity of output.
b)
Marginal costing is presented by showing
contribution per unit and fixed cost as a total amount. Whereas Differential
costs are presented in totals in both formats – i.e. under marginal cost as
well as absorption cost techniques.
c)
Product cost under differential cost analysis
may contain fixed costs, which will not be so under marginal costing.
d)
Marginal
Cost can be incorporated in the accounting system but Differential cost is
determined separately from the analysis of accounting records.
e)
In
Marginal Costing Managerial Decisions are based mainly on Contribution. But in
Differential Costing Differential Costs are compared with incremental or
decremental revenues for evaluating managerial decisions.
Absorption Costing Notes for B.Com, BBA and MBA
Introduction to Absorption costing
Variable costing is generally used for the managerial decision making
whereas as per the Generally Accepted Accounting Principles (GAAP), an
organization is bound to use the absorption costing method for financial
reporting purposes.
Advantages and Disadvantages of Absorption Costing System
Advantages of Absorption Costing System
1. Absorption costing recognizes fixed costs in product cost. As it is
suitable for determining price of the product. The pricing based on absorption
costing ensures that all costs are covered.
2. Absorption costing will show correct profit calculation than variable
costing in a situation where production is done to have sales in future (e.g.
seasonal production and seasonal sales).
3. Absorption costing conforms to accrual and matching accounting
concepts which requires matching costs with revenue for a particular accounting
period.
4. Absorption costing has been recognized for the purpose of preparing
external reports and for stock valuation purposes.
5. Absorption costing avoids the separating of costs into fixed and
variable elements.
6. The allocation and apportionment of fixed factory overheads to cost
centers makes manager more aware and responsible for the cost and services
provided to others.
Disadvantages of Absorption Costing System
1. Absorption costing is not useful for decision making. It considers
fixed manufacturing overhead as product cost which increase the cost of output.
As a result, it does not help in accepting specially offered price for the
product. Various types of managerial problems relating to decision making can
be solved only with the help of variable costing system.
2. Absorption costing is not helpful in control of cost and planning and
control functions. It is not useful in fixing the responsibility for incurrence
of costs. It is not practical to hold a manager accountable for costs over which
he/she has not control.
3. Some current product costs can be removed from the income statement
by producing for inventory. As such, managers who are evaluated on the basis of
operating income can temporarily improve profitability by increasing production.
Difference Between Marginal Costing and Absorption Costing
1.
Marginal costing is the practice of charging only variable costs to products,
outputs or processes and absorption costing variable and fixed cost to
products, outputs or processes.
2.
There is no apportionment of fixed costs and they are charged to profit and
loss account under marginal costing. But fixed costs are apportioned and
charged to outputs or processes under absorption costing.
3.
Under marginal costing, inventories or stocks are valued at marginal costs and
under absorption costing they are valued at total costs.
4.
Under marginal costing, the profitability of a product or department is judged
on the basis of the contribution that it gives but under absorption costing it
is judged on the basis of the ultimate profit that it gives.
5.
Under marginal costing, profit is ascertained by deducting fixed costs from
contribution and under absorption costing it is ascertained by deducting total
costs from sales.
Conclusion: After going through this post, you will clearly understood Marginal Cost, Marginal Costing and Absorption Costing. Various Advantages and Limitations of Marginal Costing are also explained. Thanks for regularly viewing our post.
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