Module : 4 Marginal Costing and Absorption Costing

Meaning of Marginal Cost and Marginal Costing

The Chartered Institute of Management Accountants, England defines the terms Marginal
Cost and Marginal Costing as follows :

Marginal Cost: “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,

Note: In this context a unit may be a single article, a batch of articles, an order, a stage of
the change in output in the particular department. It relates to or a production capacity
circumstances under consideration”.

From the above definition of marginal cost, it is clear that the total variable cost is regarded
as the total marginal cost because only variable cost changes with change in output and
fixed cost remains same.

Marginal Costing: “The ascertainment of marginal costs and the effect on profit of
changes in volume or type of output by differentiating between fixed costs and variable
costs.

Note: In this technique of costing only variable costs are charged to operations. Processes
or products, leaving all indirect costs to be written off against profit in the period in which
they arise.” Many times marginal costing and direct costing are treated as synonymous, the
latter term being most popular in U.S.A. But the Chartered Institute of Management
Accountants, England has made the distinction between these two terms by defining direct
costing as follows:

Direct Costing: “The practice of charging all direct costs to operations, processes or
products, leaving all indirect costs to be written-off against profit in the period in which
they arise.

Note: This differs from marginal costing in that some fixed costs could be considered to be
Direct costing in appropriate circumstances.”

Marginal Costing Concept of Profit

The technique of marginal costing assumes that the difference between the aggregate
sales value and the aggregate marginal cost of the output sold provides a fund to meet the
fixed cost and profit of the firm. In respect of each product, the difference between its sales
value and the marginal cost is, technically known as “contribution”, or gross margin made
by the product to this fund. This contribution is the difference between the sale value and
the marginal cost of sales and it contributes towards fixed expenses and profit.
Contribution can be represented as:

Contribution = Selling price – Marginal Cost

Or Contribution = Fixed Expenses ± Profit/Loss
Or Contribution – Fixed Expenses = Profit/Loss

If more than one product are produced, contribution of all products are merged into the
fund out of which fixed expenses are deducted to get the figure of the profit. Following
diagram represents a firm manufacturing three products and shows how individual product
contributions are merged into the fund, the total amount of which should be sufficient to
meet the fixed expenses and provide the desired profit.

Contribution or gross margin is different from the profit which is the net gain in activity or
the surplus that remains after deducting fixed expenses from the total contribution.

IMPORTANCE OF MC

• Marginal cost is an important concept in managerial accounting, as it can help an

Organization optimize its production through economies of scale.
• A company can maximize its profits by producing to where marginal cost (MC)
equals Marginal revenue (MR).
• Fixed costs are constant regardless of production levels, so higher production leads
To a lower fixed cost per unit as the total is allocated over more units.
• Variable costs change based on production levels, so producing more units will add
More variable costs.
• Companies must be mindful of when increasing production necessitates results in
Step costs due to changes in relevant ranges (i.e. additional machinery or storage
Space needed).

Features or Characteristics of Marginal Costing

•It is not a method of costing. It is a technique for marginal decision making

•All cost are classified into fixed and variable. Only variable cost are changed to
product.
• The stock of finished product and work in progress are valued at variable cost.
• Selling price =Variable Cost + Contribution
Contribution = sales – Variable Cost
• The profitability of a product or department is based on contribution made by each
production department.
Objective of Marginal Costing

• To help management in profit planning, cost control and decision making.

• To help in the preparation of flexible budget.
• To determine the maximum sale value to avoid losses.
• To determine the sale value at which the profit goal of the firm will be achieved.
• To evaluate the effect of change in selling price on profitability.
• To evaluate the performance of the organisation.

Applications of Marginal Costing

Marginal costing is a technique of a ascertaining cost used in any method of Costing.

Following are the applications of marginal costing;

1. Fixation of selling price

Price is one of the most significant factor that a determines the market for the products as
well as the volume of profit for the organisation normal circumstances, The price of a
product must cover the total cost of product + margin of profit. However under certain
cases price has to be fixing even below the total cost.

2. Accepting bulk orders or foreign market orders

Some bulk orders maybe received from local dealers or foreign dealers asking for a price
which is below the market price this called for a decision to accept or reject the order. The
orders from local dealer should not be accept below the price of market because it will
affect the goodwill and vice versa from foreign dealers.

3. Profit planning
Profit Planning means planning of future operations. So as to attain maximum profit. These
are four ways to improve profitability of a business.

• By increasing volume of sales

• By increasing selling price
• By decreasing Variable cost
• By decreasing fix at cost

4. Make or buy division

The technique of marginal costing help the management to decide whether to make a
particular product or to buy it from outside such a decision can be taken only by compare
marginal costing of manufacture and the outside price.
 5. Problem of key factor
With the help of marginal costing technique the probability of a product is always measure
with reference to its contribution. The key factor is the factor which a limit the volume of
production and profit of an enterprise. There may be one or more factors like demand,
material, labour, capital, plant etc.

6. Action of a new product

A Production firm may add additional products with the available facility. The new product
is sold in the market at a reasonable price, in order to sell it in large quantities. It may
become popular in Favourable the sale can be increased.

7. Discounting a product

Marginal costing technique shows the contribution of each product to fixed cost and profit.
If a department or product contributes the least unit then the department can be closed its
production or can be discontinued.

8. Cost control
The two types of cost variable and fixed are controllable and a non-controllable
respectively. The variable cost is controlled by production department and the fixed cost is
controlled by the management.

9. Evaluation of performance
Evaluation of performance efficiency of various department or product line can be made
with the help of marginal costing. The management has to discontinue the production of
non profitable products or department. So as to maximise the profit in each such cases,
decision to discontinue will be on the basis of lowest contribution or P/V ratio.

10. Alternative methods of production

Marginal costing is helpful in comparing the alternative method of production machine
work or hand work. The method which give maximum contribution is to be adopted keeping
in mind the limiting factor.

11. Selection of a suitable product mix

It concerns, Which manufactures more than one product may have to decide in what
proportion should these product be produced or sold. The techniques of marginal costing
helps to a great extent in the determination of most profitable product or sales mix.
Cost Volume Profit Analysis (CVP Analysis )

Analysis of three factor cost, volume and profit is known as cost the volume profit analysis
volume effect cost and cost effect profit CVP analysis examine the relationship among
cost, volume and profit. It means variations of cost and volume and their impact on Profit.

According to CVP analysis there is a direct relationship between volume and profit, and
indirect relationship between volume and cost.

Objectives or Uses of CVP Analysis

• To forecast the profit accurately.

• To help management in determining the pricing policy.
• Evaluate the performance of the business.
• To facilitate the preparation of flexible budget.
• To achieve Cost Control and cost reduction.
• To determine break even point.
• To help management in decision making.

Elements Of CVP Analysis

• Marginal cost equation

• Contribution
• Break Even analysis
• Margin of safety
• Profit Volume ratio
• Break even chart

❖ Marginal Cost Equation

For the sake of convenience, the elements of costs can be written in the form of an
equation as follows:

Sales = Variable Cost + Fixed Expenses ± Profit/Loss

Or Sales – Variable Cost = Fixed Expenses ± Profit/Loss
Or S –V = F ± P

where ‘S’ stands for sales, ‘V’ for variable cost, ‘+ P’ for profit and ‘P’ for loss.

Or S – V =C

where ‘C’ stands for contribution (C = F ± p))

To make profits, contribution must be more than fixed expenses and to avoid any loss,
contribution must be equal to fixed expenses.

The marginal cost equation of S – V = F ± P is very helpful to the students in solving

questions on marginal cost because they are able to find any of the four factors, i.e., S, V, F
or P if they know any three of them.

❖ Contribution

Contribution Margin indicates the profit potential of a business firm. Contribution margin is
the excess of sales revenue over variable cost. From contribution margin, when fixed cost
is deducted , the resultant figure gives the amount of profit or loss. Thus contribution
margin is used to cover fixed costs and once the fixed costs are recovered, any remaining
contribution margin adds directly to the profit/loss of the firm. It is most commonly used
technique for planning and decision making,

Contribution per unit = selling price per unit – Variable cost per unit.
Total contribution = Total sale – Total variable cost

As selling price per unit and variable cost per unit are assumed to be constant, CM per unit
also remains constant.

The term contribution margin (CM) is different from the term gross profit. Contribution
margin is the excess of sales over variable cost whereas gross profit is the excess of sales
over cost of goods sold.

Uses or Importance of Contribution

• It helps in fixing the selling price.

• It help to determining break even point.
• It has to find out the probability of various products department etc.
• It guide the management in selecting the profitable product mix or method of
production.
• It help the management in taking may or by decision.
 ❖ Breakeven Analysis

Meaning

This analysis helps management in finding out the relationship revenues to profit. The
important objective of an organisation is usually to earn maximum profit which depends on
a large number of factors, the most important of which are the cost of production and the
volume of sales effected. Both these factors are interdependent Volume of sales depends
on cost of production which in turn depends on volume of production. Cost of production
per unit usually decreases with increase in volume of production because fixed expenses
remain same up to the optimum level of production inspite of increase in volume of
production. There may be change in the level of production due to many reasons, such as
competition, introduction of a new product, trade depression or boom, increased demand
for the product, scarce resources, change in the selling prices of products, change in the
unit cost, etc. In such cases, management wants to know the effect or profit on account of
the changing levels of production. A number of techniques can be used as an aid to
management in this respect. One such technique is the break-even analysis.

In other words, it helps in locating the level of output which evenly breaks the costs and
revenues. Used in its broader sense, it means that system of analysis which determines
profit, cost and sales value at different levels of output. The break-even analysis
establishes the relationship of cost, volume and profits, so this analysis is also known as
‘Cost Volume Profit Analysis’. This analysis furnishes a picture of profit at various levels of
activity and helps in understanding the behaviour of profit in relation to output and sales.
The results of such analysis are usually presented in the form of Break Even Charts.

Break Even Point

A business is said to break even when its total sales value is equal to its total costs. It is the
sales volume at which there is neither profit nor loss, costs being equal to sales value. At
this point of sales, contribution is equal to fixed expenses. The formula for the calculation
of break even point is as follows:

It may be noted that the answer will be in units and not in value because the above formula
of break even point is based on unit cost.
 ❖ Margin of Safety

The margin of safety is the difference between total sales actual or projected) and the
break- even sales. Low BEP may leave a higher margin of safety. It may be expressed in the
monetary terms or as a percentage of actual or projected sales.

Margin of Safety (M/S) = Actual or Sale Projected-Break even sales

(Monetary terms)
Margin of Safety (Units) = Profit/Contribution per unit
Margin of Safety (%) = (Actual sales - Break even sales)/Actual Sales × 100

Margin of Safety con also be calculated with the help of P/V ratio as under:

Margin of Safety (M/S)= profit / ( P/V ratio )

The size of margin of safety is an extremely valuable guide to the strengths of a business. It
indicates by how much sales may decrease before a loss occurs. If luge, this mean, that
there can be substantial falling off sales and yet a profit can still be made. It is a sign of
soundness of business since even with a substantial reduction in sales, profit is earned by
the business. On the other hand, if the margin is small, any loss may be a serious matter.
Low margin of safety implies that reduction in sales even by a small amount may the
profitability of the fires very adversely. Margin of safety serves as an indicator of strength of
the business firm.

Safety is unsatisfactory possible steps to rectify the matters are listed below:

• Increase in the selling price – for this to the possible, the company must be in a very
strong and favorable position. It should be able to influence the price change they.
The demand must be in elastic; otherwise the same quantity will not be sold.
• Reduce fixed cost.
• Reduce variable cost.
• Substitution of existing products (s) by more profit table lines.
• Increase the volume of output.

❖ Profit Volume Ratio

It is used to measure the profitability of the company. Contribution is the excess of sales
over variable cost. So basically P/V ratio is used to measure the level of contribution made
at different volumes of sales.

P/V ratio = Contribution/ Sales

If P/V ratio is to be expressed as a % of sales;

P/V ratio = Contribution / Sale × 100

Contribution = Sales × P/v ratio

Sales = Contribution
P/V ratio

P/V Ratio = Contribution = Change in contribution = Change of profit

Sale Changes in sales Changes in sale

Uses in P/V Ratio

• It helps in the determination of Break-even-point [BEP = Fixed cost P/V ratio]

• It helps in the determination of profit at any volume of sales

[Sales x P/V Ratio = Contribution, Profit = Contribution – Fixed Cost]

• It helps in the determination of sales to earn a desired amount of profit

Sale = Fixed Cost + Desired Profit

P/V Ratio

• It helps in determining the required selling price per unit

Selling price per unit = Variable Cost

(1 – P/V Ratio)

• It helps in determining the variable cost for any volume of sales

Variable Cost = Sales × (1 – P/V Ratio)

• It helps in Compare the Profitability of various product, a high P/V ratio indicate high
profitability and low P/V ratio indicate low profitability.
• With the help of P/V ratio the management can estimate sale, profit and variable
cost of future operations.
• It is useful in taking pricing policy.
• It is important tool in managerial decision making.
Factors influencing P/V Ratio

• Selling Price: It directly influences the P/V ratio. An increase in selling price directly
increases the P/V ratio as it increases the contribution margin assuming per unit
variable cost to remain unchanged. Similarly, a decrease in selling price decreases
the contribution margin and thus the P/V ratio decreases.
• Variable Cost: Variable cost per unit affects the PVV ratio inversely. An increase in
Variable cost decreases P/V ratio as it decreases the contribution margin assuming
per Unit selling price to remain unchanged. On the other hand, a decrease in
variable cost Increases the contribution margin assuming per unit selling price to
remain unchanged and thus P/V ratio is improved.
• Simultaneous change in selling price per unit and variable cost per unit: A
simultaneous increase in selling price and a decrease in per unit variable results in
better P/V ratio and thus improved profitability. A decrease in selling price and an
increase in per unit variable cost results in worse P/V ratio and thus decrease in
profits.
• Product Mix: A change in the product mix has an impact on the P/V ratio for the firm
as whole. If the share of the product with higher P/V ratio in total output and sales.
Increases, the overall P/V ratio will increase. This can be calculated as:

(Total contribution)/(Total Sales) 100

❖ Graphical Representation of Break Even Analysis (Break Even Chart)

A break even chart is a graphical representation of marginal costing. It is considered to be

one of the most useful graphic presentations of accounting data. This chart shows the
inter-relationship between cost, volume and profit. It shows the break-even point and also
indicates the estimated cost and estimated profit or loss.

First Method

On the X-axis of the graph is plotted the number of units produced, sold and on the Y-axis
are show’s caste and sales revenues.

The fixed cost line is drawn parallel to X-axis. This line indicates that fixed expenses remain
the same The variable cost with any volume of production. The variable cost line different
levels of activity are plotted over the fixed cost line. The variable cost line is joined to fixed
cost line at zero volume of production. This line can also be regarded as the total cost line
because it starts from the point where ere fixed cost has been incurred and variable cost
can zero. Sales values at various level of Output are plotted joined and the resultant line is
the sales line. The sales line will cut the total cost line at a point where the total cost are
equal to total revenue and this point of intersection and measuring the horizontal distance
from the zero point – the point of no profit no loss. The number of unit to be produced at the
breakeven point is determined by drawing a perpendicular to the x-axis from the point of
interaction and measuring the horizontal distance from the zero point to the point at which
the perpendicular is drawn. The sales value at break even point is determined by drawing a
perpendicular to the why Axis from the point of interaction and measuring the vertical
distance from the zero point to the point at which the perpendicular is drawn. Loss and
profit are as have been shown in the chart which show that if production is less than the
break even point, the business shall running at a lose and if the production is more than the
break even level, profit shall result.

Second Method

A variation of the first method is that variable cost line is plotted first and then fixed cost
line over the variable cost line. The letter line is the total cost for because it is drawn over
the variable cost line and represents the total cost ( variable and fixed ) at the various level
of output. The method is more helpful to the management for division making because it is
shows the recovery of fixed cost at various level of production before profits are realised.
Contributions at various levels of production are automatically disclosed in the chart.

Third Method

Under this method, the fixed cost line is drawn parallel to the x – axis.

The contribution line is drawn from the origin and this line goes up with the increase in
output. The sales line is plotted as usual. The question of interaction of sales line with cost
line does not arise because the total cost line is not drawn in the method. In this method,
break even point is that point were the contribution line cut the fixed cost line. At this point,
contribution is equal to fix at expenses and the is no profit no loss. If the contribution is
more than the fixed expenses, profit Shark arise and if the contribution is less than the fixed
expenses, loss shall arise.

In this example the recite of Rs 1,00,000 when the output is 50,000 units. At this level of
output, contribution is Rs 2,50,000 (i.e., 50,000 units @ Rs 5), and fixed cost is Rs 1,50,000
resulting in the profit of ₹ 1,00,000 i.e., contribution minus fixed cost.
Arithmetical Verification

Break Even Point = Fixed Expenses

Contribution per unit

= ₹1,50,000 = 30,000 units of output

₹5

Or 30,000 units × Selling price

= 30,000×154,50,000 sales

Profit when the output is 50,000 units

Contribution for 50,000 units @₹5 = ₹ 2,50,000

Less: Fixed Expenses = ₹ 1,50,000

Profit = ₹ 1,00,000
Angle of Incidence

This is the angle formed in the break even chart at the break even point at which the sales
line cuts the total cost line. This angle indicates the rate at which profits are being earned.
Large angle of incidence is an indication that profit are being made at a high rate. On the
other hand, a small angle indicates a low rate of profit and suggests that variable cost form
a major part of cost of production. A large angle of incidence with a high margin of safety
indicates sound business conditions or the most favourable position of a business and
even the existence of monopoly condition. To illustrate a line chart is given below:

Angle of incident (0) is the angle with the total cost line and the total sale line.

Assumptions underlying Break Even Chart

• All costs can be separated into fixed and variable cost.

• Fixed cost will remain constant and will not changing with the change in level of
output.
• Variable costs will fluctuate in the same proportion in which the volume of output
varies i.e., variable cost per unit will remain constant for different level of output and
sales. In other words, prices of variable cost factors i.e., majoring price of material
etc. will remain and changed.
• Selling price will remain constant even through there maybe competition or change
in volume of production.
 • The number of unit produced and sold will be the same so that there is no opening
or closing stock.
• There will be no change in operating efficiency.
• There is only one product or in the case of many products, product mix will remain
unchanged.

Advantages of Break Even Chart

• Information provide by the break even chart can be understood by the management
more easily that contained in the profit and loss account and the coast statement
because a break even chart is the simple presentation of cost, volume and profit
structure of the company. It is summarises a great mass of detailed information in a
graph in such a way that it is significance may be graphs even with a cursory glance.
• Being future-oriented, it serves as a valuable aid in forecasting costs, sales and
profit at various volume of sales.
• It is useful for studying the relationship of cost, volume and profit. The chart is very
useful for taking managerial deficient because it is shows the effect on profit of
changes in variable costs, selling price, volume of sales and fixed costs.
• It is a told for ghost control because it is shows the relative importance of the fixed
costs and the variable cost.
• It helpful in the determination of the sale price which would give a desired profit or
break even point.
• Profitability of various product can be compared with the help of break even chart
and the most profitable mix can be adopted.
• It is helpful in knowing the effect on increase or reduction in selling price.

Limitations of Break Even Chart

• A break even chart is based on a number of assumptions which may not hold good.
Fixed costs assumed to be fixed vary somewhat with a change in the level of output.
Variable costs assumed to be cent per cent variable do not vary proportionately if
the law of diminishing or increasing returns is applicable in the business. Similarly,
sales revenue do not vary proportionately with changes in volume of sales due to
reduction in selling price as a result of competition of increased production.
• A limited amount of information can be shown, in a break even chart. A number of
charts Will have to be drawn up to study the effects of change in fixed costs, variable
costs and selling prices.
• The effect of various product mixes on profits cannot be studied from a single break
even chart.
 • A break even chart does not take into consideration capital employed which is a very
important factor in taking managerial decisions. Therefore, managerial decisions on
the basis of break even chart may not be reliable.

In spite of the above limitations, the break even chart is a useful management device for
analysing the problems, if it is constructed and used by those who fully understand its
limitations

Profit Volume Graph

Profit volume graph is a simplified form of break even chat and is an improvement over the
break even chart as it clearly shows the relationship of profit to volume of sales. This graph
suffers from the same limitation with which break even chart suffers. It is possible to
construct a P/V graph for any data relating to a business from which a break even chart can
be drawn.

Construction of this graph is relatively simple and the procedure of construction is as

follows :

1. Scale for sale on horizontal axis is selected and other scale for profit and fixed cost
on the vertical axis is selected. The area below the horizontal axis is the ‘ loss area ‘
and that about it ‘profit area'.
2. Points of profits of corresponding sale or plotted and joined. The resultant line is the
profit / loss line.

Marginal Costing and Decision Making

Marginal costing is very useful tool for management because of it is following application
and the merits which are given below.

1) Cost control

Marginal costing divides the total cost in to fixed and variable cost. Fixed cost can be
controlled by the top management and that too to a limited extent. Variable cost can be
controlled by the lower level management, marginal costing by concentrating all efforts on
the variable costs can control the cost and thus provide a tool to the management for
control of total cost. There may be situations where the profits of the concern are
decreasing inspite of increase in sales. If the data is presented on the basis of absorption
costing basis the management may not be able to comprehend the results. Marginal
costing analysis will correctly bring out the reason as to why the profits are decreasing
inspite of increase in sale.
Moreover, it should be not that in marginal costing fixed cost are not eliminated at all.
These are Shown separately as the deduction from the contribution instead of merging with
cost of sales and inventories. This help the management to have control on fixed cost and
in the long period as these cost are programmed in advance.

2) Profit planning

Marginal costing help profit planning, i.e., planning the future operations in such a way as
to maximize the profit or to maintain a specified level of profit. Profit of a firm can be
increased by increasing sales volume and selling price, by decreasing variable costs per
unit, by decreasing fixed cost and by following a better sales mix. Absorption costing due to
merging together of fixed and variable costs fails to bring out the correct effect of change in
sale price, sales volume, variable costs or product mix on the profit of the concern.
Marginal costing through the P/V ratio brings out the effect of changes in sale price, variable
costs or protective mix clearly on the profits of the concerns.

3) Decision making

The information provided by the total cost method is not sufficient in solving the
management decision-making, especially in dealing with the problems requiring short-
term decisions where fixed costs are excluded.

Following are important areas where managerial problems are simplified by use of the
marginal costing:

a) Fixation of selling price b) Make or buy decisions c) Assessment of

capital investment plans d) Key or limiting factor e) Effect of change in sales
price f) Maintaining a desired level of profits g) Selection of a suitable
product mix h) Alternative methods of production i) Diversification of
products j) Closing down or suspending activities k) Alternative course of
action l) Level of activity planning m) ) Cost Indifferent Point.

• Fixation of Selling Prices

Although prices are more controlled by market conditions and other economic factors than
by decisions of the management, yet fixation of selling price is one of the most important
functions of management. This function is to be performed:

(a) Under normal circumstances (b) In tires of competition (c) In times of trade
depression (d) In accepting additional orders for utilizing idle capacity
(e) In exporting and exploring new markets (f) Quotation in a jobbing undertaking
In normal circumstances, the price fixed must cover total cost as otherwise profits cannot
be earned. It can also be fixed on the basis of marginal cost by adding a high margin to
marginal cost which may be sufficient to contribute towards fixed expenses and profits. But
under other circumstances, product may have to be sold at a price below total cost, if such
a step is necessary to meet the situation arising due to competition, trade depression,
additional orders for utilising spare capacity, exploring new markets etc. Thus, in special
circumstances, price may be below the total cost and it should be equal to marginal cost
plus a certain amount (if possible). Pricing in Depression. Prices fall during depression and
the product may be sold below the total cost. In case there is a serious but temporary fall in
the demand on account of depression leading to the need for a drastic reduction in prices
temporarily, the minimum selling price should be equal to the marginal cost. If the selling
price at which the goods can be sold is equal to marginal cost or more than marginal cost,
the product should be continued. Fixed expenses will be incurred even if the product is
discontinued during depression for a short period. If the product can be sold at a price
which is a little more than marginal cost, loss on account of fixed expenses will be reduced
because price will recover fixed expenses to some extent.

Concept of Absorption Costing

Absorption costing is a costing technique in which all manufacturing costs, whether fixed
variable, are considered while valuing inventories and determining cost of production,
Absorption costing is also known as full costing and this is one of the traditional methods
for determining value of inventory and cost of production. As the name suggests this is a
technique in which we absorb the fixed manufacturing cost for the number of units
produced.

Absorption of fixed cost is done by an absorption rate which is obtained by dividing the
fixed cost by budgeted number of units. In this technique there can be over and under
absorption of fixed manufacturing costs as absorption is done. Through a fix per unit rate
for the number of unit produced. If the number of units produced is less than the budgeted
units then. Shall have under absorption of fixed manufacturing cost and vice-versa. This
over/under absorbed cost is adjusted while preparing the income statement If it is over
absorption, number of units produced more than budgeted, then we shall deduct the over
absorbed amount from the cost of production and vice versa.

The net profit ascertained under the absorption costing method will not be the same as
under the marginal costing method because of:

a. Difference in Stock Valuation: Stock of work-in-progress and finished goods are

valued at marginal cost not including fixed costs under the marginal costing method
 whereas in the absorption costing or total cost method, they are valued at cost of
production which includes fixed costs. In other words, the valuation of stocks will be
done at lower figure in the marginal costing method as compared to the total cost
method, therefore, profits under these two methods of costing will differ.
b. Over- or Under-absorption of Overheads: In absorption costing method, there can
never be hundred per cent absorption of fixed overheads because of the difficulty in
forecasting costs and volume of output. There will be either over-absorption or
under-absorption, whereas in the marginal costing method, the actual amount of
fixed overheads is wholly charged to Profit and Loss Account. Hence, profits under
the two methods will differ.

Advantages of Absorption Costing

Following are the main advantages of absorption costing:

a) It suitably recognises the importance of including fixed manufacturing costs in

product cost determination and framing a suitable pricing policy. In fact all costs
(fixed and variable) related to
b) It is consistent with the matching concept in in which manufacturing costs of sales
are matched with the sales revenue. This is why financial reporting standard
requires absorption costing.
c) A facilitates cost-plus pricing strategy. In the long run for survival and profitability,
prices must cover fixed costs
d) It avoids separation of costs into fixed and variable which cannot be easily and
accurately done.
e) The presentation of over/under absorption of factory overheads discloses inefficient
or efficient utilisation of production resources which is not possible in variable
costing.
f) It provides awareness to the managers about the overheads for different
departments through the allocation and apportionment of fixed manufacturing
overheads.

Limitation of Absorption Costing

a) Difficulty in comparison and control of cost: Absorption costing method is

dependent on level of output, so different unit costa are obtained for different levels
of output. An increase in the volume of output normally results in reduced unit cost
and a reduction in output results in an increased cost per unit due to the existence
of fixed expenses. This makes comparison and control of cost difficult and obscures
cost-volume-profit relationship.
b) Not helpful in managerial decisions: Absorption costing is not very helpful in
taking managerial decisions such as selection of suitable product mix, whether to
buy or manufacture, whether to accept the export order or not, choice of
alternatives, the minimum price to be fixed during the depression, number of units
to be sold to earn a desired profit etc. In all such decisions, the technique of
marginal costing is suitable because it takes into consideration the additional cost
involved (Le., variable expenses) only assuming fixed expenses remaining constant.
c) Cost vitiated because of fixed cost: Under absorption costing method, a portion of
fixed cost is carried forward to the next period because closing stock is valued at
cost of production which is inclusive of fixed cost. In marginal costing technique, it
is not so because all fixed expenses of a particular period are deducted from the
fund (i.e., total contribution of various products) for arriving at the figure of profit.
Therefore, in marginal costing technique, costs pertaining to a particular period are
not vitiated as they are vitiated in absorption costing method because in absorption
costing method all fixed costs are not charged against the profit of the year in which
they are incurred.
d) Profit of a particular period will be affected by the amount of overheads absorbed
into closing inventories or charged against the next period when opening inventories
are used in the next period’s production or are sold.
e) Fixed cost inclusion in cost not justified: Many accountants argue that fixed
manufacturing, administration and selling and distribution overheads are period
costs and do not produce future benefits and, therefore, should not be included in
the cost of product.
f) Apportionment of fixed overheads on arbitrary methods: The validity of product
costs under this technique depends on correct apportionment of overhead costs.
But in practice many overhead costs are apportioned by using arbitrary methods
which ultimately make the product costs inaccurate and unreliable.
g) Not helpful for presentation of flexible budget: Under absorption costing no
distinction is made between fixed and variable costs. It is not possible to prepare
flexible budget without making this distinction. Flexible budget is very important for
control function.
h) In decision making process: In absorption costing, fixed overheads are assigned to
products by establishing overhead absorption rates based on budgeted or normal
output. By using absorption costing principles, it is possible for profit to decline
when sales volume increases. If the stock levels fluctuate significantly, profits may
be distorted because stock changes will significantly affect the amount of fixed
 overheads allocated to a period. If profits are measured on monthly or quarterly or
on periodical basis, seasonal variations in sales may cause significant fluctuations
in profits. Internal profit statement on monthly or quarterly basis are used for
measuring the managerial performance. In the circumstances, managers may
deliberately actor inventory levels to influence profit if absorption costing is used.
When sales are less and the closing inventory increases, a part of the pixel
overheads constraint in the value of the closing stock is reduced from the fixed
costs allocated to production for the period. Thus if sales are reduced, inventories
will increase and absorption cost post higher profit. Similarly if sales are increased
as compared to production, inventories will be reduced and absorption costing will
return lower profits.

Difference between Absorption Costing and Marginal Costing

 • Make or Buy Decision

Management sometimes may be confronted with the problem of making a choice between
manufacturing the component parts of a product or buying them from outside. Such a
problem will arise when the firm has the idle capacity and the technical capacity of
manufacturing the component parts. In arriving at such a make or buy decision, qualitative
and quantitative factors relating to the problem will be taken into consideration. The
quantitative factors to be considered are the differential costs of the make and buy
alternatives and the consequences of the alternative uses of the idle capacity which exists
in the firm. The relevant costs of buying the component part will include the purchase price
and other costs related to purchasing the component part.

Similarly, costs relevant for make decision will include the variable cost of making the
component and fixed costs which are avoidable if the component is not made. Fixed costs
which are not expected to change would be ignored being irrelevant in the make or buy
decision. Management should compare the differential cost of the two alternative and
follow the course which is cheaper one. It should also be seen that if a more profitable use
of the idle capacity than manufacturing the component part is available, then the firm may
use the idle capacity for the more profitable alternative and buy the component part from
outside. For example, the total cost of making a component part comes to ₹8, consisting of
₹6 as variable cost and ₹2 as fixed cost. Suppose further an outside supplier is ready to
supply the same component part at ₹7. On the basis of total cost method, it appears that it
is cheaper to buy the component. But on the basis of marginal cost, the offer of the outside
supplier should be rejected because the acceptance will mean that the total cost of the
purchased part from the outside supplier will come to₹9 i.e., 7 (supplier’s price) plus ₹2
(fixed cost which cannot be saved even if the component is purchased from outside
source).

Important Factors in Make or Buy Decisions

a) Process Available in-house

If the necessary process is not available then the decision is “to buy”. (There may be some
exceptions, like in the long-run, company may decide to use a new technology, which is
currently not used in-house)

b) Production Quantity
Number of units are Important. High volume favours “make”, while low volume favours
“buy” decision.

c) Product Life
Long product life favours in-house production (make).

d) Standard Items
Catalog items (like bolts, screws, nuts etc.) are produced by specialized producers (they
generally produce in cheapest manner). It is better to “buy” those components.

e) Alternative Source
Sometimes factories may “buy” some parts from vendors, as an alternative source to
ensure an uninterrupted supply of parts in their production plan.

❖ Make or Buy Decision when there increasing fixed cost

In some cases in spite of lower variable cost of production, there may be an increase in
fixed costs. It becomes essential to final out the minimum requirement of volume in order
to justify the making instead of buying. This volume can be calculated by the following
formula:

Increase in fixed costs

Contribution per unit (i.e., Purchase price – Variable cost of production)

❖ Make or Buy Decision when there is NO idle capacity

If there is no idle capacity and making of the spare part in the factory involved the loss of
other work, the loss of contribution arising from displacement of work should be
considered along with variable cost of production. The loss of contribution is found with
reference to key or limiting factor. If the Purchase prices higher than the total of variable
cost of protection plus traceable fixed costs plus the loss of contribution of production, it
will be more profitable to manufacture.
 ❖ Sales Mix Determination
Any business firm which manufactures more than one product generally faces a decision
problem as to in what proportion the products should be manufactured and sold i.e., what
should be the composition of its sales mix. In other words, the firm has to decide as to how
much quantity of which product should be manufactured and sold. The CVP analysis
technique helps in determining the best sales mix. The best suitable sales mix is one which
gives the maximum contribution. Here, contribution under various sales mix is computed
and compared and the sales mix giving the maximum contribution is selected.

Selection of suitable product mix

When a factory manufacture more than one product, a problem is faced by the
management as to which product mix will give the maximum profits. The best product mix
is that which yields the maximum contribution. The products which give the maximum
contribution are to be retained and their production should be increased to the extend of
their demand in the market and their capacity of production. The products which you
comparatively less contribution should be reduced day or closed down altogether. The
effect of sales mix can also be seen by comparing the P/V ratio and break even point. The
new sale mix will be favourable if it is increased the P/V ratio and reduce the break even
point. However, management should keep in view the effect of new sales mix on physical
and financial resources of the organisation and arrange them accordingly.

• Key (or limiting)Factor

A key factor is that factor which puts a limit on production and profit of business. Usually
this limiting factor is sale. A concern may not be able to sell as much as is can produce. But
sometime a concern cancel all it produces but production is limited due to the shortage of
materials, labour, plant capacity, or capital. In such a case, decision has to be taken
regarding to choice of the product whose production is to be increased, reduced or
stopped. Ordinary when there is no limiting factor, the choice of the product will be on the
basis of the highest P/V ratio. But when there are scare or limited resources, selection of
the product will be on the basis of contribution per unit of scare factor of production. In
short, scare resources Should be utilised in those direction where contribution per unit of
limited resources is the maximum. For example, materials are limited in supply and
product X and Y use the same materials. Three units of material are used for producing
product X and five for Y. Suppose further contribution per unit is ₹12 in case of product X
and ₹15 in case od product Y. In this case, contribution per unit of materials is ₹4 (i.e.,
₹12/3) in case of product X and ₹ 3 (₹15/3) in case of product Y. Hence the material should
first be used for manufacturing product X up to limit of demand for it and then the balance
of materials ( if any) for Y because product X yields more contribution per unit of scare
resources i.e., materials.

As mentioned earlier, usually limiting factor is sale. Therefore, in addition to limiting factor
from the production side, limiting factor may also be difficulty in selling the items
produced. In such a case ranking of items produced will be based on relative contribution
for unit of limiting factor of production but the number of units of a product to be produced
getting rank one will be restricted to the number of units as per demand for that protecting
and then the production of the other product getting second rank will be done but
restricted to sales demand if balance of limiting factor is available and so on.

If the number of limiting productive factor is more than one and the ranking given by
contribution per unit of limiting factor conflicts with that given by the contribution per unit
of another limiting and factor, the problem of taking decision becomes complicated
Limiting factor. Mathematical technique like linear programming are to be applied for
handling such a type of problems.

Ascertainment of cost under marginal costing and absorption costing

The ascertainment of cost under marginal costing and absorption costing varies in how
fixed overheads are treated. Here is a brief overview of both methods:

1. Marginal costing
Under marginal costing, the cost of production is ascertained by considering only the
variable production costs, which can change with the level of production. These variable
costs typically include direct materials, direct labor, and variable overhead.

To ascertain the cost under marginal costing, the following steps are typically followed:

a. Identify and separate the variable costs from the fixed costs. Variable costs are
directly attributable to the production of each unit, while fixed costs remain
constant regardless of the level of production.
b. Calculate the total variable production costs by summing up the direct materials,
direct labor, and variable overhead for the production output.
c. Divide the total variable production costs by the number of units produced to
determine the variable cost per unit.
d. Multiply the variable cost per unit by the number of units produced to obtain the
total variable production cost for the production output.

By following these steps, the cost under marginal costing is ascertained based on the
variable production costs, providing a clearer view of the cost structure and aiding in
decision-making related to pricing, production levels, and profitability analysis.
 2. Absorption Costing
Absorption costing is a costing method that includes all manufacturing costs in the cost of
a product, including direct materials, direct labor, variable manufacturing overhead, and
fixed manufacturing overhead. To ascertain the cost under absorption costing, the
following steps can be followed:

a. Calculate the direct materials cost: This includes the cost of all materials used in
the production of the product.
b. Calculate the direct labor cost: This includes the cost of all labor directly involved in
the production of the product.
c. Calculate the variable manufacturing overhead cost: This includes the cost of
variable manufacturing overhead expenses, such as utilities and indirect materials,
which vary with the level of production.
d. Calculate the fixed manufacturing overhead cost: This includes the cost of fixed
manufacturing overhead expenses, such as rent and depreciation, which do not
vary with the level of production.
e. Add all the above costs together to ascertain the total cost under absorption
costing.
f. Divide the total cost by the number of units produced to ascertain the cost per unit
under absorption costing.

By following these steps, a business can ascertain the cost under absorption costing,
which includes all manufacturing costs in the cost of the product. This information is
useful for pricing decisions and financial reporting purposes.

ACCEPTING SPECIAL ORDERS, BULK ORDERS, ADDITIONAL ORDERS, EXPORT

ORDERS AND EXPLORING NEW MARKETS

Bulk orders, additional orders and orders from foreign or new markets, may be accepted at
a price below the normal market price so as to utilise the idle capacity. Such orders are
received usually asking for a price below the market price and hence a decision is to be
taken to accept or reject the order. The order may be accepted at any price above the
marginal cost because the fixed costs have to be incurred even otherwise. Any contribution
resulting from the additional sales would mean an additional profit. But care must be taken
to see that accepting an order below the market price does not affect the normal selling
price adversely. For example, an order from a local merchant should not be accepted at a
price below the normal market price because it will affect the relationships with other
customers buying at a normal price. But, if it is a foreign order, it may be accepted at a price
below the normal price keeping in view the additional costs of exporting, if any and direct
and indirect benefits of exporting such as, goodwill, subsidies, quotas, etc.

Determining optimum level of activity

Marginal costing is a cost accounting method that focuses on analyzing the impact of
changes in activity levels on the cost of production. It includes only variable costs in the
cost of goods sold and treats fixed costs as period costs.

To determine the optimum level of activity using marginal costing, the following steps can
be followed:

a. Identify the variable and fixed costs associated with the production process.
b. Calculate the contribution margin, which is the difference between sales revenue
and variable costs. This shows how much each unit sold contributes to covering
fixed costs and generating profits.
c. Determine the breakeven point, which is the level of sales at which total
contribution margin equals total fixed costs. This helps in understanding the
minimum level of activity required to cover all fixed costs.
d. Conduct sensitivity analysis to assess the impact of changes in activity levels on the
contribution margin and overall profitability. This can help in identifying the point at
which additional production becomes unprofitable due to increasing variable costs
or decreasing sales prices.
e. Use cost volume profit (CVP) analysis to assess the relationship between sales
volume, costs, and profits. This can help in determining the optimum level of activity
that maximizes profits by considering the trade-off between higher sales volumes
and increasing variable costs.

By following these steps, companies can use marginal costing to determine the optimum
level of activity that maximizes profits and helps in making informed decisions about
production levels and pricing strategies.