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Marginal and absorption costing of income statements

Marginal costing Basic idea The marginal cost of an item is its variable cost. The marginal production cost of an item is the sum of its direct materials cost, direct labour cost, direct expenses cost if any and variable production overhead cost.

  • Being a manager, you constantly strive to relate these elements in order to achieve the maximum profit;
  • But then, cost is based on the following factors;
  • When production and sales are equal i;
  • This is because fixed overhead brought forward in opening inventory is released, thereby increasing cost of sales and reducing profits;
  • In this case, selling price remains fixed, fixed remains fixed and then there is a change in profit.

So as the volume of production and sales increases total variable costs rise proportionately. Fixed costs, in contrast are cost that remain unchanged in a time period, regardless of the volume of production and sale. Marginal production cost is the part of the cost of one unit of production service which would be avoided if that unit were not produced, or which would increase if one extra unit were produced.

From this we can develop the following definition of marginal costing as used in management accounting: Marginal costing is the accounting system in which variable costs are charged to cost units and fixed costs of the period are written off in full against the aggregate contribution.

Note that variable costs are those which change as output changes - these are treated under marginal costing as costs of the product.

  1. For this reason, the contribution concept is frequently employed by management accountants. Marginal production cost is the part of the cost of one unit of production service which would be avoided if that unit were not produced, or which would increase if one extra unit were produced.
  2. Absorption costing is a method of building up a full product cost which adds direct costs and a proportion of production overhead costs by means of one or a number of overhead absorption rates. The presentation of information through marginal costing statement is easily understood by all mangers, even those who do not have preliminary knowledge and implications of the subjects of cost and management accounting.
  3. Where production is more than sales.

Fixed costs, in this system, are treated as costs of the period. Marginal costing is also the principal costing technique used in decision making.

Marginal Costing (Variable Costing) Income Statement – Format:

The key reason for this is that the marginal costing approach allows management's attention to be focussed on the changes which result from the decision under consideration. The contribution concept The contribution concept lies at the heart of marginal costing.

Contribution can be calculated as follows. For this reason, the contribution concept is frequently employed by management accountants. Contribution gives an idea of how much 'money' there is available to 'contribute' towards paying for the overheads of the organisation.

At varying levels of output and sales, contribution per unit is constant.

Explanation with Solved Examples:

At varying levels of output and sales, profit per unit varies. The fixed costs actually incurred are deducted from contribution earned in order to determine the profit for the period. Absorption costing is a method of building up a full product cost which adds direct costs and a proportion of production overhead costs by means of one or a number of overhead absorption rates. Absorption costing income statement Valuation of inventory - opening and closing inventory are valued at full production cost under absorption costing.

Your FeedbackWe value your feedback on the topics or anything else you have found on our site, so we can make it even better. Give Feedback The effect of absorption and marginal costing on inventory valuation and profit determination Marginal costing values inventory at the total variable production cost of a unit of product.

Absorption costing values inventory at the full production cost of a unit of product. Inventory values will therefore be different at the beginning and end of a period under marginal and absorption costing.

Preparation of Income Statement under Marginal and Absorption Costing

If inventory values are different, then this will have an effect on profits reported in the income statement in a period. Profits determined using marginal costing principles will therefore be different to those using absorption costing principles.

  • Management has no control over market;
  • Other fixed expenses Rs;
  • 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;
  • 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;
  • Volume of production Internal efficiency and the productivity of the factors of production Methods of production and technology Size of batches Size of plant Thus, one can say that cost-volume-profit analysis furnishes the complete picture of the profit structure.

Reconciling profits reported under the different methods When inventory levels increase or decrease during a period then profits differ under absorption and marginal costing.

If inventory levels increase, absorption costing gives the higher profit. This is because fixed overheads held in closing inventory are carried forward thereby reducing cost of sales to the next accounting period instead of being written off in the current accounting period as a period cost, as in marginal costing. If inventory levels decrease, marginal costing gives the higher profit. This is because fixed overhead brought forward in opening inventory is released, thereby increasing cost of sales and reducing profits.

If inventory levels are constant, both methods give the same profit.

Cost and Management Accounting

The advantages and disadvantages of absorption and marginal costing Advantages of marginal costing Advantages of absorption costing Contribution per unit is constant unlike profit per unit which varies with changes in sales volumes There is no under or over absorption of overheads and hence no adjustment is required in the income statement.

Fixed costs are a period cost and are charged in full to the period under consideration Marginal costing is useful in the decision-making process It is simple to operate Absorption costing includes an element of fixed overheads in inventory values in accordance with SSAP 9.

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