Cost and Management Accounting

# MARGINAL AND ABSORPTION COSTING:Contribution Margin, Marginal cost per unit

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MARGINAL AND ABSORPTION COSTING:Contribution and profit >> Cost & Management Accounting (MGT-402)
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LESSON# 27 & 28
MARGINAL AND ABSORPTION COSTING
(Product costing systems)
Following diagram helps to recall the behavior of different cost elements.
Cost Elements
Direct Material
Direct Labor
Variable & Fixed Cost
Variable Cost
Marginal cost is the cost the variable cost that changes with the production of each next unit.
Marginal and Absorption Costing
So far we have been looking at the various different types of cost and have gradually built up the
total cost of a cost unit by aggregating the cost of direct materials, direct labor, direct expenses,
variable overheads and fixed overheads (absorbed into cost units). We can display this total cost as
part of a profit and loss account (namely cost of sales). In doing so we must remember to adjust
the profit and loss account for any overhead under- or over-absorbed.
This adjustment is only necessary because we are including fixed overheads in the cost of the cost
unit. In other words, we are presenting cost information according to absorption costing
principles. However, there is another method of presenting cost information, i.e. marginal costing.
Marginal Costing
Under this system, we do not attempt to absorb fixed overheads into cost units, and so we avoid
the difficulties of setting absorption rate, adjusting for under or over-absorbed overhead, etc.
Cost units are valued at their marginal cost only (not their fully absorbed cost). In other words the
cost of a cost unit is presented as the total of direct materials, direct labor, direct expenses and
Of course, this does not mean that we can simply ignore fixed overheads It is simply that we
choose to treat all fixed overheads as period costs, rather than trying to attribute them to individual
cost units You will find that this presentation of cost information has distinct advantages over-
absorption costing when it comes to decision making.
A key concept in marginal costing is that of contribution margin.
Contribution Margin is defined as the sales value of a cost unit minus its variable cost.
Absorption and marginal costing
167 Cost & Management Accounting (MGT-402)
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In absorption costing, fixed manufacturing overheads are absorbed into cost units. Thus stock is
valued at absorption cost and fixed manufacturing overheads are charged in the profit and loss
account of the period in which the units are sold.
In marginal costing, fixed manufacturing overheads are not absorbed into cost units, Stock is
valued at marginal (or variable) cost and fixed manufacturing overheads are treated as period costs
and are charged in the profit and loss account of the period in which the overheads are incurred.
Practice Question
A Company produces a single product and has the following budget:
Company Budget Cost Per Unit
Rs.
Selling price
10
Direct materials
3
Direct wages
2
1
Fixed production overhead is Rs. 10,000 per month; production volume is 5,000 units per month.
Calculate the cost per unit to be used for stock valuation under:
(a) Absorption costing
(b) Marginal costing.
Solution
(a) Absorption cost per unit
Rs
Direct materials
3
Direct wages
2
1
Rs 10,000
2
5000 units
Cost per Unit
8
(b) Marginal cost per unit
Direct materials
3
Direct wages
2