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

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Cost & Management Accounting (MGT-402)

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

Factory Overhead Cost

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

variable overheads (but not fixed overheads).

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

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Cost & Management Accounting (MGT-402)

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

Direct materials

Direct wages

Variable overhead

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

Direct materials

Direct wages

Variable overhead

Absorbed fixed overhead

Rs 10,000

5000 units

Cost per Unit

(b) Marginal cost per unit

Direct materials

Direct wages

Variable overhead

Cost per Unit

The stock valuation will be different for marginal and absorption costing. Under absorption

costing stock will include variable and fixed overheads whereas under marginal costing stock will

only include variable overheads.

Further practice question explaining the concept of product cost, period cost and cost per unit

under two product costing systems:

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