Page 94 - DMGT202_COST_AND_MANAGEMENT_ACCOUNTING

Unit 6: Marginal Costing and Absorption Costing

Notes
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Caution This technique is called traditional costing, as this system of costing emerged from
the beginning of the factory stage. In this technique, “fixed cost” refers to the closing stock of

material held by the firm. These are charged against the sales later, as a part of the goods sold.

6.3.1 Income Determination under Marginal and Absorption Costing

Under marginal costing, only factory overheads costs that tend to vary with volume are charged
to product cost in addition to prime cost. While evaluating inventory only direct materials, direct
labour and variable factory overheads are included and are considered as product costs. Fixed
factory overheads under direct or marginal costing are not included in inventory. It is treated as
a period cost and charged against revenue when incurred. Under absorption costing, sometimes
called full or conventional costing, all manufacturing costs, both fixed and variable are charged

to product costs. Thus, absorption costing is “a principle whereby fixed as well as variable costs

are allotted to cost units”. It means a system under which cost per unit includes fi xed expenses,
especially fixed production overheads in addition to the variable cost.

The following format gives an idea as to how income is arrived at in marginal costing techniques.

Absorption Costing ` Marginal Costing `
Sales Revenue Sales Revenue
Less: Manufacturing Less: All variable

expenses (both fixed and variable) costs (both production and non-production)
Gross profi t. ... Contribution
Less: Non-production Less: All fi xed
costs (both fixed and variable) ... costs (both production and non-production)

PBT PBT
Less: Tax Provision Less: Tax Provision ...
Net Income Net Income

6.3.2 Absorption Costing and Marginal Costing Compared

Since the closing stocks do not have any element of fixed costs, profit shown by marginal costing
technique may be different from that shown by absorption costing. When the entire stock is

sold, there is no inventory i.e., neither there is opening nor closing stock, the profit revealed by
both the methods will be same. But when sales and production are out of balance, difference
in net profi t is reported. When absorption costing is applied, the fi xed manufacturing costs are
shifted from one year to another year as a part of the inventory cost i.e. stock. If a company
produces more than it sells in a given period, not all of the current manufacturing overheads
will be deducted from sales i.e., closing stock will include a portion of fixed overheads. In other

words, in absorption costing, inventory will be valued at a higher figure; therefore, profit will be

more as revealed by absorption costing than marginal costing. Hence, profits will not necessarily
increase with an increase in sale value. The position will be reverse, in case a company produces

less than it sells in a given period. Thus, marginal costing can produce a net profi t figure which is

similar than or greater than or equal to the net profit as shown under absorption costing.

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