Marginal and Absorption Costing  
                                                    Marginal costing 
               Marginal costing is a costing method that uses only variable costs to calculate the costs of 
               production  and  excludes  the  fixed  production  overhead  costs  in  the  calculation  of  cost  of 
               production i.e. it uses only the direct costs (which are also called variable costs, prime costs or 
               relevant costs) to calculate the cost of production. 
                
                 The marginal costing method is based on the following fundamental principles:
               
                        Cost of production only includes all variable costs i.e. all costs that can be traced 
                        directly to the production units, because without those costs production is not possible 
                        and hence, those costs are very important to the goods produced. 
               
                        Fixed overhead costs (also known as production overhead costs) are costs that must 
                        be incurred with or without production activities, and are excluded when calculating 
                        the cost of production because the overhead cost do not affect the production decision 
                        on goods to be produced, especially in the short run. 
               
                        Under marginal costing, the fixed production overhead costs are written off in full as an 
                        overhead period expense, when preparing the profit or loss statement to derive the 
                        profit or loss at the end of the period. See preparation of profit or loss statement later 
               
                 The key element in marginal costing is the assertive treatment and clear distinction between 
                   variable and fixed production overhead costs.
               
                 Under the marginal costing method, unit cost of production is calculated as below:
                                                           
                    Marginal unit cost of production       
                                                           £ 
                                                           
                    Direct material                       xx 
                                                           
                                                           
                    Direct labour                         xx 
                                                           
                    Direct expenses i.e. any other                         Marginal cost of production is also 
                                                                              called variable cost of 
                                                          xx
                    variable cost                          
                                                                            production, and also known as 
                                                                               
                       Prime cost (i.e. total variable    xx                  contributory method 
                           cost of production)             
                
               The marginal costing method is always used in the decision-making process such as make or 
               buy decisions, deciding on number of goods to produce in the presence of a limiting factor and to 
               derive minimum contract price. (See chapter 5 later) 
                
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               Marginal and Absorption Costing  
                
                
                
                
                
                
                
                
                
                
               3.1 Illustrative Q 
                
                
               Azeez plc wishes to estimate the unit cost of a proposed new product based on the following 
               information 
                
               1.  Estimated costs 
                
                              Direct material            3.5 kg per unit at £4.00 per kg 
                
                              Direct labour              0.45 hour per unit at £9.00 per hour 
                
                              Other direct expenses      £1.5 per unit 
               2.  Fixed production overhead costs are budgeted at £80,000 for the next period with a 
                   budgeted activity level of 7,500 direct labour hours. 
                
                
               Required: 
                
               Calculate the unit cost of the proposed new product using a marginal costing approach. 
                
                
                
                
                
               3.1b ACCA CAT Paper B2 Cost Accounting Systems J03 
                
                
               A company uses marginal costing. In valuing stocks of finished goods which of the following 
               would NOT be included in the valuation? 
                
                   A.  Machine operator’s wages 
                   B.  Factory rent 
                   C.  Royalty fees per unit 
                   D.  Raw materials 
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                                                                                                                                                       Marginal and Absorption Costing  
                                                                                                                                                        
                                                                                                                                                        
                                                                                                                                                        
                                                                                                                                                        
                                                                                                                                                        
                                                                                                                                                       3.1 Solution 
                                                                                                                                                        
                                                                                                                                                        
                                                                                                                                                       Estimated unit cost of the proposed new product under marginal costing 
                                                                                                                                                        
                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                           Unit 
                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                   
                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                  
                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                          cost (£) 
                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                  
                                                                                                                                                                                                                                                                                                  Direct material: (3.5 kg per unit at £4.00 per kg)                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                      14.00    
                                                                                                                                                                                                                                                                                                  Direct labour: (0.45 hour per unit at £9.00 per hour)                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                   4.05      
                                                                                                                                                                                                                                                                                                  Direct other expenses                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                   1.50      
                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                         
                                                                                                                                                                                                                                                                                                                                                                                                                                                                       Marginal cost per unit                                                                                                                                                                                                                                                                                                                                                                                                                                           19.55    
                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                  
                                                                                                                                                        
                                                                                                                                                       Note 
                                                                                                                                                        
                                                                                                                                                       The marginal cost is also called prime cost and total variable cost 
                                                                                                                                                        
                                                                                                                                                                                    Also note the exclusion of the production overhead cost in the above calculation, even 
                                                                                                                                                                                    though the question gave some information on the fixed production overhead cost, it is 
                                                                                                                                                                                    always ignored at this stage of the calculation of the unit cost, until later, when calculating 
                                                                                                                                                                                    profit or loss using marginal costing principles. (see later) 
                                                                                                                                                        
                                                                                                                                                        
                                                                                                                                                        
                                                                                                                                                        
                                                                                                                                                        
                                                                                                                                                       3.1b Solution 
                                                                                                                                                        
                                                                                                                                                        
                                                                                                                                                       Machine operator’s wages, royalty fees per unit, raw materials are all direct costs and are included 
                                                                                                                                                       in the valuation of the stocks of finished goods but the factory rent is an overhead and would NOT 
                                                                                                                                                       be included in the valuation. 
                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                      Option B is correct
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        Marginal and Absorption Costing  
         
         
         
         
         
                  Benefits of marginal costing method (advantages) 
          Helps in product decision making process: Marginal costing is useful in the short-term 
          decision-making on product, such as product mix decision, discontinued decision etc. All 
          these areas of decision are always based on analysis of costs that directly affect the 
          production of goods. 
          Useful in the calculation of the minimum price: It is very useful in calculating relevant 
          costs of a product when deriving minimum price charged for a product, as the calculation of 
          the minimum price is always based on the analysis of all direct costs of production 
          Usefulness in other areas of study: marginal costing method is useful in other areas of 
          study such as cost-volume-profit analysis (popularly known as CVP analysis). The analysis 
          makes use of contribution to calculate the breakeven sales i.e. a level of activity where 
          there is neither profit nor loss. In the analysis, contribution is calculated as “selling price 
          less variable costs” hence, knowledge of marginal costing will be of help in gathering the 
          variable costs elements. 
          Meeting profit target: marginal costing method is also useful when using CVP analysis to 
          calculate the volume of sales required to meet a target profit 
         
                   Criticisms of marginal costing (disadvantages) 
          Planning and controlling of cost problem: Marginal costing places too much emphasis on 
          direct costs and pays cursory attention to the fixed production overhead costs which may not 
          be of help to the managers in planning and controlling of fixed production overhead costs 
          from the beginning of the production process. In reality, all costs must be planned and 
               
          controlled.
        
          Problem of application in an automated production environment: marginal costing 
          method  is  not  appropriate  in  an  automated  production  system  where  fixed  production 
          overhead costs are far higher than the direct costs. Since the method does not consider the 
          fixed production overhead cost at the beginning, when gathering the costs of production, 
          important costs may be considered too late.
        
          Confusion on treatment of overhead cost: The management team may be under the 
          illusion that the marginal costing method completely ignores fixed production overhead costs, 
          which may lead to confusion and argument later when calculating the profit or loss at the end 
                
          of the period.
        
          Price quotation problem: the marginal  costing  method may  not  be  suitable  for  price 
          quotation of jobs or contracts that involve huge overhead cost, since the overhead costs are 
          ignored at the early stage of the calculation of the total costs
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