Marginal and Absorption Cost

Marginal Cost

  Marginal cost distinguishes between fixed cost and variable cost.

  >> It is an accounting system in which variable costs are charged to cost units and fiexed costs of the period are written-off in full against aggregate contribution. Its special value is in decision making.

 Note : Contribution = Sales - Marginal Cost.

 

Marginal cost = Var. Direct Labour cost +Direct Material +Direct Expenses+ Variable overheads

Explanation:

  If a firm produces X unit at 300$ and X+2 cost 320$, the cost of an additional unit is 20$, ie., Marginal cost = 20$ in this case.

        Additional Cost  20$

Marginal cost/unit =  --------------------- = --------------    =  10$

         Additional Units          2

  Basic principles

1. For a given time, Fixed cost is same, any in production or sales  will affect..

i. Revenue will increase.

ii. Costs will increase by variable cost per unit.

iii. Profit will increase by amount of contribution enarned from the extra item.

2. similarly on decrease on sale

     i. Revenue will decrease .

     ii. Costs will decrease  by variable cost per unit.

     iii. Profit will decrease by amount of contribution enarned from the extra item.

3. So profit analysis should be based on contribution. 

        Note : Contribution = Fixed cost+ profit

                   at Break-even point : Profit will be zero so.  Contribution = FC.

4. when a unit of product is made, extra cost incurred in its manufacture are variable production costs. Fixed costs are unaffected and no extra fixed costs are incurred when output is increased.

Features:

1. Cost Classification:

        MC makes distinction b/w fixed and variable cost. Based on MC, the  production,sales policies are designed by firm.

2. Stock/Inventory

      Under MC, Inventory/stock for profit measurement is valued at marginal cost.

3. Marginal Contribution

MC uses marginal contribution (Sales - MC), it forms basis for judging the profitablity of different products or departments.

Advantages

1. Simple to understand.

2. by not changing fixed overhead to cost of prod, effect of varying charges per unit is avoided.

3. Effects of alternative sales or production policies and decision will be taken.

4.Helps in short-term profit planning .

Disadvantages

1. Separation of costs into fixed and variable is difficult.

2. Exclution of fixed cost from inventories affect profit, and fair view of financial affairs of an organization may not

be clearly transparent.

3. MC data becomes unrealistic in case of highly fluctuating levels of production.