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Absorption Costing

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When a production process is undertaken, there are a number of financial aspects associated with it. It is based on those initial financial aspects that profits incurred, and further investments are determined. In this regard, both total and variable costs are of prime importance, and it is the segregation of those that results in getting a financial statement that deduces the final cost associated results.

Hence, it is imperative that certain terms associated with finance are understood, and its practical applications are seen as well.

Understanding Absorption Costing:

Speaking on a general note it can be termed as computing of cost of a product by taking into account both direct costs as well as indirect expenses.However, seen from a practical point of view, fixed overheads cannot be absorbed completely due to problems associated with choosing out the costs and volume of a product.

As per The Institute of Cost and Management Accountants (U.K), this costing is a format that includes charging of variable and fixed costs operation, process and products. It is also termed as full costing method.

Marginal Costing: Its applications:

The technique of marginal costing is used to find cost per unit to a certain level of output.

Some of its primary functions include:

  • Profit Planning:

The primary function of a production firm is to generate a certain amount of profit so that it can carry on with its production process. Hence, planning for a certain profit level is part of its operational planning, and with help of marginal costing contribution ratio can be computed.

However, on a general note profits are affected by factors as total fixed costs, selling price, marginal cost per unit and volume of sales. With a change in any of these aspects, one can notice a change in profit quantity.

  • Profit Volume Ratio:

As one of the most important tools for studying profitability of business and expressed in percentage, the ratio of contribution/income to sales is known as profit volume ratio.

  • Break Even Point:

This is that point in sales volume where total revenue is equal to total costs. At this point, total production costs revived and are known as no loss or no gain point.

When sales of a company exceed this break-even point, that company incurs profit, whereas, for sales below this point, company incurs a loss.

Break Even Point = Income =Expenditure.

Break = Divide

Even = Equally

Point = Position

Other aspects associated with this marginal costing:

  • Decision to purchase:

This is the most important factor since costs should never exceed the profits that are incurred. At times, it may so happen that certain products have to be purchased by a firm from some external sources. In those cases, it should be seen that marginal costs should be lowered. If marginal cost incurred from an external source is higher, it should be produced within the firm itself.

Also acting as a price-fixer, in case price is equal to marginal price, firm has to face loss if the competitors are not removed, and there is strict competition.

  • Maintaining a certain level of profit:

The primary aspect of business is generating profit via sales of units. However, at times there can be certain issues such as lowering of price and restrictions on sale of that product due to government policies or market demands.

With help of marginal costing techniques that particular firm can determine what amount to be sold to maintain the profit level.

  • Checking out the performance:

Operational efficiency of sales department can be determinedwith help of marginal costing. Those with high P/V ratio have the best performance.

  • Making the margin of safety:

Subtracting the actual sales/production over break-even production gives margin of safety. With marginal costing technique, a detailed monetary aspect can be understood for garnering profits.

  • Fixing the selling price:

While setting the price for a particular product, certain factors as labor cost, cost of raw materials, and a host of overheads are to be added. It is based on total costs incurred by the firm that price of a certain product is set.

Marginal costing of any product represents the minimal cost that is associated with that product, since beneath that loss will be incurred by the company.

  • Level of activity planning:

For any business in present times to succeed it is important that there should be certain business activities associated with it. With help of marginal costing, that ideal level of marketing and management activity can be monitored.

  • Introducing new products in the market:

There are times when a particular company could add certain new ranges in its line. In such a scenario, there may occur certain times when prices of the newly launched products have to be kept low for increasing rate of sales in the market.

With help of marginal costing techniques, it can be found as to what level of price are suitable for what units of sale.

  • Other modes of production:

It is important that when a certain production process is undertaken, costs incurred in that production is low in comparison to estimated profits. With help of marginal costing techniques, marginal contribution of each mode of production is checked and that with the highest production contributory value is taken for carrying on production.

  • Accepting bulk orders:

In case of receiving production orders, be it of sample quantity or bulk orders, it is the marginal costing technique that provides an idea regarding which order to accept.

These are the multiple areas where marginal costing technique is used.


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