There are mainly two techniques of product costing and income determination:
(a) Absorption costing
(b) Marginal costing.
What is Absorption Costing
This is a total cost technique under which total cost (i.e., fixed cost as well as variable cost) is charged as production cost. In other words, in absorption costing, all manufacturing costs are absorbed in the cost of the products produced. In this system, fixed factory overheads are absorbed on the basis of a predetermined overhead rate based on normal capacity. Under/over absorbed overheads are adjusted before computing profit for a particular period.
Closing stock is also valued at production cost including fixed factory overhead (and sometimes administration overhead also). Absorption costing approach is the same as used in Cost Sheet. It is a traditional approach and is also known as 'Conventional Costing' or full costing'.
Marginal Costing Definition
Marginal costing is perhaps the most interesting topic in this subject and is an alternative to absorption costing. Also known as variable costing' or
'direct costing. Under this technique, only variable costs are charged as product costs and included in inventory valuation. Fixed manufacturing costs are
not allotted to products but are considered as period costs and thus charged directly to the Profit and Loss Account of that year, this explains the
marginal costing definition. Fixed costs also do not enter in stock valuation.
Both absorption costing and marginal costing treat non-manufacturing costs
(i.e. administration, selling and distribution overhead) as period costs. In other words, these are not inventorial costs.
Product Costs and Period Costs
Product costs are those costs which become a part of production cost. Such costs are also included in inventory valuation. Period costs, on the other hand,
are those costs which are not incurred for production and are not included in the cost of products or stocks. Such costs are treated as an expense of the period in which these are incurred and transferred to P; L A/c of the period.
Meaning of Marginal Cost
Marginal cost is the additional cost of producing an additional unit of product. It is the total of all variable costs. It is composed of all direct costs and variable overheads. The meaning of marginal cost from CIMA of UK is defined as the amount at any given volume of output by which aggregate costs are changed, if volume of output is increased or decreased by one unit’. It is the cost of one unit of product which would be avoided if that unit were not produced. An important point is that marginal cost per unit remains unchanged irrespective of the level of activity. Examp1e. A romr1y manufactures 100 units of a product per month. Total fixed cost per month is Rs 5,000 and marginal cost per unit is Rs. 250.
Characteristics of Marginal Costing
The important characteristics and mechanism of marginal costing technique might be summed up as follows:
1. Segregation of costs into fixed and variable elements. In marginal costing, all costs are classified into fixed and variable. Semi-variable costs are also segregated into fixed and variable elements.
2. Marginal costs as product costs. Only marginal (variable) costs are charged to products produced during the period. In other words, marginal costs are treated as product cost.
3. Fixed costs as period costs. Fixed costs are treated as period costs and are charged to the Costing Profit and Loss Account of the period in which they are incurred.
4. Valuation of inventory. The task in progress and finished stocks are valued at limited cost only.
5. Contribution. Contribution is the difference between sales value and marginal cost of sales. The relative profitability of products or departments is based on a study of ‘contribution’ made by each of the products or departments.
6. Pricing. In marginal costing, prices are depending on marginal cost as well as contribution.