Absorption Costing Vs. Marginal Costing - Assignment Example

Absorption Costing Vs. Marginal Costing   Introduction: the Basic Concepts Explained   Lucey (2002, p defines costing as “the establishment ofbudgets, standard costs and actual costs of operations, processes, activities or products; and the analysis of variances, profitability, or the social use of funds.” From this definition it is apparent that costing basically encompasses the estimation of the costs of goods and services so as to provide information to management and facilitate management decision making. As such in deciding between various costing methods one must keep the ultimate objective in mind: which method is most appropriate for a given business and gives the information that is necessary in order to achieve such business’ strategic and operational goals?   Absorption costing and Marginal costing are two such costing methods. They differ to quite an extent, however whether one method is better than the other depends largely on the situations in which they are applied and the underlying objectives of the businesses in which they are applied.   Before looking at these two concepts in detail, it is appropriate to discuss the components that make up the ultimate cost of a good or service. The cost of something can be broadly broken up into fixed costs and variable costs.  Fixed costs are those costs that are incurred irrespective of the level of production. So for example, in a garment factory business, fixed costs would include the rent on the factory. This rent would largely be the same, irrespective of the volume of garments produced in that factory. On the other hand, the variable costs would include the costs of the materials used (‘direct material’), the daily wages of the staff producing the garments (‘direct labour’) and even perhaps the electricity charges on the machines used (‘direct variable overheads’). These costs increase directly with the volume of production. More garments being produced would mean more fabric being used, more people being employed or the same people being employed for longer and machines using more electricity by being worked for longer or at higher capacities.   It is in deciding how, when and which of these costs are to be included when costing a good or service that the two methods of costing mentioned above differs.   Absorption Costing   This method is also called the full costing method. As the terminology implies, under this method, the full cost of the good or service is used in arriving at the cost per unit. ‘Full costs’ mean that both the variable costs and the fixed costs are included in the calculation of cost per unit. That is, this method does not differentiate between them-all the manufacturing costs are included.   In the garment factory example mentioned above, this would mean that in addition to the cost of fabric, labour and electricity used in making a single garment, the cost of that garment would also include a portion of the rent of the factory. A somewhat complex calculation involving three general steps will follow in deciding what portion of the factory rent will be included in the garment unit cost. It is in general this same three step process that applies to all fixed overheads under this absorption costing method.   The first general step is the allocation of the overheads to particular cost units or cost centers. These are overheads directly relating to the cost centre. So in the garment factory example, if the whole factory was only used for production, then the total factory rent would be allocated to the production cost centre.   The second step is apportionment. This is where indirect overheads are apportioned to fairly between cost centers. So for example if the garment factory included a canteen on its premises for the purpose of feeding the workers, then this canteen could be seen as a separate cost center from the production department and so the factory rent could be ‘apportioned’ between the two cost center by means of a suitable basis, such as perhaps the proportion of floor area used by each center.   The third step is absorption.  This applies when there are service (or non-production) departments which are cost centers and which ‘service’ or support the main production centers.  The canteen in the garment factory is a good example. The costs of this canteen will be ‘absorbed’ into overheads of the production department of the factory. This is done by the use of ‘absorption rates’. The canteen costs could be £X per machine hour or labour hour in the production department. This would be included in the cost per unit my multiplying the calculated absorption rate with the number of machine hours or labour hours used per unit in making one garment.   It must be noted that these absorption rates are notional and are no more than estimates. Furthermore, under this method it is almost invariable that the actual overheads suffered and the overheads absorbed will differ resulting in an over or under absorption. This amount is transferred to the Income Statement at the end of the given period. However, the goods are costed according to the notional absorption rates.   In essence, however, the hallmark of this method of absorption costing is that the full or total costs of manufacturing are included in the cost per unit of the goods produced.   Marginal Costing   It is under this method that the differentiation between fixed costs and variable costs are seminal. Here, when calculating the cost per unit, only variable costs are included. As such, in the garment factory example the garment would be costed at just the fabric, labour and electricity costs. The factory rent, canteen costs etc. would not be included in the calculation of cost per unit.   The rationale behind such differentiation is that variable costs are controllable while fixed costs are not. So in calculating costs per unit, it is more appropriate to only include such variable (and controllable) costs. Marginal costing also introduces the concept of ‘contribution’. This is equal to sales less the variable costs. In essence, contribution refers to the amount left over to ‘contribute’ to the fixed costs. Fixed costs are written off against this contribution at the end of the period to arrive at the profit for that period.   So for example, if the garment factory produced 100 dresses in a given period, and each dress used £2 in fabric, £2.50 in wages and 50p in electricity during the time it took to make that dress, the total variable costs would be £500. If the dress was sold for £10 each, total sales would equal £1000. When the variable costs are deducted from this, there is £500 left over. It is this £500 that is the contribution as it the amount left over to ‘contribute’ to the fixed costs.   It is from this £500 that the factory rent, canteen costs etc will be deducted at the end of the period to arrive at the profit. There is no necessity therefore to go through complex calculations to determine notional and approximate ways to distribute overheads and other fixed costs to production units. They are simply expensed at the end of the given period.   Effect of Absorption Costing and Marginal Costing on Profit   It is clear from the above discussion that the main difference between the two methods is that the absorption costing includes all manufacturing costs, both fixed and variable, in calculating cost per unit of the goods produced while marginal costing only takes the variable costs into its cost per unit and writes off the total fixed costs at the end of the period.   As long as the opening and closing inventory figures are identical, the profit figure under both methods will be the same. As noted in FTC Foulks Lynch ACCA Text on Financial Information for Management (2004 p. 133), any differences between budgeted and actual expenditure and production giving rise to under or over absorption does not have any effect on the differences in the profit figures. This is because any over or under absorption is written off in the Income Statement ant the end of a given period, thereby eliminating the difference. Instead, these differences arise due to the different inventory valuations and as such only crystallize where there is a difference between opening and closing inventory.   Under absorption costing the inventory will be valued at full cost per unit, i.e. both variable and fixed costs, while under marginal costing it is valued at only variable costs. So if a dress had variable costs of £5 and there was £1000 in fixed costs spread over 1000 dresses, in terms of absorption costing the dress would be £5 + £1000/1000=£6 while the marginal costing method would give a cost per unit of £5 only, with the £1000 being expensed against the contribution at the end of the given period. The difference therefore is that under absorption costing the fixed costs are being expensed only as the goods are sold and not when they are produced, whereas in the case of marginal costing, the entire value of the fixed costs are expensed in the period of production.   When closing and opening levels of inventory are equal it means that sales are equal to production. In such a case the profits under both methods are the same because then all the fixed costs would have been absorbed in that period because the entire inventory produced has been sold. Hence the same amount of fixed costs would have been expensed as under the marginal costing method.   Where however the closing and opening values are different, it means that only some of the fixed costs are being expensed or that fixed costs from prior production periods are being expensed now. As such, the amount of fixed costs expensed under absorption costing in such cases will not be the same as the fixed costs expensed under marginal costing as period costs.   If inventory levels are falling with opening inventory being more than closing inventory, then the profit under absorption costing will be lower than that under marginal costing because it means fixed costs from prior periods are also being charged against the profit. On the contrary, if inventory levels are rising, with closing inventory being more than opening inventory, absorption costing would give a higher profit because it means some of the fixed costs are being held up in the unsold goods to be set off against future profits.   Therefore the effect that the two methods have on the profit is a significant way in which the two costing methods differ.   Contrasting Absorption Costing with Marginal Costing     Advantages of Absorption Costing over Marginal Costing One main arguments in favour of absorption costing is that it is in accordance with international GAAPs for inventory valuation such as IAS 2.  As per IAS 2.10 fixed costs must be included in the valuation of inventory. As such it is this method of costing, as opposed to marginal costing, that can be used in businesses for financial reporting purposes.   There are also more theoretical arguments. It has been contended that as fixed costs have also been incurred in the production function and that without these costs being incurred that good could not have been produced, it is logical that such costs should also be included in the value of that good. Just because they do not vary with the level of production does not mean that such costs are unrelated to that product.  Fixed costs arguable contribute as much value to the product as the variable costs so it is rational for such costs to be included in the value of the inventory produced. This argument is even stronger where the fixed costs take up a significant proportion of the total costs.   It might even be argued that absorption costing failing to make a distinction between fixed and variable cost is actually advantageous. Coulthurst (1999, p.24) points out that “a behavioral classification of costs, as well as classification by element, function and directness, is required in marginal costing”. Sometimes, the distinction between fixed and variable costs is not always clear cut. Some costs vary in the mid-term though they are fixed in the short term. Some costs vary not with production but with other factors that themselves vary with the production level. It is not always clear-cut as to whether something is a variable or fixed cost.    There is also the general argument that this method of costing is in line with the almost proverbial accounting concepts: the matching and accruals bases, where revenue is matched with the costs as and when the revenue is earned.   Even in a more practical sense, it can be argued that absorption costing gives us a ‘full view’ of the costs of production and as such has the practical benefit of enabling businesses to estimate costs and give price estimates or to conduct profitability analysis. Further more, with the calculation of over and under absorption rates comes the added information of how well a business is using its production resources, because such figures directly depend on whether budgeted production levels are being achieved and whether overheads are being estimated and controlled properly.    Advantages of Marginal Costing over Absorption Costing The underlying advantage of this method is its simplicity. There are no complex calculations of apportioning and allocating overheads nor is there any fictional absorption rates being applied to value the inventory. As such it can be argued that the profits under the absorption costing method are not realistic and are misleading because they tend to differ depending on the differences between opening and closing inventory levels which have nothing to do with the sales in that period. Furthermore, it is the general consensus that marginal costing is a much better decision making tool than absorption costing. In making decisions, it is logical to disregard fixed costs because they are ‘sunk’ costs and not within ones control. Instead one can evaluate a number of proposals such as ‘make or buy’ decisions and choosing what mix of products to manufacture by looking at how much they contribute to the covering of fixed costs rather than looking at the overall profitability. Conclusion: Evaluation of the two methods   Each of the two methods has its own advantages and disadvantages. As noted by Crowther (2004, p.190), the advantages of one method are roughly the same as the disadvantages of the other method, and as such neither method of costing is superior to the other in all circumstances. Hence whether a business applies one method or another depends largely on what kind of information the business needs as well the circumstances of the business itself.  The fact that both these methods have its merits is apparent from the fact that they still form the basis of all cost accounting. Over the years newer methods such as Activity Based Costing have evolved, but they themselves are but improving on these two ‘classic’ methods which as yet still underlie almost all costing processes today.                   Reference List   Coulthurst, N., 1999. ‘Cost Accounting - System Requirements’.  Student Accountant. April. pp. 23-5 Crowther, D., 2004. Managing Finance: A Socially Responsible Approach. Butterworth-Heinemann, Oxford.    Financial Information for Management, 2004. FTC Foulks Lynch Association of Chartered Certified Accountants (ACCA) Official Publication, Berkshire. Lucey, T., 2002. Costing. 6th ed. Thomson Learning, London. Read More