Difference between Marginal and Absorption Costing - Term Paper Example

 Difference between Marginal and Absorption Costing Table of Contents Table of Contents 1 Introduction 2 Absorption Costing 2 Marginal Costing 3 Limitations and advantages of Marginal Costing 4 Features distinguishing marginal and absorption costing 5 Difference between absorption costing and marginal costing 6 Conclusion 9 Reference 11 Bibliography 12 Introduction The accounts department is entrusted with the task of accounting for the costs and revenues that are incurred in the organization. This department has to ensure that all the costs are rightly allocated such that the users of the financial statements can get a fair idea about the financial position of the business. Besides this the records must be kept in a way that it facilitates the process of decision-making by the top management. Marginal Costing and Absorption Costing are the two different techniques of recording the costs associated with the product. The former does not give consideration to fixed costs while the latter adds alls the direct as well as indirect costs to ascertain the total cost of per unit of output. This means that Absorption costing does not make any differentiation between fixed and variable costs whereas Marginal costing accounts for only the variable expenses. Absorption Costing Under this technique the costs are segregated into manufacturing, administrative and selling costs. Here all the manufacturing expenses-fixed as well as variable- are deducted from revenues to obtain gross margin and then the selling & administrative costs-fixed as well as variable- are subtracted from gross margin to obtain the net income. The fixed manufacturing overhead charges are allocated to the units on a per unit basis. This is obtained by dividing “Standard fixed manufacturing overhead” by “Normal Output”. If the production is higher or less than the standard output, necessary adjustments are done with respect to volume variances. In the case of “favorable volume variance” i.e. if the actual production exceeds normal capacity, the amount relating to over-absorption is subtracted from the cost of goods produced and sold. If the variance is “unfavorable”, the amount relating to under-absorption is added with the total cost of goods produced and sold (Lal & Srivastava, 2008, pp.628). Under this method a proportion of fixed costs are carried forward to the next accounting period as a constituent of closing inventory. This is criticized by the supporters of marginal costing on the ground that costs relating to an accounting period are transferred to the subsequent period. Marginal Costing Marginal Costing differentiates between variable and fixed costs. The marginal cost refers to the variable cost of a product or it comprises direct material, direct expenses, direct labor and variable portion of the overheads. Marginal Costing is an accounting system under which the variable expenses are charged to the units and the fixed costs relating to the period are charged fully against contribution. ‘Contribution’ refers to the excess of sales over marginal cost (Kuppapally, 2008, pp.432). Contribution can be simply referred to as profit prior to the realization of fixed expenses. This means that contribution margin goes towards the realization of profit and fixed cost and is also equivalent to fixed cost plus profit. If the firm fails to make profit then contribution is equivalent to the fixed costs and this point is referred to as “break-even point”. Limitations and advantages of Marginal Costing This system is easy to interpret. As the fixed expenses are not charged to the cost of manufacturing it helps in avoiding the varying charges on each unit. The entire amount of fixed expenses is charged to the particular period thus preventing the concept of carrying forward the fixed overhead costs of the current year (Murthy & Guruswamy, 2009, pp.3). This does not hold good in absorption costing as the fixed expenses are allocated to the units to which it relates. In the valuation of closing stock under absorption costing, the fixed costs relating to it are carried forward to the next accounting period. Many argue that this is an unsound practice as the inclusion of costs relating to a previous year distorts the cost of the subsequent period. The marginal costing technique facilitates control of costs. It helps in avoiding random allocation of fixed costs. Under this system the stock is measured at marginal cost which is distinctly apart from the total cost per unit under absorption costing technique. Marginal Costing is not free from limitations. This method accounts for only the variable expenses but there are certain costs that are difficult to segregate. Like there are certain overhead expenses that are partly fixed and partly variable in such cases it is difficult to distinguish between the two types of expenses. Moreover as the value of closing stock does not contain the fixed expenses it leads to understating their true value. The omission of fixed costs from the valuation of inventory influences the profit figure thereby distorting the financial information. Features distinguishing marginal and absorption costing In absorption costing method, the stock is valued so as to include the fair portion of the fixed overhead charges but in marginal costing the inventory or stock is valued at variable costs only. This raises the value of the closing inventory or stock under absorption costing as compared to marginal costing. As the fixed cost element of the closing stock is carried forward the “cost of sales” used for determining profit under absorption costing will include fixed overheads incurred in the previous year. Similarly, it will omit the fixed costs of the current period as the same will be included in the value of the closing stock of the period. Marginal Costing on the other hand charges the fixed costs of the relevant period fully to the profit and loss account of that period. In absorption costing method the ‘actual’ costs relating to a unit are lowered by manufacturing higher quantities but the unit cost under marginal costing is not affected by the production volume. The per unit profit in a period is influenced by the actual production volume in absorption costing but this is not same under marginal costing. The segregation of variable expenses and contribution facilitates decision-making by the company management. It makes it easier to understand the impact of sales volume on contribution and profit. However under absorption costing the impact of changes in production and sales volume is not seen on the profits. Difference between absorption costing and marginal costing The main difference between the two methods of costing exists in the treatment of “fixed costs”. In absorption costing the costs relating to fixed overhead are absorbed by the unit and all the items of stock are expressed at their full cost of production. Marginal costing on the contrary values the items in the stock at their marginal or variable cost. Fixed costs are recorded as period costs and are fully charged to the profit and loss account for the period. For this reason marginal costing is also known as ‘Period Costing’. As both the systems have different cost allocation basis the profit figure obtained under the two methods is different. Marginal Costing and absorption costing differ because of the under mentioned reasons- Cost element in unit cost- Marginal and absorption costing differ with regard to the treatment of “fixed factory overhead” in the financial statements. Both the techniques recognize the administrative and selling expenses as period costs with the effect that these costs do not form a part of the inventories cost. Both the methods also consider variable production costs as product costs. The two methods only differ regarding the treatment of manufacturing costs that are fixed in nature. Valuation of inventories- Both the techniques influence the valuation of inventory differently. The inventory value under marginal costing is stated at a lower amount as the determination of inventory is based on the variable costs of production only. Similarly under absorption costing the value of inventory is stated at a higher level as it takes into account the variable costs of production as well as factory overheads that are fixed in nature. Difference in income-The inclusion of “fixed factory overhead” brings about variations in the net income estimates of the two techniques. The extent of this variation in net income depends on the inventory level changes and fixed production costs of each unit. Preparation of profit statements under the two methods In marginal costing the variable portion of costs are deducted from the sales revenue. This items that are deducted includes variable portion of selling expenses, production costs etc. The sum of the above mentioned costs gives the “variable cost of sales” which is subtracted from the revenue to obtain ‘contribution’. From the contribution margin the fixed costs relating to selling, production and administration are deducted to obtain profit. Under absorption costing the full cost of production is deducted from sales revenue. With this the necessary adjustments are made with respect to over absorption and under absorption of fixed overheads. If the overheads are over absorbed then this signifies that excess costs have been charged as production cost. This excess amount is then subtracted to obtain the full cost of production. If there is under absorption this amount is added back to raise the production cost. Reconciliation of profits under the two methods As the method of recording the costs are different under both the methods this results in varying profit figures. The reason for the differences in the profit is because of the different closing stock valuations. Under absorption costing a portion of fixed overhead is carried over in the stock to a subsequent period and is accounted with the sales of that period. If there is a rise in the stock then the profits under absorption costing will be higher as compared to the profits obtained under marginal costing. The reason for this is that the fixed overhead is carried forward in the closing stock and is not charged against the sales of the period. If there is a reduction in stocks, then the profit obtained under marginal costing will be more as compared to absorption costing. The reason for this is that the fixed costs that would have been carried forward to the next period under absorption costing are charged against the sales of that period thus lowering the profits. To align the profit under marginal costing with the profit under absorption costing the fixed overhead adjustments relating to stock increase or decrease can be made (Scarlett, 2006, pp. 2). Conclusion Marginal costing technique facilitates the revenue and cost analysis thereby guiding the management in taking crucial business decisions. The information presented under this technique can be easily interpreted by the managers. Absorption costing is mostly used for the purposes of cost control and marginal costing for control and decision-making. The major difference underlying the two methods relates to the treatment of “fixed factory overheads”. While under absorption costing the overheads relating to the period are absorbed into the units that are manufactured during that period and if these units remain unsold a portion of the fixed overheads of a period is transmitted into the subsequent period. This technique supports the matching or accrual principle in the way that the full unit cost is charged against revenue whenever these units are ultimately sold (Pizzey, 1989, pp.263).Marginal costing considers the fixed overhead as costs of a specific time period and thus charges it to the period in which it is incurred. Irrespective of whether all the goods are sold or not the fixed overheads are charged against the profit of that period. This results in carrying forward of the closing inventory to the subsequent period at its variable cost and overlooks the absorbed costs. The supporters of absorption costing consider this to be wrong as it violates the matching principle. As the full costs of a unit are not matched against sales it distorts the profit position. It is said that marginal costing facilitates only short term decision-making. Reference Kuppapally, J.J. 2008. Accounting for Managers. PHI Learning Pvt. Ltd. Lal, J. Srivastava , S. 2008. Cost Accounting. Tata McGraw-Hill. Murthy, A. Guruswamy, S. 2009. Cost Accounting. Tata McGraw-Hill. Pizzey, A. 1989. Cost and Management Accounting: An Introduction for Students.SAGE. Scarlett, R. 2006. CIMA Learning System 2007 Performance Evaluation. Butterworth-Heinemann. Bibliography Burke, L. Wilks, C. 2006. CIMA Learning System 2007 Management Accounting Decision Management. Butterworth-Heinemann. Chadwick, L. 1993. Management accounting. Routledge. Read More