The Basic Differences between Absorption Costing and Marginal Costing - Coursework Example

ACCOUNTING AND FINANCE Absorption costing and marginal costing, compared and contrasted Introduction Modern business contexts need frequent information of business activities and costs incurred so as to plan accurately for the future and to control business results. A business can make proper appraisal of the performance of people working in the business only if it uses accurate costing methods. Costing methods can play significant roles in the growth of advanced manufacturing technologies and management philosophies as strict adherence to a specific costing method has long been considered to be vital to the business. Among various costing methods, absorption costing and marginal costing are the two management tools that can be used for managerial decision making despite the fact that marginal costing has an edge over the other methods as far as decision making is concerned. This piece of research work is an attempt to describe the meanings and underlying principles and theories of both absorption costing and marginal costing. This paper compares and contrasts both of these methods of costing and outlines the relevance of these methods to various managerial and business purposes. Marginal Costing Marginal costing is an accounting system in which variable costs are charged to cost units for a period of time and fixed costs are written off in full against the total contribution. Contribution is the sales value less variable costs (Lucey and Lucey, 2002, p. 296). Marginal costing is a basic tool that helps management to take appropriate decisions. Marginal cost is variable production cost as it tends to vary in direct proportion to the changes in production and output. As and when an extra unit of the output is manufactured, the extra cost incurred for the production of that extra unit will be ultimately variable because the fixed cost remains constant. In the valuation of stocks and in calculating or determining the total cost of goods sold, marginal costing methods is widely used mainly because it only variable manufacturing costs are considered in marginal costing method. More specifically, only variable manufacturing costs are attributed and thus they only are considered to be the production costs. These variable costs include direct materials, direct labor and variable factory costs. Fixed manufacturing costs are not considered as production costs and these are never considered in the stock valuation and in managerial decision making process (Weygandt, Keiso and Kimmel, 2005, p. 265), According to Glautier and Underdown (2001), marginal costing is an invaluable management accounting tool used to provide managerial information about costs incurred in the business operation, volume and profit relationship in an easy form to understand. He found that the key advantage of marginal costing is that it facilitates managerial decision making, profit estimation or profit planning and cost management (p. 441). Bendrey, Hussey and West (2003) emphasized that marginal costing system builds up product costs taking into consideration cost behavior. Costs may be variable or fixed in nature and only variable costs are considered in marginal costing technique (127). As discussed earlier, marginal costing emphasizes the difference between fixed and marginal or variable manufacturing costs. As marginal costing makes clear distinction between fixed and variable manufacturing costs, this distinction is significant and very critical in a number of managerial decision making processes. The marginal costing is used to interpret cost data so as to measure profitability and productivity of various products, manufacturing processes and cost centers. Marginal costing can be used in connection with various costing techniques like job costing, process costing etc (Boardguess, 2009). Absorption Costing Absorption costing, which is also known as full costing, is a costing method in which all the manufacturing costs, including variable and fixed costs are considered to be production costs. All manufacturing costs are fully absorbed to the finished goods (Jawahar-Lal, 2008, p. 627). In absorption costing, direct costs are directly attributed to cost units as they are then easily identifiable and manufacturing overhead costs are charged to the product and other overheads including administration and selling expenses are added up to the product costs as a percentage of total production costs (Bendrey, Hussey and West, 2003, p. 127). Absorption costing or full cost method considers both fixed and variable costs. The variable costs like direct material costs, direct labor costs etc are directly charged to the product and fixed costs are charged on a proportion basis over different product manufactured during a particular period of time (Williams, Haka and Bettner, 2004, p. 923). The main difference from marginal costing is that all costs are identified with manufactured products. The absorption costing method has been criticized that it assumes prices are the functions of the costs, demand of the product is not considered and it includes past costs that are often not relevant to the current pricing and decision making processes. The absorption costing may not provide accurate information in order to help decision making in a very dynamic market environment (Boardguess, 2010). According to Broadbent, Broadbent and Cullen (2003), all overhead costs are absorbed in to the product together with direct costs in the system of absorption costing. SSAP 9 requires absorption costing technique for the external reporting purposes because costs of stocks must include all production overheads including both fixed and variable costs (p. 92). Comparison of marginal costing and absorption costing Arguments for absorption costing Fixed manufacturing costs are incurred for making output and therefore it is fair in the view of accounting to charge any output with a share of these costs It meets the international accounting standard because closing inventory values include a share of fixed production overhead A proportion of the production costs are matched against future sales and therefore absorption costing is consistent with the concept of accuracy In the contexts of job costing or batch costing, absorption costing is suitable in order to take decisions of pricing so that it can be ensured that profit markup is enough to meet fixed costs (Cost Accounting System, 2010, p. 7). Cost price or full cost pricing ensures that all costs are covered (Davies and Pain, 2002, p. 295). Stock valuation under absorption costing method complies with SSAP 9, because an element of fixed production costs is absorbed in to inventories. Absorption costing avoids separation of costs in to fixed and variable element that are not easily or accurately identified (Davies and Pain, 2002, p. 295). Arguments for marginal costing Marginal costing method id convenient and easy to operate in the business. There is no chance of under or over absorption of overheads. Marginal costing is best suitable measure for managerial decision making There are no apportionments that are done on arbitrary basis. It is more accurate to value closing inventory at easily and directly attributable costs. Fixed factory costs like depreciation relate to a particular period of time and therefore it should be better charged against the revenue of that period of time. Absorption costing may encourage over production because reported profits can be increased by inventory level increases (Cost Accounting System, 2010, p. 8). Fixed costs are never variable in the long run. There are different alternative bases of overhead allocation that may represent different interpretation (Davies and Pain, 2002, p. 295). Fixed costs often will be under-absorbed if activity is not equal or not greater than the budgeted level of activity. Main differences between Absorption costing and Marginal costing Marginal costing and absorption costing differ in the following ways: Cost element in product cost: The treatment of fixed factory overhead in the accounting record and financial statement is entirely different in both absorption and marginal methods of costing. Selling and administrative expenses of both variable and fixed nature are considered to be period costs and these are not treated as product costs in both marginal and absorption methods of costing. These are not included in the costs of goods sold or cost of stock. But, it is obvious that the difference is between absorption and marginal costing is related to the treatment of fixed manufacturing expenses (Jawahar-Lal, 2008, p. 628). Net-income As both absorption costing and marginal costing are different in terms of the treatment of fixed factory overheads, the net income result in both costing methods will necessarily be different. Inventory values As discussed earlier, absorption costing and marginal costing influence the value of inventory in different levels. In marginal costing, inventories are calculated and considered in terms of variable production costs only and therefore the inventory value in marginal costing method is comparatively in a lower value. The absorption costing considers fixed factory overheads as well as variable production costs and hence the value of inventory under marginal costing technique will be higher than that in absorption costing system (Jawahar-Lal, 2008, p. 628). Jobs and Products Chadwick (1993) emphasized that marginal costing seems to be more realistic than absorption costing method because it considers only those costs that are easily identifiable with the job or product. As marginal costing considers only variable costs incurred, these variable costs are easily identifiable and attributable to a particular product or job (p. 77). As far as absorption costing is considered, it considers fixed overheads and many of it vary more with time than with output. He argued that marginal costing is more suitable with internal financial reporting and decision making and same time for external reporting of financial information, Statement of Standard Accounting Practice (SSAP) has suggested absorption costing. Applicability for decision making To use absorption costing for decision making is dangerous because the costs that absorption costing considers are of imprecise nature. Marginal costing is highly recommended for decision making because the costs that it considers can be traced to a particular product and thus it is useful for decision making and evaluation. Marginal costing and Absorption costing contrasted Marginal costing approach is considering the variable costs of products rather than full production costs. The following example can help us illustrate the profit calculation and stock valuation differences while using both absorption costing and marginal costing. Example: the following information is of a company All fixed manufacturing costs are amounted to be $ 400, 00 per annum. Variable overheads- $ 2 per unit Direct labor and direct materials total - $ 3 per unit Sales are constant at 1000 units per annum at $ 12 per unit Production in first year is 1200 units, second year is 1500 units and third year is 900 units The results under the two methods are as follows: ============================================================= Year 1 2 3 ============================================================= Marginal costing (1) Sales 12, 000 12,000 12,000 Less variable cost: 6000 7500 4500 Add opening stock: - 1000 3500 Less valuation of closing stock 1000 3500 3000 = 5000 5000 5000 Fixed manufacturing costs 4000 4000 4000 (2) = 9000 9000 9000 Gross Profit = (1) - (2) = 3000 3000 3000 =============================================================== Absorption Costing (1) Sales 12000 12000 12000 Less variable costs; 6000 7500 4500 Fixed manufacturing costs 4000 4000 4000 = 10000 11500 8500 Add opening stock - 1666 5366 Less closing stock 1666 5366 5666 (2) = 8334 7800 8200 Gross Profit (1)- (2) 3666 4200 3800 =========================================================== Graphical representation of gross profit differences calculated under absorption costing and marginal costing methods: Marginal costing and Absorption costing: impacts on profits 1- Net Profit will be same in both absorption and marginal methods of costing if sales and production levels are constant over the time. 2- When production remains same and sales fluctuate, profit may increase or decreases with the sales levels, assuming that costs and prices are constant. The fluctuations in net profit figures will be normally greater with marginal costing than that of absorption costing. 3- When sales are constant, but production varies from year to year, marginal costing method provides constant profit but absorption costing shows profit fluctuating. The above illustration gives clear picture that when sales are constant but production fluctuates, there can be difference in the profit being calculated under absorption costing and marginal costing. Profit is, in such case, same under marginal costing but fluctuating under absorption costing. From the above illustration, under marginal costing method, profit is constant in all three years as $3000, but under absorption costing, profit for the first year is $ 3666, second year is $ 4200 and for third year is $ 3800. 4- When production exceeds sales, profit will be higher under absorption method than that of marginal costing method because the absorption of fixed overheads in to closing stock increases the value and thus reduces costs of goods sold. 5- Whenever sales exceed production, profit will be higher under marginal costing methods than that of absorption costing technique. Under absorption costing, the fixed factory costs are charged against revenue and thence the value of fixed costs charged against revenue will be higher than that incurred for the period of time (Glautier and Underdown, 2001, p. 447). The Reality of absorption costing and marginal costing This paper has clearly outlined that the major difference between absorption costing and marginal costing is that absorption costing considers all costs, irrespective of fixed or variable and marginal costing takes in ton account only variable costs incurred in manufacturing a product. It was emphasized that profit calculated under these two methods can be different if sales or production fluctuates. But in the long run, over several accounting periods, the total recorded profit will be same regardless of whether marginal costing or absorption techniques are used (Davies and Pain, 2002, p. 295). According to Davies and Pain (2002), the actual amounts of the costs are not different, but instead, only the periods in which the costs are charged against profit are different. The difference in profit happens from one period to another depending on which costing methods is used (p. 294). Conclusion This piece of research work has outlined the basic differences between absorption costing and marginal costing. Both these costing methods differ in terms of cost elements, methods of calculation, appropriateness for decision making, net income, inventory value and job and products. This work has detailed how both of these costing methods impact profit differently in different contexts of sales and products. This work emphasizes that profit will be different under absorption and marginal costing methods if sales fluctuate, or production fluctuate or sales exceeds production. References Bendrey M, Hussey R and West C (2003), Essentials of management accounting in business, Illustrated edition, Cengage Learning EMEA Boardguess (2009), Chapter 8- Absorption costing and Marginal costing, retrieved 08/04/10 from http://www.boardguess.com/universitiesdeemed-universities/ignou/ignou-mca/ebook-mca/absorption-marginal-costing/1993-1993.htm Broadbent M, Broadbent M and Cullen J (2003), Managing financial resources, Illustrated Third edition, Butterworth-Heinemann Chadwick L (1993) Management Accounting, Illustrated Edition, Routledge Cost Accounting System (2010), Marginal Costing and Absorption Costing, Docstoc.com, Retrieved 07/04/10 from http://www.docstoc.com/docs/20677157/Marginal-costing-and-absorption-costing/ Davies T and Pain B (2002), Business Accounting and Finance, McGraw Hill Publishers Glautier M.W.E and Underdown B (2001), Accounting theory and Practice, Seventh Edition, FT Prentice Hall, Financial Times Jawahar-Lal (2008), Cost Accounting, Tata McGraw-Hill Lucey T and Lucey T (2002), Costing, Illustrated Sixth Edition, Cengage Learning EMEA Weygandt J.J, Keiso D.E and Kimmel P.E (2005), Managerial Accounting Tools for Business Decision Making, Third Edition, John Wiley and Sons Williams J.R, Haka S.F and Bettner M.S (2004), Financial and Managerial Accounting: The basis for business decisions, McGraw Hill Read More