Absorption Costing and Marginal Costing - Term Paper Example

Compare and Contrast Absorption Costing and Marginal Costing Table of Contents Introduction 3 Marginal Costing 3 Absorption Costing 5 Comparison between absorption costing and marginal costing 7 Conclusion 9 References 10 Introduction Costing has been one of the most crucial aspects of any business as none of the business organizations can be operated without considering the costs that are associated with it. Two of the most significant elements of costs are labor and materials. In general elements of cost are divided into two different categories which are fixed cost and variable cost. There are different techniques for calculating costs and there are different aspects that are associated with the process. Two of the most common and important costing techniques are marginal costing and absorption costing. This report attempts to include the major aspects of these two types of costing methods. The report includes description of each of the techniques. Furthermore, it also includes a comparative analysis of the two costing processes. The report first deals with marginal costing technique. Absorption costing is then described separately. Once the two techniques are properly portrayed in the report, a comparative analysis that involves two costing processes is provided. Finally, the report ends with a proper conclusion. Marginal Costing The idea of marginal costing is mainly based on the concept of marginal cost. Marginal cost can be viewed from both accountants’ as well as economists’ angle. In economics marginal cost is referred to the cost incurred in the process of producing an extra unit of product or service. Whereas, in accountancy marginal cost refers to the entire cost that is obtained after adding the variable cost and prime cost. According to Murthy “all costs other than fixed costs are the marginal cost” (Murthy, 2009). I.C.M.A. London has defined marginal cost properly. According to it, marginal cost is “the amount at any given volume of output by which aggregate costs are change, if the volume of output is increased or decreased by one unit” (Murthy, 2009). The same organization has defined marginal costing as “the ascertainment of marginal costs and of the effect on profit of changes in the volume or the type of output by differentiating between fixed costs and variable costs” (Murthy, 2009). In this method of costing, mainly those costs that are variable in nature are charged against processes, products and operations. All the indirect costs are written off against the profit. Major features of marginal costing are as follows – Marginal costing is mainly based on the difference between variable costs and fixed costs. In this type of costing all the fixed or indirect costs are written off against the profit, whereas the variable costs are applicable to the products. Fixed costs are not included in the process of valuation of stocks. The stocks of finished goods and work-in-progress are considered in the process of calculating variable cost. Products which are moved from one process to another one are valued at marginal cost. In marginal costing profit is measured by deducting the fixed cost from the contribution (Murthy, 2009). Marginal costing is one of the most important techniques in the decision making process of management. It is a crucial tool that is heavily used in the present business environment for the purpose of planning profit and controlling cost. The major advantage of marginal costing technique is that it is one of the simple costing techniques. Furthermore, it can easily be used in combination with standard costing. Marginal costing helps in understanding the relationship that exists among the volume of output, cost and selling price. An important aspect of marginal costing is that it clearly brings out the contribution of each and every product to the profit and this helps the managers to make more effective decisions. Moreover, marginal costing also helps to figure out the utmost overall profit which can be made. A major advantage of marginal costing technique is that it eliminates large balances that are left in the accounts of overhead control (Murthy, 2009). Like any other costing technique marginal costing is also not limitations free. One of the most important disadvantages of marginal costing is that it is mainly useful in case of short term analysis rather than in long term analysis. Moreover, use of marginal costing requires separation of variable and fixed costs. However, this separation is not an easy task to do on a regular basis. In fact, sometimes misleading results are obtained from such separation process (Murthy, 2009). Absorption Costing According to Michael Armstrong, “absorption costing is the practice of assigning all costs, both fixed and variable, to operations or products” (Armstrong, 2001). It is also known as full costing, total costing or historical costing. B.M. Nigam and I. C. Jain have defined absorption costing as the technique that recovers or absorbs both variable as well as fixed costs (Nigam and Jain, 2004). In absorption costing technique all the manufacturing costs, be it variable or be it fixed, are considered as the cost of production. They are used in calculating the cost regarding inventory valuation and goods produced. All the manufacturing costs are entirely absorbed into the finished goods. Costs that are incurred in the non-manufacturing areas are considered as period costs. One of the main reasons behind the popularity of absorption costing technique is the fact that it covers all the costs. Michael Armstrong opined that “absorption costing is based on the full recovery of overheads” (Armstrong, 2001). Moreover International Accounting Standards Body has approved this technique as a proper method for valuing the work-in-progress products as well as the finished stocks. Absorption costing is such a costing technique where the process of cost separation is avoided. In the language of David Crowther, “the split between fixed and variable costs is often arbitrary and many costs are mixed, containing an element of both fixed and variable costs” (Crowther, 2004). As a consequence there was always a demand of a costing technique that would avoid such splitting and absorption costing has fulfilled that demand. In addition to these, absorption costing generates an awareness regarding the resources that are used in the production process. Furthermore, it also tells that whether resources are used efficiently or not. In the language of David Crowther it can be said that “the total cost of overheads is charged to production in each period by using the overhead absorption rate” (Crowther, 2004). This actually means that the level of business activity in a particular area is reversely proportional to the rate of overhead absorption. Like marginal costing, absorption costing also has some disadvantages. Under absorption costing, fixed costs are distributed based on the assumptions regarding the output level. A change in output volume is likely to affect the entire unit cost as the fixed costs are spread out over a smaller or larger number of units. Overheads are then over or under-absorbed. The total cost that is associated with each unit is over or under stated. The problem in absorption costing is that when a budget is prepared, the figures that are revealed from it are expected to be used to make decisions regarding profit planning and pricing, although they become irrelevant whenever the output levels get changed. Another major disadvantage of absorption costing is that in this costing technique there is no suitable method for assigning fixed expenses that are indirect in nature to the finished product. According to Michael Armstrong, “arbitrary methods are adopted, usually related to the volume of production (e.g. direct labor hours), even though the results obtained from one method in a given circumstance may differ significantly” (Armstrong, 2001). In addition to these, absorption costing is not the best costing technique to obtain proper guidance regarding the relationships between profit, volume and cost (Armstrong, 2001). Comparison between absorption costing and marginal costing There are several aspects in which absorption costing and marginal costing can be compared to each other. These are as follows – Cost element in the product cost: Absorption costing and marginal costing differ from each other in the processing of fixed manufacturing (factory) overheads in the financial statement and accounting records. In both absorption and marginal costing techniques administrative and selling expenses are treated as period costs. However, they are not considered as product costs. As a result, these two expenses are not considered in the costs of goods sold and costs of inventories. Inventory values: inventory values are influenced differently by absorption costing and marginal costing. Under marginal costing value of inventories is at lower figures as compared to the value of inventories in the absorption costing technique. The principle reason behind such difference is the fact that in marginal costing inventories are valued in terms of variable production costs only. On the other side in case of absorption costing inventories are valued in terms of both variable as well as fixed production costs. Difference in total income: since fixed factory overhead is treated differently in the two costing techniques, net income figures also come differently in these two techniques (Jawahar-Lal, 2008). In addition to above discussed aspects, there are other areas which show the major differences between absorption costing and marginal costing. One of the crucial differences between these two costing techniques lies in the fact that under absorption costing both variable and fixed costs are obtained from production and under marginal costing solely variable costs are considered. Furthermore, in case of absorption costing, valuation process of finished goods and work-in-progress goods involves the total costs that include both variable as well as fixed cost. On the other hand under marginal costing such valuation is done considering the variable cost only. Absorption costing is more relevant in case of long run decision making process, whereas marginal costing is more effective for the decision making process that is short term in nature. Moreover, absorption costing lays importance on production, process and operation, while marginal costing technique focuses on pricing and selling aspects (Periasamy, 2009). Absorption costing is mainly used for the purpose of external reporting (reporting to government, shareholders and tax authorities). Marginal costing, on the other hand is usually used in case of internal reporting (reporting to organization’s management for better decision making). Furthermore, marginal costing is considered to be simpler when compared to absorption costing in the context of their understandability. It is often observed that managers are finding absorption costing especially the aspect of under and over-absorption of overheads difficult to understand. Conclusion Both marginal and absorption costing is important for organizations like Ball Dolbear Ltd. as it is very difficult to suggest any specific costing technique for a specific organization. However, marginal costing technique is generally considered as the more preferable option as the statements that are obtained from this technique provide more effective and useful information for the managers to make better decisions. Supporters of absorption costing, however, argue that fixed overheads related to production must be included in unit cost that is used for the valuation of stock (Scarlett, 2006). The most important fact to notice is that there are several advantages as well as disadvantages of both marginal and absorption costing. When an organization is making decision regarding the choice of costing technique, these advantages and disadvantages should be given proper importance. References Armstrong, M. 2001, A handbook of management techniques, Kogan Page Publishers Crowther, D. 2004, Managing finance: a socially responsible approach, Butterworth-Heinemann Jawahar-Lal, 2008, Cost Accounting, Tata McGraw-Hill Kinney, M. R. and Raiborn, C. A. 2008, Cost Accounting: Foundations and Evolutions, Cengage Learning Murthy, 2009. Cost Accounting 2E, Tata McGraw-Hill Nigam, N. B. and Jain, I. C. 2004, Cost Accounting: An Introduction, PHI Learning Pvt. Ltd. Periasamy, 2009, Financial Management, 2E, Tata McGraw-Hill Scarlett, R. 2006, CIMA Learning System 2007 Performance Evaluation, Butterworth-Heinemann Read More