Absorption and Marginal Costing - Assignment Example

Absorption and Marginal Costing Introduction Marginal costing which is also known as variable costing is a procedure of costing which incorporates only variable manufacturing costs. These variable manufacturing costs are taken into account in the form of direct labour, direct materials, and variable manufacturing overheads. These costs help in determining the unit cost of a product (Sikdar, 2008). While Absorption costing, is a technique which includes all manufacturing costs taken into account in the form of direct labour, direct materials, and both variable and fixed manufacturing overheads when finding out the cost per unit of a product. This technique of costing is also known as the full-cost technique (Sikdar, 2008). In reality the technique of marginal costing takes into consideration the behavioural features of costs by segregating the costs into fixed and variable elements. The segregation is done because per unit variable cost is fixed and total costs are variable in nature but actually total fixed costs are fixed and per unit fixed cost is variable in nature. In addition variable costs are handy in nature, whereas total fixed costs are unmanageable in nature. Short term planning makes use of the Marginal costing technique. Control and decision making in particular reference to production of multi-products also uses marginal costing (Sikdar, 2008). The contribution in marginal costing technique is computed after taking away variable costs from sales value. This is the way in which the total share from all products/services incurred towards the total fixed costs by the business is also taken into account. Since the fixed costs are dealt with as period costs they are subtracted from total share to compute net profit (Sikdar, 2008). In the perspective of costing for a product/service, an absorption costing regards a share of all costs incurred by a business with regard to each of its products/services. Costs are segregated based on their functions under absorption costing technique. Apart from this costs which are incurred with reference to other business functions are subtracted to compute the net profit. Thus we can infer that absorption costing is a better info give to price products since it takes into account both variable and fixed costs (Sikdar, 2008). Meaning and definition of Marginal costing and Absorption costing The costs that fluctuate with a resolution should only be included in decision analysis. For many decisions that engage comparatively small fluctuations from accessible practice and/or are for comparatively restricted periods of time, fixed costs are not applicable to the decision. This is as either fixed costs have a tendency to be impractical to change in the short term or managers are hesitant to change them in the short term (Janet et., all, 2002). Marginal costing is properly defined as: “the accounting system in which variable costs are charged to cost units and the fixed costs of the period are written-off in full against the aggregate contribution. Its special value is in decision making’. (Terminology) The theory of marginal costing is set out in “A report on Marginal Costing” published by CIMA, London and it is as follows: “In relation to a given volume of output, additional output can normally be obtained at less than proportionate cost because within limits, the aggregate of certain items of cost will tend to remain fixed and only the aggregate of the remainder will tend to rise proportionately with an increase in output. Conversely, a decrease in the volume of output will normally be accompanied by less than proportionate fall in the aggregate cost” (Http://www.acca.ora.uk, accessed on 13th April, 2010). The CIMA has defined marginal cost as “the cost of one unit of product or service which would be avoided if that unit were not produced or provided. It is the accountings system in which variable costs are charged to cost units and fixed costs of the period are written-off in full against the aggregate contribution. Its special value is in decision- making.” (Http://www/bized.ac.uk - Learning resources contain summary notes on main topics accessed on 14th April 2010). Absorption costing is a costing technique where all normal costs whether it is variable or fixed costs are charged to cost units produced (http://basiccollegeaccounting. com/what-is-absorption-costing-its-advantages-and-disadvantages/ accessed on 14th April 2010). Absorption costing is “an accounting practice in which fixed and variable costs of production are absorbed by different cost centers. Providing all the products or services can be sold at a price that covers the allocated costs, this method ensures that both fixed and variable costs are recovered in full. However, should sales be lost because the resultant price is too high, the organization may lose revenue that would have contributed to its overhead” (http://dictionary.bnet.com/definition /absorption+costing.html accessed on 14th April 2010). Calculation of profits in Marginal costing and Absorption costing Marginal costing may show the way to lower prices than which is tendered if the firm tends to operate below its full capacity. But customers may still anticipate these lesser prices as demand/capacity increments (Sikdar, 2008). A Worked out Example on Marginal and Absorption Costing techniques (Mohan & Goyal, 2000): Data for a Quarter of a manufacturing company:— Level of Activity 60% 100% Sales and Production(Units) 36,000 60,000 $. (’000) $. (’000) Sales 432 720 Production costs : (Variable and fixed) 366 510 Sales, distribution and administration costs (Variable and fixed) 126 150 The normal level of activity for the current year is 60,000 units, and fixed costs are incurred evenly throughout the year. There were no stocks of the product at the start of the quarter, in which 16,500 units were made and 13,500 units were sold. Actual fixed costs were the same as budgeted. Then, various calculations regarding Absorption vs. Marginal costing can be worked out as under:— Production Costs $ Sales etc costs $ Total costs of 60,000 units (fixed plus variable) 5,10,000 1,50,000 Total costs of 36,000 units (fixed plus variable) 3,66,000 1,26,000 Difference = variable costs of 24,000 units 1,44,000 24,000 Variable costs per unit $ 6 $ 1 Production Costs ($) Sales etc. Costs ($) Total costs of 60,000 units 5,10,000 1,50,000 Variable costs of 60,000 units 3,60,000 60,000 Fixed costs 1,50,000 90,000 The rate of absorption of fixed production overheads will therefore be: $1,50,000 ÷ 60,000 = $ 2.50 per unit. (i) The fixed production overhead absorbed by the products would be 16,500 units produced × $ 2.50 = $ 41,250 (ii) Budgeted annual fixed production overhead = $1,50,000 $ Actual quarterly fixed production overhead = budgeted quarterly fixed production overhead (1,50,000 ÷ 4) 37,500 Production overhead absorbed into production [see (i) above] 41,250 Over -absorption of fixed production overhead 3,750 (iii) (a) Profit statement for the quarter, using Absorption Costing $ $ $ Sales (13,500× Rs.12) 1,62,000 Costs of production (no opening stocks) Value of stocks produced (16,500 × Rs. 8.50) 1,40,250 Less value of closing stock (3,000 units × full production cost of Rs. 8.50) (25,500) 1,14,750 Sales etc costs Variable (13,500 × Re. 1) 13,500 Fixed (1/4 of Rs. 90,000) 22,500 36,000 Total cost of sales 1,50,750 Less over-absorbed production overhead 3,750 1,47,000 Profit 15,000 b) Profit statement for the quarter using Marginal Costing $ $ Sales (13,500×Rs.12) 1,62,000 Variable costs of production (16,500 × Rs. 6) 99,000 Less value of closing stocks (3,000 × Rs. 6) 18,000 Variable production cost of sales 81,000 Variable sales etc. costs (13,500 × Re.1) 13,500 Total variable cost of sales (13,500 × Rs. 7) 94,500 Contribution (13,500 × Rs. 5) 67,500 Fixed Costs: Production 37,500 Sales etc. 22,500 60,000 Profit 7,500 Source of the above problem: (Mohan & Goyal, 2000). From the above it can be concluded that profits under Marginal and Absorption Costing techniques are not similar. This is due to the following reasons (http://basiccollege accounting.com/comparing-absorption-costing-to-marginal-costing/ retrieved on 14th April, 2010). 1. Over and under Absorption of overheads Fixed overheads in absorption costing can never be taken in accurately due to the difficulty in estimating costs and amount of output. Thus these balance of under or over absorbed/recovery are written off to costing profit and loss account. This is the reason that the real amount incurred is not shown. Where as in marginal costing, the definite fixed overhead incurred is completely committed against contribution and thus, there will be some deviation in net profits. 2. Variation in stock valuation Work in progress and completed stocks are always estimated at marginal cost in marginal costing, where as they are valued at total production cost in absorption costing. Thus the difference in profit also arises as the amounts of fixed overheads considered in both accounts are not the same (Johnson and Kaplan, 1987). Difference in profit arising out of different stock valuation is summed up as follows (Johnson and Kaplan, 1987): a. No difference in profit occurs when there is no opening and closing stocks. b. No difference in profit occurs when the opening and closing stocks are of the same amount. c. In situations where closing stock is more than opening stock, the profit derived under absorption costing will be higher because a larger portion of fixed cost is incorporated in closing stock and carried forward to next period. d. In situations where closing stock is less than opening stock, the profit derived under absorption costing will be less because a larger portion of fixed cost is incorporated in opening stock and is debited in the current period (http://basiccollege accounting.com/comparing-absorption-costing-to-marginal-costing/ retrieved on 14th April, 2010). It can be presumed from the above that marginal costing allows for decisions to be made on product cost since it can influence the selling price for a product. Apart from this other crucial decisions with regard to manufacturing the product or purchasing the same can also be taken with the help of marginal costing. Even though during certain accounting period marginal costing may show higher profit than absorption costing the total profit will remain the same irrespective of the techniques used (Dyson, 1988). Long term decision with regard to the company affairs can be take with the help of absorption costing since it provides the total cost of the production of goods. This is due to the reason that the total revenue has to cover the direct costs of company and its overheads as well. Also the company can take a decision with regard to increasing or decreasing the selling price of a product with the help of absorption costing. This is because the decision involves in either increasing the selling price or decreasing the overheads so that the product produced at a cheaper cost. On the other hand, any decisions taken will also have to take into account the reality that absorption costing trusts on info from budgets and so may be faulty (Dyson, 1988). The fundamental concern between absorption costing and marginal costing is the method in which the costs of a business's input resourcefulness are best coordinated and exhibited so as to key out individual product/service and entire business profit (Johnson and Kaplan, 1987). The selection of costing arrangement may be regulated by the costing method. Precise order costing systems will regularly set up full absorption costing. One argument for this is that the valuation of each singular piece of work will constantly make reference to the total costs implemented. Constant operation costing means are more liable to set up marginal costing due to the opportunities presented in such environs to use cost-volume-profit analysis (Miles and Scott, 2002). In product/service costing, a marginal costing arrangement stresses the behavioural, instead of the functional, features of cost. The spotlight is on sorting out costs into variable elements and fixed elements. Despite the fact that this is not effortlessly accomplished with correctness, and is a generalization of realism, marginal costing info can be very helpful for short-term planning, decision-making and control particularly in a multi-product business. Absorption costing is a mode of inventory costing and all variable manufacturing costs and all fixed manufacturing costs are integrated as inventorial costs. Under an absorption costing system, the profit accounted for a manufacturing business for a period will be determined by the quantity of production and by the level of sales (Miles and Scott, 2002). Thus we can infer that marginal and absorption costing vary in only one way and that is ‘how to account for fixed manufacturing costs’. Under marginal costing, fixed costs are not included in inventory costs. Where as under absorption costing these costs become a part of the cost of goods sold during the period when the sales occur. At the same time under marginal costing, accounted operating income is determined by the unit level of sales. Under absorption costing, the same is determined by the unit level of production and by the unit level of sales. Even though absorption costing is the requisite inventory technique for external reporting in many countries, many companies employ marginal costing for internal accounting (Martin, 1994). Full absorption costing which is also known as full costing and absorption costing is a conventional process where all manufacturing costs are capitalized in the stock, i.e., added to the inventory and become assets. This only means that these costs are not taken as expenses till the inventory is sold. This results in more close approximation in matching. All the costs relating to selling and administrative expenses are also charged to expenditure account (Martin, 1994). Conclusion Thus we can conclude by stating that marginal cost is the cost management procedure for the study of cost and revenue information and for the direction of management. The display of information through marginal costing statement is well inferred by all mangers, even those who do not have basic knowledge and entailments of the subjects of cost and management accounting. In reality we can say that absorption costing and marginal costing are two different methods of cost accounting. Absorption costing is extensively used for cost control function whereas marginal costing is used for managerial decision-making and control. In variable costing profit can be expressed as a function in terms of sales while absorption costing system, profit is a function of both production and sales. Under absorption costing system, if all other factors remain unchanged then sales may increase and profit may decline. While under marginal costing, if sales increase, then it is always true that profits also increases. Even though variable costing is not allowed for financial accounting, many managers find it constructive for management accounting and decision making. Where as variable costing inclines to show prices in the same mode as they are incurred. Variable costs are expressed on a per-unit basis and fixed costs in total. Reference 1. Brammer, Janet; Cox, David; Fardon, Michael; Penning, Aubrey. 2002. “Active Accounting”. Osborne Books Ltd. 2. Dyson, J., 1998. “Accounting or Non-Accounting Students”. London, Pitman 3. Man Mohan, Goyal, S. N., 2000. “Principles of Management Accounting”. Sahitya Bhawan Publications. 4. Martin J.R.1994. “A controversial-issues approach to enhance management accounting education” Journal of Accounting Education, 12 (1). 5. Miles, David, and Scott, Andrew. 2002. “Macroeconomics: understanding the wealth of nations.” India. Wiley. 6. Sikdar, P. K., 2008. “Marginal Costing vs. Absorption Costing: a practical perspective.” The Management Accountant. 43(6) 7. Thomas, Johnson, H., and Robert, Kaplan, S.1987. “Relevance Lost”. Harvard Business School Press. 8. http://dictionary.bnet.com/definition /absorption+costing.html accessed on 14th April 2010 9. http://basiccollege accounting.com/comparing-absorption-costing-to-marginal-costing/ retrieved on 14th April, 2010. 10. http://basiccollegeaccounting. com/what-is-absorption-costing-its-advantages-and-disadvantages/ accessed on 14th April 2010 11. Http://www/bized.ac.uk - Learning resources contain summary notes on main topics accessed on 14th April 2010. 12. Http://www.acca.ora.uk, accessed on 13th April, 2010 Read More