Absorption and Marginal Costing - Assignment Example

Comparative Analysis of Absorption and Marginal Costing Calculate the profit at actual sales volume of 200,000 units, using the following methods: A) Absorption costing B) Marginal costing Simpson Ltd Calculation of Profit under Absorption Costing units Price/unit Total Sales 20, 000 35 700, 000 Variable Costs 20, 000 15 300, 000 Fixed Cost 300, 000 Profit 100, 000 Calculation of Profit under Marginal Costing sales 20, 000 35 700, 000 Less Variable Costs 20, 000 15 300, 000 Contribution 400, 000 Less Fixed Cost 300, 000 Profit 100, 000 Explain the two costing methods and their different results. Discuss how the absorption costing method manipulates profits. It is evident from the above calculation that the profits under both methods remain the same. It implies that marginal costing and absorption costing produce the same results with the exception that the procedure of ascertaining profit does not match. Absorption costing popularly known as full costing involves the calculation of profit by deducting all types of costs irrespective of its variability. It means both fixed and variable costs are deducted from sales proceeds to ascertain profit. Naturally, the profit shown under full costing method is the surplus made by the firm after providing for all kinds of costs. In contrast to this, marginal costing, which is also called variable costing, takes into account only the variable cost as product cost for the calculation of profit. The profit calculation under this method involves two stages, namely contribution and profit. Contribution is the difference between sales proceeds and variable costs. The calculation of contribution is essential in certain types of firms where there are many period costs and also it is necessary to calculate the costs of each product and / or department or process. Once contribution is ascertained, the next step is the computation of profit of the business, which represents the overall profits of all product, department or process, by deducting fixed expenses from the contribution so achieved. If the contribution exceeds the fixed costs, the resultant figure is known as profit. When it is negative, the firm is incurring a loss. There are also chances of both contribution and fixed expenses being the same, such a situation is called no profit no loss point or technically, break-even point. The following differences can be identified between absorption and marginal costing: Product Costing: Under absorption costing, all costs whether fixed or variable are treated as product costs. The cost units are made to bear the burden of full costs even though fixed costs are period costs and have no relevance to current operations. Under the marginal costing technique, however, only variable costs are treated as product costs and the fixed costs are transferred to costing profit and loss account in full to be deducted from the contribution to ascertain profit/loss Inventory Valuation: Under absorption costing technique, inventories of work-in-progress and finished goods are treated at full costs, while marginal costing values finished and work-in-progress inventory at their variable cost. Naturally, the method of valuation has the effect of carrying over fixed cost to the subsequent period under absorption costing and this will not happen in the case of marginal costing Profit Concept In the case of absorption costing, profit is the difference between sales revenue and total cost. As such managerial decision making is wholly depended upon this concept of profit. Opposite to this, the excess of sales revenue over marginal costs are coined as contribution and managerial decision making revolves around this concept of profit. Under and over absorption of Overhead Under absorption costing, since fixed costs are also treated as product cost, the inclusion of the same and their arbitrary apportionment over the products give rise to the problem of under or over absorption of overheads. Marginal costing does not give rise to any such problem since fixed costs are excluded from the purview of product costs. Compare the two costing methods and analyse their strength and weakness in financial reporting (the aspect of Financial Accounting) and management decision-making (the aspect of Management Accounting). Examples are required. Cost is the base for ascertaining profit or fixing selling price or valuing inventory. Different bases are used to for classifying costs for different purposes. The methods of ascertaining product cost and profit are of two types: 1. Absorption Costing, and 2. Marginal Costing Before discussing these costing methods, it is desirable to have a brief note on the type of costs on the basis of periodicity, namely product cost and period cost. Product costs are associated with unit of output. They are the costs absorbed by or attached to the units produced. These costs go into the determination of inventory valuation (finished goods and work-in-progress), hence are called product costs. In contrary to this, period costs are costs associated with time period rather than unit of output or manufacturing activity. These costs are not treated as part of inventory and hence treated as expenses of the period in which they are incurred. Administration, selling and distribution costs are treated as period cost and are deducted as an expense for the determination of income and are not regarded as a part of inventory. Absorption Costing It is a costing accounting method of charging all direct costs and all production costs of an organisation to specific units of production. Absorption costing is also known as full cost or total cost method. In fact, it is an approach to product costing, wherein the total cost is considered. The production cost of product, process or operations consists of manufacturing costs, both fixed and variable as well as direct and indirect cost. In absorption costing method, most of the fixed cost is treated as part of product cost and inventory values are arrived at accordingly. It is the simplest and conventional method in practice. The following are the some of the important features of this method: All costs are charged to units manufactured; Price computed based on absorption costing ensures that all costs are recovered; It ensures the adherence to the accounting matching concept wherein all costs are matched with the revenue of the period in which they are incurred; It makes calculation of gross profit and net profit separately in income statements possible; It discloses the efficient and inefficient utilisation of resources by indicating under absorption and over absorption of factory overheads; Limitations of Absorption Costing Even though, absorption costing is having so many advantageous, it is not free from limitations. The following are the important limitations: Comparison and control of cost is difficult because it depends on the level of output. An increase in the level of output reduces the unit cost and a decrease in the production level increases the unit costs. Managerial decisions such as make or buy a product, choice of alternatives, fixation of selling price, number of units to be produced to earn a desired profit, etc cannot be taken with the help of absorption costing because it considers the total cost and not the variable cost which is important for taking such decisions. In absorption costing, closing stock is valued at cost of production (fixed cost and variable cost), which means a portion of fixed cost is carried forward to the next period. The above limitations do not imply that absorption costing can be completely avoided as a method of costing. It can still be used and preferred in certain contexts. The following points will detail the circumstances in which this method is extensively applied: Production cannot be achieved without incurring fixed costs. As such fixed costs are related to production. Absorption costing allows incorporating both fixed and variable costs Inclusion of fixed costs in the valuation of inventory becomes absolutely necessary if building up of stock is necessary part of business operations. For instance, in the case of timber seasoning and fireworks, stock have to be built up. If fixed costs are avoided from inventory valuation that would result in fictitious assets to be shown in earlier years and excessive profit when goods are actually sold. Profit fluctuations are less when production is constant but sales fluctuate This technique enables matching of costs and revenue in the period in which revenue arises and not when costs are incurred The inclusion of fixed costs does not give room for fixation of price below total costs although some contribution is generated Marginal Costing It is also known as variable costing or direct costing. This technique takes into account only the variable cost as product cost. In other words, fixed costs under this method are considered as period costs and charged directly to profit and loss account. According to CIMA, London, marginal costing is the “ascertainment of marginal costs and the effect on profit of the changes in the volume or type of output by differentiating between fixed costs and variable costs”. Features of Marginal Costing All costs are classified into fixed and variable costs. Variable cost varies according to the level of activity but per unit variable cost remain fixed. Fixed cost is fixed in absolute value at any level of activity. Under marginal costing, fixed costs are treated as period costs and variable costs as product costs. Inventories are valued at marginal cost. When marginal costing is followed in process costing, products are transferred from process to process at marginal cost. Product is priced at marginal cost and contribution. The profitability of products and divisions are determined on the basis of contribution margin Under marginal costing, the importance is given to total contribution and contribution from each product while presenting the data. There is no effect of differences in the amount of opening stock and closing stock on unit cost of production in marginal costing. Limitations of Marginal Costing Separation of all cost into fixed and variable is practically difficult, because neither the variable cost is absolutely variable nor the fixed expenses are absolutely fixed. This problem of classification becomes more complicated with the presence of semi-variable and semi-fixed expenses Time factor in not given due importance in marginal costing and all those expenses connected to time are excluded. Therefore, the pricing decision based on marginal costing is useful in short run but not in the long run. The long run decisions are based only on total cost and not o variable cost Marginal cost understates the stock of finished goods and work-in-progress, because of which balance sheet will not show a true and fair view of the state of affairs of the business As the closing stock is valued at variable cost under marginal costing technique, the entire loss on account of goods destroyed cannot be recovered from the insurance company It fails to reveal the effect of change in manufacturing practice, for example, replacement of labour force by machine Marginal costing may be preferred on the following grounds: Since fixed costs accrue on a time period, they are independent on production. Therefore, no attempt is made to relate fixed cost with production. This avoids complicated and misleading statements Profits are not overstated since fixed costs are not absorbed in unsold stock The technique does not give rise to under or over absorption of overheads Contribution is a more effective measure of the effect of making and selling a product than the profit figures obtained from absorption costing Invisible fixed costs need not be apportioned on an arbitrary basis Accounts prepared under this method more nearly approach the actual cash flow position. Value of Marginal Costing to management By separating the costs into fixed and variable costs, marginal costing exercise effective control over it and also facilitates responsibility-oriented control Marginal costing, by analysing the cost data, showing the variable cost and contribution for each product and product line, aids the management in taking appropriate decisions Marginal costing leads to accuracies in calculation of profits as the valuation of closing stock of finished goods and work-in-progress are easy and simple The data presented are more reliable and more acceptable, as it excludes the fixed costs and also avoids allocation and apportionment. Usually the fixed costs are not allocated and apportioned on scientific basis The cost information presented under marginal costing is simple, comparable and more effective tool for managerial decision making process References Baumol, J. William, 1996, Microtheory: applications and origins, MIT Press Broadbent, Michael and John Cullen, 2003, Managing Financial Resources, 3, Butterworth-Heinemann Chadwick, Leslie, 1993, Management accounting, illustrated, Routledge Conkling, Roger L. 2004, Marginal cost in the new economy: a proposal for a uniform approach to policy evaluations, llustrated, M.E. Sharpe Crowther, David, 2004, Managing finance: a socially responsible approach, illustrated, Butterworth-Heinemann Drury, Colin, 2007, Management and Cost Accounting, 7, Cengage Learning EMEAISBN Lucey, Terry, 2002, Costing, 6, Cengage Learning EMEA, 2002 Friedlob, G. Thomas, Lydia Lancaster Folger Schleifer, and Franklin James Plewa, 2002, Essentials of corporate performance measurement, illustrated, John Wiley and Sons Kahn, Alfred Edward, 1988, The economics of regulation: principles and institutions 2, MIT Press Lock, Dennis and Gower Publishing Company, 1998, The Gower handbook of management, 4, Gower Publishing, Ltd Read More