Marginal and Absorption costing notes PDF

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Difference Between Marginal Costing and Absorption Costing There are two alternative approaches for the valuation of inventory, they are: Marginal Costing and Absorption Costing. Marginal Costing excludes fixed cost of production, whereas Absorption Costing includes the same. Marginal Costing Vs Absorption Costing 1. Comparison Chart 2. Definition 3. Key Differences 4. Conclusion

Comparison Chart BASIS FOR COMPARISON

MARGINAL COSTING

ABSORPTION COSTING

Meaning

A decision making technique for ascertaining the total cost of production is known as Marginal Costing.

Apportionment of total costs to the cost center in order to determine the total cost of production is known as Absorption Costing.

Cost Recognition

The variable cost is considered as product cost while fixed cost is considered as period costs.

Both fixed and variable considered as product cost.

Classification Overheads

Fixed and Variable

Production, Administration and Selling & Distribution

Profitability

Profitability is measured by Profit Volume Ratio.

Due to the inclusion of fixed cost, profitability gets affected.

Cost per unit

Variances in the opening and closing stock does not influence the cost per unit of output.

Variances in the opening and closing stock affects the cost per unit.

Highlights

Contribution per unit

Net Profit per unit

of

cost

is

Resource: kfknowledgebank.kaplan.co.uk › ACCAPEDIA › Wiki Page Difference between Absorption Costing and Marginal Costing

Main Difference – Absorption Costing vs. Marginal Costing Marginal costing and absorption costing are two different approaches dealing with fixed production overheads. In other words, this involves determining whether or not to include fixed overheads in decision making such as inventory valuation, pricing, etc. Absorption costing is a method of costing a product in which all fixed and variable production costs are apportioned to products. This method ensures that costs incurred are recovered from the selling price of a product. Marginal costing is an accounting system in which variable costs are charged to products and fixed costs are considered as periodic costs. The main difference between absorption costing and marginal costing lies in how the two techniques treat fixed production overheads. Under marginal costing, fixed manufacturing overhead costs are not allocated to products. This is contrasted withabsorption costing, where fixed manufacturing overheads are absorbed by products. Absorption costing is a procedure of tracing both variable costs and fixed costs of production to the product whereas marginal costing traces only variable costs of production to the product while fixed costs of production are considered periodic expenses.

What is Absorption Costing Absorption costing is a method of calculating the full cost of a product. As a result, absorption costing is also known as full costing. Under absorption costing, the entire cost of production is apportioned to products. These costs could be direct costs or indirect costs (variable and fixed overheads). Fixed overheads are usually applied based on a predetermined overhead absorption rate. One or more overhead absorption rates could be employed. Costs assigned to products under absorption costing are as follows;

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Direct material: Materials included in a finished product

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Direct labour: Labour cost required to construct a product

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Variable manufacturing overheads: Cost of operating a manufacturing facility, which vary with production volume i.e. electricity for production equipment

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Fixed manufacturing overheads: Cost of operating a manufacturing facility, which do not vary with production volume i.e. rent

Absorption costing ensures that all incurred costs are recovered from selling price of a good or service. Opening and closing inventory are valued at full production cost under absorption costing.

Definition Absorption costing is a method of costing a product in which all fixed and variable production costs are apportioned to products. Marginal costing is an accounting system in which variable costs are charged to products and fixed costs are considered as periodic costs.

Inventory Valuation Absorption Costing values inventory at full production cost. Fixed cost relating to closing stock is carried forward to the next year. Similarly, fixed cost relating to an opening stock is charged to the current year instead of the previous year. Thus, under absorption costing, all fixed cost is not charged against revenue of the year in which they are incurred. Marginal Costing values inventory at a total variable production cost. Therefore, there is no chance of carrying forward unreasonable fixed overheads from one accounting period to the next. However, under marginal costing, the value of inventory is understated.

Effect on Profit As inventory values are different under absorption and marginal costing, profits too differ under two techniques.

1. If inventory levels increase, absorption costing gives the higher profit. This is because fixed overheads held in closing inventory are carried forward to the next accounting period instead of being written off in the current accounting period.

2. If inventory levels decrease, marginal costing gives the higher profit. This is because the fixed overhead brought forward in opening inventory is released, thereby increasing the cost of sales and reducing profits.

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If inventory levels are constant, both methods give the same profit.

Treatment of Fixed Cost Absorption Costing includes fixed production overheads in inventory values. However, fixed overheads cannot be absorbed exactly due to difficulties in forecasting costs and volume of output. Therefore, there is the possibility that overheads could be over or under absorbed. Overhead is over-absorbed when the amount allocated to a product is higher than the actual amount and it is under absorbed when the amount allocated to a product is lower than the actual amount. In Marginal Costing, fixed production overheads are not shared out among units of production. Actual fixed overhead incurred is charged against contribution as a periodic cost.

Usefulness of the Technique Absorption Costing is more complex to operate and it does not provide any useful information for decision making like marginal costing. Cost data produced under absorption costing is not very useful for decision making because product cost includes fixed overhead obscuring cost-volume-profit relationship. However, absorption costing is required for external financial reporting and income tax reporting. Marginal Costing does not allocate fixed manufacturing overheads to a product. As a result, marginal costing could be more useful for incremental pricing decisions where a company is more concerned about additional cost required to build the next unit. Identification of variable costs and contribution enables management to use cost information more easily for decision making.

Presentation in Financial Statements Absorption Costing is acceptable under IAS 2, Inventories. Thus, absorption costing is required for external financial reporting and income tax reporting. Marginal Costing is often useful for management’s decision making. Exclusion of fixed cost from inventory affects profit. Therefore, true and fair view of financial statements may not be clearly transparent under marginal costing.

References: ACCAPEDIA – Kaplan.” Kaplan Financial Knowledge Bank. N.p., n.d. Web. 30 Oct. 2015. “Criticism of Marginal Costing | Limitations of Absorption …” tutorsonnet.com.N.p., n.d. Web. 30 Oct. 2015. “Cost Accounting | Case Study Solution | Case Study Analysis.” Accounting Blog. N.p., n.d. Web. 30 Oct. 2015

The advantages and disadvantages of absorption and marginal costing

Advantages and disadvantages of absorption and marginal costing

 

The main disadvantages of marginal costing are that closing inventory is not valued in accordance with SSAP 9 principles and that fixed production overheads are not 'shared' out between units of production, but written off in full instead. The main disadvantages of absorption costing are that it is more complex to operate than marginal costing and it does not provide any useful information for decision making (like marginal costing does).

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Advantages of Absorption Costing and Marginal Costing According to ACCA (2006) the following arguments have been advanced for using absorption costing: 1. It is necessary to include fixed overhead in inventory values for financial statements. This is because routine cost accounting using absorption costing produces inventory values which include a share of fixed overhead. Based on this argument, financial statements prepared using absorption costing present a true and faithful representation of the actual results of operation of the company. The inventory values are also calculated in accordance with International Accounting Standards (IAS2) and UK

GAAP. HMRC also require absorption costing to be the basis for inventory values for taxation computations 2. For a small jobbing business, overhead allotment is the only practicable way of obtaining job costs for estimating and profit analysis. 3. Analysis of under/over-absorbed overhead is useful to identify inefficient utilisation of production resources. ACCA (2006) also identifies a number of arguments in favour of marginal costing. Preparation of routine cost accounting statements using marginal costing is considered more informative to management for the following reasons: 1. Contribution per unit represents a direct measure of how profit and volume relate. Profit per unit is a misleading figure. Contribution is also much more useful for decision making as any contribution towards the fixed overheads of an organisation is deemed to be beneficial. 2. Build-up or run-down of inventories of finished goods will distort comparison of operating profit statements. In the case of closing inventory, the inventory is valued only at the variable cost per unit. This makes the profit under a situation where there is closing inventory to be the same as the case when there is no closing inventory thereby enabling the comparison of operating profit statements over time. 3. Unlike under absorption costing, marginal costing avoids the arbitrary apportionment of fixed costs, which in turn result in misleading product cost comparisons. Source: https://www.ukessays.com

Definition of Marginal Costing Marginal Costing, also known as Variable Costing, is a costing method whereby decisions can be taken regarding the ascertainment of total cost or the determination of fixed and variable cost in order to find out the best process and product for production etc. It identifies the Marginal Cost of production and shows its impact on profit for the change in the output units. Marginal cost refers to the movement in the total cost, due to the production of an additional unit of output. In marginal costing all the variable costs are regarded as product related costs while fixed costs are assumed as period costs. Therefore, fixed cost of production is posted to the Profit & Loss Account. Moreover, fixed cost is also not given relevance while determining the

selling price of the product or at the time of valuation of closing inventory (whether it is finished goods or Work in Progress). Definition of Absorption Costing Absorption Costing is a method for inventory valuation whereby all the manufacturing expenses are allocated to the cost centers to recognize the total cost of production. These manufacturing expenses include all fixed as well as variable costs. It is the traditional method for cost ascertainment, also known by the name Full Absorption Costing. In an absorption costing system, both the fixed and variable costs are regarded as product related cost. In this method the objective behind the assignment of the total cost to cost center is to recover it from the selling price of the product. On the basis of function, the expenses are divided into Production, Administration and Selling & Distribution. The following are the types of Absorption Costing: 

Activity Based Costing

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Job Costing

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Process Costing

Key Differences Between Marginal Costing and Absorption costing 1. The costing method in which variable cost is apportioned exclusively, to the products is known as Marginal Costing. Absorption Costing is a costing system in which all the costs are absorbed and apportioned to products. 2. In Marginal Costing, Product related costs will include only variable cost while in case of Absorption costing, fixed cost is also included in product related cost apart from variable cost. 3. Marginal Costing divides overheads into two broad categories, i.e. Fixed Overheads and Variable Overheads. Look at the other term Absorption costing, which classifies overheads in the following three categories Production, Administration and Selling & Distribution.

4. In marginal costing profit can be ascertained through the help of Profit Volume Ratio [(Contribution / Sales) * 100]. On the other hand, Net Profit shows the profit in case of Absorption Costing. 5. In Marginal Costing variances in the opening and closing inventory will not influence

the per unit cost. Unlike Absorption Costing, where the variances between the inventory at the beginning and at the end will show its effect by increasing / decreasing per unit cost....