a costing and decision making technique

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Marginal costing is the increase or decrease in costs incurred as a result of one more or one less unit of output. It is a costing and decision making technique that uses the marginal costs of the cost units and fixed costs are treated as a lump sum that is deducted from the total contribution in obtaining the profit or loss of the period.

Absorption costing is a method in which the overheads of an organisation are charged to the production by means of the process of absorption. Costs are apportioned to cost centres. This is where they are absorbed using absorption rates.

With an absorption costing system, fixed manufacturing overheads are allocated to the products and these are included in the inventory valuations. With a variable costing system, only variable manufacturing costs are assigned to the product; fixed manufacturing costs are regarded as period costs and written off as a lump sum to the profit and loss account. Both variable and absorption costing systems treat non-manufacturing overheads as period costs.

With a variable costing system manufacturing fixed costs are added to the variable manufacturing cost of sales to determine total manufacturing costs to be deducted from sales revenues. Manufacturing fixed costs are assigned to products with an absorption costing system. Therefore, manufacturing cost of sale is valued at full cost (manufacturing variable costs plus manufacturing fixed costs). With an absorption costing system fixed manufacturing costs are unitized by dividing the total manufacturing costs by estimated output. If actual output differs from estimated output an under or over recovery of overheads arises. This is recorded as a period cost adjustment in the current accounting period.

When production exceeds sales, absorption costing systems report higher profits. Variable costing systems yield higher profits when sales exceed production. Nevertheless, total profits over the life of the business will be the same for both systems. Differences arise merely in the profits attributed to each accounting period.

The proponents of variable costing claim that it enables more useful information to be presented for decision making but such claims are questionable since similar relevant cost information can easily be extracted from an absorption costing system. The major advantage of variable costing is that profit is reflected as a function of sales, whereas with an absorption costing system, profit is a function of both sales and production. It is possible with absorption costing, when all other factors remain unchanged, for sales to increase and profit to decline. In contrast, with a variable costing system, when sales increase, profits also increase. A further advantage of variable costing is that fixed overheads are not capitalized in unsaleable stock. The argument that have been made supporting absorption costing include: absorption costing does not understate the importance of fixed costs, absorption costing avoids the possibility of fictitious losses being reported, fixed manufacturing overheads are essential to production and therefore should be incorporated in the product costs and internal profit measurement should be consistent with absorption costing profit measurement that is used for external reporting requirements.

Marginal costing is usually used for short term decision. If a full cost approach were adopted in these circumstances th wrong decision could be made. Regards fixed costs as period costs which wil be incurred simply as a result of being open for business. They are not therefore charged as a unit cost. Consequently if a sale is made revenue increases by the value of unit sold, costs increase by the variable costs that are incurred, if the fixed costs are already covered, the profit will increase by the sales less variable cost i.e. the contribution and the reverse is true if the volume of sales falls by one.

Absorption costing is used for long term dicisions under stable market conditions, Absorption costing uses the principle that al costs must b covered and a satisfactory profit made if the company is to survive. The method allocates direct costs to products and services, and apportions indirext costs firstly to cost centres and finally absorvs them into products suing an appropriate base. Production overheads are separated from other overheads because finished goods are valued at production cost, Selling, administration and distributing (SAD) overheads are added to arrive to total cost. It is used as a basis from which to apply a selling price, value stocks and compare profitability of different products.

Criticisms of marginal costing is that it is not easy to divide costs into fixed and variable costs, Variable does not always vary in direct proportion to increases in sales, e.g. advantages gained from bulk-buying: direct labour is often fixed in the short-term. Fixed costs may change to some extent as activity increases or decreases. Or disappear altogether if the organisation closes. A decision about one product may affect another if they are interdependent. The danger of working towards contribution is that fixed costs must ultimately be recovered. Non-cost factors also need to be taken into consideration. Despite the above, if used with caution, it is still a useful technique to use as part of the decision making process.

Criticisms of absorption costing are that the choice of an appropriate base is subjective. If an inappropriate apportionment or absorption method is used, the total cost will be inaccurate. Methods must therefore be continually reviewed. Rates of overhead absorption are pre-determined. Consequently, there is a danger they could either be under or over recovered. The complexity of many of todays businesses means that to use one cost driver to absorb overheads into products is inappropriate.

Executive summary This report will present an explanation of four main costing systems; it will describe the advantages and the disadvantages of marginal costing, absorption costing, process costing and service costing. It will also reveal whether these costing systems are suited to the company BP. Marginal costing is suitable for BP to use internally to calculate the number of units needed to be sold to break even. Marginal costing is appropriate for BP because it has many variable costs such as the products sold in stations and the transportation of the petrol; these are all dependent on the level of activity

1. Over and Under Absorbed Overheads

In absorption costing, fixed overheads can never be absorbed exactly because of difficulty in forecasting costs and volume of output. If these balances of under or over absorbed/recovery are not written off to costing profit and loss account, the actual amount incurred is not shown in it. In marginal costing, however, the actual fixed overhead incurred is wholly charged against contribution and hence, there will be some difference in net profits.

2. Difference in Stock Valuation

In marginal costing, work in progress and finished stocks are valued at marginal cost, but in absorption costing, they are valued at total production cost. Hence, profit will differ as different amounts of fixed overheads are considered in two accounts.

The profit difference due to difference in stock valuation is summarized as follows:

When there is no opening and closing stocks, there will be no difference in profit.

When opening and closing stocks are same, there will be no difference in profit, provided the fixed cost element in opening and closing stocks are of the same amount.

When closing stock is more than opening stock, the profit under absorption costing will be higher as comparatively a greater portion of fixed cost is included in closing stock and carried over to next period.

When closing stock is less than opening stock, the profit under absorption costing will be less as comparatively a higher amount of fixed cost contained in opening stock is debited during the current period.

The features which distinguish marginal costing from absorption costing are as follows.

In absorption costing, items of stock are costed to include a 'fair share' of fixed production overhead, whereas in marginal costing, stocks are valued at variable production cost only. The value of closing stock will be higher in absorption costing than in marginal costing.

As a consequence of carrying forward an element of fixed production overheads in closing stock values, the cost of sales used to determine profit in absorption costing will:

include some fixed production overhead costs incurred in a previous period but carried forward into opening stock values of the current period;

exclude some fixed production overhead costs incurred in the current period by including them in closing stock values.

In contrast marginal costing charges the actual fixed costs of a period in full into the profit and loss account of the period. (Marginal costing is therefore sometimes known as period costing.)

In absorption costing, 'actual' fully absorbed unit costs are reduced by producing in greater quantities, whereas in marginal costing, unit variable costs are unaffected by the volume of production (that is, provided that variable costs per unit remain unaltered at the changed level of production activity). Profit per unit in any period can be affected by the actual volume of production in absorption costing; this is not the case in marginal costing.

In marginal costing, the identification of variable costs and of contribution enables management to use cost information more easily for decision-making purposes (such as in budget decision making). It is easy to decide by how much contribution (and therefore profit) will be affected by changes in sales volume. (Profit would be unaffected by changes in production volume).

In absorption costing, however, the effect on profit in a period of changes in both:

production volume; and

sales volume;

is not easily seen, because behaviour is not analysed and incremental costs are not used in the calculation of actual profit.

In marginal costing, the identification of variable costs and of contribution enables management to use cost information more easily for decision-making purposes (such as in budget decision making). It is easy to decide by how much contribution (and therefore profit) will be affected by changes in sales volume. (Profit would be unaffected by changes in production volume).

Managerial cost is a cost management tool that guides management and analyses information of cost and revenue of the business. It is easily understood by all managers, even for managers who have not had any preliminary knowledge of the subject of cost and management accounting.