Absorption Costing Vs Marginal Costing | Case Study

As Marabs Manufacturing Limited deals in different products, some standard while others customised, it should accordingly adopt different but suitable techniques for costing these products. Absorption costing and marginal costing are two different techniques of cost accounting which can be used by Marabs Manufacturing. These techniques may be suited under different circumstances.

How is Absorption Costing Different from Marginal Costing?

Absorption costing is a traditional method of inventory costing that traces all manufacturing costs (the variable and the fixed costs of production) to the product. These costs do not become expenses until the inventory is sold. Absorption costing considers normal manufacturing costs as product costs and includes them for inventory valuation. As sales occur, the cost of inventory is transferred to cost of goods sold. Absorption costing emphasises the functional characteristics of cost. Using this system, the profit reported for a manufacturing business for a period is influenced by the level of production as well as by the level of sales. The rationale for absorption costing is that it causes a product to be measured and reported at its complete cost. Absorption costing is based on the premise that even though it is difficult to trace costs like fixed manufacturing overhead to a particular unit of output it does not mean that they are not a cost of that output. As a result, such costs are allocated to products.

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In contrast, marginal costing is a costing technique of presenting cost data wherein variable costs and fixed costs are shown separately for managerial decision-making. Marginal costing system emphasises the behavioural characteristics of cost. The focus of this system of costing is on separating costs into variable elements and fixed elements. Under marginal costing, variable costs are charged to cost units and the fixed costs are treated as period costs and, as such, are simply deducted from contribution in the period incurred to arrive at net profit. Inventory/stock for profit measurement under marginal costing is valued at marginal cost. It is in sharp contrast to the total unit cost under absorption costing method.

There are various other points of difference. The key differences between marginal and absorption costing are:

• Accounting for Fixed Manufacturing Costs

Marginal and absorption costing differ in terms of treatment of fixed manufacturing costs. Under marginal costing, fixed manufacturing costs are excluded from inventory costs and are a cost of the period in which they are incurred. On the other hand, under absorption costing, these costs are included in the cost of inventory and become a part of cost of goods sold in the period when sales occur.

• Presentation of Sales and Cost Data Facilitating Decision-Making

Absorption costing does not differentiate between variable and fixed cost in the calculation of profits. But marginal cost statement very clearly indicates this difference in arriving at the net operational results of a firm. The differences in presentation are clearly shown in the costing pro-forma below.

ABSORPTION COSTING PRO-FORMA

MARGINAL COSTING PRO-FORMA

• Absorption of Fixed Overheads

In absorption costing, fixed overheads can never be completely absorbed. However, this is not so under marginal costing. Under marginal costing, the actual fixed overhead incurred is wholly charged against contribution.

• Stock Valuation

In marginal costing, work in progress and finished stocks are valued at marginal or variable cost, but in absorption costing, they are valued at total production cost.

• Difference in Profits

The net profits under absorption costing method and marginal costing methods differ if there is a difference between opening and closing stock values. 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 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.

Thus, absorption costing and marginal costing differ in their approach and treatment of costs. However, each method has its own advantages and disadvantages.

Arguments in Favour of Using Absorption Costing

Absorption costing is simple to administer and easy to understand, and may be appropriate when direct costs are of significance. Besides, absorption costing is required for outside reporting where other methods of costing such as marginal costing are not accepted. It is also widely used for cost control purpose. Thus, there are various arguments in favour of absorption costing are:

• Absorption costing does not need to separate costs into fixed and variable costs. This is especially useful in situations where separation of costs into fixed and variable is difficult and gives misleading results.
• Under marginal costing, stocks and work in progress are understated. The exclusion of fixed costs from inventories affect profit and true and fair view of financial affairs of an organisation may not be clearly transparent.
• Absorption cost data is more realistic than marginal cost data in case of highly fluctuating levels of production, e.g., in case of seasonal factories. Besides, volume variance in standard costing also discloses the effect of fluctuating output on fixed overhead.
• Application of fixed overhead depends on estimates and not on the actuals and as such there may be under or over absorption of the same. Absorption costing takes care of this while marginal costing may not be able to do so.
• Absorption costing controls cost by means of budgetary control. This is an acceptable process to many.
• In order to know the net profit, one needs to take into account fixed overheads also. A system like marginal costing which ignores fixed costs is less effective since a major portion of fixed cost is not taken into account. Thus, absorption costing proves to be better.

Arguments in Favour of Using Marginal Costing

Despite its various advantages, absorption costing may not always prove to be the best approach to costing or pricing a product. It may not help management take important decisions about a product.

Marginal costing may prove to be a better system of costing. For the decision-making purpose of management, better information about expected profit is obtained from the use of variable costs and contribution approach in the accounting system. The arguments that favour marginal costing are:

• It is simple to understand and avoids having varying charges per unit as it does not charge fixed overhead to cost of production.
• It prevents the illogical carry forward in stock valuation of some proportion of current year’s fixed overhead.
• It facilitates cost control as it avoids arbitrary allocation of fixed overhead. Marginal costing uses cost control methods such as flexible budgets.
• It facilitates cost-volume-profit (CVP) or breakeven analysis and profitability analysis and thus helps in short-term profit planning. It also helps an organization compare profitability and performance between two or more products and divisions and help the management in decision making.
• Under marginal costing system, large balances are not carried under overhead control accounts and thus there is no difficulty of ascertaining an accurate overhead recovery rate.
• As marginal costing is much closer to cash flow managers usually find it easier to understand marginal costing reports.

Using Both Absorption Costing and Marginal Costing

Like any other organization, a manager at Marabs Manufacturing Limited will need to take decisions when he encounters problems and alternative courses of action are available. In deciding which option to choose he will need all the relevant information. In most cases cost information proves to be relevant to any decision making.

However, no single costing approach can provide appropriate information for taking decisions in all circumstances. In certain cases absorption costing will provide more complete information while in other cases marginal costing information will be more relevant. The theoretical basis for absorption costing is that decisions should be based on the matching principle for all manufacturing costs. Marabs Manufacturing incurs fixed manufacturing cost with the expectation that the resources represented by these costs will be used in the production of inventory. Hence, these costs should be matched against the revenue generated from the sale of that inventory. In contrast, the theoretical reasoning for marginal costing is that fixed manufacturing overhead will be incurred in the short-run irrespective of the volume of production or level of inventory. A significant portion of the fixed manufacturing overhead costs is unavoidable in the short run even when the facilities are idle.

Marabs Manufacturing Limited is in a multi-product business. Some products are standard products while others are based on specific orders or are customized according to specifications provided by customers. Wherever the company is costing for standard products it may use absorption costing. It is also given in the scenario that the standard products tend to be seasonal and highly fluctuating. Absorption cost data is more realistic than marginal cost data in case of highly fluctuating levels of production. Absorption costing will also be useful while making certain decisions, for example the price to be charged for external services. However, all decisions related to specific orders and or products adapted to meet the requirements of individual customers should be based on marginal costs.

Thus, Marabs Manufacturing Limited should not restrict itself to just absorption costing or just marginal costing and use cost data based on both approaches. The chosen approach should depend on the nature of decision required. As a guideline, if the required decision relates to cost control, cost data based on absorption costing will be more appropriate. However, cost data based on marginal costing will be more appropriate for short-term managerial decision-making and control. Decision analysis should ideally include costs that vary with a decision. Though marginal costing identifies both fixed and variable costs its decisions are based on only the variable component of costs of an activity. Fixed costs are not relevant in case of many decisions that involve relatively small variations from existing practice and/or are for relatively limited periods of time. This is because fixed costs are difficult to alter in the short term. Variable cost corresponds closely with the expenditure necessary to produce and sell products and services and can therefore be used more readily in incremental analysis than absorption costing data. Marginal costing is also appropriate for decision making when an activity centre has short-term spare capacity.

Marginal costing will also help the company in taking a decision on the minimum price that could be charged for a product. This can be particularly useful for pricing additional sales at special reduced rates when sales have already been made at the normal selling price. As fixed costs have already been paid of all that is required to cover the variable costs of any additional sales

Finally, marginal costing can help Marabs Manufacturing take decisions related to:

• Budget planning and determining the volume of sales required to make a profit
• Pricing and sales volume decisions.
• Sales mix decisions, to determine in what proportions each product should be sold.
• Decisions that will affect the cost structure and production capacity of the company.
• Whether or not to close down a factory, department, product line or other activity, either because it is making losses or because it is too expensive to run.

To sum it up, both absorption as well as marginal costing techniques are appropriate for the company and one cannot be treated as better than the other. The choice of a technique should be dependent on the costing objective.

References:

• Charles T. Horngren, George Foster, Srikant M. Datar, Cost Accounting: A Managerial Emphasis, Prentice Hall
• John K. Harris, Cost Accounting Student Guide, 12th Edition, Prentice Hall
• Michael W. Maher, William N. Lanen, Madhav V. Rajan, Fundamentals of Cost Accounting, McGraw-Hill/Irwin
• Ronald W. Hilton, Frank H. Selto, Michael W. Maher, Frank Selto, Cost Management: Strategies for Business Decisions, McGraw-Hill College

• Absorption Costing / Full Costing accessed from: http://www.valuebasedmanagement.net/methods_absorption_costing.html