Defining marginal and absorption costing

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Marginal and absorption costing are costing systems used by all businesses to identify all the costs of their product or service and total business profit.

Marginal costing is used for short term decision making. It regards fixed costs as period costs therefore they are not charged as a unit cost. As a result if a sale is made, revenue will increase by the unit sold and costs will increase by the variable cost incurred. If fixed costs have already been covered by the business then profit will increase by the sales less variable cost i.e. the contributions and the reverse happens if the sales fall by one.

Absorption costing is mainly used for long term decision making when market conditions are stable. Absorption costing allocates direct costs to products and services and then apportions indirect costs to cost centres. It then absorbs them into products by using an appropriate base. For example in the case of JK Precision Ltd the factory overhead cost of machinery deprecation can be apportioned using the Value of Machinery base. As finished goods are valued at production cost, production overheads are separated from other overheads. Selling, administration and distribution costs are added to arrive at a total cost.

2. Executive summary

This report will introduce what marginal and absorption costing is. It will discuss the similarities and differences between managerial and absorption costing and where it may prove useful for businesses. In addition it is important to look at the advantages and disadvantages of marginal and absorption costing in order to evaluate which technique is the most effective to use for JK Precision Ltd.

3. Similarities and Differences between marginal and absorption costing

There are many similarities and differences between marginal and absorption costing. The net profit for marginal and absorption costing are not the same (Globusz 2001-2009). In absorption costing when production is higher than sales, it reports higher profits (Drury, C. 2006). However in marginal costing when sales exceed production it yields higher profits (Drury, C. 2006). “Nevertheless total profits over the life of the business will be the same for both systems. Differences arise in the profits attributed to each accounting period” (Drury, C. 2006: p227).

In absorption costing fixed manufacturing costs are absorbed by dividing the total manufacturing costs by estimated output. If estimated output is different to budgeted output then an under or over recovery of overhead arises. This is recorded as a period cost adjustment in the current accounting period. However, fixed overheads cannot always be absorbed as it is difficult to forecast costs and volume of output (Globusz 2001-2009). With a marginal costing system the actual fixed overhead incurred is charged against contribution and therefore there will be certain amount of difference in net profits (Globusz 2001-2009).

In marginal costing, the work that is in progress and the finished stocks are all valued at their marginal cost. However, in absorption costing they are valued as total production cost. Thus profits will differ as different amounts of overheads are taken into account (Globusz 2001-2009).

In absorption costing, the cost of items of stock are to include a ‘fair share’ of the fixed production overhead, whereas in marginal costing, stock are valued at variable production cost. Therefore the value of closing stock will be higher for absorption costing than marginal costing (Globusz 2001-2009). As a result carrying an element of fixed overheads in closing stock values forward, the cost of ales that determines 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 and 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 in full for that period. As a result marginal costing is therefore sometimes known as period costing (Globusz 2001-2009).

Profit per unit can be affected in any period for absorption costing as the actual absorbed unit costs are reduced by producing greater quantities, however this is not the case for marginal costing as the unit variable cost are unaffected with any increase or decrease in production activity (Globusz 2001-2009).

Managerial costing is widely used for managerial decision making and control, whereas absorption costing is mainly used for cost control purposes.

The absorption costing method allocates fixed manufacturing overheads to the products and these are included in the inventory valuations (Drury, C. 2006). With the marginal costing method, the variable manufacturing costs are allocated to the product and fixed manufacturing costs are regarded as period costs (Drury, C. 2006). This is then written off as a lump sum to the profit and loss account of the period (Drury, C. 2006). In comparison both marginal and absorption costing systems treat non-manufacturing overheads as period costs.

4. Advantages and Disadvantages of marginal and absorption costing

The advantages of absorption costing are that it recognizes the importance of fixed costs in production. It shows less fluctuation in net profit when production is constant and sales fluctuate (College Accounting Coach 2006). In addition it avoids the possibility of untrue losses being reported. However the criticisms are that the total cost will be inaccurate if an inappropriate apportionment of absorption method is used (Drury, C. 2006). Rates of overhead absorption are predetermined and as a result there is a threat of under and over recovery.

Marginal costing is easy to understand. It separates fixed and variable costs (College Accounting Coach 2006). Profit is reflected as a function of sales and no production and sales which is used in absorption costing. In marginal costing when sales increase, profits also increase and the main advantage is that fixed overheads are not capitalized as unsalable stock. The disadvantages of marginal costing are that it is not easy to separate fixed and variable costs. In addition variables costs may not vary in direct proportion to sales, e.g. economies of scales. Moreover fixed costs may not stay the same with increase and decrease in activity (Drury, C. 2006).

5. Situation where these methods prove useful

Marginal costing is mainly used for short term decision making as it provides better information. Marginal costing had proved to be a very useful short term survival technique especially when a business is in a competitive environment or a recession where orders are only accepted if it covers the marginal cost of the business and any excess over this is contributed into fixed costs so that losses are kept to a minimum (College Accounting Coach 2006), In addition, marginal costing helps in short-term profit planning by profitability analysis and breakeven. IT is used for internal reporting by many companies. Profitability and performance between products can be compared and divisions can be easily accessed and brought to the notice of management for decision making (College Accounting Coach 2006),

Absorption costing is particularly useful for long term decision making, where market conditions are stable. This method has been accepted by Inland Revenue as stock is not undervalued (College Accounting Coach 2006). Absorption costing is a very useful tool to prepare financial accounts for the business. Companies add selling, administration and distribution overheads as a basis for which to apply a selling price, value stocks and compare profitability of other products (Drury, C. 2006).

6. Evaluation

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 those who have not had any preliminary knowledge of the subject of cost and management accounting. However the difficulty of marginal costing is that it is not easy to separate fixed and variable costs and therefore it may not be a suitable technique to use for JK Precision Ltd. Absorption costing is a long-term decision making tool, however if an appropriate apportionment of absorption method is not used then the total costs will be inaccurate. Therefore JK Precision Ltd must continually review their method.