An insight into marginal and absorption costing

Published: Last Edited:

This essay has been submitted by a student. This is not an example of the work written by our professional essay writers.

Accounting is the process of identifying, measuring and communicating financial information about an entity to permit informed judgments and decisions by users of the information. Management accounting is a specialist branch of accounting which has developed to serve the particular needs of management. {Pauline Weetman, 2009, Management Accounting, p.4}

The costs that vary within a process should only be included in decision analysis. For many decisions that of a short time span, fixed costs are not relevant to the decision. This is because either fixed costs tend to be impossible to alter in the short term or managers are reluctant to alter them in the short term.

What is marginal costing?

Marginal Cost: is a part of the cost of a unit, which would be avoided if the unit wasn't produced, or would increase if the unit was produced.

Marginal costing is a technique of costing which includes only variable manufacturing costs, in the form of direct materials, direct labour, and variable manufacturing overheads while determining the cost per unit of a product. The marginal costing technique considers the behavioural characteristics of costs; it is useful for short-term planning, control and decision-making, particularly in a business where multi-products are produced. Contribution is calculated after deducting variable costs from sales value, where it treats fixed manufacturing overheads as period costs

In marginal costing, variable costs are charged as cost of sale. Fixed costs are treated as period costs and are charged in full to the income statement in the periods they are incurred. Marginal costing argues that fixed costs don't change with sales volume. So when selling extra; revenue will increase by sales value, costs will increase by variable costs and profit will increase by the contribution earned.

Marginal Costing Arguments:

It is simple to operate.

Fixed costs will be the same regardless of the volume of output, because they are period costs. It makes sense, therefore, to charge them in full as a cost to the period.

The cost to produce an extra unit is the variable production cost. It is realistic to value closing inventory items at this directly attributable cost.

Under or over absorption of overheads is avoided.

Marginal costing provides the best information for decision making.

Fixed costs (such as depreciation, rent and salaries) relate to a period of time and should be charged against the revenues of the period in which they are incurred.

What is absorption costing?

Absorption costing assigns direct cost and all overhead costs to the cost units, using a predetermined absorption rate.

Absorption costing is a costing technique that includes all manufacturing costs, in the form of direct materials, direct labour, and both variable and fixed manufacturing overheads, while determining the cost per unit of a product. Absorption costing considers a share of all costs incurred by a business to each of its products/services. Costs are classified according to their functions. The gross profit is calculated after deducting production costs from sales and from gross profit, Absorption costing gives better information for pricing products as it includes both variable and fixed costs. In absorption costing techniques these costs are absorbed into the cost of goods produced and are only charged against profit in the period in which those goods are sold.

Absorption Costing argues that fixed costs are an integral part of the production cost and should be absorbed by the products produced in the time it's incurred. From that we can notice that absorption costing encourages over production so that each unit will take a lower rate of the fixed costs.

Fixed production costs are incurred in order to make output; it is therefore 'fair' to charge all output with a share of these costs.

Closing inventory values include a share of fixed production overhead.

Absorption costing is consistent with the accruals concept as a proportion of the costs of production are carried forward to be matched against future sales.

Since both accounting methods take fixed costs in different ways, if any changes happen in the inventory it will result in different levels of profit, but in the long run, reported profit by the two methods will be equal.

We find that absorption costing is widely used for general accounting purposes and inventory valuation. Fixed costs should be charged to units in fair and meaningful way.

Marginal vs. Absorption

Stock Evaluation differences:

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, so 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.

In King Plc. Case, comparing both first calendar quarters, using absorption and marginal costing we conclude that:

Absorption costing production costs includes the variable cost of the product, added to it the fixed cost.

Production = (Units produced * Variable cost) + Fixed costs.

So, if production was lower than expected that will result in higher variable cost for the products produced, which leads to less profit.

Closing stock cost in absorption costing calculates the variable cost of the unit plus the rate of absorption by the unit multiplied by the inventory level.

Closing Stock = (Variable cost + absorption rate of a unit) * Ending Inventory

As for marginal costing, the production only includes the variable cost of the product. Fixed costs are treated as a normal cost.

Production = Units produced * Variable cost

Closing stock cost using the marginal cost differs, because it only takes the variable cost of the unit into calculating the cost.

Closing Stock = Variable cost * Ending Inventory