In any business the main aim of the company is to maximise the profit in order to run the company for the long term. This takes us to the decision making which is the most important part to keep an entity running successfully making good profits. Decisions of the management of a business actually depends on the type of the costing system being adopted by the company, different costing systems ends up with different profit for the period. In different regions different costing systems are adopted by the entities. So choosing the correct type of the costing system leads the company towards better future. There are three basic approaches to the costing systems named as variable, absorption and activity-based costing. Variable and absorption costing system are the general type of the costing systems tends to be seen in medium or small sized company, while activity based costing is more kind of complex costing system. It normally depends on the type of the business to choose suitable costing system. But to select appropriate costing system, management of an entity should be enough capable to evaluate different costing systems under their situation and to asses which costing would affect the profit in maximising and the factors related to them.
Evaluation of AC and MC
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Before we get into depth analysis of absorption and marginal costing, it is more important for us to know what actually differentiate these two from each other. The main thing which distinguishes absorption and marginal costing is the fixed cost. Now if we say it's just the fixed cost which keeps apart these two systems this is not specific enough. The key issue is that in AC fixed costs are treated as production costs and thus a part of the product's cost where as under marginal costing the fixed cost element is not treated as a part of the production cost of the product, instead it is treated as a period cost and would be written off hence not considered in any kind of stock valuation. This results in a different profit or loss when a business analyses its profit for the period in which completed goods stock level has changed, depending on which costing system is established in the organization either marginal or absorption.
Absorption costing could be defined in a typical way as such a costing system in which all the manufacturing costs incurred are absorbed by the product's units produced. In other words we could briefly say it apportions share of all the costs incurred like direct material, labour, fixed and variable overheads by the business to each of its products or services. It helps in recognizing in the long run whether each product or service makes a profit. Whereas we need to consider arbitrary assumptions about the allocation of the many of the costs which tends to remain fixed during a period, will also be subjected to the level of the activity.
An absorption costing system traditionally classifies costs by function. Sales less production costs (of sales) measures the gross profit (manufacturing profit) earned. Gross profit less costs incurred in other business functions establishes the net profit (operating profit) earned.
Using an absorption costing system, the profit reported for a manufacturing business for a period will be influenced by the level of production as well as by the level of sales. This is because of the absorption of fixed manufacturing overheads into the value of work-in-progress and finished goods stocks. If stocks remain at the end of an accounting period, then the fixed manufacturing overhead costs included within the stock valuation will be transferred to the following period.
Marginal or variable Costing
A marginal cost is another term for the variable cost.
This term "marginal" costing is generally applied to the variable cost of a unit of product or service, on the other hand the term "variable cost" is applied to the cost of material, labour and other resource cost.
It is normally defined as a sum of Direct Material costs, Direct Labour, Direct Expenses and Variable Overheads.
Marginal costing could also be defined as "an accounting system in which variable costs are ascertained to the cost units and the fixed costs for that period are fully written off against the cumulative contribution.
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Its special value is in distinguishing the cost behaviour and hence assisting in decision making.
In decision analysis about a certain product under marginal costing, whether to abandon that product/service or not it is very important that we only bring the costs that varies with the decision, like for many decisions that are for relatively limited period of time or they involve relatively small variation from the existing practice, fixed costs are not relative to the decision.
The term "contribution" is normally taken as sales price less the variable cost of that unit/product/service.
A company XYZ manufactures and produces a single product. In each month 1 and 2 company manufactures 10 units and the standard cost card of the product is as follow:
Direct Labour: £30
Direct Material: £25
Fixed Overheads: £45
Total Cost: £100
Each unit made were sold for £20. All the units made in month 1 were sold while only 8 units were sold in month 2.
Calculation for cost/unit under marginal and absorption costing would be as follow;
Under Marginal Costing
Cost/unit: 55/10 = £5.5 (using variable costs only)
Under absorption costing
Cost/unit: 100/10 = £10 (using all costs)