Learning Objectives:
After studying this, you should be able to:
·
explain the
concepts and differences between marginal and absorption costing.
·
explain the
equation, advantages and limitations of marginal costing.
·
discuss the
importance of contribution margin in managerial decision making.
·
use marginal
costing as a technique for short-term tactical planning and decision-making.
·
make decisions on
whether to make or buy a component, accept or reject an order, among others.
8.1
Marginal Versus
Absorption Costing
8.1.1 Introduction
In taking short
term, medium term or long term decisions, management of organisations in both
the public and private sectors of the economy must adopt some tools that would
aid better decision making for the achievement of organizational goals. In
Accounting there are many tools to be used in guiding effective decision making
by management. Two of the most popular decision making techniques are marginal
costing and absorption costing.
The two
techniques are expected to be appropriately used in short term tactical
managerial decision making exercise that would amount to efficient management
of resources for the production of income, profit and wealth. The decision to
be taken would normally be about the future, which is full of risks and
uncertainties. This calls for a lot of care and attention when using any of the
two techniques.
This section of
the chapter explains the concepts of marginal costing and absorption costing;
the differences between marginal and absorption costing; and the environments
for the application of marginal and absorption costing.
necessary
corrections is in progress.
Thanks.
8.1.2 The Concepts of Marginal and Absorption
Costing
Marginal costing
has been described by different names in different continents. The term
'Marginal costing' is common in the United Kingdom (UK) and other countries of
the European continent, while the expression 'Direct Costing' or 'Variable
Costing' is preferred in the United States (US). The technique has generated
strong views both for and against it with the result that it has become a
subject of lively raging controversy during recent times.
'Marginal Cost',
is derived from the word 'margin', which is a well- known concept in economic
theories. Thus, quite in tune with the economic connotation of the term, it is
described in simple words as the cost which arises from the production of
additional increments of output and it does not arise if the additional
increments are not produced. This shows that marginal cost is the cost of
additional unit of product or service produced in any production process.
From this point
of view, marginal costs will be synonymous with variable costs, i.e. prime
costs and variable overheads, in the short run but, in a way, would also
include fixed costs in planning production activities over a long period of
time involving an increase in the productive capacity of the business. Thus,
marginal costs are related to change in output under a particular circumstance
of a case. Marginal costing is, therefore, about costing an additional product
or service on its merit without relating it to the general cost being incurred
by the producer in the course of the production process.
Marginal costing
is not a system of costing in the sense in which other systems of costing, like
process or job costing, are but it has been designed simply as an approach to
the presentation of accounting information meaningful to management from the
viewpoint of adjudging the profitability of an enterprise by carefully studying
the impact of the entire range of costs according to their respective nature.
The concept of
marginal costing is a formal recognition of ideas underlying flexible budgets,
break-even analysis and/or Cost-Volume-Profit relationships. It is an
application of these relationships which involves a change in the conventional
treatment of fixed overheads in relation to income determination.
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The concept of
marginal costing is based on the important distinction between product costs
and period costs, the former being related to the volume of output and the
latter to the period of time rather than the volume of production. Marginal
costing regards as products costs only those manufacturing costs which have a
tendency to vary directly with the volume of output. This is in complete
contrast to the conventional system of costing under which all manufacturing
costs - fixed as well as variable are treated as product costs.
Absorption
costing, on the other hand, is the technique of costing that is used in
preparing income statements to ascertain the result of operations of private
and public sector organisations. The term absorption is about absorbing the
general overhead (fixed) costs being shared to all the units of goods or
services produced to ascertain total cost of production per unit rather than
total variable(marginal) cost per unit.
Absorption
costing, therefore, is about costing a product or service with due regards to
all the cost elements involved in the production process and, so, appropriate
apportionment is to be made for indirect costs to be incorporated into the
total cost for each unit of goods or services produced.
8.1.3 Major Differences between Marginal and
Absorption Costing
Marginal costing,
as explained above, is a technique of costing that considers fixed costs as a
period cost and ,so, irrelevant when taking decision on the total cost of a
product to be compared against its benefit for the determination of its
profitability/ viability. It is conceptually about variable or direct costing.
Absorption costing, on the other hand, is about appreciating all cost elements as
essential for production and sales and, so, all of them are to be captured when
determining total cost at all levels of production up to sales.
As the two
techniques are used in preparing income statements, some important differences
could be noticed when the income statements are compared. The most fundamental
difference is in the treatment of fixed overhead production cost. While
absorption costing accepts the overhead cost as part of the cost of goods sold,
marginal
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costing treats it
as a period cost which must be incurred whether or not there is production and,
so, it is not to be part of the cost to be aggregated for a product or service.
The second
difference is in the determination of cost of closing stock, where absorption
costing recognizes total cost per unit to be multiplied by the closing units to
get the value of closing stock while marginal costing recognizes only the total
variable cost per unit for that purpose as all fixed costs (production,
administrative and selling) must have been covered by contribution margin.
The third
difference is in the initial profit shown under each of the two techniques.
While absorption costing income statement first shows gross profit before net
profit and so on, marginal costing income statement first shows contribution
margin, which is the difference between sales and total variable costs. This
shows that unless where all the units produced are sold, the two income
statements would not amount to the same level of profit at the initial stage.
Absorption
costing is used in preparing income statements at the end of an accounting
period by all the three forms of businesses (sole proprietorship, partnership
and company) in an economy and various governmental establishments. The method
is, therefore, better used to aid decision on performance evaluation in respect
of result of operations at the end of an accounting period. Marginal costing
technique is only relevant for short term tactical managerial decision making,
focusing the future happenings of businesses. The areas of application of
marginal costing would be discussed in this chapter.
Students would
learn more about the differences and the environments for application in the
subsequent section and subsections of the chapter.
8.1.4 Basic Equation, Advantages and Limitations of
Marginal Costing
(a) Basic Equation of Marginal Costing
The technique of
marginal costing hinges on the contribution made by a product towards fixed
costs and profit of the undertaking.
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Contribution can
be looked at from two angles - either as the total of fixed costs and profit or
as the difference between sales and variable costs.
For the sake of convenience, contribution can
be stated by way of equation as: Sales - variable costs = Fixed costs + profit.
This is sometimes
shortened as: S - V = F + P
The formula has
been so framed that, if some of the above four factors are known, the remaining
one can be easily found out. From this point of view, the equation is of
fundamental importance.
Moreover, its
significance also lies in the fact that a formula for calculating sales at
break-even point has been derived from the basic equation and the formula is:
Sales at
break-even point - Fixed Cost X Sales
Sales - Variable costs
(b) Advantages of Marginal Costing
i. Constant in nature: Marginal costs remain the same per unit of
output irrespective of the volume of production.
ii. Facilitating cost control: The clear-cut division of costs into their
fixed and variable components paves the way for a better cost control
through flexible budgeting which is based on this important distinction.
iii. Simplicity of overhead treatment: Marginal costing does away with the need for
allocation, apportionment and absorption of fixed overheads thereby
removing an important source of accounting complications by way of
under-absorbed or over-absorbed overheads.
iv. Basis for pricing and tendering; Marginal costing furnishes a better and more
logical basis for the fixation of sales prices as well as in tendering for
contracts when business is at a low ebb.
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v. Aid to Profit planning: The technique of marginal costing enables data
to be presented to management in a manner as to show cost-volume profit
relationships.
vi. Realistic valuation: Elimination of fixed overheads from the cost
of production means that finished goods and work-in-progress are valued
at their marginal cost and, therefore, the valuation is more realistic and
uniform as compared to the one when they are valued at their total cost.
(c) Limitations of Marginal Costing
i.
Difficulty in
analysis: Considerable
difficulty is always experienced in analysing overheads into their fixed
and variable components.
ii. Lop-sided Emphasis: Marginal costing has a tendency to attach more
importance to the selling function which has the effect of relegating
the production of function to a comparatively unimportant position. However,
the efficiency of a business is to be judged by taking together its selling as
well as production functions into account.
iii. Difficulty in application: The technique of marginal costing cannot be
adequately applied in the case of industries in which, according to the
nature of business, large stocks have to be kept in the form of
work-in-progress.
iv. Limited Scope: As marginal costing distinguishes between the
treatment of fixed and variable components of costs, it is difficulty to
adopt the technique in capital-intensive industries where fixed costs are very
large.
v.
Inappropriate
basis for pricing: Selling price
cannot reasonably be fixed on the basis of contribution alone.
In the light of
these advantages and disadvantages, marginal costing may be considered to be a
very useful technique from the point of view of management but it must be
applied with a full awareness of its limitations as well as of the
circumstances in which it can be fruitfully used.
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corrections is in progress.
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8.2
Preparation of
Income Statements
8.2.1 Income Determination: Under Absorption and
Marginal Costing
According to
traditional costing system, fixed costs of production are assigned to products
to be subsequently released by way of expenses as part of cost of goods sold or
are carried forward as part of the cost of inventory. Such an approach to the
treatment of fixed costs has brought into vogue various methods of allocation
of overheads to different departments on an equitable basis and their proper
apportionment to units produced. However the various methods devised fail to
give precise results and sometimes even lead to absurd situations.
Marginal costing
removes all the difficulties involved in the allocation, apportionment and
recovery of fixed costs; it is able to accomplish this by excluding fixed costs
from product costs and by covering them off entirely using contribution margin.
Consequently, when the volume of output differs from the volume of sales, the
net income reported under marginal costing will differ from the net profit
reported under absorption costing.
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