Marginal Costing differentiated from Absorption Costing

Marginal Costing

In economics, the marginal cost is the change in total production cost that comes from making or producing one additional unit. To calculate marginal cost, divide the change in production costs by the change in quantity. The purpose of analyzing marginal cost is to determine at what point an organization can achieve economies of scale to optimize production and overall operations. If the marginal cost of producing one additional unit is lower than the per-unit price, the producer has the potential to gain a profit.

Need for Marginal Costing

• Total fixed cost remains unchanged up to a certain level of production and does not vary with increase or decrease in production. It means the fixed cost remains constant in terms of total cost.
• Variable cost per unit remains constant; any increase or decrease in production changes the total cost of output.
• Fixed expenses exclude from the total cost in marginal costing technique and provide us the same cost per unit up to a certain level of production.

Marginal Cost = Direct Material + Direct Labor + Direct Expenses + Variable Overheads

Features of Marginal Costing

• Break-even analysis is an integral and important part of marginal costing.
• Contribution of each product or department is a foundation to know the profitability of the product or department.
• Marginal costing is used to know the impact of variable cost on the volume of production or output.
• Addition of variable cost and profit to contribution is equal to selling price.
• Marginal costing is the base of valuation of stock of finished product and work in progress.
• Fixed cost is recovered from contribution and variable cost is charged to production.
• Costs are classified on the basis of fixed and variable costs only. Semi-fixed prices are also converted either as fixed cost or as variable cost.

Ascertainment of Profit under Marginal Cost

‘Contribution’ is a fund that is equal to the selling price of a product less marginal cost. Contribution may be described as follows:

Contribution = Selling Price – Marginal Cost

Contribution = Fixed Expenses + Profit

Contribution – Fixed Expenses = Profit

It simply works like this:

• Sale or Unit price > Marginal cost = More production = Profit

• Marginal cost > Sale or Unit price = Less production = Loss

Advantages:

• Constant in nature: Variable costs fluctuate from time to time, but in the long run, marginal costs are stable. Marginal costs remain the same, irrespective of the volume of production.
• Effective cost control: It divides cost into fixed and variable. Fixed cost is excluded from product. As such, management can control marginal cost effectively.
• Treatment of overheads simplified: It reduces the degree of over or under-recovery of overheads due to the separation of fixed overheads from production cost.
• Uniform and realistic valuation: As the fixed overhead costs are excluded from product cost, the valuation of work-in-progress and finished goods become more realistic.
• Helpful to management: It enables the management to start a new line of produc­tion which is advantageous. It is helpful in determining which is profitable whether to buy or manufacture a product. The management can take decision regarding pricing and tendering.
• Helps in production planning: It shows the amount of profit at every level of output with the help of cost volume profit relationship. Here the break-even chart is made use of.
• Better results: When used with standard costing, it gives better results.
• Fixation of selling price: The differentiation between fixed costs and variable costs is very helpful in determining the selling price of the products or services. Sometimes, different prices are charged for the same article in different markets to meet varying degrees of competition.
• Helpful in budgetary control: The classification of expenses is very helpful in budgeting and flexible budget for various levels of activities.
• Preparing tenders: Many business enterprises have to compete in the market in quoting the lowest price. Total variable cost, when separately calculated, becomes the ‘floor price’. Any price above this floor price may be quoted to increase the total contribution.
• “Make or Buy” decision: Sometimes a decision has to be made whether to man­ufacture a component or a product or to buy it ready-made from the market. The decision to purchase it would be taken if the price paid recovers some of the fixed expenses.
• Better presentation: The statements and graphs prepared under marginal costing are better understood by management executives. The break-even analysis presents the behaviour of cost, sales, contribution etc. in terms of charts and graphs. And, thus the results can easily be grasped.

Disadvantages

• Difficulty to analyse overhead: Separation of costs into fixed and variable is a difficult problem. In marginal costing, semi-variable or semi-fixed costs are not considered.
• Time element ignored: Fixed costs and variable costs are different in the short run; but in the long run, all costs are variable. In the long run all costs change at varying levels of operation. When new plants and equipment are introduced, fixed costs and variable costs will vary.
• Unrealistic assumption: Assumption of sale price will remain the same at different levels of operation. In real life, they may change and give unrealistic results.
• Difficulty in the fixation of price: Under marginal costing, selling price is fixed on the basis of contribution. In case of cost plus contract, it is very difficult to fix price.
• Complete information not given: It does not explain the reason for increase in production or sales.
• Significance lost: In capital-intensive industries, fixed costs occupy major portions in the total cost. But marginal costs cover only variable costs. As such, it loses its significance in capital industries.
• Problem of variable overheads: Marginal costing overcomes the problem of over and under-absorption of fixed overheads. Yet there is the problem in the case of variable overheads.
• Sales-oriented: Successful business has to go in a balanced way in respect of selling production functions. But marginal costing is criticised on account of its attaching over- importance to selling function. Thus it is said to be sales-oriented. Production function is given less importance.
• Unreliable stock valuation: Under marginal costing stock of work-in-progress and finished stock is valued at variable cost only. No portion of fixed cost is added to the value of stocks. Profit determined, under this method, is depressed.
• Claim for loss of stock: Insurance claim for loss or damage of stock on the basis of such a valuation will be unfavourable to business.
• Automation: Now-a-days increasing automation is leading to increase in fixed costs. If such increasing fixed costs are ignored, the costing system cannot be effective and depend­able.

Marginal costing, if applied alone, will not be much use, unless it is combined with other techniques like standard costing and budgetary control.

Absorption Costing

Absorption costing, sometimes called “full costing,” is a managerial accounting method for capturing all costs associated with manufacturing a particular product. The direct and indirect costs, such as direct materials, direct labor, rent, and insurance, are accounted for by using this method.

Absorption costing is an inventory valuation, which means that it is not a regular expense but rather a capitalized cost that is tracked on the balance sheet until the product is sold. GAAP requires the use of absorption costing when generating external financial reports and income tax reports.

Costs can be categorized as product costs or period costs. Administrative and sales costs should be assigned to reporting periods period costs instead of inventory product costs. This is because they are related to a specific period more than they are associated with goods produced. Product costs are more directly related to the manufacturing of the product.

In absorption costing, expenses related to production are listed as an asset in inventory accounts until the product is sold, then they are allocated to the cost of sold goods. Common inventory accounts include raw materials, works in progress and finished goods or variants of these names. These accounts track costs through the production stages: before production begins, during production and once production is completed.

Components of Absorption Costing

Direct Materials

Direct materials are materials that are included in a finished product.

Direct Labor

Direct labor includes the factory labor costs required to construct a product.

Variable Manufacturing Overhead

Variable manufacturing overhead includes the costs to operate a manufacturing facility, which vary with production volume. Examples are supplies and electricity for production equipment.

Fixed Manufacturing Overhead

Fixed manufacturing overhead includes the costs to operate a manufacturing facility, which do not vary with production volume. Examples are rent and insurance.

Formula:

Absorption Cost Per Unit = (Direct Labour Costs + Direct Material Costs + Fixed Manufacturing Overhead Costs + Variable Manufacturing Overhead Costs) / Number of Units Manufactured

Advantages:

(i) Consideration of Fixed Costs:

Absorption costing rightly recognises the importance of including fixed production costs in product cost determination and in determining a suitable pricing policy. Supporters of absorption costing argue that fixed production costs are just as much used in the production of goods and services as the variable production costs.

The pricing based on absorption costing similarly ensures that all costs are covered. The pricing determined in terms of only variable costs (as is advocated in variable costing) may, in the long-run, result in a contribution margin failing to cover the fixed costs. It is important, however, that sales are equal to or exceed the budgeted production level otherwise all fixed manufacturing costs will not be covered and will be under-absorbed.

(ii) Seasonal Sales:

In a situation where production is done to have sales in future (e.g., seasonal sales), absorption costing will show correct profit calculation than the variable costing. In such a case, under variable costing, sales will be zero but all fixed costs will be shown as an expense in the same accounting period. The result is that losses will be reported during out of season periods and large profits will be reported in the periods when the goods are sold.

On the contrary in absorption costing, fixed manufacturing overheads are included in closing stock valuation and are deferred and recorded as an expense only in the period in which goods are sold. Losses, therefore, will not be reported in absorption costing when sales are nil or quite low and stocks are being built-up. Thus, absorption costing will report correct profit situation than variable costing.

(iii) Conformity with Accrual and Matching Concepts:

Absorption costing conforms with accrual and matching accounting concepts which requires matching costs with revenue for a particular accounting period.

(iv) External Reporting:

Absorption costing has been recognised for the purpose of preparing external reports and for stock valuation purpose. For instance, FASB (USA), ASC (UK), ASB (India) have recommended the use of absorption costing for these purposes.

(v) No Need to Separate Costs as Fixed and Variable:

Absorption costing avoids the separation of costs into fixed and variable elements which cannot be easily and accurately done.

(vi) Relevance of Under-absorption and Over-absorption:

The presentation of under- absorption and over-absorption of factory overheads in absorption costing discloses inefficient or efficient utilisation of production resources which is not possible in variable costing.

(vii) Accountability of Departmental Managers:

The allocation and apportionment of fixed factory overheads to cost centres or departments makes managers more aware and responsible for the costs and services provided to their centres/departments.

Limitations of Absorption Costing:

(i) Fixed Costs are Period Costs:

Many accountants argue that fixed costs, whether related to manufacturing or to selling and administration, are period costs which produce no future benefits and therefore, should not be included in the cost of the product and inventory.

(ii) Apportionment of Overhead Costs:

The validity of product costs determined under absorp­tion costing depends upon the appropriateness of apportionment of overhead costs in a reasonably correct manner. But in practice, many overhead costs are apportioned by using arbitrary methods. The resulting costs figures, therefore, are doubtful and if included in the costs of products can make the product costs inaccurate and unreliable.

(iii) Not Useful in Decision Making:

Absorption costing is not helpful to management in decision making. Various types of managerial problems, such as selection of production volume and optimum capacity utilization, selection of product-mix, whether to buy or manufacture, evaluation of performance, choice of alternatives can be solved only with the help of variable costing analysis.

(iv) Not Useful in Cost Control:

Absorption costing is not helpful in control of costs and planning and control function. It is not useful in fixing the responsibility for incurrence of costs. It is not practical to hold a manager accountable for costs over which he has no control. Once he learns that he cannot control part of the costs with which he is charged, his sense of responsibility for controlling his direct cost somehow seems to weaken. Allocating indirect costs also distorts results of operations besides complicating control and decision-making. Distortion occurs because different bases of apportionment produce different allocation to products and affect different results.

(v) Inflated, Not Real, Profit:

Absorption costing helps a manager to increases operating income in a specific periods by increasing the production, even if there is no customer demand for the additional production. When absorption costing method is used, production fixed production overheads are charged to products and are included in product costs.

Consequently, the closing stocks are valued on total cost (including fixed overheads) basis. The net effect is that the charge of fixed overheads to P/L account gets reduced, if the closing stock is greater than the opening stock. This situation has the effect of inflating the profit for the period. One motivation could be a manager’s bonus plan that is based on reported operating income.

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