The key issue between absorption costing and marginal costing is how the costs of a business's input resources are best organised and presented so as to identify individual product/service and total business profit.
The choice of costing system may be influenced by the costing method. Specific order costing methods will frequently deploy full absorption costing. One reason for this is that the pricing of each unique piece of work will invariably make reference to the total costs incurred. Continuous operation costing methods are more likely to deploy marginal costing (although this may be in addition to absorption costing) because of the opportunities in such an environment to use cost-volume-profit analysis.
3.2 Marginal and absorption costing
Marginal costing is a method of inventory costing in which all variable manufacturing costs are included as inventoriable costs. All fixed manufacturing costs are excluded from inventoriable costs. They are instead treated as costs of the period in which they are incurred. Inventoriable costs are all costs of a product that are regarded as an asset when they are incurred and then become costs of goods sold when the product is sold.
In product/service costing, a marginal costing system emphasises the behavioural, rather than the functional, characteristics of cost. The focus is on separating costs into variable elements (where the cost per unit remains the same with total cost varying in proportion to activity) and fixed elements (where the total cost remains the same in each period regardless of the level of activity). Whilst this is not easily achieved with accuracy, and is an oversimplification of reality, marginal costing information can be very useful for short-term planning, control and decision-making, especially in a multi-product business.
In a marginal costing system, sales less variable costs measures the contribution that individual products/services make towards the total fixed costs incurred by the business. The fixed costs are treated as period costs and, as such, are simply deducted from contribution in the period incurred to arrive at net profit.
Absorption costing is a method of inventory costing in which all variable manufacturing costs and all fixed manufacturing costs are included as inventoriable costs.
In product/service costing an absorption costing system allocates or apportions a share of all costs incurred by a business to each of its products/services. In this way, it can be established whether, in the long run, each product/service makes a profit. Arbitrary assumptions have to be made about the apportionment of many of the costs which, given that some costs will tend to remain fixed during a period, will also be dependent on the level of 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.
The choice of costing system that an organisation uses will, however, have implications not only for the way that its profit statements are laid out, but also for the amount of profit that is recorded.
One of the reasons that organisations use a costing system is so that the value of the stock of finished goods (and work in progress) can be calculated and incorporated into profit statements. Since the different approaches to costing give different costs per unit, they will result in different valuations of stock. This will in turn affect the profit calculation when stock levels change.
The method of valuation of the closing stock is therefore critical as it will affect both the costs of sales and also the level of recorded profit.
The example below shows how the same data is treated using different costing systems.
The "X Company" manufactures a single product and produces monthly management accounts.
In each of month 1 and month 2, 10.000 units were produced, and the following costs were incurred:
Direct Material100.000
Direct Labour150.000
Fixed Overheads250.000
Total Costs500.000
Both the costs and the volume of output were in line with the budget.
Units were sold for 70 each, and in month 1 the whole production of 10.000 units was sold, whereas in month 2 only 8.000 units were sold. There was no stock at the start of month 1.
Direct Material and Direct Labour are variable costs.
1. Calculation of cost per unit
A) Absorption costing (using all costs)
500.000 / 10.000 = 50 per unit
B) Marginal costing (using variable costs only)
250.000 / 10.000 = 25 per unit
2. Producing management accounts
A) Absorption costing
Month 1month 2
Sales700.000 560.000
Less cost of sales:
Opening stock--
Cost of production (10.000 x 50 )500.000500.000
Less closing stock (2.000 x 50 )-100.000
500.000 400.000
Profit200.000 160.000
B) Marginal costing
Less variable cost of sales:
Variable cost of production
(10.000 x 25 )250.000250.000
Less closing stock
(2.000 x 25 )-50.000
250.000 200.000
Contribution450.000 360.000
Less fixed costs250.000 250.000
Profit200.000 110.000
3. Comments on the reasons for differences in profit
The profits are identical when there is no change in stock level, as in month 1, when both opening and closing stocks are zero. However when the stock level changes between the start and end of the period (as in month 2) the stock valuation has an impact on profit.
The additional reported profit of 50.000 (160.000 compared with 110.000 ) by using the absorption systems is due to 50.000 of the fixed costs being absorbed into the closing stock and effectively carried into the next period. If the stocks again fell to nil in month 3 the profit difference would be reversed.
The differences in reported profits are only timing differences - the differences in profit are just reported in different periods.
Where stock levels increase, absorption costing will record a higher profit than marginal costing, as more of the cost incurred is pushed into the next period.
Where stock levels decrease, absorption costing will record a lower profit than marginal costing, as more of the costs from the previous period are set against income.
3.3 Summary
Marginal and absorption costing differ in only one respect: how to account for fixed manufacturing costs. Under marginal costing, fixed manufacturing costs are excluded from inventoriable costs and are a cost of the period in which they are incurred. Under absorption costing, these costs are inventoriable and become a part of cost of goods sold in the period when sales occur.
Under marginal costing, reported operating income is driven by the unit level of sales. Under absorption costing, reported operating income is driven by the unit level of production as well as by the unit level of sales.
Although absorption costing is the required inventory method for external reporting in most countries, many companies use marginal costing for internal reporting.
Concept Application Discuss the alternative theories to profit maximization ranging from perfect competition to strict monopolies
Perfect Competition Perfect competition is a market form in which no producer or consumer has the power to influence prices in the market. This leads to an outcome which is efficient, according to the economic definition of pareto efficiency The analysis of perfectly competitive markets provides the foundation of the theory of supply and demand. One example of perfect competition in the real world is the agricultural industry, whose large amount of suppliers, relatively inelastic demand and almost perfectly substitutable product makes it a close approximation of the perfect competition model.
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Critically evaluate marginal and absorption costing
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