Absorption Costing & Marginal Costing

Absorption Costing: Absorption Costing technique is also termed as Traditional or Full Cost Method. According to this method, the cost of a product is determined after considering both fixed and variable costs. The variable costs, such as those of direct materials, direct labor, etc. are directly charged to the products, while the fixed costs are apportioned on a suitable basis over different product manufactured during a period. Thus, in case of Absorption Costing all costs are identified with the manufactured products. This system of costing has a number of disadvantages: i. ii. iii. iv. It assumes prices are simply a function of costs. It does not take account of demand. It includes past costs that may not be relevant to the pricing decision at hand. It does not provide information that aids decision making in a rapidly changing market environment.

Thus, the technique of Absorption Costing may lead to rather odd results particularly for seasonal businesses in which the stock level fluctuate widely from one period to another. The transfer of overheads in and out of stock will influence their profits for the two periods, showing falling profits when the sales are high and increasing profits when the sales are low. The technique of Absorption Costing may also lead to the rejection of profitable business. The total unit cost will tend to be regarded as the lowest possible selling price. An order at a price, which is less than the total unit cost may be refused though this order, may actually be profitable. Marginal Costing: Marginal costing is a special technique used for managerial decision making. The technique of marginal costing is used to provide a basis for the interpretation of cost data to measure the profitability of different products, processes and cost centers in the course of decision making. It can, therefore, be used in conjunction with the different methods of costing such as job costing, process costing etc., or even with other techniques such as standard costing or budgetary control. . In marginal costing, cost ascertainment is made on the basis of the nature of cost. It gives consideration to behaviour of costs. In other words, the technique has developed from a particular conception and expression of the nature and behaviour of costs and their effect upon the profitability of an undertaking. In the orthodox or total cost method, as opposed to marginal costing method, the classification of costs is based on functional basis. Under this method the total cost is

According to economists. 18.. be used in conjunction with the different methods of costing such as job costing. processes and cost centers in the course of decision making. the total cost per unit will remain constant only when the level of output or mixture is the same from period to period.the sum total of the cost of direct material. poses a serious problem to the management in taking sound decisions. the actual total cost will vary from one period to another. Therefore. Moreover with additional production the economist’s marginal cost per unit may not be uniform since the law of diminishing (or increasing) returns may be applicable. fixed cost is taken into consideration according to the economist’s concept of marginal cost. variable direct expenses and variable overheads. direct expenses. administration overheads. the cost of producing one additional unit of output is the marginal cost of production. Such fluctuating manufacturing activity. direct labor. has defined Marginal Cost as “the amount at any given volume of output by which aggregate costs are changed if the volume of output is increased or decreased by one unit”. manufacturing overheads. therefore. Thus. but not according to the accountant’s concept. the application of marginal costing has been given wide recognition in the field of decision making. The Institute of Cost and Management Accountants. This shall include an element of fixed cost also. Utility of Marginal Costing: Marginal costing is a special technique used for managerial decision making. Marginal Cost ordinarily is equal to the increase in total variable cost because within the existing production capacity an increase of one unit in production will cause an increase in variable cost only. In this system. Marginal Cost: The technique of marginal costing is concerned with marginal cost. Since these factors are continuously fluctuating. It can. selling and distribution overheads. while the accountant’s marginal cost in taken as constant per unit of output with additional production. The accountant’s concept of marginal cost is different from the economist’s concept of marginal cost. Hence. other things being equal. and consequently the variations in the total cost from period to period or even from day to day. or even with other 2 . Thus. The variable cost consists of direct materials. it is possible for the costing department to say one day that a thing costs Rs. This situation arises because of changes in volume of output and the peculiar behaviour of fixed expenses comprised in the total cost. direct labor. process costing etc. Marginal Cost refers to increase or decrease in the amount of cost on account of increase or decrease of production by a single unit. The technique of marginal costing is used to provide a basis for the interpretation of cost data to measure the profitability of different products. London. 20 and next day it costs Rs. The unit may be a single article or a batch of similar articles.

Thus. In marginal costing. These are listed below:      Volume of production: Marginal costing helps in determining the level of output which is most profitable for running concern.techniques such as standard costing or budgetary control. The technique of marginal costing has become more relevant and useful in today’s business environment of globalization. particularly in the times of depression. and volume in the business which helps the management in fixing best selling prices for its products Selecting product lines: The marginal costing technique helps in determining the most profitable production line by comparing the profitability of different products. Thus. in marginal costing there is under recovery of overheads. Marginal costing techniques helps management in several ways in the present day context of global business environment. or a service is computed only on the basis of variable costs. in marginal costing only variable overheads are charged to production. In marginal costing only variable costs are charged to production. In case the procurement price is lower than the marginal cost of production. Comparison of Marginal & Absorption Costing: Absorption Costing technique is also termed as Traditional or Full Cost Method.   Recovery of Overhead: In absorption costing both fixed & variable overheads are charged to production. price. stocks of work in progress and finished goods are valued at works cost & total cost. Global companies want to take advantage of cheap labour in developing or backward countries. Method of manufacturing: If a product can be manufactured by two or more methods. it will be advisable to procure the product from outside source. Shut down or continue: marginal costing. This is because in marginal costing the cost of a product. ascertaining the marginal cost of manufacturing the product by each method will be helpful in deciding as to which method should be adopted. can be utilized to the maximum possible extent. Fixed costs are ignored. The production capacity. Following are differences between them. helps in deciding whether the production in the plant should be suspended temporarily or continued in spite of low demand for the firm’s products. According to this method. In contrary to this. the cost of a product is determined after considering both fixed and variable costs. Produce or procure: The decision whether a particular product should be manufactured in the factory or procured from outside source can be taken comparing the price at which it can be had from outside. closing stock in marginal costing is under-valued as compared to absorption costing. 3 . Valuation of stocks: In absorption costing. It helps in determining the most profitable relationship between cost. only variable cost is considered while computing the value of work in progress or finished products. therefore.

it is not so useful for management to use to make decision. it is cost into the stock value hence distorting stock valuation. 4. Advocates of marginal costing argue that under the marginal costing technique. The marginal cost remains constant per unit of output whereas the fixed cost remains constant in total. Overheads are recovered in marginal costing on the basis of pre-determined rates. The management can compare the actual 4 . As absorption costing emphasized on total cost namely both variable and fixed. 3. there will be under-recovery of overheads if production is less or if overheads are more. As the manager’s emphasis is on total cost. This method is accepted by Inland Revenue as stock is not undervalued. Limitations: 1. 4. Since marginal cost per unit is constant from period to period within a short span of time. 2. If fixed overheads are included on the basis of pre-determined rates. Marginal costing helps in carrying out break-even analysis. The manager needs to use his intuition to make the decision. 2. It recognizes the importance of fixed costs in production. If fixed cost is included. planning and control. 2. Marginal costing avoids such under or over-recovery of overheads. There will be over-recovery of overheads if production is more than the budget or actual expenses are less than the estimate. the unit cost will change from day to day depending upon the volume of output. the cost volume profit relationship is ignored. When production remains constant but sales fluctuate absorption costing will show less fluctuation in net profit and 5.Absorption Costing: Advantages & Limitations: Advantages: 1. the stock of finished goods and work in progress are carried on marginal cost basis and the fixed expenses are written off to profit and loss account as period costs. which shows the effect of increasing or decreasing production activity on the profitability of the company. Segregation of expenses as fixed and variable helps the management to exercise control over expenditure. This creates the problem of treatment of such under or over-recovery. 5. This method is always used to prepare financial accounts. Marginal Costing: Advantages & Limitations: Advantages: 1. This shows the true profit of the period. Unlike marginal costing where fixed costs are agreed to change into variable cost. This will make decision-making task difficult. firm decisions on pricing policy can be taken. 3.

5 . the constraint is a policy (such as a poorly designed compensation scheme for sales persons) that prevents the company from using its resources more effectively. 3. 2. direct labor is generally considered to be a fixed cost. If direct labor is not the constraint.. Contribution itself is not a guide unless it is linked with the key factor. Hence. there is no reason to increase it. In simplest case constraint is a machine. In TOC companies. 6. Limitations: 1. Since layoffs often have devastating effects on employee morale. 4. are not necessarily true in a realistic situation. sustained continuous improvement virtually impossible. many companies have a commitment--sometimes enforced in labor contracts or by law--to guarantee workers a minimum number of paid hours. which will result in loss or low profits. direct labor is not usually a constraint. In many companies direct labor is not really a variable cost. Without committed and enthusiastic employees. 5. etc. First. sales staff should be cautioned while giving marginal cost. the assumption that fixed cost will remain static throughout is not correct. Hiring more direct labor would increase costs without increasing the output of salable products and services. Second. Some of the assumptions regarding the behaviour of various costs etc. TOC emphasizes continuous improvement to maintain competitiveness. Most of the expenses are neither totally variable nor wholly fixed. Marginal costing helps the management in taking a number of business decisions like make or buy. In order to show the correct position fixed over heads should be included in work-in-progress. discontinuance of a particular product. Variable Costing and Theory of Constraints (TOC): The Theory of Constraints (TOC) focuses on managing constraints in a company as the key to improving profits. Sales staff may mistake marginal cost for total cost and sell at a price. In more complex cases. replacement of machines. Even though direct labor may not be paid on an hourly basis. One difference is that in Theory of Constraints (TOC) approach. It is difficult to classify costs exactly into fixed and variable. there are two additional reasons to consider direct labor to be a fixed cost.variable expenses with the budgeted variable expenses and take corrective action through analysis of variances. managers involved in TOC are extremely reluctant to lay off employees. Companies involved in Theory of Constraints (TOC) use a form of variable costing. For example. Overheads of fixed nature cannot altogether be excluded particularly in large contracts while valuing the work-in-progress.

(3) all variable costs. Discussion Questions and Answers: Questions: 1. fixed and variable) which contribute to the production of the product and traced to output and inventories is: (1) job order costing. Select the answer which best completes the statement: (a) The term meaning that all manufacturing costs (direct and indirect. What hidden dangers or disadvantages are present in direct costing? 10. most managers in TOC companies regard direct labor as a committed fixed cost rather than as a variable cost. Distinguish between period costs and product costs. (3) an irrelevant cost. Has the Internal Revenue Service approved direct costing for tax purposes? 9. Why should the chart of accounts be expanded when direct costing is used? 7. List the arguments for and against the use of direct costing. (2) a product cost. A speaker remarked that even though direct costing has attractive merits. (b) The term that is most descriptive of the type of cost accounting often called direct costing is (1) out of pocket costing. 11. 2. (3) relevant costing. Differentiate between direct costs and direct costing. (2) variable costing. in the modified form of variable costing used in TOC companies. Hence. there are certain items that should be concerned before converting the present system. (d) The basic assumptions made in direct costing with respect to fixed costs is that fixed cost is: (1) controllable cost. Why does the direct costing or variable costing theorist exclude fixed manufacturing costs from inventories? 4. (2) process costing. what kind of cost figures are likely to be most helpful? 5. (4) all variable and fixed manufacturing costs. (2) variable production costs only. A manufacturing concern follows the practice of charging the cost of direct materials and direct labor to work in process but charges off all indirect costs (factory overhead) directly to income summary. (4) prime costing. 8. (4) a period cost (e) Operating income computed using direct costing would generally exceed operating income computed using absorption costing if: (1) units sold exceed 6 . (3) absorption costing.For these reasons. (c) Costs treated as product costs under direct costing are: (1) prime costs only. (4) direct costing. In the process of determining a proper sales price. direct labor is not usually included as a part of product costs. 3. State the effects of this procedure on the concern's financial statements and comment on the acceptability of the procedure for use in preparing financial statements. Why is it said that an income statement prepared by the direct costing procedure is more helpful to management than an income statement prepared by the absorption costing method? 6.

(2) units sold are less than units produced. (4) sales as recorded under the direct costing method and sales as recorded under the absorption costing method. Expenses that apply to the production of goods are called product costs. 7 . When a firm uses direct costing: (1) the cost of a unit of product changes because of changes in the number of units manufactured. the contribution margin discloses the excess of: (1) revenue over fixed cost. (4) not determinable from the information given. In direct costing. respectively. If the fixed factory overhead application rate is $2 per unit. Direct costs are direct materials. (3) gross profit (absorption costing method) and contribution margin (direct costing method). (4) amount of fixed costs that will be incurred. Absorption costing differs from direct costing in the: (1) fact that standard costs can be used with absorption costing but not with direct costing. (2) inventoried discretionary costs in the beginning and ending inventories. (2) a decrease in the number of units produced. Period costs are costs charged against the income of the current period. the operating income using absorption costing is: (1) $40. (3) an idle capacity variance is calculated by a direct costing system. direct labor. (4) variable cost over fixed cost. (3) units sold equal units produced. unit product cost would most likely be increased by: (1) a decrease in the remaining useful life of factory machinery depreciated by the units of production method. Beginning and ending inventories for that period were 13.000.000. Answers: 1. (3) revenue over variable cost.000. Direct costing or variable costing is a procedure by which only prime costs plus variable factory overhead are assignable to a product or inventory. 2. (4) an increase in the commission paid to salespersons for each units sold. (2) kinds of activities for which each can be used to report . (3) an increase in the remaining useful life of factory machinery depreciated by the sum of the years digits method. (2) profits fluctuate with sales.(f) (g) (h) (i) (j) (k) units produced. the fixed factory overhead as well as selling and administrative expenses are treated as period costs. (4) product cost include variable administrative costs.000 units and 18. (4) the unit fixed cost is zero A company has operating income of $50. Operating income under absorption costing can be reconciled to operating income determined under direct costing by computing the difference between: (1) inventoried fixed costs in the beginning and ending inventories and any deferred over or under applied fixed factory overhead.000 units.000. (3) amounts of costs assigned to individual units of product. using direct costing for a given period. (2) projected revenue over the break even point. (2) $50. Under the direct costing concept. Variable manufacturing costs are typical product costs in direct costing and are charged against income when the units to which they relate are sold. When using direct costing information. (3) $60. and other costs directly assignable to a product. all fixed costs are considered period costs.

Of at least equal importance is the effect on the recorded results of operations. if these inventories at the end of the year exceed the corresponding totals at the beginning of the year. they should be added to the direct costs and flow through inventories. costs and revenue will not be matched in the usual manner. profits will be overstated. It seems probable that direct costing is more appropriate in making short run decisions with regard to production schedules and pricing products offered for sales. Thus the direct costing income statement is preferred by the management because it follows management's decision making processes more closely that the statement based on absorption costing. all variable expenses are channeled into the fixed category at the time the expenses are incurred. Fixed manufacturing costs are the expenses of maintaining capacity. but at the time they are incurred. Unless the sum of the work in process and finished goods accounts happens to be the same at each balance sheet date. but this does not mean that some sales of a single product or sales of products could not be made at a price which recovers at least the variable costs or makes a contribution to the recovery of fixed expenses. At any particular time. they are recoverable from future revenues. and certain other variances and usual items may be treated as period costs. 7. These variable costs. 4. facilitate computing a contribution margin figure. While the costs of idle facilities. excessive spoilage. (c) total assets are under stated. This procedure means that the chart of accounts has to be expanded to take care of the new accounts needed. if these inventories are below those at the beginning of the year. by omitting indirect factory costs from work in process (WIP) the concern is understanding inventory accounts in comparison with concerns which follow the usual practice. the usual indirect costs are considered assignable to the production of the period. Profits will be understated. resulting in a corresponding distortion of reported income. An income statement prepared by the direct costing method presents cost of goods sold figures with variable costs only. 5. provided the total cost recovery in the long run is kept in mind. Thus. Consequently. These indirect factory costs are ordinarily not as easily assignable to products as are the direct cost. The sales price must exceed all costs of every kind before a profit is realized. 8 . (b) current assets are understated and so is the net working capital--and therefore the current ratio is understated. (d) stockholder's equity is understated--particularly the retained earnings amount. direct labor. It is not accepted accounting practice to omit all factory overhead from inventories.3. Therefore. and applicable indirect factory costs. There is no way to prove that one type of cost figure is going to be more helpful than another in the determination of the sales price. The marginal costing or direct costing approach looks at the short run profit contribution aspect of immediate sales. Under a direct costing plan. 6. then. such expenses occur with the passage of time and not with the utilization of the facilities. based on the number of units sold. its financial position (balance sheet) is incorrectly stated because: (a) work in process and finished goods are understated. The cost to manufacture usually includes the sum of direct materials. The absorption or conventional cost approach to pricing looks at the long run total cost recovery.

the full cost to develop. direct cost profits are higher than under absorption costing. (c) Direct costing reports are more easily understood by management because the statements follow management's decision making process more closely than do absorption costing statements. (f) When used as the sole vehicle for the management decisions. increasing or reducing production and differences in the number of units produced versus the number sold do not affect the per unit production cost. The opposite is true when sales lag behind production. 9 . and standard costs facilitates the adoption and use of these methods for reporting. (b) Since fixed factory overhead is absorbed as a period cost. which involves estimates and personal judgment. (b) A seasonal business which produces for six months and sells its entire production in the next six months would show a sizeable loss for the first six months and a sizeable profit for the last six months. Under these conditions. (g) Direct costing provides a means of costing inventory that is similar to management's concept of inventory cost as the current out of pocket expenditures necessary to produce or replace the inventory. kinds of customers. produce. etc. 9. (f) The similarity of the underlying concepts of direct costing. Using direct costs and looking at marginal contributions only would certainly be fallacious when new extensive use of existing expensive equipment or expansion of facilities. 10. (c) Those who use direct costing figures must understand the difference between conventional gross profit on sales and contribution to fixed costs and profits and realize the limitations of the contribution theory. direct costing can lead to a disregard for the need to recover fixed costs. The hidden dangers or disadvantages present in direct costing are: (a) A change to direct costing will prohibit a comparison with the company's accounting information for any prior year unless past periods are changed to a direct costing basis. cost control and financial planning.8. and market a product must be known. The Internal Revenue Service (IRS) does not permit the use of direct costing for tax purposes because it does not clearly reflect income. (i) The computation of product costs is simpler and more reliable under direct costing because a basis of allocating the fixed cost. management requires cost volume profit relationship data which are more readily available from direct cost statement than from absorption costing. (d) Reporting the total fixed cost for the period in the income statement directs management's attention to the relationship of this cost to profits. (d) In planning price and sales policies. break even analysis. flexible budgets. is eliminated. sales areas. Arguments for the use of direct costing include the following: (a) For profit planning purposes. (e) The elimination of allocated joint fixed cost permits a more objective appraisal of income contributions according to products. Cost volume relationships are highlighted. (e) Direct costing might bring unsatisfactory management action when sales outrun production and inventories are being drawn on.

(g) 3. (f) 3*. (e) 1. (f) The elimination of fixed costs from inventory results in a lower figure and consequent reduction of reported working capital for financial analysis purposes. all costs--including fixed costs--are variable at some level of production and in the long run.000 + $10. (h) 2. and inventory. (b) Long-range pricing of products and other long range policy decisions require a knowledge of complete manufacturing cost which would require additional separate computations to allocate fixed overhead. Moreover. Production would not be possible without plant facilities. (b) 2. (d) 4. (d) Direct costing has not been recognized as conforming with generally accepted accounting principles (GAAP) applied in the preparation of financial statements for stockholders and general public. (a) 3. 11. Fixed costs occur with the passage of time. especially when such costs are semi variable in nature. To disregard these fixed costs violates the general principle of matching costs with revenues. equipment. The decrease in working capital may also weaken the borrowing position. (c) The pricing of inventories by the direct costing method is not acceptable for income tax computation purposes. etc. Arguments against the use of direct costing include the following: (a) Separation of costs into fixed and variable costs might be difficult. (e) Profits determined by direct costing are not "true and proper" because of the exclusion of fixed production costs which are a part of total production costs. (i) 1.000 = $60. (c) 2.000 10 . (j) 1 (k) 3 *Operating income under direct costing + Cost deferred in inventory $50.(j) A "true and proper" profit results from direct costing because only variable costs should be identified with production.

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