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REPORT ON MARGINAL AND ABSORPTION COSTING ON OVERHEADS

ELENI OPSIMOU

Marginal costing and Absorption costing are two alternative cost accounting systems used to ascertain product or inventory valuation and for cost of goods sold. As you know, before we assign the manufacturing costs to products we need to decide whether they are fixed or variable. Absorption costing regards all manufacturing costs including the fixed and variables costs in the cost units and also included in the stock valuations using predetermined absorption rate. By contrast the marginal costing includes only the variable costs as the product cost units and fixed costs are treated as period costs. Absorption costing and marginal costing behave overheads differently. The two main differences are that in the absorption cost system is considered both fixed and variable cost for product costing and inventory valuation and the fixed cost is charge to the cost of production however marginal cost system use only variable cost and the fixed cost is considered as a period cost. This results a different value in the stock valuation in the two costing technique. One other difference is that the stocks of work in progress and finished goods are valued only at the marginal costing. Also, the treatment of fixed factory overhead brings differences in the net income under each costing system since the magnitude of the two net incomes is related to the fixed manufacturing costs per unit and to the change in inventory levels. In other words, if the value of stock increases during a period, the marginal costing will show less net profit but absorption cost will show gain on net profit. The following example is about budgeted operating statement (for the follow two years) by using absorption costing system first and then by using marginal costing system. This example shows us the differences from the two costing systems, as we cite them before. Then we can see the difference in the values of absorption costing profit and the marginal costing profit. Mercedes Industrial Limited for each product which makes and sells, it has the following variable production costs per unit: Direct materials cost $50 , Direct labour cost $120, Variable production overheads costs $30. The budgeted selling price per unit is $400 for the following two years. The production budget (in units) is $50000 for first year, $60000 for the second year and the sales budget (in units) is $40000 for the first year and $70000 for the second year. It given that the budgeted fixed production overhead costs are $20 per unit, and they are engrossed based on a normal production level of 54000 units per annum. Also, the variable non- production overhead costs is $10 per unit sold and the fixed non-production overhead costs is $2000000 per annum for both two coming years. Statement using absorption costing system first year $000 16,000 10,000 1,000 11,000 2,200 8,800 80 8,880 7,120 400 2,000 2,400 4,720 second year $000 28,000 2,200 12,000 1,200 15,400 15,400 (120) 15,280 12,720 700 2,000 2,700 10,020

Sales Less: Production costs of sales Opening inventory Add: Variable production overhead costs (W1) Fixed production overhead costs Less: Closing inventory Under/(Over) absorbed fixed production costs (W2) Gross profit Less: Variable non-production overhead costs (W3) Fixed non-production overhead costs Net profit

Statement using absorption costing system first year $000 16,000 10,000 10,000 2,000 8,000 400 8400 7,600 1,080 2,000 3,080 4,520 second year $000 28,000 2,000 12,000 14,000 14,000 700 14700 13,300 1,080 2,000 3,080 10,220

Sales Less: Production costs of sales Opening inventory Add: Variable production overhead costs (W1) Less: Closing inventory Variable non-production overhead costs (W3)

Contribution Less: Fixed production overhead costs Fixed non-production overhead costs Net profit Workings: (W1) first year : $(50 + 120 + 30) 50,000 = $10,000,000 second year : $(50 + 120 + 30) 60,000 = $12,000,000 (W2) first year: (54,000 50,000) x $20 = $80,000 second year: (54,000 60,000) x $20 = ($120,000) (W3) first year: $10 40,000 = $400,000 second year: $10 70,000 = $700,000

Reconciliation of the budgeted profits for the two years Absorption costing profit First year Fixed overheads in inventory (10,000 units $20) Second year Fixed overheads in inventory (10,000 units $20) Marginal costing profit first year $000 4,720 (200) 4,520 second year $000 10,020 200 10,220

The method chosen to prepare the profit statement has the potential to provide management with useful and relevant information for planning and of course for control purpose. Hence the following could be considered to be advantages of each costing system. In absorption costing all production costs are considered, variable or fixed. This is very essential point when it related with pricing decisions since the manufacturer will be able to have a clear picture of the profit margin to be made on each sale where all costs would have been included into the product cost. Another advantage of absorption costing is that provides realistic periodic profits in the sense that all production costs are matched to sales volume. Also, It is

consistent with external reporting requirements since is considered more useful for internal reporting. In marginal costing the distinction between the fixed and variable costs results to the fact that we will have more effective and easier control over the cost and also the standards can be established for fixed cost in order to exercise full control over the total activities. Furthermore, it removes the effect of inventory changes on profit and reduces the dysfunctional behaviour in employees by encouraging managers to produce more inventory than can be sold which occur in the case in the absorption costing. Other advantage of marginal costing is that it brings out contribution and profit margin per unit of output, it clearly brings out the effect of the change in activity and it is making policy decision in a number of managerial problems which is a main part of a business. Under marginal costing, us we said before, all fixed costs are treated as period costs and hence they are all written off in the accounting period to which they relate and this avoids capitalization of fixed overheads in stocks which dont sale yet. As a conclusion to the above, since fixed cost does not enter in to product cost, it eliminates the process of allocating, apportioning and absorbing overheads with result this method to be simpler to operate. In the other hand both costing methods have some disadvantages. Under the absorption costing method as costs are not differentiated into fixed and variables, this method is not useful and relevant in control and managerial decision. Aborting costing employs highly uninformed method of apportionment of overhead, in practice, with result the practical utility of cost data gets reduced, for control purpose. The fixed cost is not charged against the expenditures of the year in which they are incurred. This means that the fixed cost connected to closing stock is charge to the next year and the fixed cost connected to opening stock is charged to the previous year. Also, under the absorption costing the pricing decision manager has no direct facts of cost volume profit relationship. Under marginal costing method it produces a belief that fixed costs have no connection with the production since they dont apply to the productions. It is a difficult task to classifying all the expenses in two groups of either fixed or variable since many of them are neither totally fixed nor totally variable at various levels of activity. Also, the hypothesis about behavior of cost such as fixed cost remains unchanging is often not realistic. Thus, the application of variable overheads is based on estimation only. In marginal cost system contribution is not the only key to take future decision. For example, in the case where fixed cost is very high, the selling price should not be fixed on the basis of contribution alone without taking into consideration other main factors such as capital employed. According to the advantages and disadvantages of each method, there is no main advantage via either absorption costing system or marginal costing system in order to say that one is more efficient that the other. Nevertheless, the marginal cost method provides more reliable results for decision making. According to the absorption cost method the collection of cost data is not very helpful for decision making and the reason is that the cost-volume-profit relationship gets obscured by a reasonable share of fixed overhead through the process of assigning product cost. In contrast, under the marginal cost method, distinguishes between fixed costs and variable costs provides significant information about costs for decision making purposes. In other words, when fixed and variable costs are split, it is easier to manage costs since the managers can see clearly how

costs behave. For example by changing the activity level, management can select an optimal production level. In the case when the management is face up to with a problem of loss, it has to decide what will be the next step in order to avoid the net loss. By using the absorption costing method would conclude that there is no reason to run the department which shows loss and it should be closed down. But by using the marginal costing method would suggest that it would be profitable to continue the production of a product which shows loss if it is able to recover the full marginal cost and a part of the fixed cost. Hence, the marginal costing method is more relevance to decision making. Concluding, marginal costing and absorption costing are two accounting systems which have their uses and the fact that their results can be reconciled indicates that there is a strong connection between them.

BIBLIOGRAPHY Book Cost Accounting 4E, By Jawahar-Lal Websites http://www.hkiaat.org/images/uploads/articles/AAT%20P3%20Absorption%20cos ting.pdf http://www.slideshare.net/khalid1173/absorption-and-marginal-costing-13158049 http://www.stamfordonline.com.my/courses/des/des2204/DES%202204%20Cha pter%206.pdf http://banadurga.blogspot.com/2012/02/difference-between-absorptioncosting.html http://costingbotswana.blogspot.com/2010/01/marginal-costing-vs-absorptioncosting.html

http://www.tutorsonnet.com/homework_help/cost_accounting/marginal_costing/cr iticism_of_marginal_costing_assignment_help_online_tutoring.htm http://www.scribd.com/doc/6988302/DecisionMaking-Using-Marginal-CostingI