Absorption Costing Vs Marginal Costing | Case Study

engrossment greeting Vs Marginal Costing Case StudyAs Marabs Manufacturing moderate deals in different products, some standard while others customised, it should accordingly adopt different but qualified techniques for compriseing these products. assimilation be and fringy monetary valueing ar two different techniques of bell accounting which can be employ by Marabs Manufacturing. These techniques may be suited under different circumstances.How is Absorption Costing Different from Marginal Costing?Absorption be is a traditional method of schedule tolling that traces all manufacturing be (the multivariate and the set cost of production) to the product. These cost do non plump expenses until the inventory is sold. Absorption costing considers commonplace manufacturing be as product costs and includes them for inventory valuation. As gross revenue occur, the cost of inventory is transferred to cost of goods sold. Absorption costing emphasises the functional chara cteristics of cost. apply this system, the returns inform for a manufacturing business for a period of time is influenced by the level of production as well as by the level of deals. The rationale for density costing is that it causes a product to be measured and account at its complete cost. Absorption costing is based on the premise that even though it is operose to trace costs like unbending manufacturing overhead to a particular unit of output it does not mean that they argon not a cost of that output. As a result, such costs be allocated to products.In contrast, fringy costing is a costing technique of presenting cost data wherein variable costs and indomitable costs ar shown separately for film directorial decision-making. Marginal costing system emphasises the behavioural characteristics of cost. The charge of this system of costing is on separating costs into variable elements and fixed elements. infra marginal costing, variable costs be charged to cost uni ts and 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. line of descent/ striving for profit measurement under marginal costing is treasured at marginal cost. It is in sharp contrast to the total unit cost under intentness costing method.There are various other points of difference. The key differences between marginal and soaking up costing areAccounting for hardened Manufacturing CostsMarginal and submergence costing differ in terms of treatment of fixed manufacturing costs. Under marginal costing, fixed manufacturing costs are excluded from inventory costs and are a cost of the period in which they are incurred. On the other hand, under assiduity costing, these costs are included in the cost of inventory and become a part of cost of goods sold in the period when gross revenue occur.Presentation of gross sales and Cost Data Facilitating Decision-MakingAbsorption costing does not differentiate between variable and fixed cost in the calculation of profits. But marginal cost statement very clear indicates this difference in arriving at the net operational results of a firm. The differences in presentation are understandably shown in the costing pro-forma below.ABSORPTION COSTING PRO-FORMASalesthirtyProduction cost of Sales curtain raising StockthirtyProduction CostsDirect MaterialsDirect LabourProduction Cost thoughtlessthirtythirtyxxxxxxxxxLess Closing stock(xxx)(xxx)Production bash absorbedxxxProduction Overhead incurredxxxOver absorbed / Under absorbedxxx or (xxx)xxxAdministration overheads incurredxxxSelling and distribution costsxxx(xxx) networkxxxMARGINAL COSTING PRO-FORMASalesxxxVariable cost of SalesOpening StockxxxVariable Production CostsDirect MaterialsDirect LabourVariable Production CostxxxxxxxxxxxxxxxLess Closing stock(xxx)Variable Production Cost of SalesxxxVariable Selling and DistributionxxxTotal Variable Cost of Sales(xxx)ContributionxxxF ixed Costs Fixed Production CostFixed administration costFixed selling and distributionxxxxxxxxxTotal Fixed Costs(xxx)ProfitxxxAbsorption of Fixed OverheadsIn absorption costing, fixed overheads can never be completely absorbed. However, this is not so under marginal costing. Under marginal costing, the actual fixed overhead incurred is only charged against contribution.Stock ValuationIn marginal costing, work in progress and finished stocks are valued at marginal or variable cost, but in absorption costing, they are valued at total production cost.Difference in ProfitsThe net profits under absorption costing method and marginal costing methods differ if at that place is a difference between coal scuttle and closing stock values. When closing stock is more than possibleness stock, the profit under absorption costing allow for be higher as comparatively a greater portion of fixed cost is included in closing stock and carried over to next period.When opening and closing stocks are same, there will be no difference in profit, provided the fixed cost element in opening and closing stocks are of the same amount.Thus, absorption costing and marginal costing differ in their start out and treatment of costs. However, each method has its own advantages and disadvantages.Arguments in Favour of Using Absorption CostingAbsorption costing is simple to administer and easy to understand, and may be appropriate when direct costs are of significance. Besides, absorption costing is undeniable for outside reporting where other methods of costing such as marginal costing are not accepted. It is overly widely used for cost moderate purpose. Thus, there are various arguments in favour of absorption costing areAbsorption costing does not choose to separate costs into fixed and variable costs. This is especially useful in situations where separation of costs into fixed and variable is difficult and gives misleading results.Under marginal costing, stocks and work in progr ess are understated. The ejection of fixed costs from inventories affect profit and true and fair view of financial affairs of an administration may not be clearly transparent.Absorption cost data is more realistic than marginal cost data in case of highly fluctuate levels of production, e.g., in case of seasonal factories. Besides, heap variance in standard costing also discloses the effect of fluctuating output on fixed overhead.Application of fixed overhead depends on estimates and not on the actuals and as such there may be under or over absorption of the same. Absorption costing subjects care of this while marginal costing may not be able to do so.Absorption costing controls cost by means of budgetary control. This is an acceptable process to many.In order to know the net profit, one demand to take into account fixed overheads also. A system like marginal costing which ignores fixed costs is less effective since a major portion of fixed cost is not taken into account. Thus , absorption costing proves to be crack.Arguments in Favour of Using Marginal CostingDespite its various advantages, absorption costing may not always prove to be the best attack to costing or pricing a product. It may not help management take important decisions about a product.Marginal costing may prove to be a better system of costing. For the decision-making purpose of management, better information about expected profit is obtained from the use of variable costs and contribution approach in the accounting system. The arguments that favour marginal costing areIt is simple to understand and avoids having varying charges per unit as it does not charge fixed overhead to cost of production.It prevents the illogical carry forward in stock valuation of some proportion of current years fixed overhead.It facilitates cost control as it avoids arbitrary allocation of fixed overhead. Marginal costing uses cost control methods such as conciliatory budgets.It facilitates cost-volume-profi t (CVP) or breakeven analysis and profitability analysis and thus helps in short-term profit planning. It also helps an system compare profitability and performance between two or more products and divisions and help the management in decision making.Under marginal costing system, large balances are not carried under overhead control accounts and thus there is no difficulty of ascertaining an accurate overhead re reporty rate.As marginal costing is much closer to cash flow managers usually find it easier to understand marginal costing reports.Using Both Absorption Costing and Marginal CostingLike any other organization, a manager at Marabs Manufacturing Limited will need to take decisions when he encounters problems and alternative courses of action are available. In deciding which option to choose he will need all the relevant information. In more or less cases cost information proves to be relevant to any decision making.However, no single costing approach can provide appropriat e information for taking decisions in all circumstances. In certain cases absorption costing will provide more complete information while in other cases marginal costing information will be more relevant. The theoretical basis for absorption costing is that decisions should be based on the matching principle for all manufacturing costs. Marabs Manufacturing incurs fixed manufacturing cost with the expectation that the resources represented by these costs will be used in the production of inventory. Hence, these costs should be matched against the revenue generated from the sale of that inventory. In contrast, the theoretical reasoning for marginal costing is that fixed manufacturing overhead will be incurred in the short-run irrespective of the volume of production or level of inventory. A significant portion of the fixed manufacturing overhead costs is unavoidable in the short run even when the facilities are idle.Marabs Manufacturing Limited is in a multi-product business. Some pr oducts are standard products while others are based on specific orders or are customized according to specifications provided by customers. Wherever the company is costing for standard products it may use absorption costing. It is also given in the scenario that the standard products tend to be seasonal and highly fluctuating. Absorption cost data is more realistic than marginal cost data in case of highly fluctuating levels of production. Absorption costing will also be useful while making certain decisions, for exercising the impairment to be charged for external services. However, all decisions related to specific orders and or products adapted to reckon the requirements of individual customers should be based on marginal costs.Thus, Marabs Manufacturing Limited should not restrict itself to just absorption costing or just marginal costing and use cost data based on both approaches. The chosen approach should depend on the nature of decision required. As a guideline, if the re quired decision relates to cost control, cost data based on absorption costing will be more appropriate. However, cost data based on marginal costing will be more appropriate for short-term managerial decision-making and control. Decision analysis should ideally include costs that vary with a decision. Though marginal costing identifies both fixed and variable costs its decisions are based on only the variable component of costs of an activity. Fixed costs are not relevant in case of many decisions that involve comparatively small variations from existing practice and/or are for relatively limited periods of time. This is because fixed costs are difficult to alter in the short term. Variable cost corresponds closely with the expenditure necessary to produce and sell products and services and can therefore be used more readily in incremental analysis than absorption costing data. Marginal costing is also appropriate for decision making when an activity centre has short-term spare cap acity.Marginal costing will also help the company in taking a decision on the minimum price that could be charged for a product. This can be particularly useful for pricing additional sales at special reduced rates when sales have already been made at the normal selling price. As fixed costs have already been paid of all that is required to cover the variable costs of any additional salesFinally, marginal costing can help Marabs Manufacturing take decisions related toBudget planning and determining the volume of sales required to make a profitPricing and sales volume decisions.Sales mix decisions, to determine in what proportions each product should be sold.Decisions that will affect the cost structure and production capacity of the company.Whether or not to close down in the mouth a factory, department, product line or other activity, either because it is making losses or because it is too expensive to run.To sum it up, both absorption as well as marginal costing techniques are ap propriate for the company and one cannot be treated as better than the other. The choice of a technique should be dependent on the costing objective.ReferencesCharles T. Horngren, George Foster, Srikant M. Datar, Cost Accounting A Managerial Emphasis, Prentice vestibuleJohn K. Harris, Cost Accounting Student Guide, 12th Edition, Prentice HallMichael W. Maher, William N. Lanen, Madhav V. Rajan, Fundamentals of Cost Accounting, McGraw-Hill/IrwinRonald W. Hilton, bold H. Selto, Michael W. Maher, Frank Selto, Cost Management Strategies for Business Decisions, McGraw-Hill CollegeAbsorption Costing / Full Costing accessed from http//www.valuebasedmanagement.net/methods_absorption_costing.html