1
Absorption and marginal costing systems
Lecture 5& 6
Marginal and Absorption Costing
A popular topic for examination has been the preparation of profit statements
in both absorption and marginal costing formats, and the reconciliation of the
profits reported by the two systems.
1
Absorption and marginal costing systems
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.
First, it is important to understand the key difference between AC and MC. It has
often been said that the difference between these two costing principles is the
way in which fixed costs are treated. This is not specific enough. It is the
treatment of the fixed production costs that is the key issue. In AC, these are
treated as part of the product cost, and it is the product cost which is the basis
for the valuation of stocks. Under MC, the fixed production cost is not included
in the product cost, but is treated instead as a period cost.
, 2
Absorption and marginal costing systems
Essentially marginal costing separates costs into their variable and fixed
elements using contribution as the dividing line, whereas absorption costing
separates them according to whether they are production or non-production
with gross profit as the divide.
Marginal costing makes a clear distinction between fixed cost and variable cost.
The marginal cost of a product is its variable cost. Under marginal costing only
the variable production costs are allocated to the product and are included in
the Inventory Valuation. However absorption costing is the basis of all financial
accounting statements. Under absorption costing, all costs are absorbed into
production and thus operating statements do not distinguish between fixed
and variable costs. The valuation of opening and closing inventories contains
both fixed and variable costs.
Absorption and marginal costing systems
The choice of costing system may be influenced by the costing method adopted.
For example, specific order costing methods will frequently deploy full
absorption costing methods. One reason for this is that the pricing of each
unique piece of work will invariably make reference to the total costs incurred.
However, continuous operation costing methods are more likely to deploy
marginal costing as costing methods.
Absorption Costing Principles
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. This can only be a guide.
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.
, 3
Absorption and marginal costing systems
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.
Absorption and marginal costing systems
Example:
A firm makes 1,000 units in January
Direct material costs Rs 3 per unit
Direct labour costs Rs 4 per unit
Fixed costs are Rs 5,000 a month, i.e Rs 5 per unit
Sales are 900 units at Rs 20 per unit.
Absorption and marginal costing systems
Lecture 5& 6
Marginal and Absorption Costing
A popular topic for examination has been the preparation of profit statements
in both absorption and marginal costing formats, and the reconciliation of the
profits reported by the two systems.
1
Absorption and marginal costing systems
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.
First, it is important to understand the key difference between AC and MC. It has
often been said that the difference between these two costing principles is the
way in which fixed costs are treated. This is not specific enough. It is the
treatment of the fixed production costs that is the key issue. In AC, these are
treated as part of the product cost, and it is the product cost which is the basis
for the valuation of stocks. Under MC, the fixed production cost is not included
in the product cost, but is treated instead as a period cost.
, 2
Absorption and marginal costing systems
Essentially marginal costing separates costs into their variable and fixed
elements using contribution as the dividing line, whereas absorption costing
separates them according to whether they are production or non-production
with gross profit as the divide.
Marginal costing makes a clear distinction between fixed cost and variable cost.
The marginal cost of a product is its variable cost. Under marginal costing only
the variable production costs are allocated to the product and are included in
the Inventory Valuation. However absorption costing is the basis of all financial
accounting statements. Under absorption costing, all costs are absorbed into
production and thus operating statements do not distinguish between fixed
and variable costs. The valuation of opening and closing inventories contains
both fixed and variable costs.
Absorption and marginal costing systems
The choice of costing system may be influenced by the costing method adopted.
For example, specific order costing methods will frequently deploy full
absorption costing methods. One reason for this is that the pricing of each
unique piece of work will invariably make reference to the total costs incurred.
However, continuous operation costing methods are more likely to deploy
marginal costing as costing methods.
Absorption Costing Principles
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. This can only be a guide.
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.
, 3
Absorption and marginal costing systems
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.
Absorption and marginal costing systems
Example:
A firm makes 1,000 units in January
Direct material costs Rs 3 per unit
Direct labour costs Rs 4 per unit
Fixed costs are Rs 5,000 a month, i.e Rs 5 per unit
Sales are 900 units at Rs 20 per unit.
