Being an assistant accountant manager for a company called Atmospheric LTD that manufactures scented candles. A new chief executive has recently been appointed and one of his initiatives is to ask his fellow directors to give guest lecturers to the board and senior managers on areas in their field of expertise. The finance director has been asked to present to the board of directors on the differences between marginal/variable costing and absorption costing.
The memo is to be presented on November 28th to the board of directors. Towards the accomplishment of the memo the presentation will be following up as follows.
In management accounting; internal & external reporting are the two kinds of approaches that are used for marginal and absorption costing. Therefore, managers that make decisions internally always go for the marginal costing method and they could also use it for internal financial reporting because, it is more simpler to work with as compared with absorption costing; while, the absorption costing method is used externally for financial reporting.
(Atkinson A.A. Et Al., 2007) states that Marginal Costing is known to be "a system in accounts which acts towards variable costs in order for them to be charged into cost units and fixed costs in a period which is then written in full against its total contribution". The charge of product costs includes; direct material, direct labor, direct expenses and variable overheads. Furthermore, fixed costs are then treated period costs, in this way it is charged against sales each period. Moreover, a unit cost in line with a marginal costing method does not have any fixed manufacturing cost; however, it only has the items mentioned above. When marginal cost is certain, contribution then falls in, so that it assists in the breakeven output in order to recover the fixed costs. Therefore, when both fixed cost and contribution are equal, a breakeven output is reached. For example, for a firm such as Carphone warehouse, which operates in a marginal costing method because, marginal costing is more of an information type of costing in order for management to manage the firm well enough. Furthermore, marginal costing would then help Carphone warehouse to find the basics of contribution towards its products and can then work out how much a product should be sold for in a breakeven process.
On the other hand, Absorption costing is known to be all manufacturing costs being absorbed by most of the units that are produced. In short, how much it costs to produce a product when it reaches its final stage of completion in inventory will include things such as, direct labor, direct material, and variable costs/fixed manufacturing costs. It could also be said that, absorption costing is also known full costing or called the full absorption method. Furthermore, Absorption costing is mostly put in with variable overheads or direct costing. However, for variable (which is used for decision-making by management) or direct costing, fixed manufacturing costs are not absorbed by the products that have already been processed. However, as explained above, absorption costing is only used for external financial reporting, and could also be used for income financial reporting. For example, firm's such as Nokia incorporate all products they make through indirect overheads and fixed costs. For this reason, Nokia does this because they assign all costs through a budgeted overhead absorption rate, which then enables them to find and sort out all unattended overheads in a more precise because absorption costing is a more reliable method Nokia feel suits them best and as it also takes into all company costs from an items unit cost once its calculated together with the indirect and fixed costs. However, if costs are not found immediately, then absorption has to fall in place separately through cost centers on a fair and reasonable surface.
Absorption costing and marginal costing are relating systems of costing. Both of these approaches have their own advantages and disadvantages. As for marginal costing:
It is an easy approach for firms to understand.
It does not charge fixed cost to cost of production, so the effect of charges per unit is avoided meaning the approach is more accurate compared to absorption costing.
Production plans are always available and can be easily assessed, together with decisions made by management, which then return positive yields towards the business. For example in the case of Carphone warehouse. The firm can use Contribution methods to make profits and improve their performance through products that they sell, in order for them to work out exactly how many products are to be sold which will bring a profit and which products will not be of a benefit to the firm.
Also, it is easy in a way to control all figures (Kaplan 1984 pg.20) "that do not enhance the long term competitive position of the firm".
(Pizzey, 1989) states "Apportionment and the absorption of cost expenses is costly and time consuming". Therefore, if marginal costing is introduced in a firm, these costs are avoided.
However:
Marginal cost does have its limitations; meaning when decisions are made by management for future activity, historical data shall be made as well.
Secondly, fixed costs are ignored towards products that are made, making it look like they are not important for production.
Also, when it comes to a long run period, fixed costs may tend to become variable. (Cowe, 1988) states that "Difficulties may be experienced in trying to analyse fixed and variable elements of overhead costs".
When it comes to stock valuations in marginal costing, it requires absorption costing method to help process it.
In marginal costing, when the method has been used wrongly towards selling prices, to correct the error would be very difficult for management to do. This mostly happens when a firm faces depression or is in a competition with other firms, this would therefore bring out a contribution margin that does not make sense.
Lastly, "the value of inventory is higher under absorption costing than marginal costing" (Admin, 2011).
On the other hand, both absorption and marginal costing are different from each other in a noticeable and interesting way, rather than complementary ones. Their advantages and disadvantages are vice versa. Moreover, the advantages of absorption costing are summarized as follows:
The fixed costs that are together with production are simply identified.
When it comes to financial records, the absorption costing method takes more authority over the marginal costing method and is used to prepare it accurately.
Thirdly, when it comes to net profits, absorption costing method shows a less frequent change in the amount of valid production but fluctuating sales. (Pizzey, 1989) states "… the full cost of production services used to make a product in the cost of that product carried forward and set against eventual revenue from its sale".
Also, in absorption costing, stock is check through in order to include a fair share of fixed production costs, while in marginal costing, stock is checked through at variable production cost only. Therefore, "when it comes to the closing stock, it is noted to be higher in absorption costing compared to marginal costing". (Wiki. Answers, 2012)
However:
Management cannot use absorption costing to make decisions, plan and control towards costs because it works with variable and fixed overheads.
Also, the relationship to do with the cost volume profit is most of the time, or may I say always ignored.
Absorption costing does not calculate contribution; this is only calculated by a marginal costing system, whereas absorption costing only deals with the gross profit.
Moreover, rates of absorption are forecasted in absorption costing, meaning that it is a risky situation because illustrations under absorption concerning the overheads have been absorbed to a greater or a less actual overhead. For example, Nokia's capacity levels towards an overhead absorption rate are based on an historical event and this is likely to change.
Lastly, it is time consuming, its expensive and a very complex method to use.
Absorption costing could be more appropriate than marginal costing because, in absorption costing products are checked through or costed in order for a fixed production overhead to include a fair share in it, whereas in marginal costing, products are only valued at variable production overhead. Moreover, when it comes to the value of closing stock, this is known to be a lot higher in absorption costing compared to marginal costing. Despite it being a consequence in taking forward an important basic part of something complicated due to the fixed production overheads in closing stock values. The revenue that is used to distinguish the profit in absorption costing will therefore include, fixed production overhead costs that were taken previously in a period, however these fixed production overhead costs are taken forward into opening stock values of the current period. Also, in absorption costing, unit costs that are fully absorbed are then reduced because greater quantities are produced, whereas in marginal costing, unit costs are not really touched or affected by the increase in production. In short, this means that the unit costs provided remain unchanged at the changed level of production activity. However, when it comes to profit to each unit in any period, this could or can be affected by the increase of production in absorption costing, whereas in the case of marginal costing, it does not occur.
Furthermore, when we come to marginal costing, the variable costs and the contribution are identified easily, which then enables decision-making for management more easily to construct concerning the purposes required, such as decisions towards the budget. This then makes it easy to decide how much contribution and profit will be affected by the increase and changes in sales. However, profits gained will not be affected when changes in production volume are applied. In absorption costing, however, the period it takes for changes to be applied in the production and sales volume could or can have an effect on the profit gained. This is because a proper analysis and due to increases of costs are not used when it comes to calculating the actual profit.
Relating to ideas and principles, absorption costing is in a way a simple and basic method of trying to find out the cost of a product or service. Therefore, when a product is being manufactured, the cost of the materials used, the wages and any other type of expenses that are together with the product are then calculated and then an estimated amount is added to cover the costs and profit. In this case, the direct costs are then calculated and at times this could be difficult to decide on a more reasonable charge for the costs and profits. Furthermore, the problem of calculating the overhead cost has been "proved to be a topic being used for years and years, and has been put out to be an introduction of being a substitute system, for marginal costing, prior to Second World War" (Cowe, 1988). For example, during the times of the First World War, absorption costing was used widely, mostly by the government, when it came to supplying military equipment. This was because the system was an easy method to cover profit. Moreover, it is shocking in way that marginal costing was not used when it came to such projects. However, the problems that are faced in absorption coasting are quite difficult to correct, making people that support marginal coasting being more dominate over absorption with their reasons. Nevertheless, despite those that support marginal coasting, absorption coasting continues to be more successfully used so much that accounting standards recommend that absorption costing is more valued and includes production overhead.
As we know marginal costing method guides management in decision-making through costs and data being presented, and is not a method of costing. Whereas, absorption costing method, is a well known approach that does not make any difference between variable and fixed cost when it comes to the calculations of profits. However, a marginal cost statement will produce the difference of the net operational results of a firm. Therefore, below is a numerical example and reconciliation of two of the methods.
Example:
The following information has been provided:
£ per unit
Sales price 20
Materials 4
Variable production costs 2
Fixed production overheads £53,000 per month
Budgeted production £9,000 per month
Budgeted sales 8,500 units
Profit statement - marginal costing:
Contribution per unit
£
Sales price 20
Materials (4)
Variable cost (2)
Contribution 14
£ £
Sales Revenue (8,500 x £20) 170,000
Opening stock -
Cost of production 54,000
(9,000 x (4+2))
Closing stock (3,000)
((9,000-8,500) x 4+2
(51,000)
Contribution 119,000
Fixed overhead per unit
Budgeted fixed overhead Budgeted production
£53,000 = £5.8 per unit £9,000
Fixed overheads (53,000)
Profit 66,000
Profit statement - absorption costing:
£ £
Sales revenue (8,500 x £20) 170,000
Opening stock
Cost of production 90,000
Profit per unit
£ Per unit
Sales price 20
Materials (4)
Variable cost (2)
Fixed overhead (5.8)
Profit 8.2
(9,000 x 10)
Closing stock (5,000)
((9,000-8,500) x 10)
(85,000)
Profit 85,000
Reconciliation:
Difference in profit = change in stock x fixed Production overhead cost per unit
£
Marginal costing profit/loss 66,000
Difference in profit 2,900
((9,000-8,500) x 5.8)
Absorption costing profit/loss 68,900
: - Difference - £2,900
Why? This is because under absorption costing the value of closing stock is higher, as we carry ((9,000-8,500) x £5.8) = £2,900 of fixed overheads.
To conclude, both methods differ, especially when their inventory level is changing or has changed. Furthermore, in absorption costing when the stock is rising higher than marginal costing, this means that the absorption coasting can differ with the fixed costs, only once a sell has been made. However, in marginal costing the stock reduces leading to it being a higher profit than absorption costing. The two methods are then looked at together concerning their reported profits and this is done by looking deeply into the fixed overhead absorption rate and how much has changed in inventory. Moreover, both absorption and marginal have no clear advantage towards them; meaning that both methods could be used differently and them being used together indicates that they are capable of existing together.
Reflective journal:
During my tutorial and lecture classes that I have attended till today, I can say I have really learnt a lot concerning Management Accounting. Management accounting is used "to help management record, plan and control the activities of a business and to assist in the decision-making process" (Tutor2u).
Firstly, when I heard that we had an accounts assignment to do until the 28th of November, I was a little tense about it, firstly on hearing the words to accomplish and the work required in it. My main concern was how I was going to do the numerical example because I have not done it before, although we have had examples of it done in our classes, I still found it quite difficult to construct. However, with help from friends, adorable teacher, and my personal tutor, I got the whole concept of it. My aim was not to give up, I wanted to achieve this without copying, I mainly wanted to prove myself wrong that I could do this and this is what I am here for because, I have a destination to reach once my direction is found. This all involved commitment and hard work.
Concerning the research topic "absorption costing vs. marginal coasting" was a very difficult task to do because, my knowledge concerning the topic was very limited and where to allocate the information from and how it had to be written down in to written words. Although, the course is what I need for my future use, my knowledge concerning the topic was very limited. As time went by, as I researched and got the required help I needed. I finally obtained some knowledge about the topic; where to start from and how to answer my question. Moreover, me gaining the knowledge, experience, and how to structure it concerning the topic, will help me a lot in my areas of studies.
Furthermore, I also came to understand the skills needed in order for you to answer a research question, which was a proper analysis of selected words concerning the topic and being able to understand it in a short form of words. I was able to Research on the topic; find its required information, and also being able to select the required data and materials needed to answer such question, such as the internet, journals, books, etc. However, when it came to the advantages and disadvantages concerning the two methods, I can say that was the easiest part I enjoyed working on. I now feel more confident in carrying out research about a certain topic, gathering the required information, and selecting the required information, and choosing the required data and material concerning the topic.
Due to accomplishment of this project, I have learnt a lot of things about management accounting from beginning till today, although I find it being a difficult subject, I will not give up but aim to get want I am here for because, I personally think it will be very useful for me in future. To sum up, I am thankful to complete my project and I enjoyed creating this because, it is a challenge that is enabling me to face reality to the next level of my education.
