Marginal v Absorption Costing

INTRODUCTION

In previous study units we have considered only costing systems that arrange for all costs to be included in or absorbed into individual costs, i.e. absorption costing.  This approach aims at identifying the total cost of an activity or a unit of production, and is frequently applied to job costing and process costing.

Marginal costing makes no attempt to apportion fixed costs to individual cost units.  This means that in calculating the profit for a period using marginal costing, the unit cost of sales would be equal to the marginal or variable cost, which would be deducted from selling price to give contribution.  All fixed costs would be written off in the period in which they are incurred, i.e. they would be deducted from total contribution, to give the profit for the period.

In contrast to marginal costing, in absorption costing (sometimes known as total absorption costing or full costing) all production costs are absorbed into cost units, including a share of fixed production overhead.  This means that in a situation where stock is carried forward to future periods, with absorption costing a certain amount of fixed production overhead would also be carried forward, and therefore the reported profit figure would be different from that obtained with marginal costing.

 LIMITATION OF ABSORPTION COSTING

Let us consider the following scenario.  B Bloggs & Co., a small company, manufactures three products – A, B and C.  It follows the principle of absorption costing, allocating both its factory overheads and its selling overheads on what it considers to be a correct basis.  After six months, the following profit statement was produced.

FIXED, VARIABLE AND SEMI-VARIABLE COSTS

Before going any further, it is necessary to recall the definitions of fixed, variable and semivariable cost given in an earlier study unit.

Fixed Cost (See diagram in Study Unit 3: Cost behaviour Patterns )

A fixed cost is one which tends to remain fixed regardless of the level of production.  Examples are rent, rates, salary of the production manager.  It should be clear that any expense classified as “fixed” is only fixed for a certain time period and only within certain levels of production.

For instance, the uniform business rate is likely to increase once a year or once every few years, so clearly rates are not fixed for ever.  However, within the year, they are fixed regardless of the level of production at the factory.  If, though, production increased so greatly that it was necessary to acquire a new factory, clearly there would be additional rates to pay.  Therefore a fixed cost can only be regarded as fixed over a certain period of time and only within certain levels of production.

Variable Cost

This is a cost which tends to follow (in the short term) the level of activity.  Consider a selling expense such as travellers’ commission.  If the organisation makes no sales, no payment or expense will arise; but as sales begin to rise from zero the cost of commission will increase according to the level of sales achieved.  This is an example of variable cost.

Semi-Variable Cost (See diagram in Study Unit 3: Cost behaviour Patterns )

Between these two extremes, one of which reacts in complete sympathy with production activity, while the other is not affected by activity, there is another type of overhead which is partly fixed and partly variable.  It is known as a semi-fixed or semi-variable cost, that is to say, a cost containing both fixed and variable elements, and which is thus partly affected by fluctuations in the level of activity.  An example is the charge for electricity, which consists of a standing charge per quarter (the fixed element) and a charge per unit of usage (the variable element).  Any semi-variable cost can be separated into fixed and variable components, as follows.

. DEFINITION OF MARGINAL COST

The Chartered Institute of Management Accountants defines marginal cost as:  “The variable cost of one unit of a product or a service; i.e. a cost which would be avoided if the unit was not produced or provided.”

From the above descriptions of fixed, variable and semi-variable cost, it should be clear to you that producing one item less does not avoid any fixed cost or any of the fixed element of semi-variable costs.

THE MARGINAL COST EQUATION:  TERMINOLOGY OF MARGINAL COSTING

When the total variable (or marginal) cost of a number of products is deducted from the total sales revenue, the amount that is left over is called the contribution.  Since fixed costs have not yet been taken into account, this contribution has to cover fixed costs and then any amount remaining is profit.  (That is why it is called the contribution – it is a contribution towards fixed costs and then profit.)  We can write this symbolically as S  –  V  =  F  +  P.  This is the basic equation of marginal costing.  (Sales revenue  –  Variable cost  =  Fixed cost  +  Profit.)

The term “contribution” is defined as the difference between sales value and the variable cost of those sales, expressed either in absolute terms or as a contribution per unit.

Contribution is not profit, it is sales less variable cost.

RWF

Sales                                                                                        x

Less Variable Costs                                        x

= Contribution                                                x

We can also talk about the contribution per unit of a product:  this is simply the selling price minus the variable (marginal) cost.  It should be clear to you that under marginal costing we cannot talk about the profit from any one product, since fixed costs are only considered in total and are not apportioned to the individual products.  However, a number of decisions can be made by looking at the contribution – clearly if a company maximises its contribution it is also maximising its profit, provided fixed costs are truly fixed.

USES OF MARGINAL COSTING

 Deciding on a Selling Price

Marginal costing is useful when a company has carried out some market research to ascertain the likely sales of a product at different selling prices.

Deciding Whether to Accept an Additional Contract

In times when it is short of work, a firm can accept additional work provided that the sales revenue is more than the marginal cost of that work and any additional fixed costs incurred.  This is because, although the new work might not show a profit on an absorption full cost basis (where it was given a share of the total fixed costs), it will provide an additional contribution and so reduce any overall loss (or increase overall profit).  In the long term, of course, a firm will not survive unless it covers all its fixed costs.

Setting a Selling Price for Additional Work

In the long run, of course, a company must set selling prices which ensure that all its costs are covered.  However, in the short term, it will accept work at lower prices than normal, rather than lose the work altogether, if it is short of work.  Marginal costing can be used to determine the minimum price which should be charged for such additional work.

ARGUMENTS AGAINST MARGINAL COSTING

The above examples have illustrated situations where marginal costing must be used for better decision-making.  There are, however, some arguments against marginal costing.

Inadequate Sales Mixture

A company which is short of work will accept reduced-price work provided the selling price covers marginal cost and any additional fixed costs incurred.  This was illustrated in Section F of this study unit.  Indeed, in the short term, a firm might even accept work at a price below marginal cost, if it wanted to avoid laying off workers.  However, if a company takes on too much reduced-price work, it will be unable to take on more profitable work which becomes available at a later date.  Therefore, the indiscriminate use of marginal costing techniques can lead to an inadequate sales mixture, with the firm being unable to concentrate on its most profitable product.

Price-Fixing Policy

We have studied an example where marginal costing was used to establish a short-term price (see Section F of this study unit).  However, as already pointed out, such a method could not be used for fixing long-term prices.

Where a total cost system is in operation, selling prices can be fixed by finding the total cost of each product and adding on a percentage to give the desired level of profit.  If marginal costing is used, however, the percentage added on has to cover fixed costs as well as profit, and this makes the selling price very difficult to calculate.

This is a serious objection to marginal costing for those businesses which do one-off jobs to customers’ specifications, and where a price must be worked out for each order individually.  For businesses which have a ready market for their product, however, the objection is not quite as serious.  This is because in practice few companies are entirely free to determine their own selling price.  It is in part determined for them by the extent of the competition and what the market will bear.  They will lose sales if they charge much more than their competitors and/or more than people are willing to pay.  Therefore many businesses must take the selling price as given, and concentrate on keeping their costs down in order to make a profit.

Stock Valuation

When marginal costing is used, valuations of the closing stock of finished goods or work-inprogress exclude any element of fixed cost.  This is contrary to the IAS International Accounting Standard No. 2 which says that these stock valuations should include a fair share of production overheads.

ASSUMPTIONS OF MARGINAL COSTING

  • Fixed expenses will remain unchanged over the relevant period. In the short term it may be valid but over the longer term unforeseen circumstances may arise which will require additional fixed expenses being incurred (e.g. renting of additional premises).  This can create stepped fixed expenses with multiple break even points.
  • Selling price will remain constant. A drop in demand may lead to a reduction in the selling price to maintain a reasonable share of the market.  Some goods may be sold below normal selling price to attract customers who will then buy more profitable goods (loss leaders).
  • The contribution percentage will remain constant. This ignores economy of scale which enables variable costs to be reduced.  It also assumes that materials will be available at the same price during the relevant period.  The recent fluctuations in the price of fuel due to political instability and regional conflicts are a very good example of circumstances, which can completely invalidate break even assumptions.
  • Only one product is sold. For multiple products break even analysis is very complicated and assumptions are made that the ratio of sales of the different products will remain constant.  An average contribution is calculated.  This assumption may prove to be inaccurate over an extended period of time.
  • Expenses can be categorised into variable and fixed. There are a number of grey areas and different firms will treat some expenses as variable whereas others may treat them as fixed.

. MARGINAL AND ABSORPTION COSTING COMPARED

Most management accounting theorists agree that marginal costing is more useful in decision-making, where a choice has to be made between alternatives.  Marginal costing would provide information about differential costs, which would be most relevant to the situation.

However, a choice has to be made between marginal and absorption costing in the routine internal cost accounting system.  There is no straightforward answer as to which system should be used.  The system designer must consider all the advantages and disadvantages and what is required from the system, before making a decision.

Remember these points if you are given a scenario in the examination and need to decide on the best option.

Arguments in Favour of Absorption (Full) Costing
  • When production is constant but sales fluctuate, absorption costing will cause fewer profit fluctuations than marginal costing in periods when stocks are being built up to match future increased sales demand (see the example in Section C).
  • No output could be achieved without incurring fixed production costs, and it is therefore logical to include them in stock valuations.
  • If managers continually use marginal cost pricing, there is a danger that they may lose sight of the need to cover fixed costs. Absorption costing values all production at full cost, so that managers are always aware of fixed costs.
  • SSAP 9 Stocks and Long-term Contracts states that in order to match costs and revenues, the cost of stock should include all costs incurred in bringing the stock to its present condition. These costs should include all related production overheads, even if

they accrue on a time basis (i.e. do not fluctuate with the level of activity – fixed overheads).

Arguments in Favour of Marginal Costing
  • When sales are constant but production fluctuates, marginal costing will give a more logical, constant profit picture.
  • Since fixed costs accrue on a time basis, it is logical to charge them against sales in the period in which they are incurred. The recommendations of SSAP 9 are for external profit reporting purposes, but the internal costing system simply has to meet the information needs of managers.  The marginal costing system will also give a better indication of the actual cash flow of the business.
  • Under- or over-absorption of overheads is not a problem with marginal costing, and managers are never working under a false impression of profit being made, which could be totally altered by an adjustment for under- or over-absorbed overheads in absorption costing.
Further Points

It is important to remember that the difference between absorption and marginal costing arises from the treatment of the fixed costs of production.  As direct material cost and direct labour cost will always vary with production, it is the overhead cost which creates the difficulties.

In absorption costing all the overheads are absorbed using various logical bases.  It is essential to prepare an overhead summary prior to a period, dividing anticipated overheads into production and service departments.  The overheads allocated or apportioned to service departments are then apportioned to production using the most logical basis; an absorption rate is calculated on the basis of whether the production departments are labour, machines or material intensive.

In marginal costing, direct cost of production is calculated by adding direct material cost, direct labour cost and overheads which can be related to one unit of production.  By deducting this marginal cost of production (cost to produce one extra unit) from the sales revenue, a contribution towards fixed overheads from each unit of production is calculated.  Total fixed overheads divided by contribution per unit establishes the breakeven point.  This is where all fixed overheads are recovered and the business starts making contribution towards profit.

Limitations of absorption costing:

  • In absorption costing the main difficulty arises in dividing overhead expenses between production and service If they relate to one department they can be easily allocated; but if they need to be apportioned between departments then the most logical basis of apportionment has to be established.
  • The cost of production is calculated after the production has taken place. The profit or loss is therefore calculated after the event, reducing any opportunity for the management to take action to control the cost in order to improve profitability.
  • Because the absorption rate is calculated on the basis of anticipated production, and the overheads themselves are estimated, at the end of the period there will always be over- or under-absorption of overheads as actual production or actual overheads will be more or less than the estimate.
  • Absorption costing does not assist management by giving accurate information that helps in preparing quotations for future contracts or in establishing a correct selling price. This is because the overheads in the following period may be different and they may change in their variability.

Limitations of marginal costing:

  • The main difficulty in marginal or direct costing is to establish variability of overhead expenses. In reality most overheads are semi-variable.  They are neither strictly variable with production nor strictly fixed for any level of production.  Their variability can be calculated by techniques such as scattergraphs etc.  Therefore the basic argument in favour of marginal costing is flawed.
  • In the case of a business producing more than one product, it is difficult to calculate breakeven points for each product. The best we can achieve is usually to calculate an overall breakeven point based on level of activity or total sales revenue.  This again reduces the usefulness of marginal costing.

Absorption costing is useful to management because it is easy to operate.  Once the basis of apportionment and rates of absorption are agreed, adjustments can be made annually to bring them in line with the current situation.  Marginal costing is very useful to management in making decisions, e.g. on make or buy, levels of production, pricing of products.

In conclusion, both methods can and should be used by management – absorption costing for the benefits it gives in cost accumulation and cost control, and marginal costing to assist in managerial decisions.

 

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