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Absorption Costing & Marginal Costing

Absorption Costing: Absorption Costing technique is also termed as Traditional or Full Cost Method. According to this method, the cost of a product is determined after considering both fixed and variable costs. The variable costs, such as those of direct materials, direct labor, etc. are directly charged to the products, while the fixed costs are apportioned on a suitable basis over different product manufactured during a period. Thus, in case of Absorption Costing all costs are identified with the manufactured products. This system of costing has a number of disadvantages: i. ii. iii. iv. It assumes prices are simply a function of costs. It does not take account of demand. It includes past costs that may not be relevant to the pricing decision at hand. It does not provide information that aids decision making in a rapidly changing market environment.

Thus, the technique of Absorption Costing may lead to rather odd results particularly for seasonal businesses in which the stock level fluctuate widely from one period to another. The transfer of overheads in and out of stock will influence their profits for the two periods, showing falling profits when the sales are high and increasing profits when the sales are low. The technique of Absorption Costing may also lead to the rejection of profitable business. The total unit cost will tend to be regarded as the lowest possible selling price. An order at a price, which is less than the total unit cost may be refused though this order, may actually be profitable. Marginal Costing: Marginal costing is a special technique used for managerial decision making. The technique of marginal costing is used to provide a basis for the interpretation of cost data to measure the profitability of different products, processes and cost centers in the course of decision making. It can, therefore, be used in conjunction with the different methods of costing such as job costing, process costing etc., or even with other techniques such as standard costing or budgetary control. . In marginal costing, cost ascertainment is made on the basis of the nature of cost. It gives consideration to behaviour of costs. In other words, the technique has developed from a particular conception and expression of the nature and behaviour of costs and their effect upon the profitability of an undertaking. In the orthodox or total cost method, as opposed to marginal costing method, the classification of costs is based on functional basis. Under this method the total cost is
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the sum total of the cost of direct material, direct labor, direct expenses, manufacturing overheads, administration overheads, selling and distribution overheads. In this system, other things being equal, the total cost per unit will remain constant only when the level of output or mixture is the same from period to period. Since these factors are continuously fluctuating, the actual total cost will vary from one period to another. Thus, it is possible for the costing department to say one day that a thing costs Rs. 20 and next day it costs Rs. 18. This situation arises because of changes in volume of output and the peculiar behaviour of fixed expenses comprised in the total cost. Such fluctuating manufacturing activity, and consequently the variations in the total cost from period to period or even from day to day, poses a serious problem to the management in taking sound decisions. Hence, the application of marginal costing has been given wide recognition in the field of decision making.

Marginal Cost: The technique of marginal costing is concerned with marginal cost. The Institute of Cost and Management Accountants, London, has defined Marginal Cost as the amount at any given volume of output by which aggregate costs are changed if the volume of output is increased or decreased by one unit. Therefore, Marginal Cost refers to increase or decrease in the amount of cost on account of increase or decrease of production by a single unit. The unit may be a single article or a batch of similar articles. Marginal Cost ordinarily is equal to the increase in total variable cost because within the existing production capacity an increase of one unit in production will cause an increase in variable cost only. The variable cost consists of direct materials, direct labor, variable direct expenses and variable overheads. The accountants concept of marginal cost is different from the economists concept of marginal cost. According to economists, the cost of producing one additional unit of output is the marginal cost of production. This shall include an element of fixed cost also. Thus, fixed cost is taken into consideration according to the economists concept of marginal cost, but not according to the accountants concept. Moreover with additional production the economists marginal cost per unit may not be uniform since the law of diminishing (or increasing) returns may be applicable, while the accountants marginal cost in taken as constant per unit of output with additional production.

Utility of Marginal Costing:

Marginal costing is a special technique used for managerial decision making. The technique of marginal costing is used to provide a basis for the interpretation of cost data to measure the profitability of different products, processes and cost centers in the course of decision making. It can, therefore, be used in conjunction with the different methods of costing such as job costing, process costing etc., or even with other
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techniques such as standard costing or budgetary control. The technique of marginal costing has become more relevant and useful in todays business environment of globalization. This is because in marginal costing the cost of a product, or a service is computed only on the basis of variable costs. Global companies want to take advantage of cheap labour in developing or backward countries. Marginal costing techniques helps management in several ways in the present day context of global business environment. These are listed below:

Volume of production: Marginal costing helps in determining the level of output which is most profitable for running concern. The production capacity, therefore, can be utilized to the maximum possible extent. It helps in determining the most profitable relationship between cost, price, and volume in the business which helps the management in fixing best selling prices for its products Selecting product lines: The marginal costing technique helps in determining the most profitable production line by comparing the profitability of different products. Produce or procure: The decision whether a particular product should be manufactured in the factory or procured from outside source can be taken comparing the price at which it can be had from outside. In case the procurement price is lower than the marginal cost of production, it will be advisable to procure the product from outside source. Method of manufacturing: If a product can be manufactured by two or more methods, ascertaining the marginal cost of manufacturing the product by each method will be helpful in deciding as to which method should be adopted. Shut down or continue: marginal costing, particularly in the times of depression, helps in deciding whether the production in the plant should be suspended temporarily or continued in spite of low demand for the firms products.

Comparison of Marginal & Absorption Costing: Absorption Costing technique is also termed as Traditional or Full Cost Method. According to this method, the cost of a product is determined after considering both fixed and variable costs. In marginal costing only variable costs are charged to production. Fixed costs are ignored. Following are differences between them.

Recovery of Overhead: In absorption costing both fixed & variable overheads are charged to production. In contrary to this, in marginal costing only variable overheads are charged to production. Thus, in marginal costing there is under recovery of overheads. Valuation of stocks: In absorption costing, stocks of work in progress and finished goods are valued at works cost & total cost. In marginal costing, only variable cost is considered while computing the value of work in progress or finished products. Thus, closing stock in marginal costing is under-valued as compared to absorption costing.
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Absorption Costing: Advantages & Limitations: Advantages: 1. 2. 3. 4. It recognizes the importance of fixed costs in production; This method is accepted by Inland Revenue as stock is not undervalued; This method is always used to prepare financial accounts; When production remains constant but sales fluctuate absorption costing will show less fluctuation in net profit and 5. Unlike marginal costing where fixed costs are agreed to change into variable cost, it is cost into the stock value hence distorting stock valuation. Limitations: 1. As absorption costing emphasized on total cost namely both variable and fixed, it is not so useful for management to use to make decision, planning and control; 2. As the managers emphasis is on total cost, the cost volume profit relationship is ignored. The manager needs to use his intuition to make the decision.

Marginal Costing: Advantages & Limitations: Advantages: 1. The marginal cost remains constant per unit of output whereas the fixed cost remains constant in total. Since marginal cost per unit is constant from period to period within a short span of time, firm decisions on pricing policy can be taken. If fixed cost is included, the unit cost will change from day to day depending upon the volume of output. This will make decision-making task difficult. 2. Overheads are recovered in marginal costing on the basis of pre-determined rates. If fixed overheads are included on the basis of pre-determined rates, there will be under-recovery of overheads if production is less or if overheads are more. There will be over-recovery of overheads if production is more than the budget or actual expenses are less than the estimate. This creates the problem of treatment of such under or over-recovery. Marginal costing avoids such under or over-recovery of overheads. 3. Advocates of marginal costing argue that under the marginal costing technique, the stock of finished goods and work in progress are carried on marginal cost basis and the fixed expenses are written off to profit and loss account as period costs. This shows the true profit of the period. 4. Marginal costing helps in carrying out break-even analysis, which shows the effect of increasing or decreasing production activity on the profitability of the company. 5. Segregation of expenses as fixed and variable helps the management to exercise control over expenditure. The management can compare the actual
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variable expenses with the budgeted variable expenses and take corrective action through analysis of variances. 6. Marginal costing helps the management in taking a number of business decisions like make or buy, discontinuance of a particular product, replacement of machines, etc. Limitations: 1. It is difficult to classify costs exactly into fixed and variable. Most of the expenses are neither totally variable nor wholly fixed. 2. Contribution itself is not a guide unless it is linked with the key factor. 3. Sales staff may mistake marginal cost for total cost and sell at a price, which will result in loss or low profits. Hence, sales staff should be cautioned while giving marginal cost. 4. Overheads of fixed nature cannot altogether be excluded particularly in large contracts while valuing the work-in-progress. In order to show the correct position fixed over heads should be included in work-in-progress. 5. Some of the assumptions regarding the behaviour of various costs etc., are not necessarily true in a realistic situation. For example, the assumption that fixed cost will remain static throughout is not correct. Variable Costing and Theory of Constraints (TOC): The Theory of Constraints (TOC) focuses on managing constraints in a company as the key to improving profits. Companies involved in Theory of Constraints (TOC) use a form of variable costing. One difference is that in Theory of Constraints (TOC) approach, direct labor is generally considered to be a fixed cost. In many companies direct labor is not really a variable cost. Even though direct labor may not be paid on an hourly basis, many companies have a commitment--sometimes enforced in labor contracts or by law--to guarantee workers a minimum number of paid hours. In TOC companies, there are two additional reasons to consider direct labor to be a fixed cost. First, direct labor is not usually a constraint. In simplest case constraint is a machine. In more complex cases, the constraint is a policy (such as a poorly designed compensation scheme for sales persons) that prevents the company from using its resources more effectively. If direct labor is not the constraint, there is no reason to increase it. Hiring more direct labor would increase costs without increasing the output of salable products and services. Second, TOC emphasizes continuous improvement to maintain competitiveness. Without committed and enthusiastic employees, sustained continuous improvement virtually impossible. Since layoffs often have devastating effects on employee morale, managers involved in TOC are extremely reluctant to lay off employees.

For these reasons, most managers in TOC companies regard direct labor as a committed fixed cost rather than as a variable cost. Hence, in the modified form of variable costing used in TOC companies, direct labor is not usually included as a part of product costs. Discussion Questions and Answers: Questions: 1. Differentiate between direct costs and direct costing. 2. Distinguish between period costs and product costs. 3. Why does the direct costing or variable costing theorist exclude fixed manufacturing costs from inventories? 4. In the process of determining a proper sales price, what kind of cost figures are likely to be most helpful? 5. Why is it said that an income statement prepared by the direct costing procedure is more helpful to management than an income statement prepared by the absorption costing method? 6. Why should the chart of accounts be expanded when direct costing is used? 7. A manufacturing concern follows the practice of charging the cost of direct materials and direct labor to work in process but charges off all indirect costs (factory overhead) directly to income summary. State the effects of this procedure on the concern's financial statements and comment on the acceptability of the procedure for use in preparing financial statements. 8. Has the Internal Revenue Service approved direct costing for tax purposes? 9. A speaker remarked that even though direct costing has attractive merits, there are certain items that should be concerned before converting the present system. What hidden dangers or disadvantages are present in direct costing? 10. List the arguments for and against the use of direct costing. 11. Select the answer which best completes the statement: (a) The term meaning that all manufacturing costs (direct and indirect, fixed and variable) which contribute to the production of the product and traced to output and inventories is: (1) job order costing; (2) process costing; (3) absorption costing; (4) direct costing. (b) The term that is most descriptive of the type of cost accounting often called direct costing is (1) out of pocket costing; (2) variable costing; (3) relevant costing; (4) prime costing. (c) Costs treated as product costs under direct costing are: (1) prime costs only; (2) variable production costs only; (3) all variable costs; (4) all variable and fixed manufacturing costs. (d) The basic assumptions made in direct costing with respect to fixed costs is that fixed cost is: (1) controllable cost; (2) a product cost; (3) an irrelevant cost; (4) a period cost (e) Operating income computed using direct costing would generally exceed operating income computed using absorption costing if: (1) units sold exceed
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(f)

(g)

(h)

(i)

(j)

(k)

units produced; (2) units sold are less than units produced; (3) units sold equal units produced; (4) the unit fixed cost is zero A company has operating income of $50,000; using direct costing for a given period. Beginning and ending inventories for that period were 13,000 units and 18,000 units, respectively. If the fixed factory overhead application rate is $2 per unit, the operating income using absorption costing is: (1) $40,000; (2) $50,000; (3) $60,000; (4) not determinable from the information given. Absorption costing differs from direct costing in the: (1) fact that standard costs can be used with absorption costing but not with direct costing; (2) kinds of activities for which each can be used to report ; (3) amounts of costs assigned to individual units of product; (4) amount of fixed costs that will be incurred. When a firm uses direct costing: (1) the cost of a unit of product changes because of changes in the number of units manufactured; (2) profits fluctuate with sales; (3) an idle capacity variance is calculated by a direct costing system; (4) product cost include variable administrative costs. Operating income under absorption costing can be reconciled to operating income determined under direct costing by computing the difference between: (1) inventoried fixed costs in the beginning and ending inventories and any deferred over or under applied fixed factory overhead; (2) inventoried discretionary costs in the beginning and ending inventories; (3) gross profit (absorption costing method) and contribution margin (direct costing method); (4) sales as recorded under the direct costing method and sales as recorded under the absorption costing method. Under the direct costing concept, unit product cost would most likely be increased by: (1) a decrease in the remaining useful life of factory machinery depreciated by the units of production method; (2) a decrease in the number of units produced; (3) an increase in the remaining useful life of factory machinery depreciated by the sum of the years digits method; (4) an increase in the commission paid to salespersons for each units sold. When using direct costing information, the contribution margin discloses the excess of: (1) revenue over fixed cost; (2) projected revenue over the break even point; (3) revenue over variable cost; (4) variable cost over fixed cost.

Answers: 1. Direct costs are direct materials, direct labor, and other costs directly assignable to a product. Direct costing or variable costing is a procedure by which only prime costs plus variable factory overhead are assignable to a product or inventory; all fixed costs are considered period costs. 2. Period costs are costs charged against the income of the current period. In direct costing, the fixed factory overhead as well as selling and administrative expenses are treated as period costs. Expenses that apply to the production of goods are called product costs. Variable manufacturing costs are typical product costs in direct costing and are charged against income when the units to which they relate are sold.
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3. Fixed manufacturing costs are the expenses of maintaining capacity; such expenses occur with the passage of time and not with the utilization of the facilities. 4. There is no way to prove that one type of cost figure is going to be more helpful than another in the determination of the sales price. The sales price must exceed all costs of every kind before a profit is realized, but this does not mean that some sales of a single product or sales of products could not be made at a price which recovers at least the variable costs or makes a contribution to the recovery of fixed expenses. The absorption or conventional cost approach to pricing looks at the long run total cost recovery. The marginal costing or direct costing approach looks at the short run profit contribution aspect of immediate sales. It seems probable that direct costing is more appropriate in making short run decisions with regard to production schedules and pricing products offered for sales, provided the total cost recovery in the long run is kept in mind. 5. An income statement prepared by the direct costing method presents cost of goods sold figures with variable costs only. These variable costs, based on the number of units sold, facilitate computing a contribution margin figure. Thus the direct costing income statement is preferred by the management because it follows management's decision making processes more closely that the statement based on absorption costing. 6. Under a direct costing plan, all variable expenses are channeled into the fixed category at the time the expenses are incurred. This procedure means that the chart of accounts has to be expanded to take care of the new accounts needed. 7. The cost to manufacture usually includes the sum of direct materials, direct labor, and applicable indirect factory costs. Consequently, by omitting indirect factory costs from work in process (WIP) the concern is understanding inventory accounts in comparison with concerns which follow the usual practice. At any particular time, then, its financial position (balance sheet) is incorrectly stated because: (a) work in process and finished goods are understated; (b) current assets are understated and so is the net working capital--and therefore the current ratio is understated; (c) total assets are under stated; (d) stockholder's equity is understated--particularly the retained earnings amount. Of at least equal importance is the effect on the recorded results of operations. Unless the sum of the work in process and finished goods accounts happens to be the same at each balance sheet date, costs and revenue will not be matched in the usual manner, resulting in a corresponding distortion of reported income. Thus, if these inventories at the end of the year exceed the corresponding totals at the beginning of the year, Profits will be understated; if these inventories are below those at the beginning of the year, profits will be overstated. It is not accepted accounting practice to omit all factory overhead from inventories. While the costs of idle facilities, excessive spoilage, and certain other variances and usual items may be treated as period costs, the usual indirect costs are considered assignable to the production of the period. These indirect factory costs are ordinarily not as easily assignable to products as are the direct cost; but at the time they are incurred, they are recoverable from future revenues. Therefore, they should be added to the direct costs and flow through inventories.
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8. The Internal Revenue Service (IRS) does not permit the use of direct costing for tax purposes because it does not clearly reflect income. 9. The hidden dangers or disadvantages present in direct costing are: (a) A change to direct costing will prohibit a comparison with the company's accounting information for any prior year unless past periods are changed to a direct costing basis. (b) A seasonal business which produces for six months and sells its entire production in the next six months would show a sizeable loss for the first six months and a sizeable profit for the last six months. (c) Those who use direct costing figures must understand the difference between conventional gross profit on sales and contribution to fixed costs and profits and realize the limitations of the contribution theory. (d) In planning price and sales policies, the full cost to develop, produce, and market a product must be known. Using direct costs and looking at marginal contributions only would certainly be fallacious when new extensive use of existing expensive equipment or expansion of facilities. (e) Direct costing might bring unsatisfactory management action when sales outrun production and inventories are being drawn on. Under these conditions, direct cost profits are higher than under absorption costing. The opposite is true when sales lag behind production. (f) When used as the sole vehicle for the management decisions, direct costing can lead to a disregard for the need to recover fixed costs. 10. Arguments for the use of direct costing include the following: (a) For profit planning purposes, management requires cost volume profit relationship data which are more readily available from direct cost statement than from absorption costing. (b) Since fixed factory overhead is absorbed as a period cost, increasing or reducing production and differences in the number of units produced versus the number sold do not affect the per unit production cost. (c) Direct costing reports are more easily understood by management because the statements follow management's decision making process more closely than do absorption costing statements. (d) Reporting the total fixed cost for the period in the income statement directs management's attention to the relationship of this cost to profits. (e) The elimination of allocated joint fixed cost permits a more objective appraisal of income contributions according to products, sales areas, kinds of customers, etc. Cost volume relationships are highlighted. (f) The similarity of the underlying concepts of direct costing, flexible budgets, break even analysis, and standard costs facilitates the adoption and use of these methods for reporting, cost control and financial planning. (g) Direct costing provides a means of costing inventory that is similar to management's concept of inventory cost as the current out of pocket expenditures necessary to produce or replace the inventory. (i) The computation of product costs is simpler and more reliable under direct costing because a basis of allocating the fixed cost, which involves estimates and personal judgment, is eliminated.
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(j) A "true and proper" profit results from direct costing because only variable costs should be identified with production. Fixed costs occur with the passage of time. Arguments against the use of direct costing include the following: (a) Separation of costs into fixed and variable costs might be difficult, especially when such costs are semi variable in nature. Moreover, all costs--including fixed costs--are variable at some level of production and in the long run. (b) Long-range pricing of products and other long range policy decisions require a knowledge of complete manufacturing cost which would require additional separate computations to allocate fixed overhead. (c) The pricing of inventories by the direct costing method is not acceptable for income tax computation purposes. (d) Direct costing has not been recognized as conforming with generally accepted accounting principles (GAAP) applied in the preparation of financial statements for stockholders and general public. (e) Profits determined by direct costing are not "true and proper" because of the exclusion of fixed production costs which are a part of total production costs. and inventory. Production would not be possible without plant facilities, equipment, etc. To disregard these fixed costs violates the general principle of matching costs with revenues. (f) The elimination of fixed costs from inventory results in a lower figure and consequent reduction of reported working capital for financial analysis purposes. The decrease in working capital may also weaken the borrowing position. 11. (a) 3; (b) 2; (c) 2; (d) 4; (e) 1; (f) 3*; (g) 3; (h) 2; (i) 1; (j) 1 (k) 3 *Operating income under direct costing + Cost deferred in inventory $50,000 + $10,000 = $60,000

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