Critically evaluate marginal and absorption costing
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.
Prices start at $12
Prices start at $11
Prices start at $10
The choice of costing system may be influenced by the costing method. Specific order costing methods will frequently deploy full absorption costing. One reason for this is that the pricing of each unique piece of work will invariably make reference to the total costs incurred. Continuous operation costing methods are more likely to deploy marginal costing (although this may be in addition to absorption costing) because of the opportunities in such an environment to use cost-volume-profit analysis.
Marginal and absorption costing
Marginal costing is a method of inventory costing in which all variable manufacturing costs are included as inventoriable costs. All fixed manufacturing costs are excluded from inventoriable costs. They are instead treated as costs of the period in which they are incurred. Inventoriable costs are all costs of a product that are regarded as an asset when they are incurred and then become costs of goods sold when the product is sold.
In product/service costing, a marginal costing system emphasises the behavioural, rather than the functional, characteristics of cost. The focus is on separating costs into variable elements (where the cost per unit remains the same with total cost varying in proportion to activity) and fixed elements (where the total cost remains the same in each period regardless of the level of activity). Whilst this is not easily achieved with accuracy and is an oversimplification of reality, marginal costing information can be very useful for short-term planning, control and decision-making, especially in a multi-product business.
In a marginal costing system, sales less variable costs measure the contribution that individual products/services make towards the total fixed costs incurred by the business. 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.
Absorption costing is a method of inventory costing in which all variable manufacturing costs and all fixed manufacturing costs are included as inventoriable costs.
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. 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.
An absorption costing system traditionally classifies costs by function. Sales fewer production costs (of sales) measures the gross profit (manufacturing profit) earned. Gross profit fewer 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.
The choice of costing system that an organisation uses will, however, have implications not only for the way that its profit statements are laid out but also for the amount of profit that is recorded.
One of the reasons that organisations use a costing system is so that the value of the stock of finished goods (and work in progress) can be calculated and incorporated into profit statements. Since the different approaches to costing give different costs per unit, they will result in different valuations of stock. This will in turn affect the profit calculation when stock levels change.
The method of valuation of the closing stock is therefore critical as it will affect both the costs of sales and also the level of recorded profit.
The example below shows how the same data is treated using different costing systems.
The “X Company” manufactures a single product and produces monthly management accounts.
In each of month 1 and month 2, 10.000 units were produced, and the following costs were incurred:
Both the costs and the volume of output were in line with the budget.
Units were sold for 70 each, and in month 1 the whole production of 10.000 units was sold, whereas in month 2 only 8.000 units were sold. There was no stock at the start of month 1.
Direct Material and Direct Labour are variable costs.
1. Calculation of cost per unit
a) Absorption costing (using all costs)
500.000 / 10.000 = 50 per unit
b) Marginal costing (using variable costs only)
250.000 / 10.000 = 25 per unit
2. Producing management accounts
a) Absorption costing
month 1month 2
Less cost of sales:
Cost of production (10.000 x 50 )500.000500.000
Less closing stock (2.000 x 50 )-100.000
b) Marginal costing
month 1month 2
Less variable cost of sales:
Variable cost of production
(10.000 x 25 )250.000250.000
less closing stock
(2.000 x 25 )-50.000
Less fixed costs250.000 250.000
Comments on the reasons for differences in profit
The profits are identical when there is no change in-stock level, as in month 1 when both opening and closing stocks are zero. However, when the stock level changes between the start and end of the period (as in month 2) the stock valuation has an impact on profit.
The additional reported profit of 50.000 (160.000 compared with 110.000 ) by using the absorption systems is due to 50.000 of the fixed costs being absorbed into the closing stock and effectively carried into the next period. If the stocks again fell to nil in month 3 the profit difference would be reversed.
The differences in reported profits are only timing differences – the differences in profit are just reported in different periods.
Where stock levels increase, absorption costing will record a higher profit than marginal costing, as more of the cost incurred is pushed into the next period.
Where stock levels decrease, absorption costing will record a lower profit than marginal costing, as more of the costs from the previous period are set against income.
Marginal and absorption costing differ in only one respect: how to account for fixed manufacturing costs. Under marginal costing, fixed manufacturing costs are excluded from inventoriable costs and are a cost of the period in which they are incurred. Under absorption costing, these costs are inventoriable and become a part of the cost of goods sold in the period when sales occur.
Under marginal costing, reported operating income is driven by the unit level of sales. Under absorption costing, reported operating income is driven by the unit level of production as well as by the unit level of sales.
Although absorption costing is the required inventory method for external reporting in most countries, many companies use marginal costing for internal reporting.
Concept Application Discuss the alternative theories to profit maximization ranging from perfect competition to strict monopolies
Perfect Competition Perfect competition is a market form in which no producer or consumer has the power to influence prices in the market. This leads to an outcome which is efficient, according to the economic definition of Pareto efficiency The analysis of perfectly competitive markets provides the foundation of the theory of supply and demand. One example of perfect competition in the real world is the agricultural industry, whose large amount of suppliers, relatively inelastic demand and almost perfectly substitutable product makes it a close approximation of the perfect competition model.
A market is said to be one with perfect competition if:
a) There are a large number of small producers and consumers on a given market.
b) None of the producers or consumers can influence the price on their own.
c) Goods and services are perfect substitutes they are homogeneous.
d) All resources (including information) are perfectly mobile.
e) Transaction costs are zero.
f) The price is determined at the level which equates supply and demands.
This model is often criticised as being unrealistic, as in many markets larger producers are more efficient than perfectly competitive smaller producers while transaction costs and information costs can never be zero as they will involve using resources with alternative uses.
Characteristics of a Monopolistically Competitive Industry Monopolistic Competitive industry is described as “A market structure in which many firms sell a differentiated product into which entry is relatively easy in which the firm has some control over its product price and in which there is considerable non-price competition”.(1)
There are four characteristics of monopolistic competition these are: a) There are many sellers in this industry creating lots of competition b) It’s easy for firms to enter this industry and for existing firms to exit c) Firms in this industry sell differentiated products d) Firms in this industry frequently advertise often locally.
Oligopoly A market structure in which a few firms sell either a standardised or differentiated product into which entry is difficult, and in which the firm has limited control over product price because of mutual interdependence the only exception to this is when there is collusion among firms, and in which there is typically non-price competition.
Discussion If prices were to fluctuate then it could be very damaging to the firms within the market. Firms in an oligopoly do not attempt in driving out their opponents in a bid to become a monopoly as this would be a highly risky strategy and might lead to their company being the victim of such a move. Instead, firms limit competition in order to limit the risks to their own market share.
As there are no barriers to entry into this type of industry a firm will not be expected to make economic profits in the long run. If a firm is making above-normal profits, then other firms would quickly enter this industry in order to share in the profits. The profitable firm’s sales would suffer and in the long run, its economic profits would be zero.
The reverse occurs when firms lose money. The monopolistically competitive firm makes no economic profits in the long run. Profits are zero for firms in monopolistic competition because there are no barriers to entry. If profits exist in the short run, new firms would enter the industry to increase supply, lower the price and reduce economic profits.
Conclusion In conclusion, many differences can be spotted between the two markets and how they operate, for example, firms under Monopolistic Competition depend more on the price level whereas firms under Oligopoly depend more on non-price competition methods, such as advertising and marketing. Prices in oligopolies are likely to be stable as firms rely more on non-price competition to boost their sales and profits.
Resources 1. Macroeconomics: understanding the wealth of nations: Miles and Scott: 2002
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