Thursday, February 16, 2012

Difference between absorption costing and marginal costing

ABSORPTION COSTING VS MARGINAL COSTING

1) Both fixed and variable cost are considered for product costing and inventory valuation. 1) Only variable cost is considered for product costing and inventory valuation.
2) The fixed cost is charged to cost of production. Each product is to bear a reasonable share of fixed cost and profitability of product is thus influenced by subjective apportionment of fixed cost. 2) Treatment of fixed overhead is different.
Fixed cost is considered as a period cost. And profitability of different product is judged by P/V ratio.
3) Presentation of cost is on conventional pattern. Net profit of each product is determined after deducting fixed overheads. 3) Production of data is oriented to highlight the total contribution and contribution from each product.
4) The difference in the magnitude of opening stock and closing stock affects the unit cost of production due to the impact of related fixed overheads. 4) The difference in the magnitude of opening stock and closing stock does not affect the unit cost of production.
Limitations of Absorption Costing-

1) In practice, this method employs highly arbitrary method of apportionment of overhead. This reduces the practical utility of cost data for control purposes.
2) Under absorption costing, fixed cost relating to closing stock is carried forward to the next year. Similarly, fixed cost relating to opening stock is charged to current year instead of previous year. Thus under this method, all the fixed cost is not charged against the revenue of the year in which they are incurred. It is an unsound practice.
3) Under the absorption costing collection of cost data is not very useful fir decision making., because the process of assigning product cost a reasonable share of fixed overhead obscures cost-volume-profit relationship.
4) Under the absorption costing, behavior pattern of cost is not highlighted and thus many s\situations which can be utilized under the marginal costing are likely to go unnoticed under the absorption costing.
Advantage of Marginal Costing
1) Variable cost remains constant per unit of output and fixed cost remain constant in total during short period. Thus, control over the cost becomes more effective and easier. Standards can be established for fixed cost in order to exercise full control over the total activities.
2) Marginal costing brings out contribution and profit margin per unit of output and clearly brings out the effect of the change in activity. If facilities making policy decision in a number of managerial problems, such as, determining profitability of products, introducing a new product, discontinuing a product, fixing selling price, deciding whether to make or buy, utilizing spare capacity, profit planning.
3) The distinction between the product cost and period cost helps easy understanding of marginal cost statements.
4) Closing inventory of work-in- progress and finished goods are valued at marginal or variable cost only. This method leads to greater accuracy in arriving at profit as it eliminates any carry over of fixed costs of the previous period through inventory valuation.
5) As a corollary to above, since fixed cost do not enter in to product cost, it eliminates the process of allocating, apportioning and absorbing overheads, and adjusting under and over absorbed overheads. Therefore, the method is simpler to operate.
Limitation of Marginal Costing
1) The technique is based on the segregation of costs in to fixed and variable ones, while many expenses are neither totally fixed nor totally variable at various levels of activity. Thus classifying all expenses in to two categories of either fixed or variable is a difficult task.
2) The assumption regarding behavior of cost such as fixed cost remains static , are often not realistic.
3) Contribution is not only index to take future decision. Foe example, where fixed cost is very high, selling price should not be fixed on the basis of contribution alone without considering other key factors such as capital employed.
4) Marginal cost, if confused with total cost while fixing selling price may lead to a disaster.
5) Inventory valuation at marginal cost will understate profits and may not be acceptable by the Tax authorities. Any claims based on cost will be very low. As it will not have share of fixed cost.

Application of Marginal Costing-
1) Profit Planning – Profit planning involves forecasting activity level in order to gain or maintain specified amount of profit. Under profit planning start is made from the end result. profit figure is planned and activity level necessary for yielding that profit is attempted. It should be noted that the activity level will involve working out how that level will yield specified profit. In this exercise sale, cost and production activities are all reviewed in harmony with each other to determine how they will yield the desired profit figure.
2) Presentation of cost data for control purpose- Under marginal costing cost data is presented in such a way that it confirms to all the requirements of management to effect control. Data presentation is based on the behavioural study of cost. This leads the management to exercise better control over the cost. Under absorption costing cost data may be misleading for the purpose of decision making.
3) Make or Buy decision-Decision to make or buy should involve comparison of seller’s price with marginal cost of that component. But this approach will lead to wrong conclusion. When a component is produced, a art of plant capacity is utilized, i.e. some contribution is earned. If a company is running at its full capacity the contribution thus earned will be lost \by not manufacturing the component. But this approach will lead to wrong conclusion. When a component is produced a part of plant capacity is utilized,i.e. some contribution is earned. If a company is running at full capacity the contribution thus earned will be lost by not manufacturing the component. Of course, if company is not working at its full capacity the question of lost contribution will become another factor of consideration
4) Optimizing the product mix- When a concern manufactures a number of products, a problem arises as to which product or sale mix will yield maximum profit. Such a problem can be solved by marginal contribution analysis. Product mix, which gives the maximum contribution, will be the optimum mix.
5) Alternative use of production facilities-When an alternative method of manufacturing a product or alternative is available, marginal contribution analysis should be made to arrive at the decision. The alternative yielding the highest contribution will be selected.
6) Evaluation of performance- A company may have different departments or product lines. All these departments and product lines may have different revenue earning potential. A company always concentrates on the departments or the product lines which yields more contribution than others. The relative performance of each department or product is studied by marginal contribution analysis. This analysis will help the company to take decision that will maximize the profits.

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