Marginal Costing as a cost accounting system is significantly different from absorption costing. It is an alternative method of accounting for costs and profit, which rejects the principles of absorbing fixed overhead into unit costs.
**This means that the cost of sales in a period will include some fixed overhead incurred in a previous period (in opening stock values) and will exclude some fixed overhead incurred in the current period but carried forward in closing stock values as a charge to a subsequent accounting period.
This distinction**between marginal costing and absorption costing is very important and the contrast between the systems must be clearly understood. Work carefully through the following example to ensure that you are familiar with both methods.
The diagram below will help us understand the different approaches in computing the profits in both costing methods.
The normal level of activity for the year is 800 units. Fixed costs are incurred evenly throughout the year, and actual fixed costs are the same as budgeted. There were no stocks of Clauds at the beginning of the year. In the first quarter, 220 units were produced and 160 units sold.
(a) Calculate the fixed production costs absorbed by Clauds in the first quarter if absorption
costing is used,
(b) Calculate the profit using absorption costing,
(c) Calculate the profit using marginal costing,
(d) Explain why there is a difference between the answers to (c) and
d) The difference in profit is due to the different valuations of closing stock. In absorption costing the 60 units of closing stock include absorbed fixed overheads of Ksh.120 (60 x Ksh.2), which are therefore costs carried over to the next quarter and not charged against the profit of the current quarter. They are treated as product costs. In marginal costing, all fixed costs incurred in the period are charged against the profit. They are treated as period costs.
The absorption costing profit may be reconciled to the marginal costing profit by adjusting it for the fixed costs carried forward to the next period as shown below.
We can draw a number of conclusions from this example:
(a) Marginal costing and absorption costing are different techniques for assessing profit in a period.
(b) If there are any changes in stocks during a period, marginal costing and absorption costing give different results for profit obtained:
If stock levels increase, absorption costing will report the higher profit because some of the fixed production overhead incurred during the period will be carried forward in closing stock (which reduces cost of sales) to be set against sales revenue in the following period instead of being written off in full against profit in the period concerned (as in the example above),
If stock levels decrease, absorption costing will report the lower profit because as well as the fixed overhead incurred, fixed production overhead which had been brought forward in opening stock is released and is included in cost of sales.
(c) If the opening and closing stock volumes and values are the same, marginal costing and absorption costing will give the same profit figure.
(d) In the long run, total profit for a company will be the same whether marginal costing or absorption costing is used because in the long run, total costs will be the same by either method of accounting. Different accounting conventions merely affect the profit of individual accounting periods.
Distinction between marginal and absorption costing
These are two approaches of arriving at the cost of production or net profit for a given period.
The main difference between absorption costing and marginal costing is on the treatment of thefixed cost.
In absorption costing both variable and fixed production costs are included in the determination of the cost of a product. This implies that the fixed cost is treated as a product cost and not as a period expense. It is important for the student to note the term “fixed production costs” as they are the only costs that make the difference between the marginal and absorption in costs of production. In marginal costing, only variable costs are included in the determination of the production cost. This implies that fixed costs are treated as:
– Period costs
– Product costs