What is the difference between marginal and absorption costs?

geek84geek84 Trusted RegularPosts: 564MAAT
Hi Folks

I am on level 3 at the moment and reading through the chapter on marginal and absorption costs. I have read that chapter many times but just can't get my head round the similarities/differences between the 2 types of costs and when to use each one.

Could someone be kind enough to explain the similarities/differences and when it is appropriate to use each one?

Thanks in advance for your response.

Comments

  • SandyHoodSandyHood Font Of All Knowledge Posts: 2,034Registered, Moderator
    I answered another question recently and I think your question is similar - reading the book is good, but when a topic is a stumbling block there is a lot to be said in favour of the classroom.

    Absorption costing is used to cost products and to report financial performance.
    The cost of a product is made up of those direct costs that can be related directly to making it. For example the direct cost of a chair might be :
    10 metres of wood at £6.00 per metre
    1 piece of moulded plastic
    20 screws and washers
    30 minutes of time

    We would call these the direct material and direct labour costs.
    We then add the production overheads. These are not related directly to any particular chair, but they are costs that have to be paid to be able to make the chairs.
    They include the rent of the factory or workshop, the cost of machinery (often using a depreciation charge, and other related costs).
    These indirect costs are totalled before the start of an accounting period to produce a figure we call the budgeted production overheads.
    Another budgeted figure is called the basis for absorption. I am going to assume that you understand about overhead absorption rates, so I will use budgeted labour hours.
    The budgeted production overheads divided by the budgeted labour hours in a department give the budgeted overhead absorption rate (per labour hour).
    At the costing stage, the product is then costed as:
    the total direct cost per unit
    + the absorbed overhead (OAR x the budgeted labour hours)

    My next posting will look at the marginal cost of a product.


    Links that might help:

    Absorption costing
    Sandy
    [email protected]
    www.sandyhood.com
  • SandyHoodSandyHood Font Of All Knowledge Posts: 2,034Registered, Moderator
    Marginal cost is used for decision making, very often in a planning rather than reporting context.

    The marginal cost of a product is made up of the costs that increase when you make one more.
    I will be making plum jam in a few days. There is basically 2 material ingredients when you make jam, sugar and (in this case) plums.
    If my plum supplier turned up with 20kgs of plums, I would add 15kgs of sugar and work at it for about 2 hours including clearing up time.
    If she arrived with 22 kgs of plums, I'd add another 1.5 kgs but I'd probably not need any more time.

    So the marginal cost of 3 kgs of extra jam, when I'm already making a batch, would only be the cost of the plums and the cost of the sugar.

    This is crucial to decision making. It doesn't show up within financial reporting as all the costs will appear without making any distinction for adding more plums.

    In level 3 costing, marginal costing is treated as being exactly the same as variable costing. Variable costs are costs that change when production changes. Just as the example above shows.
    Sandy
    [email protected]
    www.sandyhood.com
  • SandyHoodSandyHood Font Of All Knowledge Posts: 2,034Registered, Moderator
    Reporting differences between Absorption costing and Marginal costing

    When you present profit statements there are differences in layout and in definitions.

    Absorption costing profit statement

    Sales revenue Total units sold x price per unit
    less
    Cost of Sales
    Opening Stock (Inventory) Units of finished goods in stock at start of period x absorption production cost per unit
    Plus Production Costs
    Material used in production kgs issued to production x cost per kg
    Labour cost of production hours worked x rate per hour
    Absorbed overhead labour hours worked x OAR per labour hour
    Subtotal these 3 production costs - the production cost of the units produced
    Divide the production cost by the units produced - the production cost per unit
    Less
    Closing stock Units of finished goods in stock at end of period x production cost per unit
    = Cost of Sales
    And leaves the Gross Profit

    For other students reading this posting - I have deliberately ignored under/over absorbed overheads
    Sandy
    [email protected]
    www.sandyhood.com
  • SandyHoodSandyHood Font Of All Knowledge Posts: 2,034Registered, Moderator
    Marginal costing profit statement

    Sales revenue Total units sold x price per unit
    less
    Cost of Sales
    Opening Stock (Inventory) Units of finished goods in stock at start of period x marginal production cost per unit
    Plus Marginal Production Costs
    Material used in production kgs issued to production x cost per kg
    Labour cost of production hours worked x rate per hour
    Subtotal these 2 production costs - the marginal production cost of the units produced
    Divide the production cost by the units produced - the marginal production cost per unit
    Less
    Closing stock Units of finished goods in stock at end of period x marginal production cost per unit
    = Marginal Production Cost of Sales
    And leaves the Contribution
    Less
    Total fixed production overhead costs incurred
    = Gross Profit
    Sandy
    [email protected]
    www.sandyhood.com
  • SandyHoodSandyHood Font Of All Knowledge Posts: 2,034Registered, Moderator
    geek84 wrote: »
    Could someone be kind enough to explain the similarities/differences and when it is appropriate to use each one?

    Similarities
    Both use the same information
    Differences
    They use that information in different ways

    The reason why the 2 gross profits will be different is ONLY because of the different treatment of fixed production overhead.

    Look at these 3 items:
    Opening Stock value
    (the marginal cost is only the previous period marginal cost of production per unit x the units in stock)
    (the absorption cost will be higher, it is the same marginal cost plus the absorbed overhead)
    Look at the way the cost per unit is worked out:
    marginal production cost per unit x units
    and
    absorption production cost per unit x units


    Production Cost value
    1. Marginal Cost (just the total of the variable costs of making all the units produced)
    2. Absorption Cost (the total of the variable costs plus the overhead absorbed)
    Closing Stock value
    (the marginal cost is only the current period marginal cost of production per unit x the units in stock)
    (the absorption cost will be higher, it is the current period absorption cost per unit x units in stock)

    When would you use each?
    Traditionally absorption costing is used for financial reporting, in such circumstances there are strict rules on the valuation of stock. This tends to require stock to include all costs of getting it to its present location and condition (i.e. looking backwards to see how it got there) so including the "normal" overhead cost of producing it is part of that cost.

    Control, planning and decision-making really needs to know more than a reported profit. It needs useful information. The danger of a division where the products they make are no longer what customers want to buy is that they will build up stock levels. This behaviour can lead to high reported profits, as more and more of the period's production overhead is recorded as part of the closing stock. So if you are working in financial control, you would ask for marginal costing as the profit calculation. This would expose a poor performance as the overhead incurred in a period is all charged to the costs before gross profit is found.

    I hope this gives you a step in the right direction.
    Sandy
    [email protected]
    www.sandyhood.com
  • SandyHoodSandyHood Font Of All Knowledge Posts: 2,034Registered, Moderator
    Here is a practice question
    I have calculated that the absorption profit is £1,900 and the marginal cost profit is £1,690

    Your task is to carry out the appropriate calculations to find each, then to explain why there is a difference, and finally to explain which is more suited as a calculation for internal control.
    Sandy
    [email protected]
    www.sandyhood.com
  • geek84geek84 Trusted Regular Posts: 564MAAT
    Hi SandyHood

    Thanks very much indeed for your explanations.
  • amyjayne27amyjayne27 Trusted Regular Posts: 314Registered
    Hi Sandy,

    Just to say thanks for your explanation on this subject, I too have been confused by this chapter and will be printing off your answers for reference.

    Many thanks,

    Amy
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