Lecture 7 - Marginal and absorption costing Flashcards
Variable costing known as
Marginal costing
VC or MC
Absorption costing known as
Full costing
AC or FC
Variable costing
Direct or Marginal costing
Only variable manufacturing costs are included in inventory valuation
Fixed manufacturing costs are excluded from inventory valuation
Absorption costing
Also known as full costing
All manufacturing costs are included in inventory valuation
Variable and absorption costing differ in the treatment of fixed manufacturing costs
Absorption or marginal method?
For external reporting purposes, the absorption costing system must be used
For internal reporting purposes, companies ma choose to use absorption costing or marginal costing
Choice of method - Marginal
Marginal is based on the distinction between fixed and variable costs suggesting the fixed production cost should be viewed as capacity costs, the benefit of which expires at the end of the period
Variable costs are attributed to cost units, which fixed costs are dealt with in total for a particular period
Justification for this is that fixed costs tend to be related to a period of time rather than to volume of output
Choice of method - Absorption
Absorption costing suggests that under the matching principle fixed production costs should be assigned to products because revenues derives from sale of the product and, therefore all production costs should be matched with revenue in the period of the sale
Variable costing profit statement layout
Revenue
Less cost of sales
(Unit cost = variable cost)
Opening inventory
Production
Closing inventory
Less: other variable costs
Contribution
Less: All fixed costs
Fixed production costs
Fixed admin/selling cost
Net profit/loss
Absorption costing profit statement layout
Revenue
Less cost of sales
(Unit cost = Full production cost)
Opening inventory
Production
Closing inventory
Adjustment for over/under absorption of overhead
Gross Profit
Less: All non production costs
Variable selling/admin costs
Fixed admin/selling cost
Net profit/loss
If unit sales equal production, why will AC and MC report the same profit?
Inventories neither increase nor decrease.
So the same amount of fixed overhead will be carried forward as an expense to be included in the current period in the opening inventory valuation, as will be deducted in the closing inventory valuation from the production cost figure
Difference in results between AC and MC if production exceeds sales
An AC system will show a higher profit than a MC system since inventory is increasing
When an inventory is increasing, a greater amount of fixed production overhead in the closing inventory is being deducted from the expenses of the current period than is being carried forward in the opening inventory for the period
How do we adjust for over or under recovery of overhead?
OAR = Budgeted overhead / Budgeted activity level
It is the difference between the overhead absorbed into production and the overhead incurred
Overhead absorbed = Actual activity level x OAR
Arguments in support of marginal costing
Quick, easy to use and understand
Avoids arbitrary cost allocations
Useful in identifying contribution made by different products
Provides useful information for short term decision making with the operation of fixed and variable costs
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Arguments in support of absorption costing
-Theoretically superior to marginal costing
-Avoids fictitious losses being reported as fixed overheads are deferred in periods of slack sales
-Does not ignore the fact that fixed costs must be met in the long run
-Attempts to present full product costs for pricing, inventory valuation and profit determination which is useful for long term decision making
-Useful in establishing standard costs for control purposes
