Absorption and Marginal Costing

What’s it all about?

Two techniques for dealing with the cost of overheads when setting prices, valuing stock and calculating profits.

Why have we got two different approaches?

Marginal costing –

“factory overheads do not change with production therefore they are not part of the cost of production so do not need to be considered as part of the cost of the product. You will incur the overheads regardless of the amount of production, you will have the same bill even if you don’t make anything, so it’s nothing to do with what you make.”

Absorption costing –

“factory overheads need to be incurred otherwise you could not make any product, therefore they must be considered as part of the cost of production. If you don’t have somewhere to do the work, you won’t be able to do any work, so the factory is essential to be able to make things, so that cost must be shared across what you make. And anyway, if you ignore them as you do under marginal costing then they will be uncontrolled and escalate, so absorbing them into the cost of product is the best way to keep an eye on them.”

 

Worked examples

The green text means this pdf has audio. You need to download it to Livescribe at the url in the document to get it to work. It’s worth it.

 

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Further Reading:

I keep additional materials worth reading at this location:

linoit.com/users/Jonathanrooks/canvases/Absorption%20v%20Marginal%20Costing

Possible Written Questions.

(No indication of marks – the more marks a question gets, the more you are expected to write – detail that is, not just words!) If you can’t answer these, you need to do some more reading. I do ‘find’ questions elsewhere, so these aren’t all questions I have used myself.

Comment on why the marginal costing method is considered a better method for internal reporting purposes.

Explain why under and over absorption of Factory Overhead costs occurs. 

Explain what the difference in profits would be under the two systems (marginal costing and absorption costing) if production is higher than sales, if production is lower than sales and if production is the same as sales and why this would be the case.

Explain why there is often (but not always) a difference between profits recorded when using Absorption and Marginal costing.

Discuss the arguments for adopting a Marginal costing system and an Absorption costing system. 

“Marginal Costing will bankrupt the company”; critically discuss.