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Critically evaluate marginal and absorption costing

Critically evaluate marginal and absorption costing

3.1 Introduction

The key issue between absorption costing and marginal costing is how the costs of a business's input resources are best organised and presented so as to identify individual product/service and total business profit.

The choice of costing system may be influenced by the costing method. Specific order costing methods will frequently deploy full absorption costing. One reason for this is that the pricing of each unique piece of work will invariably make reference to the total costs incurred. Continuous operation costing methods are more likely to deploy marginal costing (although this may be in addition to absorption costing) because of the opportunities in such an environment to use cost-volume-profit analysis.

3.2 Marginal and absorption costing

Marginal costing is a method of inventory costing in which all variable manufacturing costs are included as inventoriable costs. All fixed manufacturing costs are excluded from inventoriable costs. They are instead treated as costs of the period in which they are incurred. Inventoriable costs are all costs of a product that are regarded as an asset when they are incurred and then become costs of goods sold when the product is sold.

In product/service costing, a marginal costing system emphasises the behavioural, rather than the functional, characteristics of cost. The focus is on separating costs into variable elements (where the cost per unit remains the same with total cost varying in proportion to activity) and fixed elements (where the total cost remains the same in each period regardless of the level of activity). Whilst this is not easily achieved with accuracy, and is an oversimplification of reality, marginal costing information can be very useful for short-term planning, control and decision-making, especially in a multi-product business.

In a marginal costing system, sales less variable costs measures the contribution that individual products/services make towards the total fixed costs incurred by the business. The fixed costs are treated as period costs and, as such, are simply deducted from contribution in the period incurred to arrive at net profit.

Absorption costing is a method of inventory costing in which all variable manufacturing costs and all fixed manufacturing costs are included as inventoriable costs.

In product/service costing an absorption costing system allocates or apportions a share of all costs incurred by a business to each of its products/services. In this way, it can be established whether, in the long run, each product/service makes a profit. Arbitrary assumptions have to be made...

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