Tuesday, January 12, 2010

Marginal Costing vs Absorption Costing

Marginal Costing and Absorption Costing are methods which are often used to prepare profit statements, value inventory and assist in pricing decisions. The methods have some notable differences, which can be reconciled though.

Absorption Costing absorbs all manufacturing/production costs into inventory valuation. These costs include direct material, direct labour, direct expenses,variable production overheads, as well as fixed production overheads. On the contrary, Marginal Costing absorbs only variable manufacturing/production costs into inventory.

The method chosen to cost inventory or prepare the profit statement has the potential to: affect the pattern of calculated profits; influence employee behaviour, and  provide management with relevant and useful information for planning and control purposes. And, the following could be considered to be advantages of each method.

Advantages of absorption costing:

  • Gives attention to both fixed and variable costs; that is, all production costs are considered regardless of whether they are variable or fixed. And, this is very important when it comes to pricing decisions since the manufacturer can have a clear picture of the profit margin to be made on each sale, as all costs would have been incorporated into the product cost.
  • Provides realistic periodic profits if company has a natural business cycle; profits are realistic in the sense that all production costs are matched to sales volume, rather than production volume as under Marginal Costing.
  • It is consistent with external reporting requirements; in fact, International Accounting Standard Board recommends the use of absorption costing method over marginal costing, which is considered more useful for internal reporting.


Advantages of marginal costing:

  • Distinguishes between fixed and variable costs therefore providing relevant information about costs for decision making purposes. When fixed and variable costs are split, it becomes easier to manage costs as it gets clearer to management on how costs behave. So, by altering the activity level, for instance, management can choose an optimal production level.

  • Removes the effect of inventory changes on profit and reduces the danger of dysfunctional behaviour in employees. Dysfunctional behaviour may occur in the case of absorption costing by encouraging managers to produce more inventory than can be sold. Producing for stock has the effect of absorbing more fixed production overheads, hence reducing the cost of sale. The reduced cost of sale has the effect of improving the level of reported profits. However, it is possible for such stock to tie up capital and even become obsolete. This is dysfunctional.

  • Avoids capitalisation of fixed overheads in unsaleable stocks. Under marginal costing, all fixed costs are treated as period costs, meaning that they are all written off in the accounting period to which they relate. So, there is no question of using inventory to defer fixed cost expenses, as might be the case with Absorption Costing.

The difference in approach by the 2 methods has implications for reported profits, especially when the inventory level is changing. The fact that absorption costing can defer fixed costs until a sale is made means that when stock level is rising it reports a higher profit than marginal costing. On the other hand, when the stock level is reducing marginal costing reports a higher profit than absorption costing. These differences in the reported profits can be reconciled by taking into account the fixed overhead absorption rate and the extent of the change in inventory.

There is, however, no clear advantage in using either absorption or marginal costing. Both have their uses and the fact that the results from both systems can be reconciled indicates that there are strong links between the two.

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