Marginal Costing and Absorption Costing Technique

 

Impact on Profit under Marginal and Absorption Costing Technique

The concept of Marginal & Absorption costing plays a significant role in the field of management accounting. The main difference between marginal costing and absorption costing lies in how they treat fixed manufacturing overhead costs. This difference can lead to varying profits for a company under the two techniques, particularly when there are changes in production volume and inventory levels. Let us discuss the impact on profit under both techniques:

 

1. Marginal Costing:

Under marginal costing, fixed manufacturing overhead costs are treated as period costs and are not allocated to products. Only variable manufacturing costs (direct materials, direct labor, and variable manufacturing overhead) are considered as part of the product cost.

Profit is calculated as the difference between total revenue and total variable costs (both direct and variable overhead costs).

The closing stock value is valued at its variable production cost only (i.e., direct materials, direct labor, and variable overhead).

Marginal costing provides a clearer view of the contribution margin of each product and helps in making short-term decisions, as it isolates the impact of changing production levels on profitability.

 

2. Absorption Costing:

Under absorption costing, both variable and fixed manufacturing overhead costs are included in the product cost. Fixed overhead costs are absorbed into the cost of units produced.

Profit is calculated as the difference between total revenue and total cost of goods sold (which includes both variable and fixed manufacturing costs).

The closing stock value includes both variable and fixed production costs.

Absorption costing is required for external financial reporting purposes and is often used for inventory valuation.

Impact on Profit:

In periods of stable production and sales levels, both methods generally yield the same profit result.

·       If there is an increase in production levels and inventory builds up (closing stock increases), absorption costing typically results in higher reported profits compared to marginal costing. This is because fixed overhead costs get spread over more units, reducing the cost per unit.

·       On the other hand, if production levels decrease and inventory reduces (closing stock decreases), absorption costing may report lower profits than marginal costing due to the higher fixed overhead costs being allocated to fewer units.

·       If a company faces a temporary downturn in sales and has a buildup of closing stock, absorption costing may show higher profits compared to marginal costing, as fixed overhead costs get absorbed into closing stock, reducing the expense in the income statement.

In summary, the choice between marginal costing and absorption costing can significantly impact reported profits, especially when production levels and inventory levels change. Companies should be aware of these differences and use the appropriate costing method based on their reporting needs and the decision-making context. Absorption costing is generally used for external financial reporting, while marginal costing is useful for internal decision-making and short-term planning.

 

Difference between marginal costing and absorption costing

Marginal costing and absorption costing are two different methods of cost accounting used to determine the cost of production, valuation of inventory, and calculation of profit. The main difference between the two lies in the treatment of fixed manufacturing overhead costs. Let's explore the key distinctions between marginal costing and absorption costing:

1. Treatment of Fixed Manufacturing Overhead:

Marginal Costing: Under marginal costing, fixed manufacturing overhead costs are considered as period costs and are not allocated to products. These costs are treated as expenses in the period they are incurred, and they do not form a part of the product cost. Only variable manufacturing costs (direct materials, direct labor, and variable overhead) are considered as product costs.

Absorption Costing: In absorption costing, both variable and fixed manufacturing overhead costs are included in the product cost. Fixed overhead costs are absorbed into the cost of units produced and are considered as part of the inventory valuation. As a result, fixed overhead costs are recognized as expenses only when the finished goods are sold.

2. Inventory Valuation:

Marginal Costing: Closing stock (ending inventory) is valued at variable production cost only, which includes direct materials, direct labor, and variable manufacturing overhead.

Absorption Costing: Closing stock (ending inventory) is valued at both variable and fixed production costs, including direct materials, direct labor, variable manufacturing overhead, and the allocated fixed manufacturing overhead.

3. Profit Calculation:

Marginal Costing: Profit is calculated as the difference between total revenue and total variable costs (both direct and variable overhead costs). Fixed manufacturing overhead costs are not included in the cost of goods sold.

Absorption Costing: Profit is calculated as the difference between total revenue and total cost of goods sold, which includes both variable and fixed manufacturing costs.

  

4. Decision Making:

Marginal Costing: Marginal costing is useful for short-term decision-making and determining the contribution margin of each product. It helps in assessing the impact of changes in production volume on profitability.

Absorption Costing: Absorption costing is typically used for external financial reporting purposes and is required for inventory valuation under accounting standards. It may not provide the most relevant information for short-term decision-making due to the impact of fixed overhead costs on inventory valuation.

 

5. Cost Behavior Analysis:

Marginal Costing: Marginal costing segregates costs into fixed and variable components, making it easier to analyze cost behavior and perform cost-volume-profit (CVP) analysis.

Absorption Costing: Absorption costing does not clearly distinguish between fixed and variable costs within the product cost, which can make cost behavior analysis more complex.

In summary, the primary difference between marginal costing and absorption costing lies in the treatment of fixed manufacturing overhead costs and the resulting impact on inventory valuation and profit calculation. Each method has its advantages and is suited to different purposes. Marginal costing is more focused on short-term decision-making and cost behavior analysis, while absorption costing is essential for external financial reporting and inventory valuation compliance.

 

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