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Marginal and Absorption Costing

External and Internal Reporting:

Generally, there are two approaches used for internal & external reporting, Marginal costing and Absorption costing. Marginal costing approach is used for internal financial reporting and is also preferred by most managers for internal decision making as it is simpler to understand as compared with absorption costing. For external financial reporting, absorption costing approach is generally used.

Variable or Marginal Costing:

Manufacturing costs that vary with output are treated as product costs under this approach. These product costs include direct materials, direct labor and variable part of manufacturing overhead. The remaining portion of manufacturing overhead i.e. fixed overhead is treated as a period cost, so it is charged against revenue each period. Period cost does also include fixed portion of selling and administrative expenses. Unit cost under marginal costing approach does not contain any fixed manufacturing overhead; it does only contain those items mentioned earlier. It is also known as marginal costing or direct costing.

Absorption Costing:

Manufacturing costs under absorption costing contain all manufacturing cost as product cost (whether they are marginal or fixed). Under this approach, unit cost of a product contains direct material, direct labor, & manufacturing overheads (variable plus fixed). Fixed costs are allocated to each unit of product along with other costs. As it includes all product costs, it is sometimes referred as full allocated cost too.

In case of handling of selling and administrative expenses, selling and administrative expenses are never treated as a product cost, so both marginal and fixed selling and administrative expenses are always treated as period costs in both approaches (marginal and absorption) and deducted from revenues as incurred.


Impact of Marginal costing approach on profits:

Under marginal costing approach, any change in production does not make any effect on profits. Operating income or profits would remain same for years under this approach, whether production is more than sales or less than sales, a change in production has no impact on profits when marginal costing is used.

Impact of Absorption costing approach on profits:

Under absorption costing, profits are affected by the changes in production. If production goes up in a year, then profit would also increase, and if production goes down profit would also decrease. The reason for this effect can be traced to fixed FOH costs that shift between periods under absorption costing as a result of inventory Change.

Comparison of Profits-Absorption and Marginal Costing Approaches:

Increase in inventories means Absorption costing profit is higher than profit under Marginal Costing and Decrease in inventories means Absorption costing profit is less than profit under Marginal Costing. There is no change in profits if No change in inventories.

Arguments in favor of Marginal costing:

When coming towards arguments in favor of marginal costing, income statements with respect to marginal costing approach are clear and easy to understand. As it is used for internal reporting so it makes easy for the internal personnel to understand organization’s performance easily. If sales remain constant over the years, then profits would also remain unvarying. The statements are consistent with what the managers would expect to see under the situation, so they tend to generate confidence instead of confusion.

Arguments in favor of Absorption costing:

Financial statements under absorption costing are relatively somewhat difficult, but more helpful for external entities (if they understand it with great care and in deep study) as readers of financial statements should be alert to changes in inventory levels to avoid mistakes when this costing approach is used. Under this approach, if increase in inventories, fixed manufactured overhead costs are deferred in inventories and net operating income is elevated. If inventories decrease, fixed manufactured overhead costs are released from inventories and net operating income is depressed, so fluctuations in profits can be due to changes in inventories rather than to changes in sales when absorption costing is used.

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