Saturday, January 30, 2010

The features which distinguish marginal costing from absorption costing

The features which distinguish marginal costing from absorption costing are as follows.
  1. In absorption costing, items of stock are costed to include a ‘fair share’ of fixed production overhead, whereas in marginal costing, stocks are valued at variable production cost only. The value of closing stock will be higher in absorption costing than in marginal costing.
  2. As a consequence of carrying forward an element of fixed production overheads in closing stock values, the cost of sales used to determine profit in absorption costing will:
    1. include some fixed production overhead costs incurred in a previous period but carried forward into opening stock values of the current period;
    2. exclude some fixed production overhead costs incurred in the current period by including them in closing stock values.
In contrast marginal costing charges the actual fixed costs of a period in full into the profit and loss account of the period. (Marginal costing is therefore sometimes known as period costing.)
  1. In absorption costing, ‘actual’ fully absorbed unit costs are reduced by producing in greater quantities, whereas in marginal costing, unit variable costs are unaffected by the volume of production (that is, provided that variable costs per unit remain unaltered at the changed level of production activity). Profit per unit in any period can be affected by the actual volume of production in absorption costing; this is not the case in marginal costing.
  2. In marginal costing, the identification of variable costs and of contribution enables management to use cost information more easily for decision-making purposes (such as in budget decision making). It is easy to decide by how much contribution (and therefore profit) will be affected by changes in sales volume. (Profit would be unaffected by changes in production volume).
In absorption costing, however, the effect on profit in a period of changes in both:
    1. production volume; and
    2. sales volume;
      is not easily seen, because behaviour is not analysed and incremental costs are not used in the calculation of actual profit.

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