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...