Absorption vs. Marginal Costing Explained
Marginal Costing
Absorption costing calculates total unit cost of production by incorporating production overheads through use of an absorption rate. This technique can be criticised in a number of ways, not least because it uses budgeted rather than actual costs in the calculation of absorption rates.
By focusing on total cost, absorption costing has little use in decision-making and can lead to misleading profit calculations.
Many management accountants argue that marginal costing, which focuses on variable costs and contribution, is a more valuable and reliable costing technique.
The object of management accounting is to provide relevant and timely information to managers to assist them in:
- Making strategy
- Planning and controlling activities
- Decision-making
- Effective use of resources
- Disclosure to employees
Marginal Costing compared to Absorption Costing
The essential differences between Marginal Costing (MC) and Total Absorption Costing (TAC) is more clear cut and more relevant in a manufacturing environment, where there are differences in the accounting and management treatment of fixed costs. Under MC fixed are seen and treated as period costs, whereas under TAC these are seen as treated as product costs.
Period costs are those that are 'expensed' (charged) to the income statement in the period in which they are incurred; product costs are those that are included in the valuation of inventories, both of these costs will affect reported profit in a period in different ways.
Reported profit will be different under both systems where there is a change in the level of inventories between the start of a reporting period and the end of that reporting period. A change in the level of inventories will occur where inventory levels are higher or lower as compared to the inventory level at the beginning of a reporting period.
The effects on reported profit under both systems can be summarised
Inventory levels Impact on reported profit
Closing inventory = opening inventory No difference
Closing inventory > opening inventory TAC reported profit is higher
Closing inventory < opening inventory TAC reported profit is lower
