Marginal+Cost+VS+Absorption+Cost



These two costing systems are often used in cost accounting, but for different purposes:

n marginal costing – helps with short-term decision-making n absorption costing – is used to calculate inventory valuations and profit calculations in financial statements

The use of each system is dependent on the information needs of the business or organisation:

– ‘can we afford to sell 1,000 units of our product each month to Megastores Limited at a discount of 20 per cent?’ (use marginal costing) – ‘what profit have we made this year?’ (use absorption costing)

These costing systems use the same costs, but they are treated differently according to their behaviour.

For most decision-making, the marginal cost of a unit of output is, therefore, the variable cost of producing one more unit.

Marginal Cost helps with short-term decision-making in the forms of – break-even analysis – margin of safety – target profit – contribution sales ratio – limiting factors – ‘special order’ pricing

The absorption cost of a unit of output is made up of the following costs: £ Direct materials x add Direct labour x add Direct expenses x add Production overheads (fixed and variable) x

equals ABSORPTION COST x

With regard to the directors’ statement that they will use ‘the one that shows the higher profit’, the following points should be borne in mind:

•A higher profit does not mean more money in the bank.

•The two methods simply treat fixed production overheads differently and, in a year when there is no closing inventory, total profits to date are exactly the same – but they occur differently over the years. Over time, profits are identical under both methods.

•For financial statements, Chairs Limited must use the absorption cost inventory valuation of £45,000 in order to comply with IAS 2, Inventories.

Reconciliation: marginal costing and absorption costing

Marginal costing profit and absorption costing profit are the same apart from the impact of fixed overheads on stock. They can be reconciled thus Profit per AC £x Add: FO in opening stock £x Less: FO in closing stock £(x) Profit per MC

Comparison: MC vs AC