Absorption costing and marginal costing are methods which are often used to prepare profit statements, inventory valuation and assist in pricing decisions. The methods have some notable differences. Henceforth, the main objective of this essay is to review absorption costing method and critically assess it against an alternative costing system, the marginal costing system. The essay will include situations where each method will be suitable. Sources of information that will be used in this essay will range from published academic journals, text books, accounting professional magazines and online articles.
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. The advantages of using absorption costing are as follows
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 that it aligns with Generally Accepted Accounting Principles (Sharma et al. 1997). 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 costs are split, it becomes easier to manage costs as it gets clearer to management on how costs behave. So, by altering the activity level, for instance, management can choose an optimal production level.
Removes the effect of inventory changes on profit and reduces the danger of dysfunctional behaviour in employees. Dysfunctional behaviour may occur in the case of absorption costing by encouraging managers to produce more inventory than can be sold. Producing for stock has the effect of absorbing more fixed production overheads, hence reducing the cost of sale. The reduced cost of sale has the effect of improving the level of reported profits. However, it is possible for such stock to tie up capital and even become obsolete. This is dysfunctional.
Avoids capitalisation of fixed overheads in unsaleable stocks. Under marginal costing, all fixed costs are treated as period costs, meaning that they are all written off in the accounting period to which they relate. So, there is no question of using inventory to defer fixed cost expenses, as might be the case with Absorption Costing.
The difference in approach by the 2 methods has…