There are two main methodologies that are employed for the determination of the cost of production and the value of inventory: Marginal Costing and Absorption Costing. Both of these methods have got their advantages and disadvantages, an account of which has been provided below:
The Product Cost
Marginal costing is a method of accounting according to which only the variable cost is apportioned to a product’s cost. What this means is that the product costs will comprise of only the variable costs, whereas the fixed cost is ignored. The rationale behind this treatment lies in how fixed costs are treated as sunk costs and do not play a part in the overall procedure of decision making, usually.
Absorption costing, on the other hand, apportions, both, fixed and variable costs to the overall cost of the product. The logic for such a treatment lies in how, both, fixed cost and actual cost comprise of the actual cost of a product.
Considering that marginal costing ignores the fixed cost based on how it’s irrelevant for decision making, the basic purpose of marginal costing is to aid in the overall decision making process. Marginal costing identifies the impact of manufacturing one more unit of any given product and how it will affect the overall costs and profitability. Such an analysis is important for making various production based decisions, for a business would only wish to manufacture if it’s profitable, right?
On the other hand, absorption costing is best used for the external reporting requirements, considering how it encompasses both the variable and fixed costs. The rationale behind absorption costing dictates that the total cost of the product needs to be recovered, fully, from the selling price of the product. While such an approach is adequate for the determination of selling price, it won’t be of much help in decision making.
The Classification of Overheads
Marginal costing divides the factory overheads into two, broad categories: Variable Overheads and Fixed Overheads. Variable overheads refer to such factory overheads that vary directly with the number of units manufactured. The fixed overheads, on the other hand, are those manufacturing overheads that remain constant up to a certain number of units after which they increase…drastically!
Absorption costing, however, divides the manufacturing overheads into three, self-explanatory categories: production, administration, and selling and distribution.
Considering the discussion above, it should be relatively easier to notice that the value of inventory will be understated in marginal costing, as compared to absorption costing. The logic behind this is pretty simple, right? Marginal costing calls for the valuation of inventory, solely, at the variable cost of production. Since the fixed costs are ignored, the use of marginal costing for inventory valuation causes the inventory to be significantly undervalued. This is the reason why the use of marginal costing for inventory valuation is not allowed in the International Accounting Standards.
Considering the variations between the two methods of costing, it’s advisable for businesses to make use of both of these methods in their best interest. However, considering that every is unique from the other, SKB Accounting knows exactly how YOUR business can make the most of both of these methodologies…and more!