Management Accounting - Absorption costing versus marginal costing

Marginal costing

A costing method that includes only direct costs and indirect variable costs in product cost, treating fixed costs as period costs.

Absorption costing

A costing method that includes all direct costs and indirect variable and fixed costs in the cost of a product.

Direct costs

Costs that can be directly attributed to the production of a specific product or service.

Indirect costs

Costs that are not directly traceable to a product, often called overhead costs.

Fixed costs

Costs that do not vary with the level of production or sales and are incurred regardless of activity level.

Variable costs

Costs that change directly with the level of production or sales volume.

Cost per unit

The total production cost divided by the number of units produced, representing the cost associated with producing one unit.

Over-absorption

Occurs when actual production exceeds budgeted production, leading to more overheads included in the profit statement than incurred.

Under-absorption

Occurs when actual production is less than budgeted production, resulting in insufficient fixed production overheads included in product costs.

Contribution margin

The difference between sales revenue and variable costs, indicating the amount available to cover fixed costs and contribute to profit.

Budgeted production

The estimated amount of product a company plans to produce during a specific period.

P&L account

Profit and Loss account, a financial statement summarizing revenues, costs, and expenses incurred during a specific period.

Sales and admin expenses

Costs incurred for selling products and managing a business, which are not included in the direct cost of product manufacturing.

Key difference between marginal and absorption costing

Marginal costing treats fixed costs as expenses of the period, while absorption costing allocates fixed costs to products.

Impact of marginal costing on profit reporting

Under marginal costing, profit can vary significantly with changes in production levels.

Impact of absorption costing on profit reporting

Absorption costing smooths profit reporting since all manufacturing costs are included, regardless of production levels.

When to use marginal costing

Best used for decision-making and internal reporting, especially when assessing product profitability.

When to use absorption costing

Required by Generally Accepted Accounting Principles (GAAP) for external financial reporting.

Effect of inventory levels on marginal costing

Higher inventory levels do not impact profit under marginal costing since only variable costs are considered.

Effect of inventory levels on absorption costing

Increased inventory can lead to higher profits under absorption costing due to deferring some fixed costs.

Contribution margin concept

Marginal costing emphasizes the contribution margin, highlighting how sales cover variable costs before fixed costs.