Absorption vs Marginal Costing

Costing is an essential tool in the hands of management which enables it to take various important decisions such as product pricing, introduction / discontinuance of new product, entering new economies etc. The product cost can be classified under two broad categories i.e. Manufacturing and Non – Manufacturing cost. Manufacturing cost can further be breakdown in Material, Labour and overheads. The point of difference between Marginal and Absorption costing lies in the allocation of overhead. In Absorption costing, fixed overheads are allocated to the product with the assumption that product cannot be produced without fixed manufacturing overheads whereas in Marginal costing fixed overheads are treated as period costs and are not considered for decision making.

This report will highlight the differences between two costing methods and the benefits and limitations of using one system over another. Further this report discusses a situation in which a manager could distort profit in absorption costing system by overproducing and creating huge inventories.

The following sections of this report covers:-

 Comparison between absorption costing and marginal costing systems

 Example for distortion of profit by using Absorption costing

 Advantages and potential limitations of either system

 Conclusion

EXECUTIVE SUMMARY & CONTENTS

Absorption costing and marginal costing differ from each other on the point of allocation of overheads. Other components such as direct material and direct labour are treated likewise in both the costing system but while the absorption costing includes fixed manufacturing overheads also in decision making, marginal costing ignores fixed overhead assuming that these costs would continue to incur irrespective of the continuance of the product. The following diagram will further enumerate basic difference between the two costing systems.

The above diagram clearly indicates how in marginal costing system the fixed overheads are not...