There are 2 major traditional methods, which could be used to prepare accounts. These are absorption costing and marginal costing methods. The major difference in the 2 methods depends on how stock is valued ,under each of the methods.
With marginal costing, stock is valued at only variable costs of production. These costs of production include direct material, direct labour, direct expenses and variable production overheads. So, you must note that only variable production costs are used in stock or inventory valuation when marginal or variable costing is used.
Absorption costing on the other hand, in addition to the variable production costs, includes a fixed production overhead absorption rate. This fixed production absorption rate is measured by dividing budgeted fixed overheads by the budgeted or normal level of activity. Because budgeted values have been used in developing a fixed overhead absorption rate; also known as a predetermined rate, a possibility for over or under absorbing arises. It should be noted though that the under or over absorption arises only when absorption costing method is used.
There are other distinctions between the 2 methods, for instance marginal costing uses a contribution approach.(which is the difference between revenue and variable costs) In other words, when preparing accounts, under marginal costing, you will have to calculate cotal ontribution. And, then deal with fixed costs afterwards to determine the net profit for the period. Absorption costing method, on the contrary, makes use of gross profit. That is you need to find the difference between revenue and all production cost; and this is what is called gross profit. After this, you then less all non production costs to derive a net profit for the period.
The difference in approach may cause differences in the reported net profit. This happens when the amount of inventory is changing; that is, when stock is increasing or decreasing. You will know that inventory is changing when the opening and closing stocks are different or when production amounts differ from the sales volume.
The difference in profit is, therefore, attributed to 2 factors; the change in stock and the amount of the fixed overhead absorption rate. And, effectively when stock is increasing absorption costing will report a higher profit than marginal costing. When stock is decreasing it is marginal costing, which will report a higher profit. This happens because under marginal costing all fixed costs are treated as period expenses and written off in the period they are incurred. With absorption costing, however, fixed production costs are absorbed and will be transferred to future accounting period if there is a lot of closing inventory. This means less overheads are charged to the statement of comprehensive income when the amount of closing inventory is significant, hence profits will be maximised. When the stock level is reducing it means that more sales volume is registered than the amount of production, and as such a higher amount of overheads, brought forward in stock from previous accounting periods, would be released. When this happens, less profits would be reported under absorption costing.
With marginal costing, stock is valued at only variable costs of production. These costs of production include direct material, direct labour, direct expenses and variable production overheads. So, you must note that only variable production costs are used in stock or inventory valuation when marginal or variable costing is used.
Absorption costing on the other hand, in addition to the variable production costs, includes a fixed production overhead absorption rate. This fixed production absorption rate is measured by dividing budgeted fixed overheads by the budgeted or normal level of activity. Because budgeted values have been used in developing a fixed overhead absorption rate; also known as a predetermined rate, a possibility for over or under absorbing arises. It should be noted though that the under or over absorption arises only when absorption costing method is used.
There are other distinctions between the 2 methods, for instance marginal costing uses a contribution approach.(which is the difference between revenue and variable costs) In other words, when preparing accounts, under marginal costing, you will have to calculate cotal ontribution. And, then deal with fixed costs afterwards to determine the net profit for the period. Absorption costing method, on the contrary, makes use of gross profit. That is you need to find the difference between revenue and all production cost; and this is what is called gross profit. After this, you then less all non production costs to derive a net profit for the period.
The difference in approach may cause differences in the reported net profit. This happens when the amount of inventory is changing; that is, when stock is increasing or decreasing. You will know that inventory is changing when the opening and closing stocks are different or when production amounts differ from the sales volume.
The difference in profit is, therefore, attributed to 2 factors; the change in stock and the amount of the fixed overhead absorption rate. And, effectively when stock is increasing absorption costing will report a higher profit than marginal costing. When stock is decreasing it is marginal costing, which will report a higher profit. This happens because under marginal costing all fixed costs are treated as period expenses and written off in the period they are incurred. With absorption costing, however, fixed production costs are absorbed and will be transferred to future accounting period if there is a lot of closing inventory. This means less overheads are charged to the statement of comprehensive income when the amount of closing inventory is significant, hence profits will be maximised. When the stock level is reducing it means that more sales volume is registered than the amount of production, and as such a higher amount of overheads, brought forward in stock from previous accounting periods, would be released. When this happens, less profits would be reported under absorption costing.
