ADVANTAGES AND DISADVANTAGES OF ABSORPTION AND MARGINAL COSTING
The previous posts have explained the differences between marginal costing and absorption costing as methods of measuring profit in a period. Some conclusions can be made from these differences.
• The amount of profit reported in the cost accounts for a financial period will depend on the method of costing used.
• Since the reported profit differs according to the method of costing used, there are presumably reasons why one method of costing might be used in preference to the other. In other words, there must be some advantages (and disadvantages) of using either method.
Advantages and disadvantages of absorption costing
Absorption costing has a number of advantages and disadvantages.
Advantages of absorption costing
• It helps to make pricing decision on the basis of cost as in absorption costing, cost of product is calculated on full cost including variable and fixed.
• It enables for management to compute correct profit in the situation of seasonal sales if compared to marginal costing.
• It helps to conform with accrual concept in which cost is matched with revenue for specified period of time.
• It indicates efficient or inefficient utilization of capacity by indicating the under or over absorbed production overheads.
Limitations of absorption costing
• Absorption costing is not useful tool for decision making such as make or buy decision, optimal production mix in limiting factor situation. In such situation, marginal costing plays vital role in realistic decisions.
• In absorption costing, portion of fixed cost included in closing inventory is transferred to next period, as this closing inventory is treated opening inventory for next period.
• The validity of product cost under this method depends upon the correct apportionment of fixed production overhead. But in practice, many fixed production overheads are apportioned on arbitrary basis which might result inaccuracy in calculation of product cost. (Subho, 2020)
Advantages and disadvantages of marginal costing
Marginal costing has a number of advantages and disadvantages.
Advantages of marginal costing
• It is easy to account for fixed overheads using marginal costing. Instead of being apportioned they are treated as period costs and written off in full as an expense in the income statement for the period when they occur.
• There is no under/over-absorption of overheads with marginal costing, and therefore no adjustment necessary in the income statement at the end of an accounting period.
• Marginal costing provides useful information for decision making.
Disadvantages of marginal costing
• Marginal costing does not value inventory in accordance with the requirements of financial reporting. (However, for the purpose of cost accounting and providing management information, there is no reason why inventory values should include fixed production overhead, other than consistency with the financial accounts.)
• Marginal costing can be used to measure the contribution per unit of product, or the total contribution earned by a product, but this is not sufficient to decide whether the product is profitable enough. Total contribution has to be big enough to cover fixed costs and make a profit.
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