Certainly, I’d be happy to explain the concepts of Income Measurement under Marginal Costing and Absorption Costing in detail. These are two different approaches to costing and income measurement used in managerial accounting.
1. Marginal Costing: Marginal costing, also known as variable costing or direct costing, focuses on segregating costs into fixed and variable components. It treats fixed manufacturing costs as period costs that are expensed in the period incurred, rather than allocated to the products. Here’s how income is measured under marginal costing:
a. Cost Classification:
- Variable Costs: These costs vary directly with the level of production or sales activity. Examples include direct materials, direct labor, and variable manufacturing overhead.
- Fixed Costs: These costs remain constant regardless of the level of production or sales activity. They include fixed manufacturing overhead and fixed administrative expenses.
b. Income Measurement: Under marginal costing, only variable production costs are considered as product costs. Fixed manufacturing costs are treated as period costs and are charged to the income statement in the period they are incurred.
c. Calculation of Cost of Goods Sold (COGS): COGS under marginal costing includes only variable manufacturing costs (direct materials, direct labor, and variable overhead). Fixed manufacturing costs are not included in COGS but are reported as part of the total fixed costs on the income statement.
d. Impact on Income: Changes in production levels affect variable costs but do not impact fixed costs. Therefore, the contribution margin (sales revenue minus variable costs) remains constant on a per-unit basis, even if production levels fluctuate. This can result in fluctuating net income as production levels change.
2. Absorption Costing: Absorption costing, also known as full costing, involves allocating all manufacturing costs, both variable and fixed, to products. It is required for external financial reporting under generally accepted accounting principles (GAAP). Here’s how income is measured under absorption costing:
a. Cost Classification:
- Direct Costs: These costs can be traced directly to a specific product and include direct materials and direct labor.
- Indirect Costs: Also known as overhead costs, these costs cannot be directly traced to a specific product and include both variable and fixed manufacturing overhead.
b. Income Measurement: Under absorption costing, both variable and fixed manufacturing costs are included in the cost of goods sold and product inventory. This method aligns with GAAP principles.
c. Calculation of Cost of Goods Sold (COGS): COGS under absorption costing includes both variable and fixed manufacturing costs. These costs are allocated to products based on a predetermined overhead rate.
d. Impact on Income: Net income can fluctuate based on changes in production levels because both variable and fixed costs are included in the cost of goods sold. Higher production levels can lead to higher fixed costs being absorbed by inventory, potentially resulting in higher reported net income.
Comparison:
- Marginal costing provides better insight into short-term decision-making as it focuses on variable costs, which are directly affected by changes in production and sales activity.
- Absorption costing is more suitable for external financial reporting purposes, as it complies with GAAP standards.
It’s important to note that the choice between marginal costing and absorption costing can have a significant impact on reported profits and financial performance. The method chosen should be based on the specific needs of the organization and the intended use of the cost and income information.