Question

What are the advantages of the contribution margin format based on variable costing compared to the traditional format based on full absorption costing?

Answer 1

Under marginal costing only factory overheads costs that tend to vary with volume are charged to product cost in addition to prime cost. While evaluating Inventory only direct materials, direct labour, and variable factory overheads are included and are considered as product costs. Fixed factory overheads under direct or marginal costing is not included in inventory.It is treated as period cost and charged against Revenue when incurred. Under absorption costing all manufacturing costs both fixed and variable are allotted to cost units.

Since the closing stock do not have any element of fixed costs, profit shown by marginal costing technique may be different from that shown by absorption costing. In other words in absorption costing inventory will be valued at a higher figure, therefore profit will be more as revealed by absorption costing than marginal costing.

In absorption costing profit is difference between sales and cost of goods sold ( it includes fixed overhead), profit in marginal costing is ascertained by establishing the total contribution and then deducting therefrom the total fixed expenses. contribution is the excess of sales over variable cost.

In absorption costing arbitrary apportionment of fixed costs may result in under or over recovery of overhead

In marginal costing fixed costs are excluded,there is no question of arbitrary apportionment of fixed overheads and thus under or over absorption of overheads.

For decision making purpose marginal costing is to be used for better understanding of cost of product since in absorption costing profit is inflated through closing stock.