Profit Reconciliation Formula

Profit Reconciliation Formula

Absorption and marginal cost profit difference may be reconciled by the following formulas. There are two different formula used i.e. one for stock increase and other for stock level decreased

Absorption Cost profit = Marginal cost profit + stock level increased during year

Absorption Cost profit = Marginal cost profit - stock level Decreased during year

Example (Stock Increased)

Marginal costing profit = 45,000

Opening Stock level = 40,000

Closing Stock Level = 45,000

Calculate absorption costing profit?

Solution

Absorption Cost profit = Marginal cost profit + stock level increased during year

= 45,000 + 5000

= 50,000

Example (Stock Decreased)

Marginal costing profit = 50,000

Opening Stock level = 40,000

Closing Stock Level = 30,000

Calculate absorption costing profit?

Solution

Absorption Cost profit = Marginal cost profit - stock level Decreased during year

=50,000-10,000

=40,000

Advantages of Marginal Costing

Advantages of Marginal Costing

Advantages of marginal costing may be explained in terms of basic economic decision of profit maximization, decision making, profitability manipulation, and controlling of costs.

1.    Basic Economic Decision

First advantage of marginal costing is its offered explanation for continued production until marginal cost is less than marginal profit. Thus entity can maximize its profit or reduces losses till marginal cost equal to marginal revenue.

2.    Decision Making

Second advantage of marginal costing is its support for basic decision making. Marginal costing facilitates break even analyses, margin of safety analyses, desired profitability etc.

3.    Link between Sale Price, Volume, Cost

Third advantage of marginal costing is its linkage creation between sale price, variable cost and volume of sales. Marginal costing explains that how these factors contribute to the profitability of the organization.

4.    Profitability cannot be manipulated

Fourth advantage of marginal costing is its limited role in profitability manipulation. In marginal costing stock value cannot be easily manipulated, because fixed costs are not part of stock valuation. Therefore profitability cannot manipulate with stock valuation manipulation.

5.    Controlling of Costs

In marginal costing cost are divided into variable costs (controllable) and fixed cost (uncontrollable). This classification helps management to focus on the cost, which can be controlled.

Disadvantages of Marginal Costing

Disadvantages of Marginal Costing

Limitation of marginal costing may be explained in term of total cost & price setting, preparation of financial statement, fixed cost ignorance.

1.    Total Cost & Pricing

In marginal costing full cost of the product may not be determined. Therefore price cannot be set on the bases of marginal costing. If fixed costs are major cost, then wrong pricing decision may result in heavy losses.

2.    Financial Statement Preparation

Marginal costing does not support preparation of financial statement, because financial can only be prepared with accurate stock valuation.

3.    Fixed cost cannot ignored

In marginal costing fixed cost is not taking into account for product cost. This methodology is not rationale, because in many industries fixed cost forms a major portion of product cost.

Characteristics of Marginal Costing

Characteristics of Marginal Costing

1.    Fixed & Variable Cost Distinction

Marginal costing separates variable cost and fixed cost. This separation is fundamental assumption of marginal costing. In marginal costing it is considered that marginal cost has primary role, while fixed cost has limited role.

2.    Variable Cost has Primary Role

Marginal costing considers variable cost in details due to its primary role in the profitability. In marginal costing profitability can be improved by improving contribution i.e. Sales- variable costs. Therefore in marginal costing focus remain on variable cost.

3.    Fixed Cost is period Cost

Marginal costing believes that fixed cost have limited or no role in the production. Therefore fixed cost is treated as period costs.

4.    Stock Valuation at variable cost

In marginal costing stock is value at variable cost only. This is due to the fact that fixed cost is period cost and therefore need not to be included in the stock valuation. In marginal costing stock valuation differ from absorption costing, which also take into account fixed cost in stock valuation.

5.    Direct Linkage of cost & Activity

Marginal costing establishes direct linkage between sales price, variable costs and sales volume. Due to this direct linkage, marginal costing is widely used by the management   in decision making.

6.    Basic Decision making tool

Marginal costing serves as basic decision making tool for the management. Marginal costing facilitates to calculate break even profit, desired profitability sales volume. Marginal costing also helps in risk assessment i.e. margin of safety analyses.