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Marginal costing or absorption costing-which method is to use?

Marginal costing is more useful for decision-making purposes, but absorption costing is needed for financial reporting purposes to comply with accounting standards.

Reported profit in any accounting period is likely to differ according to the costing method used.

With marginal costing, contribution varies in straight proportion to the volume of units sold. Profits will increase as sales volume increases, by the amount of additional contribution earned. Since fixed cost does not alter, marginal costing gives an accurate picture of how a firm's cash flows and profits are affected by changes in sales volumes.

With absorption costing, there is no strong relationship between profit and sales volume, and as sales volume rises the total profit will rise by the sum of the gross profit per unit plus the amount of overhead absorbed per unit. This is a mystifying and unsatisfactory method of monitoring profitability.

If sales volumes are the same from period to period, marginal costing reports the same profit each period (if no change in sales prices or costs). In contrast, using absorption costing, profits can vary with the volume of production, even when the volume of sales is constant. Using absorption costing there is the probability of manipulating profit, simply by changing output and inventory levels.
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