How to Calculate Profit Margin

In marginal costing, profit is actually calculated by a two-stage strategy. First of all, contribution is determined for each and every department or product. The contributions of numerous departments or products are pooled together and such an overall of contributions-from all products is known as Fund. Then from this fund is deducted the overall fixed cost to arrive at loss or profit.

How to Calculate Profit Margin

Distinction between Absorption and Marginal Costing

The points of distinction between marginal costing and absorption costing are as follows:

1. Treatment of fixed and variable costs. In marginal costing, only variable costs are charged to products. Fixed costs are treated as period costs and charged to Profit Margin and Loss Account of the period. In absorption costing, all costs (both fixed and variable) are charged to the product. The fixed factory overhead is absorbed in units produced at a rate predetermined on the basis of normal capacity utilization (and not on the -basis of actual production).


  

2. Valuation of stock. In marginal costing, stock of work-in-progress and finished goods are valued at marginal cost only.

In absorption costing, stocks are valued at total cost which includes both fixed and variable costs. Thus stock values in marginal costs are lower than that in absorption costing.

3. How to calculate profit margin: In marginal costing, relative profitability of products or departments is based on a study of relative contribution made by respective products or departments. The managerial decisions are thus guided by contribution. In absorption costing, relative profitability is judged by profit which is also a guiding factor for managerial decisions.

Marginal Costing and Absorption Costing

The net profit under the two systems may be same or may be different. Difference in profit may be because of the different basis of inventory valuation. In marginal costing, stocks of work in progress and finished goods are valued at variable cost whereas in absorption costing, stocks are valued at total cost.

Difference in Profit under Marginal Costing and Absorption Costing

Profit margin under the two systems may be different because of difference in the stock valuation. Position in this regard is summarized as follows:

(a) Production equal to sales

(1) When there are no opening and closing stocks, profit/toss under absorption and costing systems are equal.

(ii) When opening stock is equal to closing stocks, then also profit/loss under the two systems will be equal provided the fixed cost element in opening and closing stocks is the same amount.

(b) Production more than sates

When production during a period is more than sales i.e. when closing stock is more than the opening stock, the profit as per absorption costing will be more than that shown by marginal costing. This is because in absorption costing, a part of fixed overhead included in closing stock value is carried forward to the next accounting period in the form of closing stock.

(c) Production Less than sates

When production during a period is less than sales i.e. when opening stock is more than the closing stock, profit shown by marginal costing will be more than that shown by absorption costing. This is because under absorption costing, cost of goods sold is higher because a part of fixed cost from the preceding period is added to the current year’s cost of goods sold in the form of opening stock.