The eventual aim of cost classification is providing information for inventory valuation,

selling price determination and profitability analysis. However, there is a difference in

concept of product cost and period cost between marginal costing system and absorption
costing system. Therefore, it is important to understand these differences in order to
make accurate profit analysis.
Firstly, cost classification is a critical process that involves identifying and classifying
expenses based on their nature, purpose, behavior, and other relevant factors. The
ultimate purpose of cost categorization is to give helpful information for different
business choices, such as inventory assessment, determining selling prices, and analyzing
profitability. Inventory valuation involves determining the value of inventory on hand,
which is essential for accurate financial reporting and tax purposes. Different methods of
cost classification can be used to determine the cost of inventory, such as first-in-first-out
(FIFO), last-in-first-out (LIFO), and weighted average cost. Moreover, cost
classification can help identify the costs associated with producing and selling the
product or service, as well as the revenue generated. By comparing the costs and
revenues, businesses can determine the profitability of different products, services, or
business units, and make informed decisions about where to invest resources or cut costs.
Generally, cost classification is an essential tool for businesses to understand the costs
associated with their operations and make informed decisions about inventory valuation,
selling price determination, and profitability analysis.

Secondly, we are going to find out what is marginal cost and what is absorption cost.
Marginal costing is a costing technique used for internal reporting purposes that focuses
on the analysis of the behavior of costs in relation to the volume of production or sales. It
is also known as variable costing, direct costing, or contribution margin costing. Under
marginal costing, only variable costs are considered as product costs, while fixed costs
are treated as period costs. This means that the cost of producing a product only includes
the variable costs of direct materials, direct labor, and variable manufacturing overhead.
Fixed manufacturing overhead costs are not included in the cost of production of a
product but are instead treated as period costs and expensed in the period in which they
are incurred. The contribution margin is a key concept in marginal costing. It is
calculated by subtracting the variable costs of a product from its revenue. The
contribution margin represents the amount of revenue that is available to cover the fixed
costs of the business, and any remaining amount after covering fixed costs represents the
profit. This makes marginal costing particularly useful for making short-term decisions,
such as pricing, product mix, and discontinuation of products. Marginal costing is often
contrasted with absorption costing, which includes both variable and fixed
manufacturing overhead costs as product costs. The choice of costing method can have a
significant impact on reported profits, inventory valuation, and decision-making.
Absorption costing is a method of costing that takes into account all of the costs
associated with producing a product or providing a service. This includes both direct
and indirect costs, such as materials, labor, overhead, and other expenses. Under
absorption costing, all of these costs are absorbed into the cost of the product or service,
and are included in the calculation of the cost of goods sold (COGS). This means that the
cost of the product includes not only the direct costs of producing it, but also a share of
the indirect costs that are incurred in the production process. Absorption costing is a
widely used costing method in manufacturing companies, where it is necessary to
account for all of the costs incurred in producing goods. It is often used for financial
reporting purposes, as it provides a more accurate picture of the true cost of producing a
product. However, it can also be more complex and time-consuming than other costing
methods, such as variable costing, which only includes direct costs in the cost of goods
sold. In my opinion, the difference between absorption costing and marginal costing is
the treatment of fixed manufacturing overhead costs. In absorption costing, product costs
include all direct costs (such as materials, labor, and direct overheads) as well as
indirect overhead costs that are incurred during the production process. This means that
a portion of fixed overhead costs are included in the product cost.

On the other hand, in marginal costing, only variable costs (such as materials, labor,
and variable overheads) are considered as product costs. Fixed overhead costs are
treated as period costs and are expensed in the period they are incurred. As a result, the
product cost under marginal costing is lower than under absorption costing.

The treatment of fixed overhead costs is the main difference between the two methods,
and it can have a significant impact on the profit analysis. When sales are higher than
production, absorption costing will report higher profits than marginal costing because
some of the fixed overhead costs will be deferred to the next period. Conversely, when
production is higher than sales, absorption costing will report lower profits than
marginal costing because more of the fixed overhead costs will be allocated to each unit
of product.

Therefore, understanding the concept of product cost and period cost, as well as the
differences between absorption costing and marginal costing, is crucial for making
accurate profit analysis and for making informed decisions about inventory valuation,
selling price determination, and overall profitability analysis. Many people equate the
the concepts of manufacturing cost with product cost as well as non-manufacturing cost
with period cost so there is a confusion between manufacturing costs and product costs,
as well as non-manufacturing costs and period costs. There are some ways to distinguish
them. Manufacturing costs are costs that are directly related to the production of goods,
such as materials, labor, and manufacturing overhead. Product costs, on the other hand,
include all costs associated with producing a product, including both direct costs (such
as materials and labor) and indirect costs (such as manufacturing overhead). Therefore,
product costs are a subset of manufacturing costs.

Non-manufacturing costs, also known as selling, general, and administrative (SG&A)

costs, are costs that are not directly related to the production of goods, such as
marketing, advertising, rent, salaries of administrative staff, and other expenses. Period
costs, on the other hand, are costs that are not associated with the production of goods
or services, but are instead expensed in the period in which they are incurred, such as
rent, utilities, and depreciation.

To summarize, manufacturing costs and non-manufacturing costs are broader categories

of costs that include both product costs and period costs, respectively. Product costs and
period costs, on the other hand, are specific types of costs that are included in the
broader categories of manufacturing costs and non-manufacturing costs, respectively. It
is important when managers consider a special order because it can cause mistake. For
instance, a company produces and sells a product for $50 per unit. The company's
variable costs are $30 per unit, and its fixed manufacturing overhead costs are $100,000
per month. The company's current production capacity is 5,000 units per month, and it
sells all of the units it produces.

Now, suppose the company receives a special order from a customer to produce and sell
500 units of the product for $35 per unit. The customer's order will require the company
to incur additional setup costs of $2,000, and the company will have to purchase
additional materials at a cost of $20 per unit. The company's direct labor and variable
overhead costs will remain the same as for regular production.

If the managers only consider the variable costs and ignore the fixed overhead costs, they
might be tempted to accept the special order, as the variable costs for producing 500
units would be:

Direct materials per unit x Number of units = $20 per unit x 500 units = $10,000 Direct
labor per unit x Number of units = $5 per unit x 500 units = $2,500 Variable overhead
per unit x Number of units = $5 per unit x 500 units = $2,500 Total variable costs =
$15,000

The managers might think that this special order will bring in an additional revenue of
$17,500 ($35 per unit x 500 units) while only incurring variable costs of $15,000,
leading to a profit of $2,500. However, this analysis ignores the fixed overhead costs of
$100,000 per month, which are not avoidable even if the special order is accepted.
If the managers had considered the fixed overhead costs, they would have realized that
the special order would actually result in a loss of $82,000. This is because the total cost
of producing the additional 500 units, including the fixed overhead costs, would be:

Variable costs per unit x Number of units = $30 per unit x 500 units = $15,000
Additional setup costs = $2,000 Additional fixed overhead cost allocation = (Fixed
overhead cost per unit x Number of units) + Additional setup costs = (($100,000 / 5,000
units) x 500 units) + $2,000 = $10,000 + $2,000 = $12,000 Total cost of production =
Variable costs + Additional setup costs + Additional fixed overhead cost allocation =
$15,000 + $2,000 + $12,000 = $29,000

Therefore, the company would actually incur a loss of $164 per unit ($29,000 / 500
units), despite the higher selling price per unit.

It is possible for a company to report a profit under absorption costing but a loss under
marginal costing if the company's production and sales volumes differ significantly. For
example, suppose a company produces and sells only one product at a selling price of
$20 per unit. The company's variable costs (direct materials, direct labor, and variable
overhead) are $10 per unit, and its fixed manufacturing overhead costs are $50,000 per
month. The company's total monthly production capacity is 5,000 units.

Under absorption costing, the fixed manufacturing overhead costs of $50,000 per month
are allocated to each unit of product produced, regardless of whether or not it is sold.
Therefore, the cost of production per unit would be:

Variable costs per unit + (Fixed overhead costs / Units produced) = $10 per unit +
($50,000 / 5,000 units) = $20 per unit

This means that the cost of production per unit is equal to the selling price per unit,
resulting in a gross profit of zero.

Now, suppose that the company only sells 3,000 units in a month, leaving 2,000 units
unsold. Under absorption costing, the fixed manufacturing overhead costs of $50,000 per
month are allocated to each unit of product produced, including the 2,000 unsold units.
Therefore, the total cost of production for the 3,000 units sold would be:

Total production cost per unit x Number of units sold = $20 per unit x 3,000 units =
$60,000

The gross profit would be:

Total revenue - Total cost of production = ($20 per unit x 3,000 units) - $60,000 = $0

Under marginal costing, the fixed manufacturing overhead costs are treated as period
costs and are not allocated to the cost of production. Therefore, the cost of production
per unit would only include the variable costs of $10 per unit. This means that the cost of
production per unit is lower than the selling price per unit, resulting in a gross profit of
$10 per unit or $30,000 in total for the 3,000 units sold.

In this example, the company would report a profit under absorption costing of zero and
a profit under marginal costing of $30,000, despite selling only 3,000 units.

Reference: https://www.wallstreetmojo.com/marginal-costing-vs-absorption-costing/
https://www.financestrategists.com/accounting/management-accounting/
marginal-costing/?gclid=CjwKCAjwov6hBhBsEiwAvrvN6O1rjOGXy3gX2FzwGK-f-
ySIJPzzTTYNntrjdrWkMg8vOjH4m-53ZhoCriMQAvD_BwE