Absorption costing and marginal costing are two different methods of costing that are used to calculate the cost of a product or service. While both methods are used to calculate the cost of a product, they differ in the types of costs that are included and the purposes for which they are used. The differences between absorption costing and marginal costing lie in how fixed overhead costs are treated.
What is Marginal Costing?
The marginal cost refers to the increase in production costs generated by the production of additional product units. It is also known as the marginal cost of production.
To calculate marginal cost, divide the change in production costs by the change in quantity. The purpose of analyzing marginal cost is to determine at what point an organization can achieve economies of scale to optimize production and overall operations. If the marginal cost of producing one additional unit is lower than the per-unit price, the producer has the potential to gain a profit.
In other words, Marginal cost includes all of the costs that vary with that level of production. For example, if a company needs to build an entirely new factory in order to produce more goods, the cost of building the factory is a marginal cost. The amount of marginal cost varies according to the volume of the good being produced.
Therefore, Marginal costing is a cost accounting technique that focuses on the variable costs associated with producing one additional unit of a product or service. It helps in determining the contribution margin and assists in making decisions related to pricing, production, and profitability.
Marginal costing is also known as “variable costing“. Because it only considers the variable costs associated with producing an additional unit of a product or service, such as direct labour and materials.
Under marginal costing, fixed costs, such as rent and salaries, are considered period costs that are not directly related to the production of a specific unit. Instead, fixed costs are expensed in the period they are incurred.
Marginal costing is often used for short-term decision-making, such as pricing decisions, determining the impact of changes in production levels, and evaluating the profitability of specific products or departments.
Key features of marginal costing include:
- Variable Costs Only: Marginal costing considers only the variable manufacturing costs (direct materials, direct labor, and variable overhead) as product costs. Fixed manufacturing costs are treated as period costs and are not allocated to units produced.
- Product Cost: Under marginal costing, the product cost consists of only the variable production costs directly associated with the production of each unit.
- Inventory Valuation: Closing stock is valued at the variable production cost per unit. Fixed production costs are not included in the valuation of closing stock.
- Profit Calculation: Profit is calculated by deducting only variable production costs from sales revenue. Fixed costs are considered separately and are not deducted from the contribution margin to calculate profit.
What is Absorption Costing?
Absorption costing, sometimes called “full costing,” is a managerial accounting method for capturing all costs associated with manufacturing a particular product. All direct and indirect costs, such as direct materials, direct labor, rent, and insurance, are accounted for when using this method.
In other words, Absorption costing includes anything that is a direct cost in producing a good in its cost base. Absorption costing also includes fixed overhead charges as part of the product costs. Some of the costs associated with manufacturing a product include wages for employees physically working on the product, the raw materials used in producing the product, and all of the overhead costs (such as all utility costs) used in production.
Absorption costing differs from variable costing because it allocates fixed overhead costs to each unit of a product produced in the period. This type of costing method means that more cost is included in the ending inventory, which is carried over into the next period as an asset on the balance sheet.
Absorption costing is often used for long-term decision-making and for external financial reporting purposes in accordance with accounting standards.
Key features of absorption costing include:
- Variable and Fixed Costs Included: Both variable manufacturing costs (direct materials, direct labor, and variable overhead) and fixed manufacturing overhead costs are included in the product cost.
- Product Cost: The product cost includes all costs, both variable and fixed, that are incurred in the production of each unit. This means that fixed manufacturing costs are allocated to units produced.
- Inventory Valuation: Closing stock is valued at the full production cost per unit, including both variable and fixed manufacturing costs.
- Period Costs: Fixed manufacturing costs are considered as part of the cost of goods sold (COGS) rather than being treated as period costs. This means that these costs are matched against revenue in the income statement when units are sold.
- Profit Calculation: Profit is calculated by deducting the full production cost (variable and fixed manufacturing costs) from sales revenue. This includes both the cost of goods sold and the portion of fixed manufacturing costs allocated to closing stock.
- Compliance with GAAP: Absorption costing is generally accepted accounting principles (GAAP) compliant and is used for external financial reporting to provide a more comprehensive view of the total cost of producing goods.
Key Takeaways
- Absorption costing includes all of the direct costs associated with manufacturing a product.
- Variable costing can exclude some direct fixed costs.
- Absorption costing entails allocating fixed overhead costs to all units produced for an accounting period.
- Variable costing includes all of the variable direct costs in COGS but excludes direct, fixed overhead costs.
- Variable costing can provide a clearer picture of per-unit cost and inventory value because it excludes the fixed overhead cost.
Difference In Tabular Form
| Aspect | Marginal Costing | Absorption Costing |
|---|---|---|
| Treatment of Fixed Costs | Only variable manufacturing costs are considered. Fixed manufacturing costs are treated as period costs and are not assigned to units. | Both variable and fixed manufacturing costs are included in the product cost and assigned to units produced. |
| Treatment of Variable Costs | Only variable manufacturing costs are included in the product cost. | Variable manufacturing costs are included in the product cost. |
| Unit Cost | Product cost consists of only variable production costs. | Product cost includes both variable and fixed manufacturing costs. |
| Treatment of Fixed Production Overheads | Fixed production overheads are treated as period costs. | Fixed production overheads are included in the product cost. |
| Inventory Valuation | Closing stock is valued at variable production cost only. | Closing stock is valued at full production cost (variable and fixed). |
| Profit Calculation | Profit is calculated by deducting only variable production costs from sales. | Profit is calculated by deducting both variable and fixed production costs from sales. |
| Period Costs | Fixed production costs are treated as period costs. | Fixed production costs are considered as part of the cost of goods sold. |
| Decision-Making Emphasis | Marginal costing is often used for short-term decision-making. | Absorption costing is used for long-term decision-making and for external reporting in accordance with accounting standards. |