Difference Between Absorption Costing and Marginal Costing

Edited by Diffzy | Updated on: September 24, 2022

       

Difference Between Absorption Costing and Marginal Costing Difference Between Absorption Costing and Marginal Costing

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Introduction

Absorption costing is a method of charging items or cost units with fixed expenses. Cost centres are either allocated or apportioned with fixed overheads. The production cost centre costs are then assigned to the cost units flowing through them using an overhead absorption rate. Despite the arbitrary nature of the method, the end result is that a cost unit is assigned a fair share of the fixed overhead. The behaviour of expenses when activity levels fluctuate is what marginal costing is all about. Variable and fixed costs are the two types of costs. The cost units are charged only with varying costs, and the contribution is derived by subtracting the variable costs from the income. Fixed costs are those that are not changed by variations in activity levels over time. The profit or loss is calculated by subtracting fixed costs from the overall contribution for a certain period. Both absorption and marginal costing have their benefits and drawbacks, which are discussed in this chapter. Both strategies can significantly impact stock valuation and period profit reporting.

Marginal Costing vs. Absorption Costing

The cost management methodologies of marginal costing and absorption costing are used to allocate costs to goods in order to value them. Fixed costs are recognized as period costs and taken as an expense immediately from the amount of contribution earned, while variable costs are allocated to goods separately. Fixed costs are also contributed to the cost of the product as overheads in absorption costing.

The concept of marginal costing distinguishes between product and period costs. Product costs are the variable costs incurred on the products, while period costs are the fixed costs incurred by the company within a specific period. While variable costs are added to the cost of items in marginal costing, fixed costs are removed from the contribution to arrive at the value of operational profit. As the name implies, absorption costing absorbs or charges the fixed expenses as well as the product cost. As a result, absorption costing assigns fixed costs to each product in addition to variable costs based on an absorption rate.

Difference Between Marginal Costing And Absorption Costing in Tabular Form

Table: Marginal Costing vs. Absorption Costing
Basis for Comparison
Marginal Costing
Absorption Costing
Meaning
The technique of marginal costing assumes solely variable expenses as product costs.
Absorption costing is a method of estimating product costs that include both fixed and variable expenses.
What it’s all about?
Variable cost is supposed to be product cost, whereas fixed cost is presumed to be period cost.
The cost of a product includes both fixed and variable costs.
Nature of overheads
Fixed costs and variable costs;
Production, distribution, selling, and administration are all different types of overheads in absorption costing.
How is the profit calculated?
By using the profit volume ratio (P/V ratio)
Because fixed costs are included in product costs, profit is reduced.
Determines
The cost of the next unit;
The price of each unit.
Opening & Closing stocks
Changes in opening/closing stocks have no effect on the cost per unit because the focus is on the next team.
Because the focus is on each unit, changes in opening and closing stocks have an impact on the cost per unit.
Most crucial aspect
Contribution per unit.
Net profit per unit.
Purpose
To emphasize the importance of contributing to the product cost.
To demonstrate the accuracy and fairness of product costing.
How is it presented?
By outlining the total contribution;
Financial and tax reporting is the most convenient;

What Is Marginal Costing?

Marginal costing, also known as variable costing, is a costing approach for determining the total cost or determining fixed and variable costs in order to choose the optimal process and product for manufacturing, among other things.

It calculates the Marginal Cost of Production and shows how changing production units affect profit. The shift in total cost due to the manufacturing of an additional output unit is referred to as marginal cost.

All variable expenses are considered product-related costs in marginal costing, while fixed costs are presumed to be period costs. As a result, fixed manufacturing costs are included in the profit and loss account. Furthermore, fixed costs are not taken into account when evaluating the product's selling price or when valuing closing stock (whether it is finished goods or Work in Progress).

Features

  • Classification of Costs: The marginal costing approach distinguishes between variable and fixed costs. The marginal costing technique is the changing cost on which a company bases its production and sales policies.
  • Stock/Inventory Valuation: Inventory for profit measurement is valued at a marginal cost under marginal costing. It is in stark contrast to the absorption costing method's total unit cost.
  • Marginal Contribution: A marginal contribution is used in the marginal costing technique to make various calculations. The gap between sales and marginal cost is the marginal contribution.

Now let’s talk about some advantages of Marginal Costing. The concept of variable vs. fixed costs in marginal costing is easy to grasp. A beneficial short-term survival costing approach, especially in competitive environments or recessions, where orders are accepted as long as they cover the business's marginal cost, with the excess going toward fixed costs to keep losses to a minimal. The link between cost, price, and volume is depicted using marginal costing. It is a useful managerial decision-making tool since it delivers superior information. By separating fixed and variable expenses, marginal costing focuses on the areas of the company that can be controlled. In nature, marginal costs are constant. It remains constant per unit of product regardless of production volume. It has a realistic valuation and makes cost control easier.

Coming the Marginal Costing Disadvantages of Marginal cost has a number of disadvantages because it is based on historical data, whereas management decisions are based on future events. Fixed costs to products are ignored by marginal costs as if they are unimportant to production. Third, fixed costs may become variable in the long run, and marginal costing oversimplifies expenses into fixed and variable as if it were so simple to distinguish them. Because it overlooks fixed costs, it is not a useful costing technique for pricing decisions in the long run. Finally, the scope of marginal costing is quite narrow.

Importance of Marginal Costing

For the following reasons, marginal costing may be selected.

  1. The marginal costing technique is simple to grasp and use.
  2. Fixed costs are not taken into account when calculating manufacturing costs. This keeps statements simple and straightforward.
  3. Fixed expenses are not absorbed in unsold stock. Hence profits are not inflated.
  4. There are no issues with overheads being under or over-absorbed.
  5. With the support of contribution information, management can make good decisions.
  6. Fixed costs are not distributed in an arbitrary manner.

What Is Absorption Costing?

Absorption Costing is an inventory valuation method in which all manufacturing expenses are assigned to cost centres in order to recognize the overall cost of production. All fixed and variable costs are included in these manufacturing charges. The classic method for cost estimating is often known as Full Absorption Costing.

Both fixed and variable costs are considered product-related costs in the absorption costing approach. The goal of assigning the whole cost to a cost centre in this manner is to recover it from the product's selling price.

Features of Absorption costing

  1. All costs are charged to the cost unit, and each unit's profit can be calculated.
  2. The overall profit is the sum of the profits from each cost unit.
  3. Because fixed costs are divided over a changing number of units, the total cost per unit changes when production changes.
  4. Work in progress and finished stocks are valued at full production cost since they involve a share of fixed costs.

Importance

For the following reasons, absorption costing may be selected.

  • Fixed costs are incurred for the purpose of production. As a result, it is reasonable to include fixed expenses in the assessment of closing stock or product costs.
  • If fixed costs are not included in inventory assessment, the false loss is recorded in the books when products are not sold, and excessive profit is recorded in the books when goods are sold.
  • When production remains steady, but sales fluctuate, profit variations are reduced.
  • The costs and revenues are in sync. The matching of costs and revenue is correct.
  • The inclusion of fixed cost in calculating a product's total cost helps the businessman fix the price above the total cost.

Main Differences between Absorption Costing and Marginal Costing in Points

  1. Marginal costing is a costing technique in which the marginal cost is charged to units of costs while the fixed cost is completely written off against the contribution. All manufacturing expenses, including variable and fixed costs, are classified as part of the product costs in absorption costing. It calculates the Marginal Cost of Production and shows how changing production units affect profit.
  2. In absorption costing, both variable and fixed costs are considered in the cost of the product. On the other hand, only variable costs are considered as product costs in marginal costing, and fixed costs are classified as period costs.
  3. In absorption costing, contribution per unit is considered, while net profit per unit is considered in marginal costing.
  4. In absorption costing, a major consideration of the cost of each unit is given priority. However, in marginal costing, a major consideration of the cost of producing the next unit is given priority.
  5. Absorption costing emphasizes overhead recovery, while marginal costing emphasizes the calculation of the contribution of each unit.
  6. In absorption costing, overheads are divided into administrative, production, distribution, and selling overheads. However, in marginal costing, overheads are divided into fixed and variable overheads.
  7. While absorption costing is difficult to implement, marginal costing is simple.
  8. Variations in the opening and closing stock affect the cost per unit in absorption costing. Still, differences in the opening and closing stock do not affect the cost per unit in marginal costing.
  9. While absorption costing complies with GAAP, marginal costing does not.
  10. External reporting to the government, tax authorities, and shareholders uses absorption costing, while internal reporting to management uses marginal costing.
  11. While absorption costing isn't particularly useful in making managerial decisions, marginal costing is because it takes into account additional expenditures.
  12. Marginal costing is a costing method in which variable costs are allocated only to products. Absorption costing is a method of costing in which all costs are absorbed and distributed to products.
  13. Product associated costs in Marginal Costing solely contain variable costs; however, in Absorption Costing, fixed expenses are also included in product-related expenses in addition to variable costs.
  14. In Marginal Costing, overheads are divided into two groups: Fixed Overhead and Variable Overhead. Consider the concept of absorption costing, which divides overheads into three categories: production, administration, and sales and distribution.
  15. Variations in the opening and closing stock do not affect the per-unit cost in Marginal Costing. Unlike Absorption Costing, which shows the influence of stock fluctuations at the beginning and end by raising or lowering per-unit cost.
  16. The cost data is presented in marginal costing to show the entire cost of each product. The cost data in absorption costing, on the other hand, is presented in a customary manner. The net profit of each product is calculated after deducting fixed and variable costs.

Conclusion

Both absorption costing and absorption costing are necessary for an organization to run efficiently. They each have some benefits and drawbacks. It depends on the context. They are both parts of the commerce stream. It will continue into their college education. Furthermore, they primarily use these techniques at work.

Absorption costing is the most commonly utilized method since it incorporates variable and fixed costs while also providing accurate results and a high-profit margin. Because marginal cost only uses variable costs, the outcome will be less accurate. We may also examine the disparities in their profits due to the various approaches used.

References

  • https://www.wallstreetmojo.com/marginal-costing-vs-absorption-costing/#:~:text=Marginal%20costing%20is%20a%20method,variable%20costs%20as%20product%20costs

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