MARGINAL COSTING AND ABSORPTION COSTING

There are two alternative approaches for the valuation of inventory; they are Marginal Costing and Absorption Costing. Both Marginal costing and absorption costing are the two different approaches used for the valuation of inventory where in the case of Marginal costing only the variable cost incurred by the company is applied to the inventory whereas in case of the absorption costing both variable costs and fixed costs incurred by the company are applied to the inventory.

Marginal cost: This is calculated by adding the prime cost and the variable production overheads. Marginal means part of, so this is the prime cost and the variable production overheads added together. If no products are made, then no marginal costs are incurred.

Absorption cost: This is calculated by adding the marginal cost and the fixed production overheads. Absorption absorbs all production overheads associated with making a particular product.

Important: We are only looking at the production overheads here and are not interested in anything else, such as office expenses, admin costs, selling expenses, or insurance.

Marginal costing is based on the variable costs of production and does not include any fixed costs. Absorption costing includes both the variable, or direct costs, and the fixed costs, or indirect costs, of production. Note that marginal costing is not permitted in financial reporting, but absorption costing is permitted. Both methods can be used in management accounting.

• Marginal costing is a method where the variable costs are considered the product cost and the fixed costs are considered the period’s costs. Only variable costs are charged to the operation, whereas the fixed cost is excluded from it and is charged to the profit and loss accounts for the period.
• On the other hand, absorption costing is a method that considers both fixed and variable costs as product costs. This costing method is essential, particularly for reporting purposes. Reporting purposes include both financial reporting and tax reporting.

• Marginal costing doesn’t consider fixed costs under product or inventory valuation. On the other hand, absorption costing takes both fixed and variable costs into account.
• Marginal costing can be classified as fixed costs and variable costs. Absorption costing can be classified as production, distribution, and selling & administration.
• The purpose of marginal costing is to show forth the contribution of the product cost. The purpose of absorption costing is to provide a fair and accurate picture of the profits.
• Marginal costing can be expressed as a contribution per unit. Absorption costing can be expressed as net profit per unit.
• Marginal costing is a method of costing and isn’t a conventional way of looking at costing methods. On the other hand, absorption costing is used for financial and tax reporting, and it is the most convenient method of costing.

Marginal Costing

Marginal costing creates a differentiation between product costs and period costs. Marginal Costing only takes variable costs into account and does not consider fixed costs, whereas absorption costing includes all business costs. Marginal costing is not an allowed method under Generally Accepted Accounting Principles. Instead, marginal costing can only be used for internal management reports.

The variable costs incurred on the products are treated as product costs and the fixed costs incurred by the entity during a particular period are considered period costs. Thus, in the case of marginal costing, while variable costs are added to the cost of products, fixed costs are not added to the product cost, instead, they are deducted from the contribution to arrive at the value of operating profit. 

Marginal costing is a method of allocating the costs of production to a company’s goods or services. In doing this, it measures the change in cost that occurs in relation to the change in quantity produced. This means that this method of costing considers variable costs or the costs that change in relation to output and generally ignore fixed costs that remain the same regardless of production activity up to a certain level.

Variable costs often include raw materials, direct labor, and in some cases, energy costs. Fixed costs commonly include rent, marketing, and sales costs, among others. Marginal costing is calculated by dividing the change in manufacturing costs by the change in quantity produced.

The formula for this is:

Marginal Cost = Change in Cost / Change in Quantity

Absorption Costing

Absorption costing as the name suggests absorbs or charges the fixed costs as well to the product cost. Thus, absorption costing allocates fixed costs also in addition to the variable costs to each product based on an absorption rate. Absorption costing allocates costs in relation to distinct cost centers. In contrast, marginal costing only considers the total cost of production. Absorption costing can be used for both financial and tax reporting purposes.

Absorption costing is a method of costing which includes all of the costs associated with production, including both variable and fixed overhead costs. This method identifies all of the costs in a production process and apportions them to specific products. 

This includes the direct costs of manufacturing a product, such as direct materials and direct labor, as well as fixed overhead charges such as utility costs incurred during the production process. All of these costs will be allocated to specific products for the period regardless of whether they were sold. This method of costing is required by GAAP for external reporting.

Basic Differences

Though both are widely used costing methods, there are several important differences between these two costing methods.

Here are the differences:

• Cost Treatment:Variable costs are treated as product costs and fixed costs are treated as period costs.Both variable and fixed costs are treated as product costs.
• Intended Use: Generally, marginal costing is used in order to determine the costs of production. Absorption costing is used to provide an accurate indication of profits.
• Profitability: Because marginal costing does not take fixed costs into account, it will report a much higher level of profitability relative to absorption costing.
• Acceptance Under GAAP: Absorption costing is required by GAAP in external reporting for all publicly traded companies. As a result, marginal costing can only be used in internal reports.
• Profitability Measurement:The profit volume (PV) ratio is used to measure the profits earned on products in marginal costing. PV Ratio gives the amount of contribution earned on products and fixed costs are reduced from the contribution to arrive at profits. Absorption costing appropriates a portion of fixed costs to products and as a result, the profitability of a product gets affected due to the inclusion of the fixed cost.
• Inventory Valuation: Marginal costing provides a lower cost per unit because it does not include fixed overhead costs. As a result, the cost of goods sold will be higher in this method. With absorption costing, fixed overhead costs are considered, which means that cost of goods sold is lower, and closing inventory will be recorded at a higher per-unit cost.