Have you ever wondered why some businesses prefer to use marginal costing while others stick with absorption costing? These two methods of cost accounting may seem similar on the surface, but they have significant differences that can impact a company’s financial reporting and decision-making.
Marginal Costing is a costing technique in which only variable costs are considered while Absorption Costing takes into account both variable and fixed costs.
Marginal Costing vs. Absorption Costing
|Marginal Costing||Absorption Costing|
|Marginal costing is a costing technique that considers only variable costs while computing the cost of production.||Absorption costing is a costing technique that considers both variable and fixed costs while computing the cost of production.|
|They are treated as period expenses and are not included in the cost of production.||They are allocated to the cost of production and are included in the cost per unit.|
|Profit is calculated as sales revenue minus variable costs only.||Profit is calculated as sales revenue minus total costs (both variable and fixed costs).|
|Here inventory is valued by fixed production overhead costs are not included in the valuation of closing inventory.||Here inventory is valuated by fixed production overhead costs are included in the valuation of closing inventory.|
|Marginal costing provides better insight into short-term decision making, as it focuses on variable costs that directly impact profitability in the short run.||Absorption costing provides a holistic view of costs and profitability, making it suitable for long-term decision making and financial reporting.|
|It is commonly used for internal management reporting and short-term decision making.||It is often used for external financial reporting, tax purposes, and long-term decision making.|
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What is marginal costing?
There are two main types of costing methods used in business: marginal costing and absorption costing. Both methods aim to assign costs to products or services, but they do so in different ways.
Marginal cost is the cost of producing one additional unit of a good or service. It includes all direct costs associated with the production, such as materials, labor, and overhead. The marginal cost of production can be calculated by dividing the total variable costs by the number of units produced.
What is absorption costing?
Absorption costing is a method of allocating fixed and variable costs to products and services. The purpose of absorption costing is to determine the full cost of producing a product or delivering a service, so that an organization can price its products and services appropriately and make decisions about how to manage its resources.
With absorption costing, all fixed costs are assigned to each unit produced or service delivered.
Key differences between marginal and absorption costing
The main difference is that marginal costing only includes variable costs in the product cost, while absorption costing includes both variable and fixed costs. This means that marginal costing will typically result in a lower product cost than absorption costing. Additionally, marginal costing is used for decision-making purposes, while absorption costing is primarily used for financial reporting.
Another key difference is the way that overheads are treated. In marginal costing, overheads are considered a period cost and are not allocated to products. In contrast, in absorption costing, overheads are allocated to products based on a predetermined overhead allocation rate. This can result in different product costs depending on which method is used.
Another key difference is the way inventory is valued. In marginal costing, inventory is valued at the variable cost of production. In contrast, in absorption costing, inventory is valued at the full cost of production (including both variable and fixed costs). This can have a significant impact on the bottom line and should be considered when making decisions about pricing and production levels.
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Advantages and disadvantages of marginal vs. absorption costing
With marginal costing, the variable costs are charged to the cost of goods sold, which can give a more accurate representation of the true cost of goods sold. However, this method can also lead to fluctuations in reported profits.
Absorption costing, on the other hand, includes all manufacturing costs in the cost of goods sold, which can provide a steadier reported profit but may not be as accurate in terms of the true cost of goods sold.
Examples of marginal and absorption costing
Example of Marginal Costing:
A company manufactures and sells widgets. The variable costs associated with producing each widget are direct materials, direct labor, and variable overhead, which amount to $5 per widget. The company incurs additional fixed costs, such as factory rent and salaries, of $10,000 per month. Under marginal costing, only the variable costs of $5 per widget would be considered as the cost of production, and the fixed costs of $10,000 would be treated as period expenses.
Example of Absorption Costing:
Using the same scenario as above, if the company uses absorption costing, the cost of each widget would not only include the variable costs of $5 per widget but also a portion of the fixed costs of $10,000 per month.
For example, if the company produces 1,000 widgets in a month, each widget would be allocated $10 ($10,000/1,000) of fixed costs in addition to the variable costs of $5, resulting in a total cost of $15 per widget for production purposes.
Both marginal and absorption costing can be beneficial tools to help managers understand their business better. Marginal costing is great for short-term decision making while absorption costing enables managers to take into account fixed costs when determining product pricing. Absorption costing is a method used in managerial accounting to allocate both variable and fixed manufacturing overhead costs to products or services. It is called “absorption” costing because it absorbs all manufacturing costs into the cost of each unit produced.