Absorption costing and marginal costing are two basic methods of cost accounting. Both the methods assist companies in ascertaining product costs, profitability, and pricing policies. They differ in their treatment of fixed costs, which impacts financial reporting and decision-making.
In this post, we are going to discuss the difference between both costing approaches in cost accounting, namely marginal costing and absorption costing.
Both approaches differ regarding the treatment of marginal costs. We will discuss more specific details about both approaches and will compare them with each other.
Marginal Costing
Marginal costing is a technique of accounting that may be defined as “the ascertainment of cost by differentiating between fixed cost and variable cost of marginal cost and of the effect on profits of changes in the volume of the type of output”.
Marginal costing distinguishes between fixed costs and variable costs as conventionally classified. The marginal cost of a product is its variable cost.
Under marginal costing, variable cost is charged as the cost of production and valuation of stock of work-in-progress or finished goods is done based on variable cost. The following are the elements of marginal costing.
The following are the elements of marginal costing:
- All elements of costs are classified into fixed and variable costs.
- profits are calculated by deducting the fixed cost from the contribution.
- This technique is used for cost control and decision-making.
- The profitability of various levels of activity is determined by cost-volume-profit analysis.
Absorption Costing
Absorption costing is also known as financial absorption costing. The basic principle of Absorption costing is very similar to that of costing, which is recording and estimating all the production process costs.
However, Absorption costing is much more specific because it focuses on the financial performance of an organization. Absorption costing takes into account the following four aspects:
1) Revenue.
2) Expense.
3) Fixed and Variable Costs.
4) Profitability.
Difference between Marginal and Costing Absorption
Treatment of Fixed and Variable Costs
One of the basic distinctions between marginal costing and absorption costing is how they treat costs. Marginal costing takes into account only variable costs, i.e., direct materials, direct labour, and variable overheads, while determining product costs. Fixed costs like rent, depreciation, and salaries are accounted for as period costs and debited to the profit and loss account in the period they are incurred.
By contrast, absorption costing adds fixed costs to variable costs in determining the total cost of the product so that the costs of all production are captured.
Calculation of Profit
The way fixed costs are treated results in differences in the calculation of profit between the two methods. Under marginal costing, profit is simply related to the volume of sales because only variable costs are subtracted from revenue.
However, under absorption costing profit would be affected both by sales volume and production volumes because fixed expenses are charged in respect of every unit of stock and are merely accounted for and not expensed until the commodities are sold. Consequently, the profits of an enterprise can, therefore, show a higher profit under absorption costing if it undertakes more productions than sales are made because its fixed expenses become part of closing stock valuation.
Also Learn: What is Marginal Cost and Marginal Cost Equation
Valuation of Stock
Another significant distinction lies in stock valuation. In marginal costing, only the variable costs are used to value closing stock, resulting in lower financial statement stock values. However, in absorption costing, variable costs as well as fixed costs are utilized to value inventories, thus higher stock values. This can impact the financial position shown by a company, particularly for companies operating in businesses with variable production levels.
Decision Making
Marginal costing is most valuable in decision-making for short-run analysis, for example, decisions on pricing, cost control, and contribution margin. Companies are able to make more informed price and volume-based decisions because it does not apply fixed costs to products.
A more complete perspective of total cost is given by absorption costing and is thus well-suited to long-run price strategies and external reporting. Additionally, absorption costing is compatible with both GAAP and IFRS standards, and hence it is a statutory method of external financial reporting, while marginal costing is primarily applied for internal purposes.
Also read: What Are the Assumptions and Limitations of CVP Analysis?
Conclusion
Marginal costing and absorption costing present different approaches regarding cost control and profitability. Marginal costing concentrates on variable costs and short-run financial choices, while absorption costing ensures all costs are recouped in pricing and conforms to accounting conventions. Firms usually apply both approaches to get a balanced idea of their cost structure and make wise financial choices.
