Definition
In finance, Marginal Costing is an accounting system in which variable costs are charged to cost units and fixed costs are treated as period costs. They are written off in full against the contribution for that period. On the other hand, Absorption Costing (also known as full costing) is an accounting method that includes all manufacturing costs – direct materials, direct labor, and both variable and fixed manufacturing overhead- in the calculation of product cost.
Key Takeaways
- Marginal Costing refers to the accounting system in which variable costs are charged to cost units and the fixed costs are treated as period charges. Absorption Costing, on the other hand, treats both variable and fixed production costs as product costs, regardless of the level of production activity.
- In Marginal Costing, the cost of a product or service only includes the costs that vary directly with production volume, hence it’s often used for decision-making and short-term financial analysis. Meanwhile, Absorption Costing covers all production costs, which makes it suitable for long-term pricing strategies and profitability analysis.
- Differences in these costing methods can lead to different production and pricing decisions and impact a company’s profit level. For example, Marginal Costing can show higher profits in periods of declining inventory, while Absorption Costing can lead to lower cost per unit when production volume increases.
Importance
Understanding the concepts of Marginal Costing and Absorption Costing is crucial in the field of finance because they provide two different methods for accounting for the costs of production.
Marginal costing, also known as variable costing, includes only variable costs (those that fluctuate with changes in production volume) in product costs, which directly helps in making short-term pricing decisions, cost control, and break-even analysis.
On the other hand, Absorption costing, also known as full costing, includes both variable costs and fixed costs (those that are constant regardless of production volume), giving a more comprehensive view of the total cost per unit, and therefore it is often used for long-term pricing decisions and profitability analysis.
The use of one over the other can significantly impact a company’s reported profits, management’s decisions, and the organization’s financial health, hence the importance.
Explanation
Marginal costing, also known as variable costing, is a management accounting technique that is centered on the costing of products only by their variable costs. The primary purpose of marginal costing is to allow management to make informed decisions regarding operational efficiency, pricing strategies, and profitability. It is especially useful in short-term decision making because it considers the cost behavior and how each decision can impact variable costs, such as direct labor and materials, and the overall profitability.
This approach excludes the production’s fixed costs, presuming these don’t vary with output levels. In this way, management can understand how each additional unit of product impacts their profit margin. On the other hand, absorption costing, also known as full costing, is a costing technique that assigns all direct costs and both variable and fixed overhead costs to individual products.
The purpose of absorption costing is to provide a comprehensive measure of the complete product cost, which can be beneficial in long-term pricing strategies and indicating the overall profitability of a business. It is especially relevant when inventory levels are expected to fluctuate, as this method ensures all costs associated with production are accounted for in the cost of the goods produced. Therefore, all costs, including manufacturing overhead costs, are absorbed into the product cost, facilitating an understanding of the comprehensive cost of production.
Examples of Marginal Costing vs Absorption Costing
Manufacturing Industry: Suppose a car manufacturing company uses absorption costing, it would take into account all costs related to production – direct materials, direct labor, and both variable and fixed overhead expenses. For example, if making one more car includes a cost of $4000 for materials and labor and $1000 for overhead expenses, then the absorption cost of each car would be $
However, if the company uses marginal costing, the fixed overhead expenses would not be included in the cost of each car. Therefore, the cost of making an additional car would just be $
This difference inevitably affects the pricing strategy and profitability analysis.
Food Production Industry: A bakery produces a variety of bread and uses wheat as a primary ingredient. Under absorption costing, the bakery would consider the fixed overheads like depreciation of the bakery equipment, manager’s salary, and rent while calculating the cost for making the bread. But, under marginal costing, bakery will consider only the variable costs like cost of wheat, labor, and utilities to produce additional loaves of bread.
Fashion Industry: Let’s consider a fashion apparel manufacturing company that makes designer clothes. Under the absorption costing method, the cost of producing an additional dress includes the cost of fabric, direct labor, and a share of rent and salaries of the design team. But under the marginal costing method, only the fabric cost and direct labor cost to produce the additional dress are considered, excluding the fixed overheads such as rent and salaries. Every organization’s aim is to manage costs effectively. Both absorption and marginal costing provide valuable insights, but their usefulness can depend on the company’s specific financial situation, which strategy best aligns with their goals, the nature of cost behavior, and the decision-making needs of management.
FAQs: Marginal Costing vs Absorption Costing
1. What is Marginal Costing?
Marginal Costing, also known as variable costing, is a costing method that includes only variable manufacturing costs—direct materials, direct labor, and variable manufacturing overhead—in the cost of a unit of production. Fixed manufacturing overhead costs are treated as period costs and are not product costs.
2. What is Absorption Costing?
Absorption Costing, also known as full costing or the comprehensive guide, is a costing system in which all direct costs and all production costs are included in product cost. This includes both variable and fixed manufacturing costs, therefore, it absorbs all costs of production.
3. What is the primary difference between Marginal and Absorption Costing?
The main difference lies in how fixed overhead costs are treated. In Marginal Costing, fixed overheads are treated as period cost and are written off against profits for the period in which they are incurred. In Absorption Costing, fixed overheads are treated as product costs and are absorbed into product costs.
4. Which costing method is more advantageous: Marginal or Absorption Costing?
Neither method is inherently better than the other. It really depends on the specific circumstances of the business. Marginal Costing provides better management information for decision-making since it does not mix up fixed and variable costs. On the other hand, Absorption Costing is generally preferred for external reporting purposes as it is required by most financial accounting rules.
5. Can a company use both Marginal and Absorption Costing?
Yes, it’s possible for a company to use both Marginal and Absorption Costing. The two methods can be used together in what’s known as absorption cost accounting, or fully absorbed cost accounting. This combines elements of both systems to provide a more comprehensive picture of a company’s costs and profitability.
Related Entrepreneurship Terms
- Cost Accounting
- Fixed and Variable Costs
- Product Pricing
- Contribution Margin
- Overhead Allocation
Sources for More Information
- Investopedia: A trusted online resource for finance and investing information, which includes detailed explanations and examples of various financing concepts, including absorption and marginal costing.
- Accounting Coach: A website that offers free courses on different concepts in accounting and finance, including detailed tutorials on marginal and absorption costing.
- Corporate Finance Institute: A leading provider of online finance courses and certifications. Their site includes resources on a wide variety of finance topics including marginal and absorption costing.
- Khan Academy: Known for its educational resources, Khan Academy provides clear and easy-to-understand lessons in finance and economics, including videos and articles on marginal and absorption costing.
