7 Differences Between Absorption Costing and Marginal Costing
Understanding the differences between absorption costing and marginal costing is essential for effective cost control, financial reporting, and decision-making in any manufacturing business. These two costing methods represent distinct approaches to how companies calculate and assign the cost of production and influence the way profit is determined, particularly when production volumes fluctuate.
Absorption costing is an accounting method that incorporates all fixed and variable manufacturing costs into the cost of a product. In contrast, marginal costing, also known as variable costing, includes only variable costs when calculating the cost per unit, treating fixed costs as period costs.
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- Redaction Team
- Business Planning, Entrepreneurship
Table of Contents
Absorption Costing Includes Both Fixed and Variable Manufacturing Costs
Absorption costing, also referred to as full costing, includes all costs associated with the production process in the product cost. This means it captures direct materials, direct labor, variable manufacturing overhead, and fixed manufacturing overhead.
By incorporating both variable and fixed costs, absorption costing provides a more comprehensive view of total cost of production. This method is required by GAAP (Generally Accepted Accounting Principles) and is used for external financial reporting purposes.
On the other hand, marginal costing considers only variable manufacturing costs when determining the cost of producing an item. Fixed costs are treated as expenses for the period in which they are incurred and are not included in inventory valuation.
Treatment of Fixed Costs Differs Significantly - Difference between marginal and absorption costing
One of the most notable differences between marginal costing and absorption costing is the treatment of fixed costs.
Under absorption costing, fixed manufacturing costs are allocated to each unit of a product, meaning they are included in inventory until the goods are sold. This approach matches costs with revenues more accurately for external reporting.
In contrast, marginal costing treats fixed expenses as period costs, charging them directly to the profit and loss account for the period. As a result, profits can vary greatly depending on production volume, since fixed costs are not spread across the units produced.
Impact on Profit Varies Based on Production and Sales Volume
When production exceeds sales, absorption costing tends to show higher profits because some fixed costs remain in inventory, reducing the total expenses recognized in that period.
Under marginal costing, all fixed costs are expensed in the same period, which often results in lower reported profits when inventory increases. This discrepancy highlights the difference between marginal and absorption methods, especially for performance evaluation.
In periods of high production volume, absorption costing provides a buffer in the income statement. This can lead to a more stable presentation of earnings in financial reporting, but may also mask inefficiencies in cost management.
Use in External vs. Internal Reporting
Absorption costing is GAAP-compliant and is therefore required for external financial reporting in most jurisdictions, including under IFRS and U.S. GAAP. It ensures that all manufacturing costs are recognized as assets until the goods are sold, aligning with the matching principle of accounting.
In contrast, marginal costing is often used internally by managers for decision-making, budgeting, and cost control. Since it clearly separates variable and fixed costs, marginal costing provides valuable insights for assessing how costs behave in response to changes in production volume or sales activity.
Inventory Valuation and Cost Per Unit Calculations
Another fundamental difference between marginal costing and absorption costing is in the way they value inventory and calculate the cost per unit.
Under absorption costing, the cost per unit includes a portion of fixed manufacturing overhead, resulting in a higher valuation of closing inventory.
Under marginal costing, the cost of each unit includes only variable manufacturing costs, so the closing inventory is valued lower.
This difference affects the cost of goods sold and, consequently, the net profit reported in the financial statements.
Suitability for Managerial Decision-Making
Marginal costing provides a clearer view of how costs behave, making it more suitable for short-term managerial accounting, especially in cost-volume-profit (CVP) analysis, pricing decisions, and evaluating the financial impact of producing one more unit.
It simplifies decisions about discontinuing products, entering new markets, or accepting special orders, as it isolates variable costs associated with each scenario.
In contrast, absorption costing is less useful for such managerial purposes because it spreads fixed costs across all units, potentially distorting the cost structure of individual products.
Flexibility and Use in Different Costing Systems
Both methods can be adapted into other costing systems such as job costing, standard costing, and process costing. However:
Absorption costing provides a more accurate picture for long-term planning, where understanding total cost and external reporting is necessary.
Marginal costing offers greater flexibility in internal decision-making and evaluating the profitability of products or services with a more dynamic cost structure.
Companies often use absorption costing for official reporting and marginal costing for internal reports and operational decisions.
Conclusion
The key differences between absorption costing and marginal costing lie in how they handle fixed and variable manufacturing costs, the effect on profit, their role in financial vs. managerial reporting, and the valuation of inventory.
While absorption costing is an accounting requirement for external use under generally accepted accounting principles, marginal costing shines in providing insights for cost control and short-term decisions.
By understanding these costing methods, managers and accountants can determine the cost of products more effectively and select the approach best suited for their business needs. Whether the goal is to comply with external reporting standards or improve internal operations, choosing the right costing approach makes a significant difference in financial performance and strategic planning.
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