Absorption Costing vs Marginal Costing
The system of computing the cost of production is known as costing. The main purpose of any costing system is to identify the cost incurred for the production of a unit output. In a manufacturing company, identifying the cost associated with a unit product is very important to price the product such that the company could make a profit and survive to exist in the future. Both absorption costing and marginal costing are traditional system of costing. Both methods have their own pros and cons. In modern management accounting, there are some sophisticated costing methods such as activity based costing (ABC) that are very popular. Those methods are built up just by adding and amending some principles of the principles of traditional costing system.
Marginal costing calculates the cost to be incurred when an additional unit is produced. Prime cost, which includes direct material, direct labour, direct expenses, and variable overheads are the main components of marginal costing. Contribution is a concept developed along with marginal costing. Contribution is the net sales revenue to the variable cost. Under marginal costing methods, fixed costs are not taken into account based on the argument that fixed cost like factory rent, utilities, amortization, etc. are to be incurred, whether the production is done or not. In marginal costing, fixed cost are treated as period cost. Often managers require marginal costing to make decisions as it contains costs that vary with the number of unit produced. Marginal costing is also known as ‘variable costing’ and ‘direct costing’.
Under Absorption costing method, not only the variable costs, but fixed costs also absorbed by the product. Most accounting principles require absorption costing for the purpose of external reporting. This method is always used to prepare financial statements. Adsorption costing is used to calculate profit and stock valuation in the financial statement. As stock cannot be undervalued in this method, Inland Revenue requires this costing. Fixed costs are taken into account on the assumption that they must be recovered. The terms ‘Full absorption costing’ and ‘Full costing’ also denote the absorption costing.
What is the difference between Marginal Costing and Absorption Costing?
¤ Though, marginal costing and absorption costing are two traditional costing techniques, they have their own unique principles that draw a fine line that separates one from another.
¤ In marginal costing, contribution is calculated, whereas this is not calculated under absorption costing.
¤ When valuing the stocks under marginal costing, only the variable costs are considered, whereas valuation of stock under absorption costing includes costs incurred for the production function also.
¤ Generally, the value of inventory is higher under absorption costing than marginal costing.
¤ Marginal costing is often used for internal reporting purposes (facilitate the decision making of managers), while absorption costing is required for external reporting purposes, such as income tax reporting.
¤ Contribution must be calculated under marginal costing system, whereas gross profit will be calculated under absorption costing method.