There are two alternative approaches for the valuation of inventory; they are Marginal Costing and Absorption Costing. In marginal costing, marginal cost is determined by bifurcating fixed cost and variable cost. Only variable costs are charged to operation, whereas the fixed cost are excluded from it and are charged to profit and loss account for the period.
Converselty, Absorption costing or otherwise known as full costing, is a costing technique in which all costs, whether fixed or variable are absorbed by the total units produced. It is aminly used for reporting purposes, i.e. for financial and tax reporting. There are many who say marginal costing is better, while others prefer absorption costing. So, one should know the difference between marginal costing and absorption costing to reach at conclusion, as to which one to be preferred over the other.
Content: Marginal Costing Vs Absorption Costing
|Basis for Comparison||Marginal Costing||Absorption Costing|
|Meaning||A decision making technique for ascertaining the total cost of production is known as Marginal Costing.||Apportionment of total costs to the cost center in order to determine the total cost of production is known as Absorption Costing.|
|Cost Recognition||The variable cost is considered as product cost while fixed cost is considered as period costs.||Both fixed and variable cost is considered as product cost.|
|Classification of Overheads||Fixed and Variable||Production, Administration and Selling & Distribution|
|Profitability||Profitability is measured by Profit Volume Ratio.||Due to the inclusion of fixed cost, profitability gets affected.|
|Cost per unit||Variances in the opening and closing stock does not influence the cost per unit of output.||Variances in the opening and closing stock affects the cost per unit.|
|Highlights||Contribution per unit||Net Profit per unit|
|Cost data||Presented to outline total contribution of each product.||Presented in conventional way.|
Definition of Marginal Costing
Marginal Costing, also known as Variable Costing, is a costing method whereby decisions can be taken regarding the ascertainment of total cost or the determination of fixed and variable cost to find out the best process and product for production, etc.
It identifies the Marginal Cost of production and shows its impact on profit for the change in the output units. Marginal cost refers to the movement in the total cost, due to the production of an additional unit of output.
In marginal costing, all the variable costs are regarded as product related costs while fixed costs are assumed as period costs. Therefore, fixed cost of production is posted to the Profit & Loss Account. Moreover, fixed cost is also not given relevance while determining the selling price of the product or at the time of valuation of closing stock (whether it is finished goods or Work in Progress).
Definition of Absorption Costing
Absorption Costing is a method for inventory valuation whereby all the manufacturing expenses are allocated to the cost centres to recognise the total cost of production. These manufacturing expenses include all fixed as well as variable costs. It is the traditional method for cost ascertainment, also known by the name Full Absorption Costing.
In an absorption costing system, both the fixed and variable costs are regarded as product related cost. In this method, the objective of the assignment of the total cost to cost centre is to recover it from the selling price of the product.
On the basis of function, the expenses are divided into Production, Administration and Selling & Distribution. The following are the types of Absorption Costing:
- Activity Based Costing
- Job Costing
- Process Costing
Key Differences Between Marginal Costing and Absorption Costing
The following are the major differences between marginal costing and absorption costing.
- The costing method in which variable cost is apportioned exclusively, to the products is known as Marginal Costing. Absorption Costing is a costing system in which all the costs are absorbed and apportioned to products.
- In Marginal Costing, Product related costs will include only variable cost while in the case of Absorption costing, fixed cost is also included in product related cost apart from variable cost.
- Marginal Costing divides overheads into two broad categories, i.e. Fixed Overheads and Variable Overheads. Look at the other term Absorption costing, which classifies overheads in the following three categories Production, Administration and Selling & Distribution.
- In marginal costing profit can be ascertained through the help of Profit Volume Ratio [(Contribution / Sales) * 100]. On the other hand, Net Profit shows the profit in case of Absorption Costing.
- In Marginal Costing variances in the opening and closing stock will not influence the per unit cost. Unlike Absorption Costing, where the variances between the stock at the beginning and the end will show its effect by increasing/decreasing per unit cost.
- In marginal costing, the cost data is presented to outline total cost of each product. On the contrary, in absorption costing, the cost data is presented in traditional way, net profit of each product is ascertained after deducting fixed cost along with their variable cost.
You can see the differences in the profits generated in the income statement by the two costing system because the absorption costing procedure, apportions fixed cost of production to the output whereas the marginal costing system ignores it. Moreover, the absorption costing is based on budgeted levels of output, but because fixed overheads remain same irrespective of the levels of output, it creates variances in the actual and the budgeted levels at the time of its recovery.