Marginal Costing vs Absorption Costing Marginal costing and absorption costing are two different methods of cost accounting.
Marginal costing is a cost accounting method in which only variable costs are allocated to the product or service being produced. Fixed costs are not included in the product or service cost. This method is useful in decision-making because it reflects the incremental costs and revenues associated with producing one more unit of a product or providing one more service.
Absorption costing, on the other hand, is a cost accounting method in which both fixed and variable costs are allocated to the product or service being produced. This means that the total cost of the product or service includes not only the direct costs of production but also a portion of the overhead costs. The overhead costs are absorbed or allocated to the product or service based on a predetermined overhead absorption rate.
Both methods have their own advantages and disadvantages, and the choice of which method to use depends on the specific needs of the business.
Marginal costing vs absorption costing advantages and disadvantages
Here are some advantages and disadvantages of marginal costing and absorption costing:
Advantages of marginal costing:
- Reflects the incremental costs and revenues associated with producing one more unit of a product or service, which is useful in decision-making
- Simplifies the calculation of product or service cost because only variable costs are included
- Provides a better understanding of the contribution margin, which is the difference between the selling price of a product or service and its variable cost
Disadvantages of marginal costing:
- Does not reflect the total cost of production, as fixed costs are not included in the product or service cost
- Does not provide a true picture of the profitability of a product or service, as fixed costs are not recovered through the sale of the product or service
- May lead to under-absorption of fixed costs, which can result in incorrect pricing decisions
Advantages of absorption costing:
- Provides a true picture of the total cost of production, as both fixed and variable costs are included in the product or service cost
- Helps in the proper utilization and control of resources because all costs are recognized and accounted for
- Facilitates the preparation of financial statements in accordance with Generally Accepted Accounting Principles (GAAP)
Disadvantages of absorption costing:
- Complicates the calculation of product or service cost because both fixed and variable costs are included
- May lead to over-absorption of fixed costs, which can result in incorrect pricing decisions
- Does not reflect the incremental costs and revenues associated with producing one more unit of a product or service, which is important in decision-making
Why is absorption costing better than marginal costing?
Absorption costing is generally considered to be a better method of cost accounting than marginal costing because it provides a true picture of the total cost of production. This is because both fixed and variable costs are included in the product or service cost, which helps in the proper utilization and control of resources. In contrast, marginal costing only includes variable costs in the product or service cost, which means that fixed costs are not recovered through the sale of the product or service.
Additionally, absorption costing facilitates the preparation of financial statements in accordance with Generally Accepted Accounting Principles (GAAP). This is because GAAP requires that both fixed and variable costs be included in the calculation of product or service cost.
However, it’s important to note that absorption costing has its own disadvantages, such as the complexity of calculating product or service cost and the potential for over-absorption of fixed costs, which can result in incorrect pricing decisions. Ultimately, the choice of which cost accounting method to use depends on the specific needs of the business.
Marginal costing and absorption costing Formula
Marginal costing is a costing method that only includes the variable costs in the cost of a product or service. The formula for calculating the cost using marginal costing is:
Cost = Variable costs
Absorption costing, on the other hand, includes both fixed and variable costs in the cost of a product or service. The formula for calculating the cost using absorption costing is:
Cost = Fixed costs + Variable costs
Both marginal and absorption costing methods can be useful in different situations. Marginal costing is often used in decision-making, because it provides a more accurate representation of the additional costs incurred by producing one more unit of a product or providing one more service. Absorption costing, on the other hand, provides a more comprehensive view of the overall cost of a product or service, which can be useful in financial reporting and other contexts.
How do you calculate absorption?
To calculate the absorption cost of a product or service, you need to know the total fixed costs and total variable costs incurred in producing it. You can then use the following formula:
Absorption cost = Fixed costs + Variable costs
For example, let’s say a company has fixed costs of $10,000 per month and variable costs of $5 per unit produced. If the company produces 1,000 units in a month, the absorption cost per unit will be:
Absorption cost per unit = $10,000 + ($5 x 1,000 units) = $15,000 / 1,000 units = $15 per unit
This means that the total cost of producing each unit of the product is $15, which includes both the fixed and variable costs.
It’s important to note that the absorption cost per unit will change if the number of units produced or the fixed or variable costs change. To get the total absorption cost for a given period, you would need to multiply the absorption cost per unit by the number of units produced.
Is absorption costing and marginal costing the same?
No, absorption costing and marginal costing are two different methods of costing that are used to calculate the cost of a product or service.
Absorption costing includes both fixed and variable costs in the cost of a product or service, while marginal costing only includes the variable costs. This means that the total cost calculated using absorption costing will be higher than the total cost calculated using marginal costing, because it includes a larger portion of the costs incurred in producing a product or providing a service. Marginal Costing vs Absorption Costing:
Both methods can be useful in different contexts. Marginal costing is often used in decision-making, because it provides a more accurate representation of the additional costs incurred by producing one more unit of a product or providing one more service. Absorption costing, on the other hand, provides a more comprehensive view of the overall cost of a product or service, which can be useful in financial reporting and other contexts.
