Definitions and meanings:
Absorption Costing:
Absorption costing is a management technique to incorporate cost of fixed and variable production overheads into the cost of a product.
Marginal Costing:
Marginal costing is a management technique which is used to add variable production overheads into the cost of a product. Fixed costs are treated as period costs and written off in full against contribution under marginal costing.
Formulas:
Prime Cost/Total Direct Cost = Direct Labor + Direct Material + Direct Expenses
Production Overheads = Indirect Labor + Indirect Material + Indirect Expenses
Total Production Cost = Prime Cost + Production Overheads
Total Cost = Total Production Overheads + Total Non-production Overheads
Profit = Sales – Cost
Contribution = Sales – (Prime Cost + Variable Production Overheads)
Difference between absorption costing and marginal costing:
1. Basic Idea:
Absorption costing and marginal costing are both used to include production overheads into the cost of products of a business, but the basic difference between these two methods is that while calculating the cost of products absorption costing takes into account both variable and fixed production overheads whereas marginal costing only includes variable production overheads in cost of products. Any fixed costs are deducted from the contribution margin to obtain operating profit figure.
2. Adjustment of overheads:
Marginal costing considers only variable costs and then add them to reach the cost of a product. Due to this under marginal costing no under or over absorption of overheads occurs because only marginal or additional cost of making a product is added to the volume of production and other costs (fixed costs) are subtracted in full. However, under or over absorption of overheads can occur while implementing absorption costing because a predetermined overhead rate per product is set and applied to the volume of production. This absorption rate may vary from the actually absorbed overheads and so adjustment is made.
3. Inventory valuation:
Marginal costing does not take fixed costs into account while calculating the cost of products but absorption costing technique includes both variable and fixed costs into the cost of inventory. The value of finished goods is therefore lower if management uses marginal costing than if absorption costing is used.
4. Example:
Kim and Kat Co. manufactures shoes. The planned budget for the month of July is:
| Labor hours for making a pair of Shoes | 3.5 hours |
| Leather for making a pair of Shoes | 1.75 kg |
| Labor rate per hour | $2 per hour |
| Leather rate per kg | $2.5 per kg |
| Estimated production | 10,000 |
| Estimated Sales | 9,000 |
| Sales Price per unit | $40 per unit |
| Estimated fixed production overheads | $201,000 |
| Estimated Variable Production Overheads per Unit (Pair of shoes) | $ 1.3 per unit |
By applying absorption costing the total cost and profit of Kim and Kat Co. would be:
| Cost Activity | Sub-type of Cost | Calculation | Total |
| Prime Cost | Direct Labor | 3.5 hours × $2 per hour | $7 |
| Direct Material | 1.75 kg × $2.5 per kg | $4.4 | |
| Production Overheads (both variable and fixed manufacturing overheads will be considered) | Fixed Overheads | $201,000/10,000 units | $20.1 |
| Variable Overheads | $1.3 | $1.3 | |
| Cost per unit | – | – | $32.8 |
Profit = (Sales Price – Cost per unit) × Total number of sales
= ($40 – $32.8) × 9,000
= $7.2× 9,000
= $64,800
The total overheads estimated for the production of 10,000 pairs of shoes was $201,000 but as 9,000 units are sold fixed cost of ($20.1 × 9,000) $180,900 have become part of the cost of inventory. As, these overheads of $180,900 are estimated they can be adjusted after comparing them with actual figure of fixed overheads after the month of July.
By applying marginal costing, the total cost, contribution and profit of Kim and Kat Co. would be:
| Cost Activity | Sub-type of Cost | Calculation | Total |
| Prime Cost | Direct Labor | 3.5 hours × $2 per hour | $7 |
| Direct Material | 1.75 kg × $2.5 per kg | $4.4 | |
| Production Overheads (only variable manufacturing overhead would be considered) | Variable Overhead | $1.3 | $1.3 |
| Cost per unit | – | – | $12.7 |
Contribution = (Sales Price –Cost per unit) × Total number of sales
= ($40 – $12.7) × 9,000
= $27.3× 9,000
= $245,700
Profit = Total Contribution – Total Fixed overheads
= $245,000 – $201,000
= $44,700
It can be seen that profit reported under marginal costing is lower than the absorption costing because absorption costing includes fixed costs based in per unit terms to reach cost of product by treating it as product cost while marginal cost deducts all the fixed cost in full from total contribution because it treats fixed cost as period cost.
5. Reported Profits:
The value of closing stock is higher in absorption costing than marginal costing and as this closing stock is lessened from the cost of goods sold the reported profits under marginal costing are lower than reported under absorption costing.
6. Application:
Marginal costing is easy to apply than absorption costing because it only adds marginal costs to the cost of product which is easy to trace, whereas absorption costing method can become complicated to apply especially due to adjustment of under or over absorbed overheads. Marginal costing can be used for decision-making purposes of the management because it does not follow accounting standards in terms of inventory valuation. Absorption costing can be used for reporting purposes because according to standards it shares fixed production overheads between units of production. Absorption costing is not suitable to make well-grounded management decision because absorption costing considered fixed cost while costing products and irrespective of the level of production these costs do not change while marginal costing is based purely on variable cost which can be influenced by the management.
Absorption costing versus marginal costing – tabular comparison
A tabular comparison of absorption costing and margin costing is given below:
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| Basic Idea | ||||
| Incorporates both fixed and variable production overheads. | Incorporated variable production overheads only. | |||
| Adjustment of Overheads | ||||
| Budgeted overheads are reconciled with the actual overheads to adjust for over or under absorption. | No adjustment of overheads is necessary because fixed costs are deducted in full. | |||
| Inventory Valuation | ||||
| Value of inventory is higher because fixed costs are also added while calculating cost of inventory. | Value of inventory is lower because fixed costs are not added while calculating cost of inventory. | |||
| Reported Profits | ||||
| Closing stock is of higher value therefore reported profits are higher. | Closing stock is of lower value therefore reported profits are lower. | |||
| Application | ||||
| Can become complicated to implement and is not suitable for effective decision-making. | Is easily understandable by the management and is suitable for planning purposes. | |||
Conclusion – absorption costing vs marginal costing
Costing for a business is an exercise of vital importance. A business cannot sell its products unless it knows the total costs that are incurred to produce them. Costing has various other uses including valuation of inventory, the determination of a suitable selling price for the products of business and the calculation of profitability of the organization. This is the reason why reliable estimation of costs is necessary for businesses.
