Difference between Absorption Costing and Marginal Costing

Everything you need to know about the key differences between absorption costing and marginal costing.

Absorption costing is a total cost technique in which total cost (i.e., fixed and variable) are charged to products. It is often argued that absorption costing is an orthodox or traditional method and that marginal costing is the correct technique.

Fixed costs are ignored. This is on the assumption that for additional output only variable costs are incurred, since fixed costs remain constant.

ADVERTISEMENTS:

The main points of difference between absorption costing and marginal costing are as follows:-

1. Cost Recognition 2. Classification of Costs 3. Treatment of Fixed Overheads 4. Time of Charging Fixed Overheads 5. Valuation of Inventory 6. Decision Making 7. Reporting 8. Income Recognition.

Difference between Absorption Costing and Marginal Costing – 5 Main Points

The difference between absorption costing and marginal costing is based on the recovery of fixed overheads. In absorption costing both fixed and variable overheads are charged to production. As a result, work in progress and finished goods are valued at ‘works cost’ and ‘total cost of production’ respectively, giving effect to fixed overheads.

In marginal costing only variable overheads are charged to production, thereby leading to under-recovery of overheads. This obviously leads to undervaluation of closing stock. But this does not result in carrying over of fixed overheads of one period to another, as it happens in absorption costing.

ADVERTISEMENTS:

The main points of difference between absorption costing and marginal costing may be tabulated as below:

Difference – Absorption Costing:

1. Fixed overheads are charged to the product to be subsequently released as a part of cost of goods sold i.e., it is included in cost per unit.

2. Profit is the difference between sales and cost of goods sold.

ADVERTISEMENTS:

3. Costs are rarely classified into variable and fixed. Although such a classification is possible, it fails to establish a cost-volume profit relationship.

4. If inventories increase during a period, this method will reveal more profit than marginal costing. When inventories decrease, less profits are reported because in this method closing stock is valued at higher figures. Since inventories are valued at total cost, a portion of fixed overheads is also included in inventories.

5. Apportionment of fixed costs is arbitrary and this may result in under recovery of overheads.

Difference – Marginal Costing:

ADVERTISEMENTS:

1. Fixed costs are not included while computing cost per unit.

2. Profit in marginal costing is ascertained by establishing the total contribution and then deducting therefrom the total fixed expenses. Contribution is the excess of sales over variable cost.

3. Cost-volume profit relationship is an essential part of marginal costing studies. Costs have to be classified into fixed costs and variable costs.

4. If inventories increase during a period, this method generally reports less income than absorption costing; but when inventories decrease this method reports more net income. The difference in the net income is due to difference in accounting for fixed manufacturing costs as compared to inventory valuation.

ADVERTISEMENTS:

5. There is no arbitrary apportionment of fixed overheads, as fixed costs are excluded.

Difference Between Absorption Costing and Marginal Costing – 4 Points of Differentiation

The points of differentiation between these two techniques are as follows:

1. Treatment of Fixed and Variable Costs:

ADVERTISEMENTS:

In marginal costing, only variable costs are charged to products. Fixed costs are treated as period costs and charged to profit and loss account of the period.

Absorption costing is a total costing technique. It is the practice of assigning all costs (both fixed and variable) to products.

2. Valuation of Stock:

In marginal costing, stocks of work-in-progress and finished goods are valued at marginal cost only.

ADVERTISEMENTS:

In absorption costing, stocks are valued at total cost which includes both fixed and variable costs. Thus stock values in marginal costs are lower than that of absorption costing.

3. Under/Over-Absorption of Overheads:

In marginal costing, since fixed costs are excluded from product costs, the problem of apportionment of fixed overhead does not arise. There is thus no question of under/over-absorption of overheads.

In absorption costing, as fixed costs are included in product costs, these are apportioned to various products, processes or operations which is really on an arbitrary basis. This leads to under/over-absorption of overheads.

4. Measurement of Profitability:

In marginal costing, relative profitability of products or departments is based on a study of relative contributions made by respective products or departments. The managerial decisions are thus guided by contribution.

ADVERTISEMENTS:

In absorption costing, relative profitability is judged by profit figures which are also a guiding factor for managerial decisions.

Difference Between Absorption Costing and Marginal Costing – 8 Key Differences

Difference – Absorption Costing:

1. Cost Classification – All cost i.e., variable manufacturing cost and fixed overheads are charged to product. There is no need of classifying cost into variable and fixed.

2. Profit ascertainment – Profit is ascertained between sales minus total cost.

3. Fixed Cost – Fixed cost is added to the cost of production.

4. Decision Making – Not useful for decision making.

5. Stock Valuation – Value of stock is overvalued because of the inclusion of both variable and fixed cost.

6. Effect of stock valuation – Increase in stock shows higher profit and vice versa.

7. Period cost v/s product cost – Closing Stock is valued at total cost. Thus fixed cost is also included in it and is carried forward to next year and thus treated as product cost.

8. Cost Volume Profit (CVP) Relationship – It fails to establish the analysis of cost, volume and profit (CVP).

Difference – Marginal Costing:

1. Cost Classification – It requires classification of cost into fixed cost and variable cost and only considers variable cost as cost of production.

2. Profit ascertainment – Profit is ascertained by deducting only variable cost from sales and is known as marginal contribution (S – V). Increase in contribution means increase in profit.

3. Fixed Cost – Fixed cost is not added to the cost of production.

4. Decision Making – Useful for decision making.

5. Stock Valuation – Value of stock is comparatively undervalued as only variable cost is included.

6. Effect of stock valuation – Increase in stock results in lower profit and vice versa.

7. Period cost v/s product cost – Closing stock is valued at only variable (Marginal) cost. Fixed cost is added back to the profit of that year and thus treated as period cost.

8. Cost Volume Profit (CVP) Relationship – CVP analysis is the primary part of the marginal costing.

Difference Between Absorption Costing and Marginal Costing

Difference – Absorption Costing:

1. All costs — fixed and variable are charged to product.

2. Profit = Sales — Cost of goods sold.

3. It does not reveal the cost volume profit relationship.

4. Closing inventories are valued at full cost. Absorption costing reveals more profit since the inclusion of fixed costs in inventories.

5. Costs are included in the products, this leads to over or under- absorption.

Difference – Marginal Costing:

1. Only variable costs are charged to products; fixed costs are transferred to Profit & Loss Account.

2. Contribution margin = S — VC. Profit = Contribution – F.C.

3. Cost volume profit relationship is an important part of marginal costing.

4. Closing inventories are valued at variable cost. Marginal costing reveals less profit, when compared to absorption cost.

5. Fixed costs are not included in the product; so it will not lead to the problem of under-absorption.

Difference Between Absorption Costing and Marginal Costing – Explained!

Marginal costing differs from absorption or traditional costing. Under absorption costing, full costs are charged to production i.e., all fixed and variable costs are recovered from production, while under marginal costing, only variable costs are charged to production. Fixed costs are ignored. This is on the assumption that for additional output only variable costs are incurred, since fixed costs remain constant.

There is no reason, therefore to burden the additional output with the share of fixed overheads, otherwise it gives a wrong idea about the likely profits to be earned on additional sales. On account of recovery of only variable costs to production, the valuation of closing stock is also made at marginal costs under marginal costing system. Thus, mainly there are two differences between the absorption costing system and the marginal costing system.

1. Valuation of Stocks:

Stocks of works-in-progress and finished goods are valued at works cost (including fixed works overheads) and total cos.t of production (including fixed works overheads and office overheads) respectively under absorption costing system. The two stocks are valued at marginal cost under marginal costing system. This will result in under-valuation of stocks under the later system.

2. Absorption of Overheads:

There can be under-recovery of overheads under marginal costing system as only variable overheads are absorbed to production. Under absorption costing system, all variable and fixed overheads are absorbed to production. In marginal costing actual fixed overheads are wholly transferred to Costing Profit and Loss Account, while in absorption costing, the over-or under- recovery of overheads can be transferred to Costing Profit and Loss Account.

On account of the above differences, the treatment of costs and profit differ under marginal costing and absorption costing systems. Since marginal costing system lays stress on contribution i.e., sales minus variable cost, any increase in contribution would mean increase in profit, since fixed costs remain constant for all levels of production. Profit is arrived at after deducting fixed costs from the contribution fund. Under absorption costing, all the costs are first charged to products and then total costs are deducted from sales to arrive at the figure of profit.

The above differences can be summarized as under:

Difference – Absorption Costing:

1. Charge – Full costs (fixed and variable) are charged to production.

2. Classification – Expenses are classified on functional basis.

3. Consideration of cost – Fixed costs are considered inventariable costs.

4. Focus – The emphasis is on profit (sales minus total cost).

5. Inventory Valuation – Basis of inventory valuation takes into account fixed component of overheads.

6. Overheads Absorption – Since all overheads are absorbed to production, over-recovery of overheads can be there.

7. Treatment of Overheads – Over under-recovery of overheads can be transferred to Costing Profit & Loss Account.

8. Decision-Making – Product Costing depends on total cost per unit.

Difference – Marginal Costing:

1. Charge – Only variable costs are charged to production.

2. Classification – The classification is as per nature of expenses- fixed and variable.

3. Consideration of cost – Fixed costs are considered as period costs.

4. Focus – The thrust is on contribution (sales minus variable cost). Increase in contribution means increase in profit.

5. Inventory Valuation – Inventories are valued at marginal or variable cost.

6. Overheads Absorption – On account of only variable overheads being absorbed to production, there can be under-recovery of overheads.

7. Treatment of Overheads – Actual fixed overheads are wholly transferred to Costing Profit and Loss Account.

8. Decision-Making – Product costing considers only the variable costs, hence decision making is affected.

Difference Between Absorption Costing and Marginal Costing – 6 Points of Distinction

Difference – Absorption Costing:

1. Under absorption costing, unit cost is calculated on the basis of full cost of production.

2. Under absorption costing, a part of the current period’s fixed manufacturing cost is carried forward to next period with the value of closing stock.

3. Under absorption costing, profit will fluctuate with the change in stock level.

4. Absorption costing is suitable for external reporting. This method is acceptable for valuation of closing stock as per AS-2 “Inventories”.

5. Absorption costing is not suitable for CVP analysis.

6. If absorption costing is followed, under absorption / over absorption of overhead may arise if actual production is not equal to normal production.

Difference – Marginal Costing:

1. Under marginal costing, unit cost is calculated on the basis of marginal cost of production.

2. Under marginal costing, no part of the current period’s fixed manufacturing cost is carried forward to next period. All fixed costs are treated as period cost and charged to Profit and Loss Account.

3. Under marginal costing, profit is not affected by the change in stock level.

4. Marginal costing is suitable for internal reporting. This method is not acceptable for valuation of stock as per AS-2 “Inventories”.

5. Marginal costing is suitable for CVP analysis.

6. In marginal costing, question of under absorption / over absorption of overhead does not arise because no part of the fixed manufacturing overhead is charged to production unit.

Difference Between Absorption Costing and Marginal Costing

The distinction between the two approaches lies essentially in the treatment of fixed manufacturing overheads.

The points of difference are the following:

(i) Recovery of Overheads:

In case of absorption costing, these form part of the cost of products and are included in the unit cost calculations. Here, an attempt is made’ to absorb or recover all the costs of the enterprise, including the fixed overheads. With marginal costing, fixed manufacturing costs are charged to the period to which they relate. They do not become a part of per unit cost of the product. Thus, while absorption costing gives “net income”, marginal costing gives “contribution margin”.

Take a simple example. Of a certain product, direct materials cost per unit is Rs.10, direct labour cost Rs.6, variable manufacturing overheads Rs.4, and fixed manufacturing overheads Rs.3. Here, the absorption cost per unit works out to Rs.23; and the marginal cost Rs.20 only. The marginal cost per unit is lower simply because of the exclusion of the fixed manufacturing overheads. Under the absorption costing technique, it is very much a part of the product cost.

(ii) Inventory Valuation:

In absorption costing, stocks of work-in-progress and finished goods are valued at ‘works cost’ and ‘total cost of production’ respectively. The works cost or cost of production is so defined as to include the amount of fixed overheads also. In marginal costing, only variable costs are considered while computing the value of work-in-progress or finished goods.

Thus, the closing stock in marginal costing is under-valued as compared to absorption costing. But this does not result in carrying over of fixed overheads of one period to another as it happens in absorption costing.

Difference Between Absorption Costing and Marginal Costing – 8 Key Points of Distinction

The following are the differences between marginal costing and absorption costing:

Difference – Absorption Costing:

1. Cost recognition – Both variable costs and fixed costs are included in the total cost.

2. Classification of costs – Costs are classified on functional basis as production, administration, selling and distribution costs.

3. Treatment of fixed overheads – Fixed overheads are included in the total cost.

4. Time of charging fixed overheads – A part of fixed cost included in stocks are transferred to the next year.

5. Valuation of inventory – Stocks are valued on total cost i.e. both variable and fixed costs are included in stock values.

6. Decision making – Not of much help to management in decision making.

7. Reporting – It is suitable for external reporting.

8. Income recognition – Stock valuation is accepted by tax authorities.

Difference – Marginal Costing:

1. Cost recognition – Only variable cost is included in the total cost.

2. Classification of costs – Costs are classified into variable and fixed costs.

3. Treatment of fixed overheads – Fixed overheads are charged to profit and loss account.

4. Time of charging fixed overheads – Fixed overheads are charged to the period in which they are incurred.

5. Valuation of inventory – Stocks are valued on variable cost basis only.

6. Decision making – Helpful to management in decision making.

7. Reporting – It is suitable for internal reporting.

8. Income recognition – Stock valuation is not acceptable to income tax authorities.

Difference Between Absorption Costing and Marginal Costing

The difference between marginal costing and absorption costing are as under:

(1) Part of cost – Under Absorption costing, fixed cost form part of total cost, while it does not form part of cost of production under marginal costing.

(2) Valuation of stock – Under absorption costing value of stock includes fixed expenses also. But under marginal cost fixed expenses are not included.

(3) Applications – Under Absorption costing, it is supposed that it is suitable for determination of long term cost and price. But marginal costing is used for solving various managerial decisions.

(4) Recovery of fixed cost – Under absorption costing both fixed and variable cost are recovered in cost of production. But under marginal costing fixed overheads are fully charged against contribution in the determination of profits.

(5) Variation in profit – If there is no sale in any period, the entire stock is carried forward and there is no loss under absorption costing. But under marginal costing, the entire fixed expenses are treated as loss.

(6) Emphasis – Absorption costing lays emphasis on production, while marginal costing stress is given on sales as well as variable costs.

Difference Between Absorption Costing and Marginal Costing – 6 Main Points of Distinction

The difference between Marginal Costing and Absorption Costing are as follows:

Difference – Absorption Costing:

1. The cost per unit reduces as the production increases because it includes fixed cost also.

2. As the levels of production vary from period to period, costs are found to be different due to inclusion of fixed cost under this method.

3. Stock is valued at total cost which includes fixed cost as well.

4. It is suitable for decision-making.

5. Problem of under- or over-absorption of fixed overheads.

6. Fixed cost is charged to cost of production.

Difference – Marginal Costing:

1. Marginal cost remains the same per unit.

2. It is not so with the marginal costing because this method does not include fixed cost.

3. Stock is valued at Marginal cost only.

4. It is suitable for decision-making.

5. No such problem in Marginal costing.

6. Fixed cost is treated as period cost. The profitability is judged by P.V. Ratio.