Difference Between Absorption Costing and Marginal Costing

Inventory valuation is a major component in the calculation of the cost of goods sold and can be used as collateral for loans. It can be defined as the cost associated with the inventory in an entity at the end of the reporting period. Inventory valuation is based on the costs incurred by an entity to acquire the inventory. 

The importance of inventory valuation is;

• It impacts reported profit levels whereby if an entity records a higher valuation in ending inventory, fewer expenses are charged to the cost of goods sold. On the other hand, if an entity records a lower valuation in ending inventory, more expenses are charged to the cost of goods sold. 
• In cases whereby an entity has undertaken a loan amount from the lender, there may be an agreement which restricts the set allowed amount of current assets to current liabilities. The inventory valuation is critical since inventory is the largest part of the current ratio. 
• Income taxes- Inventory valuation affects income tax, whereby the chosen method of handling cost flow can either reduce or increase the total amount of income taxes paid.  

There are two commonly used approaches in the valuation of inventory. These are absorption costing and marginal costing. 

What is an Absorption Costing?

Also referred to as full costing, it is a costing system whereby all manufacturing costs, including variable and fixed costs, are assumed to be product costs. The period costs, in this case, include administrative, selling and general costs which do not go into the cost of the product but are expensed at the period incurred. The product costs including variable manufacturing overhead, direct labor, fixed manufacturing overhead, and direct material are costs that go into the product. 

The advantages associated with absorption costing include;

• It is GAAP (Generally Accepted Accounting Principles) compliant
• Takes into account all production costs
• It helps in the estimation of job costs and profits on jobs by absorbing overheads into the costs of products.

It, however, has some disadvantages

• It provides a poor analysis of the costs of products 
• It can negatively affect a company’s profit level because all fixed costs are not subtracted from revenue unless the products are sold
• It is complex to operate

What is a Marginal Costing?

A marginal cost is the cost of one additional unit of output. Marginal costing is a costing technique whereby the marginal cost is charged to units of costs while the fixed cost is completely written off against the contribution. 

Marginal costing is helpful in certain decision making in a business on matters such as whether to carry on with a service or product, replacement of machinery and in ascertaining the appropriate level of activity, through the break-even analysis. This helps in the reflection on how the overall profit is affected by the decrease or increase in production levels. 

In marginal costing;

• The prices are determined on the basis of marginal contribution and marginal cost
• Costs involved are variable and fixed costs and are classified on the basis variability
• The profitability of a product is based on the contribution margin
• Only variable costs are taken into account when valuing the finished goods and work in progress

Advantages of marginal costing are;

• Fixed costs are classified as a period cost and are charged in full to the period in mention
• It is helpful in the decision-making process
• It prevents under or over-absorption of overheads
• Contribution per unit is constant and does not change in change volumes
• It is simple to operate

It, however, has some disadvantages

• The closing is not valued according to accounting standards
• Fixed production costs are not spread out between units of production

Similarities between absorption costing and marginal costing

• Both play a huge role in inventory valuation

Differences between Absorption Costing and Marginal Costing

1. Definition of Absorption and Marginal Costing

Absorption costing is a costing system whereby all manufacturing costs, including variable and fixed costs, are classified as part of product costs while marginal costing is a costing technique whereby the marginal cost is charged to units of costs while the fixed cost is completely written off against the contribution. 

2. Costs involved in  Absorption and Marginal costing

In absorption costing, both variable and fixed costs are considered in the cost of the product. On the other hand, in marginal costing, only variable costs are considered as product cost and fixed costs are classified as period costs. 

3. Contribution per unit

In absorption costing, contribution per unit is considered while in marginal costing, net profit per unit is considered. 

4. Costs per unit

In absorption costing, major consideration on the cost of each unit is given priority. However, in marginal costing, major consideration on the cost of producing the next unit is given priority. 

5. Overheads recovery

Absorption costing emphasizes overheads recovery while marginal costing emphasizes the calculation of the contribution of each unit. 

6. Classification of overheads

In absorption costing, overheads are classified into administration, production, distribution and selling overheads. On the other hand, in marginal costing, overheads are classified into fixed and variable overheads.

7. Ease of operation

While absorption costing is not easy to operate, marginal costing is easy to operate. 

8. Effect on cost per unit

In absorption costing, the cost per unit is affected by variances in the opening and closing stock while in marginal costing the cost per unit is not affected by variances in the opening and closing stock. 

9. GAAP compliance

While absorption costing is GAAP compliant, marginal costing is not GAAP compliant. 

10. Reporting

Absorption costing is used for external reporting to the government, tax authorities and shareholders while marginal costing is used for internal reporting particularly to the management for decision making. 

11. Decision making

While absorption costing is not very helpful in making managerial decisions, marginal costing is helpful in decision making due to the fact that it considers additional costs involved. 

Absorption costing vs. Marginal costing: Comparison Table

Summary of Absorption Costing vs. Marginal Costing

Profits generated differ, depending on which costing method is used. This is because the absorption costing method includes fixed production costs to the output while the marginal costing method does not. Absorption costing also creates variances in the budgeted and actual levels because fixed overheads remain the same, irrespective of the levels of output. Both can be used, depending on an entity’s preference and business models. 

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