The difference between marginal costing and absorption costing
/What is Marginal Costing?
Marginal cost is the cost of one additional unit of output. The concept is used to determine the optimum production quantity for a company, where it costs the least amount to produce additional units. It is calculated by dividing the change in manufacturing costs by the change in the quantity produced.
What is Absorption Costing?
Absorption costing is a method for accumulating the costs associated with a production process and apportioning them to individual products. This type of costing is required by the accounting standards to create an inventory valuation that is stated in an organization's balance sheet.
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Comparing Marginal Costing and Absorption Costing
The following differences exist between the marginal costing and absorption costing methods:
Accounting framework requirement. Absorption costing is required by the applicable accounting frameworks for financial reporting purposes, so that factory overhead will be included in the inventory asset. Marginal costing is not allowed for financial reporting purposes, so its use is restricted to internal management reports.
Amount of cost being applied. Only the variable cost is applied to inventory under marginal costing, while fixed overhead costs are also applied under absorption costing. This can result in much higher total costs being applied under absorption costing, especially when a business has a large fixed cost base that must be allocated.
Amount of reported profitability. The profitability of each individual sale will appear to be higher under marginal costing, while profitability will appear to be lower under absorption costing. This is because fixed costs are also being applied under absorption costing, which is not the case under marginal costing.
Timing of expense recognition. Overhead costs are charged to expense in the period under marginal costing, whereas they are applied to products under the absorption costing method (which may defer expense recognition to a later period).
Types of measurements used. The measurement of profits under marginal costing uses the contribution margin (which excludes applied overhead), while the gross margin (which includes applied overhead) is used under absorption costing. The reported contribution margin will always be larger than the reported gross margin.