Marginal Costing And Absorption Costing
Marginal costing and absorption costing are two different approaches used in managerial accounting to calculate the cost of producing goods or services. While both methods have their advantages and disadvantages, they differ primarily in how they treat fixed manufacturing overhead costs.
1. Marginal Costing (Variable Costing):
Marginal costing, also known as variable costing or direct costing, considers only the variable costs (costs that vary with the level of production) when calculating the cost of a product or service. Fixed manufacturing overhead costs are treated as period costs and are not allocated to individual units of production. Instead, they are expensed in the period incurred. Under marginal costing, the cost per unit includes only direct materials, direct labor, and variable manufacturing overhead costs. Marginal costing is particularly useful for short-term decision-making, such as pricing decisions and make-or-buy decisions.
Advantages of Marginal Costing:
- Provides a clear distinction between fixed and variable costs.
- Helps in analyzing the impact of changes in sales volume on profits.
- Useful for decision-making as it focuses on relevant costs.
Disadvantages of Marginal Costing:
- Fixed manufacturing overhead costs are not allocated to products, which may result in incomplete cost information.
- It can distort the overall profitability of the company in the long run.
- Financial statements prepared using marginal costing may not comply with generally accepted accounting principles (GAAP).
2. Absorption Costing (Full Costing):
Absorption costing, also known as full costing, considers both variable and fixed costs when calculating the cost of a product or service. It allocates fixed manufacturing overhead costs to individual units of production based on a predetermined rate (e.g., labor hours, machine hours). Under absorption costing, the cost per unit includes direct materials, direct labor, variable manufacturing overhead, and a share of fixed manufacturing overhead costs. Absorption costing is often used for external reporting and for preparing financial statements in compliance with GAAP.
Advantages of Absorption Costing:
- Provides a comprehensive view of the cost of production, including fixed manufacturing overhead costs.
- Helps in pricing decisions by considering the full cost of production.
- Complies with GAAP and is widely accepted for external reporting purposes.
Disadvantages of Absorption Costing:
- Fixed manufacturing overhead costs are allocated based on predetermined rates, which may result in cost distortions if the predetermined rates do not accurately reflect the actual usage of resources.
- It can make it challenging to analyze the impact of changes in sales volume on profits, as fixed costs are spread across units produced.
- May not be suitable for short-term decision-making due to the inclusion of fixed costs, which are not relevant in the short run.
In summary, marginal costing focuses on the behavior of costs in relation to production volume and treats fixed manufacturing overhead costs as period costs, while absorption costing considers both variable and fixed costs and allocates fixed manufacturing overhead costs to individual units of production. The choice between the two methods depends on the specific needs of a company and the purpose for which the cost information is being used.
