Absorption Costing V/s Marginal Costing

Marginal costing applies only those costs to inventory that were incurred when each individual unit was produced, while absorption costing applies all production costs to all units produced. This results in the following differences between the two methods:

• Cost application. Only the variable cost is applied to inventory under marginal costing, while fixed overhead costs are also applied under absorption costing.
• The profitability of each individual sale will appear to be higher under marginal costing, while profitability will appear to be lower under absorption costing.
• 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.

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 based on 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 considered 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

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).

An additional difference is that 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.

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
• Considers all production costs
• It helps in the estimation of job costs and profits on jobs by absorbing overheads into the costs of products.

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