Variable or marginal costing and full or absorption costing methods are two widely used inventory costing methods. Both come with different advantages and some limitations to implement.
The marginal costing method helps a company in key decisions such as operational efficiency and control measures. The absorption method allocates full production costs and offers accurate final pricing information.
Let us discuss both costing methods with the help of simple working examples and see their key differences.
What is Marginal Costing?
Marginal costing is the method of allocating variable costs of production to products. It is the measure of change in cost with respect to the change in quantity produced.
A product incurs two types of costs; fixed costs and variable costs. Fixed costs remain the same regardless of the production output. In contrast, variable costs change with a change in the production output.
Variable costs of production include direct material, direct labor, and direct equipment costs. Some overheads such as utilities for production can also be considered variable costs of production.
For instance, if a particular machine is used for the production facility, the energy cost that varies with the production level can be included in the total marginal cost of production.
Calculation Formula of Marginal Costing
The marginal cost can be calculated through the contribution margin formula.
The contribution margin is the sales less variable cost of production. The profit is contribution margin less fixed costs of production.
Another way of calculating the marginal cost is to record the change in production related to the change in quantity.
Marginal Cost = Change in Cost/Change in Quantity
A change in cost comes through the changing level of variable costs. The fixed costs will remain constant up to a certain production level.
Example of Marginal Costing
Suppose a company ABC produces eyeglass frames. The following data is available for its production facility.
- Units Produced in month 1= 10,000
- Units produced in month 2 = 15,000
- Variable Costs in month 1= $ 50,000
- variable costs in month 2 = $ 80,000
Marginal Cost = Change in cost/change in quantity
Marginal Cost = (80,000 – 50,000)/ (15,000 – 10,000)
Therefore, Marginal Cost = 30,000/5,000 = $ 6 per unit.
Let us consider another example using a different approach.
ABC company sells electric gadgets. The following data is available for the current month-end.
- Units Produced = 2,000
- Units sold = 1,700
- Selling price per Unit = $ 80
- Unit Costs: Direct Material = $30 and Direct Labor = $15
- Variable production Overheads= $5
- Fixed production Overheads = $5
- Fixed Costs = $ 50,000
- Total Variable Cost per unit = $ 55
|Sales (1,700 × 80)||$ 136,000|
|Variable Costs (1,700 × 55)||(93,500)|
|Closing Inventory (300 ×80)||24,000|
|Fixed Production Costs||(50,000)|
Pros and Cons of Marginal Costing
Marginal costing is a useful approach that keeps the contribution margin at the same level regardless of the production changes. It helps management in decision-making regarding product costs and pricing.
Marginal costing differentiates between the direct and indirect costs of production. It considers direct costs of production (variable costs) that affect the pricing strategy of the product.
Fixed costs are considered periodic costs in the marginal costing approach. The concept argues that fixed costs incur regardless of the production level changes. Thus, should be allocated for the production instead of cost per unit.
The disadvantage of the marginal costing approach is that it is not in accordance with accounting standards such as US GAAP. Public companies cannot adopt marginal costing against compliance rules.
Another drawback of marginal costing is that it considers fixed costs in full for the complete production period. That can distort the unit selling pricing of products. Also, it can result in inaccurate inventory costing.
What is Absorption Costing?
Absorption costing is a costing method that includes all direct costs of production including variable costs and fixed overhead costs.
Marginal costing includes all variable costs of production plus direct fixed overheads. Variable costs include direct material, direct labor, and other direct production costs.
Some fixed costs are direct product costs as well. For example, if machinery is leased to produce a specific product its lease payment is a direct production overhead cost. Thus, it should be included in the absorption costing method.
Unlike the marginal costing method, absorption costing allocates full costs of production to the per unit analysis. Hence, it is also called the full costing method.
The ending inventory amount will be different for a company using absorption costing than by using marginal costing that only considers variable costs.
Calculation Formula of Absorption Costing
The absorption costs can be calculated by adding fixed overheads to the costs of goods sold formula.
A general format for calculating the absorption costs can be given as below:
|Cost of Goods Sold:|
|Under/Over Absorption (If any)||X/(X)|
A key line item in this method is the adjustment for under or over-absorption costs. These costs may need adjustments if the total fixed overheads and absorbed overhead costs are different.
Example of Absorption Costing
Suppose ABC Company produces eyeglass frames. The following data for one production period is available. We’ll calculate the profits using the absorption costing method.
- Units Produced = 10,000
- Units Sold during period = 9,000
- Unit Price = $ 50
- Direct Material = $ 20
- Direct Labor = $ 5
- Other variable costs = $ 5
- Fixed Overheads = $ 5
- Fixed Costs = $ 30,000
|Cost of Goods Sold:|
|Over Absorption – W1||$ 20,000|
|Non-Production Costs||($ 30,000)|
|Net Profit||$ 255,000|
Fixed overheads absorbed = 10,000 × 5 = $ 50,000
Less: Overheads incurred = $ 30,000
Over absorption = $ 20,000
Pros and Cons of Absorption Costing
The absorption costing method of inventory is in accordance with the accounting standards such as US GAAP. It means all public companies must implement this rule; thus, compliance is its foremost advantage.
The absorption costing also includes fixed overheads that are direct costs of production. It reduces the profits but offers a realistic approach.
The full costing approach helps a company find appropriate and competitive product pricing. Then, there is an adjustment for any over and under absorption of fixed overheads. Thus, there is little left after considering the full costs of production.
The biggest disadvantage of the absorption method is it does not help management in the decision-making process. It is difficult to calculate actual production costs that are direct and variable to product only.
Another drawback of the full costing method is that it may hide fixed costs from the income statement. The fixed costs are allocated as production costs that means shifting fixed costs from the income statement to the balance sheet.
Marginal Costing Vs Absorption Costing – Understanding Differences
Marginal costing and absorption costing are both widely used inventory valuation methods. Even if a company does not need to use marginal costing for reporting purposes, it is used for pricing decisions.
Here are a few key differences in both costing methods.
Marginal costing is a costing method that considers the change in cost for producing one additional unit. It considers the change in cost against the change in production level.
Absorption costing is the full costing method that includes direct and indirect production costs.
Marginal costing includes only direct and variable production costs. These costs include direct material, direct labor, and other direct costs.
Absorption costing considers fixed overheads in addition to variable costs.
Impact on Inventory
The marginal costing values closing inventory at a lower cost per unit since it does not account for the fixed overheads. It means the COGS figure will be higher in this method.
Contrarily, the COGS figure will be lower in the full costing method as it also considers the fixed overhead costs. Thus, closing inventory will be recorded at a higher cost per unit.
Impact on Profits
The marginal costing calculates the contribution margin initially. As the COGS will be higher in this method, the gross profits will be lower.
The absorption costing, on the other hand, will show slightly higher profits.
Help in Decision-Making
The marginal costing method helps management in key decisions such as product pricing and operating efficiency matters.
Absorption costing includes fixed overheads that do not help in decision-making. However, the full costing method is useful in determining the selling price per unit.
Reporting and Compliance
The variable costing method is simple to implement and easier to apply. However, most accounting standards do not support this method.
It means most companies would need to follow the absorption costing method at some stage for compliance purposes. Though this method is difficult to implement.