Marginal Costing Vs. Absorption CostingComparison of Differences along with Examples

Written By:
Lisa Borga

Marginal and absorption costing are two of the most important approaches for valuing inventory used in managerial accounting.

Though both have a similar purpose which is to allocate the costs of producing goods or services, there are significant differences between the two that should be understood in order to effectively use them in making business decisions.

What Is Marginal Costing?

Marginal costing is a method of allocating the costs of production to a company’s goods or services.

In doing this, it measures the change in cost that occurs in relation to the change in quantity produced.

This means that this method of costing considers variable costs or the costs that change in relation to output and generally ignores fixed costs that remain the same regardless of production activity up to a certain level.

Variable costs often include raw materials, direct labor, and in some cases, energy costs.

Fixed costs commonly include rent, marketing, and sales costs, among others.

Marginal costing is calculated by dividing the change in manufacturing costs by the change in quantity produced.

The formula for this is:

Marginal Cost = Change in Cost / Change in Quantity

In order to calculate this, a company must identify the variable costs associated with the production process.

This is relatively easy to calculate as, over a short period of time, the only change in direct costs that will occur as production quantity changes are variable costs.

Advantages of Marginal Costing

• Useful for Decision Making: Marginal costing is a valuable tool for management to identify optimal production levels and identify which product lines are most profitable. This is extremely useful in planning for future production levels and optimizing resource allocation.
• Helps to Optimize Pricing Strategies: By using marginal costing, companies can help to identify costs at an optimal production level. This can help management to compare their products to competitors and develop an optimal sales price.
• Identifies Wastes: By using marginal costing, companies can identify their most and least profitable products. This can allow companies to focus on their most profitable products and allocate their resources more effectively.
• Easy to Compute: With marginal costing, only variable costs generally need to be considered making it relatively easy to calculate.

Disadvantages of Marginal Costing

• Undervalues Costs: Marginal costing generally only considers variable costs, which means that it ignores the impacts of fixed costs. This means that marginal costing may provide a poor indication of the actual costs of production.
• Not Accepted by GAAP: Marginal costing is not an approved method for financial reporting under GAAP. This means that public companies cannot use this method for external reporting.

What Is Absorption Costing

Absorption costing is a method of costing which includes all of the costs associated with production, including both variable and fixed overhead costs.

This method identifies all of the costs in a production process and apportions them to specific products.

This includes the direct costs of manufacturing a product, such as direct materials and direct labor, as well as fixed overhead charges such as utility costs incurred during the production process.

All of these costs will be allocated to specific products for the period regardless of whether they were sold.

This method of costing is required by GAAP for external reporting.

Advantages of Absorption Costing

• Ensures Accurate Costing: Because it links all costs associated with inventory, including fixed costs such as rent and utilities, as well as variable costs such as direct labor and materials, it provides a more accurate picture of costs.
• Useful for Pricing: Because absorption costing provides a full indication of costs incurred in production, it is useful for setting accurate prices that reflect all of the production costs.
• Compliant With GAAP: One of the primary advantages of using absorption costing is that it is compliant with GAAP. This means that it is required for public companies for external reporting purposes.

Disadvantages of Absorption Costing

• Skews Profitability: Because the costs of production are not subtracted from revenue until a product is sold, the absorption of the costs can result in a higher level of profit being reported on a company’s income statement than is actually earned in a period.
• Difficult to Use: Due to requiring the allocation of fixed costs which are often difficult to identify as being related to a given product, absorption costing can be extremely difficult to use.

Understanding the Differences Between Marginal and Absorption Costing

Though both are widely used costing methods, there are several important differences between these two costing methods.

Here are the key differences:

• Treatment of Fixed Costs: Absorption costing includes all costs, both fixed and variable, incurred in the production of a given product. On the other hand, marginal costing generally only considers variable costs.
• Intended Use: Generally, marginal costing is used in order to determine the costs of production. Absorption costing is used to provide an accurate indication of profits.
• Profitability: Because marginal costing does not take fixed costs into account, it will report a much higher level of profitability relative to absorption costing.
• Acceptance Under GAAP: Absorption costing is required by GAAP in external reporting for all publicly traded companies. As a result, marginal costing can only be used in internal reports.
• Contribution to Decision Making: Marginal costing provides an accurate picture of how a change in production will affect costs which is useful for determining optimal quantities of production output. On the other hand, absorption costing includes values that management can use to make decisions to identify inefficiencies and improve the production process.
• Inventory Valuation: Marginal costing provides a lower cost per unit because it does not include fixed overhead costs. As a result, the cost of goods sold will be higher in this method. With absorption costing, fixed overhead costs are considered, which means that cost of goods sold is lower, and closing inventory will be recorded at a higher per unit cost.

Final Thoughts

Marginal and absorption costing are both methods of valuing products.

Generally, absorption costing provides a more well-rounded view of a company’s costs.

However, marginal costing provides a better indication of the expenses incurred in changing production levels.

Both of these measures have their own advantage and applications.

It is just important to know when to use them.

Key Takeaways

• Marginal Costing only takes variable costs into account and does not consider fixed costs, whereas absorption costing includes all business costs.
• Absorption costing allocates costs in relation to distinct cost centers. In contrast, marginal costing only considers the total cost of production.
• Absorption costing can be used for both financial and tax reporting purposes, whereas marginal costing is not an allowed method under Generally Accepted Accounting Principles. Instead, marginal costing can only be used for internal management reports.