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Absorption Costing & Marginal Costing

Absorption Costing
:Absorption Costing technique is also termed as Traditional or Full Cost Method.According to this
method, the cost of a product is determined after considering bothfixed and variable costs. The
variable costs, such as those of direct materials, directlabor, etc. are directly charged to the
products, while the fixed costs are apportioned ona suitable basis over different product
manufactured during a period. Thus, in case ofAbsorption Costing all costs are identified with the
manufactured products.This system of costing has a number of
disadvantages:i. It assumes prices are simply a function of costs.ii. It does not take account of dem
and.iii. It includes past costs that may not be relevant to the pricing decision at hand.iv. It does not p
rovide information that aids decision making in a rapidly changingmarket environment.Thus, the
technique of Absorption Costing may lead to rather odd results particularly forseasonal businesses
in which the stock level fluctuate widely from one period toanother. The transfer of overheads in and
out of stock will influence their profits for thetwo periods, showing falling profits when the sales are
high and increasing profits whenthe sales are low.The technique of Absorption Costing may also
lead to the rejection of profitablebusiness. The total unit cost will tend to be regarded as the lowest
possible selling price.An order at a price, which is less than the total unit cost may be refused
though thisorder, may actually be profitable.
Marginal Costing:
Marginal costing is a special technique used for managerial decision making. Thetechnique of
marginal costing is used to provide a basis for the interpretation of costdata to measure the
profitability of different products, processes and cost centers in thecourse of decision making. It can,
therefore, be used in conjunction with the differentmethods of costing such as job costing, process
costing etc., or even with othertechniques such as standard costing or budgetary control. .In
marginal costing, cost ascertainment is made on the basis of the nature of cost. Itgives
consideration to behaviour of costs. In other words, the technique has developedfrom a particular
conception and expression of the nature and behaviour of costs andtheir effect upon the profitability
of an undertaking.In the orthodox or total cost method, as opposed to marginal costing method,
theclassification of costs is based on functional basis. Under this method the total cost is the sum
total of the cost of direct material, direct labor, direct expenses, manufacturingoverheads,
administration overheads, selling and distribution overheads. In this system,other things being
equal, the total cost per unit will remain constant only when the levelof output or mixture is the same
from period to period. Since these factors arecontinuously fluctuating, the actual total cost will vary
from one period to another. Thus,it is possible for the costing department to say one day that a thing
costs Rs. 20 andnext day it costs Rs. 18. This situation arises because of changes in volume of
outputand the peculiar behaviour of fixed expenses comprised in the total cost. Suchfluctuating
manufacturing activity, and consequently the variations in the total cost fromperiod to period or even
from day to day, poses a serious problem to the managementin taking sound decisions. Hence, the
application of marginal costing has been givenwide recognition in the field of decision making.

The difference between Marginal Costing and


Absorption Costing can be narrated as below:
Absorption Costing

Marginal Costing

Calculation of In this absorption rate include


Marginal costing rates includes
Manufacture
fixed and variable manufacturing only variable manufacturing
Overhead rates
Valuation of
Inventory

Overheads.

Overhead.

In Absorption Costing valuation is

Marginal costing it will be at prime

on Product cost ie.

Prime cost + cost + applied variable manufactur


applied fixed and variable
Classification of
are
Overhead

ing overhead.

manufacturing overheads.
In Absorption costing the over
head may be classified as

In Marginal costing overheads


are classified as variable and fixed.

factory, administrative,
selling and distribution.
Operating Profit

Net operating
Profit

Under Absorptions Costing


Gross Profit-NetSales -

income or contribution = net sales

Manufacturing cost =

- variable manufacturing cost of

Prime cost +Fixed and

goods soldvariable administrative

Variable manufacturing
Overhead.
Under Absorption costing,

selling and distribution overhead.


Under Marginal costing Net

Net operating profit = Gross

operating profit = Marginal income

Profit = administrative selling

or contribution fixed manufacturing

And distribution overheads (


Fixed and variable combined).

overheads fixed administrative


Overheads fixed selling and

Difference of When production volume


Profit

In Marginal costing, Marginal

exceeds sales volume the net


Profit under absorption costing

net profit
Net Profit. The Net profit will be
equal when production volume
is equal to sales volume.

distribution overhead
When production volume is less
than sales volume, absorption cost
ing net profit will be less than marginal

ABSORPTION COSTING VS MARGINAL COSTING


1) Both fixed and variable cost are
considered for product costing and
inventory valuation.

1) Only variable cost is considered for


product costing and inventory valuation.

2) The fixed cost is charged to cost of


production. Each product is to bear a
reasonable share of fixed cost and
profitability of product is thus
influenced by subjective
apportionment of fixed cost.

2) Treatment of fixed overhead is


different.
Fixed cost is considered as a period
cost. And profitability of different
product is judged by P/V ratio.

3) Presentation of cost is on
conventional pattern. Net profit of
each product is determined after
deducting fixed overheads.

3) Production of data is oriented to


highlight the total contribution and
contribution from each product.

4) The difference in the magnitude of


4) The difference in the magnitude of
opening stock and closing stock
affects the unit cost of production due opening stock and closing stock does
not affect the unit cost of production.
to the impact of related fixed
overheads.

What is the difference between Marginal Costing and Absorption Costing?


Though, marginal costing and absorption costing are two traditional costing
techniques, they have their own unique principles that draw a fine line that separates
one from another.
In marginal costing, contribution is calculated, whereas this is not calculated under
absorption costing.
When valuing the stocks under marginal costing, only the variable costs are
considered, whereas valuation of stock under absorption costing includes costs
incurred for the production function also.
Generally, the value of inventory is higher under absorption costing than marginal
costing.
Marginal costing is often used for internal reporting purposes (facilitate the decision
making of managers), while absorption costing is required for external reporting
purposes, such as income tax reporting.
Contribution must be calculated under marginal costing system, whereas gross
profit will be calculated under absorption costing method.