Key difference - absorption costing vs. marginal costing
Marginal cost accounting and full cost accounting are two different approaches that deal with fixed production overheads. In other words, this involves determining whether or not to include fixed overheads in decisions such as inventory valuation, pricing, etc. Absorption costing is a method of costing a product in which all fixed and variable production costs are divided between products. This method ensures that the costs incurred are covered by the sales price of a product. Marginal cost accounting is an accounting system in which the products are charged with variable costs and the fixed costs are viewed as periodic costs. The main difference between absorption costing and marginal costing is how the two techniques treat fixed production overheads. In marginal cost accounting, the fixed production overheads are not allocated to the products. This is in contrast to absorption costing , in which the fixed manufacturing overheads are absorbed by the products. Absorption calculation is a process in which both the variable costs and the fixed costs of production are traced back to the product, while marginal cost accounting only traces the variable production costs back to the product, while the fixed costs of production are considered periodic expenses.
What is Absorption Costing?
Absorption Costing is a method of calculating the total cost of a product. Therefore, full cost accounting is also referred to as full cost accounting. With full cost accounting, the total manufacturing costs are allocated to the products. These costs can be direct costs or indirect costs (variable and fixed overheads). Fixed overhead costs are typically applied based on a predetermined rate of overhead absorption. One or more overhead absorption rates can be used.
The costs allocated to products as part of the absorption calculation are as follows;
- Direct material : materials that are included in a finished product
- Direct labor : labor costs required to construct a product
- Variable manufacturing overhead : Costs of running a manufacturing facility that vary with the volume of production, e.g. B. Electricity for production plants
- Fixed manufacturing overheads : Costs for operating a manufacturing facility that do not vary with the volume of production, ie the rent
The absorption calculation ensures that all costs incurred are covered by the sales price of a product or service. Opening and closing stocks are valued at full manufacturing costs as part of full cost accounting.
Let's consider the following example.
One factory produces Product 'A', which sells for $ 50,000 each. The direct cost of making a unit of product is $ 10,000 for material and $ 20,000 for direct labor. The fixed overhead in a year is $ 10 million. The direct working hours related to each product unit are 100 hours. The work capacity in one year is 100,000 hours.
If overhead costs could be allocated on the basis of hours worked, an overhead absorption rate for product A could be calculated as follows;
Fixed overhead costs per year = $ 10 million
Total direct working hours per year = 100,000
Fixed overhead per direct hour worked = $ 100
Direct working hours per unit = 100
Fixed overhead per unit = $ 10,000
The total cost allocated to Product A using full cost accounting is the addition of direct material, direct labor, and fixed overhead, which is $ 10,000 + $ 20,000 + $ 10,000 = $ 40,000 per unit of A.
Since each product sells for $ 50,000, the absorption cost system calculates a profit of $ 10,000 for each unit of Product A sold.
What is marginal cost accounting?
When an additional unit of a product is manufactured, the additional costs incurred are the variable production costs. Fixed costs remain unaffected and there are no additional fixed costs if the service is increased. The marginal cost of a product is its variable cost, which usually consists of direct labor, direct material, direct cost, and variable production overhead. Marginal cost accounting is used to understand the impact of variable costs on the volume of production. Therefore, this technique is also known as variable cost accounting or direct cost accounting.
Marginal cost accounting is the accounting system in which the products are charged with variable costs and the fixed costs are viewed as periodic costs and are fully written off against apportionment. Under marginal cost accounting, the c EITRAG is the basis for knowing the profitability of a product. The contribution corresponds to the sales price of a product minus the marginal costs. The fixed costs are covered by the contribution. In addition, opening and closing stocks are valued at (variable) marginal costs.
Marginal cost accounting is the main cost accounting method used in decision making. The main reason for this is that the marginal cost approach allows management to focus on changes that result from the decision in question.
If we consider the same example as above, the marginal cost per unit of product A would be the addition of direct material and direct labor, which is $ 10,000 + $ 20,000 = $ 30,000 per unit of A. Because each product sells for $ 50,000, the marginal cost system calculates a contribution of $ 20,000 on each unit of Product A sold. Fixed overheads of $ 10 million are treated as recurring costs rather than product-related costs.
Difference Between Absorption Costing and Marginal Costing
Now that we have understood the two terms separately, we will compare the two to find further differences between absorption costing and marginal costing.
Absorption costing is a method of costing a product in which all fixed and variable production costs are divided between products.
Marginal cost accounting is an accounting system in which the products are charged with variable costs and the fixed costs are viewed as periodic costs.
Absorption Costing values inventory at full production cost. Fixed costs in connection with the closing inventory are carried forward to the next year. Fixed costs for an opening portfolio are also charged to the current year instead of the previous year. Therefore, in the absorption calculation, all fixed costs are not offset against the income of the year in which they are incurred.
Marginal cost accounting values inventory at variable total production costs . There is therefore no way to carry over unreasonable fixed overheads from one accounting period to the next. In marginal cost accounting, however, the value of the inventory is underestimated.
Effect on profit
Because the inventories are different in absorption and marginal costing, the two techniques also have different profits.
1. When stocks go up, the absorption calculation gives the higher profit.
This is because fixed overheads held in the closing inventory are carried forward to the next accounting period and are not written off in the current accounting period.
2. When inventory levels go down, marginal costing gives the higher profit.
This is because the fixed overhead carryforwards are released when inventory is opened, increasing the cost of sales and reducing profit.
- With constant stocks, both methods deliver the same profit.
Treatment of Fixed Costs - Result
The absorption calculation includes fixed production overheads in the inventory values. However, fixed overheads cannot be accurately absorbed due to difficulties in forecasting costs and production volumes. Therefore, there is a possibility that overhead costs will be absorbed too high or too low. Too much overhead is absorbed when the amount allocated to a product is greater than the actual amount, and too little is absorbed when the amount allocated to a product is less than the actual amount.
In marginal cost accounting, the fixed production overheads are not allocated to the production units. The fixed overheads actually incurred are offset against the premium as periodic costs.
Usefulness of technology
Absorption costing is more complex to operate and does not provide useful information for decision making like marginal costing . Cost data generated as part of the absorption calculation is not very useful for decision making because the product cost includes fixed overheads that obscure the cost-volume-profit relationship. However, an absorption calculation is required for external financial reporting and income tax reporting.
Marginal cost accounting does not assign any fixed production overheads to a product. As a result, marginal costing could be more useful for incremental pricing decisions when a company has more concerns about the additional costs required to build the next unit. Identifying the variable cost and contribution enables management to use cost information more easily in decision making.
Presentation in the annual financial statements
Absorption costing is permitted under IAS 2, Inventories. Therefore, an absorption calculation is required for external financial reporting and income tax reporting.
Marginal cost accounting is often useful for management decision making. Excluding fixed costs from inventory has an impact on profit. It is therefore possible that a true and fair view of annual financial statements for marginal cost calculations is not clearly transparent.
Summary - Absorption Costing vs. Marginal Costing
In this article, we've tried to understand the terms absorption calculation and marginal costing, followed by a comparison to highlight the key differences between them. The fundamental difference between absorption costing and marginal costing is how fixed overheads are treated in management decisions about inventory valuation and pricing. With absorption costing, fixed costs are included in both inventory value and product cost when the price decision is made, while marginal costing avoids fixed overheads in both decisions.
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