Introduction to
Absorption Costing and
Marginal Costing
Businesses need to determine the cost of their products to set prices and make informed decisions about inventory and production levels. Absorption costing and marginal costing are two methods used to calculate the cost of production.
In this article, we will explore the differences between these two methods and provide examples to help you understand how they work.
Explanation of
Absorption Costing and
Marginal Costing
Absorption costing is a method that considers all production costs, both fixed and variable, when determining the cost of a product. It is also known as full costing because it captures all costs associated with production, including direct costs like labor and materials, as well as indirect costs such as rent, utilities, and maintenance.
The total cost of production is then divided by the number of units produced to determine the cost per unit. Marginal costing, on the other hand, only considers the variable costs associated with production.
It ignores fixed production overheads, such as rent and maintenance, which are considered indirect costs. Instead, it focuses on direct costs like materials and labor.
By only considering variable costs, marginal costing helps businesses determine the additional costs of producing one more unit. The primary difference between absorption costing and marginal costing is that absorption costing includes all costs associated with production, while marginal costing only considers variable costs.
Absorption Costing
In absorption costing, the cost of production is determined by adding together direct costs, such as direct materials and direct labor, and indirect costs, such as rent and utilities. The total cost of production is then divided by the number of units produced to determine the cost per unit.
To calculate the total cost of production, businesses need to determine the predetermined overhead absorption rate (POAR), which is the amount of fixed overheads allocated to each unit of production. The POAR is determined by dividing the total expected fixed overhead costs by the expected level of production.
Calculation example of
Absorption Costing
Let’s take an example to illustrate the process of calculating the total cost of production using absorption costing:
Direct materials: $50 per unit
Direct labor: $25 per unit
Variable manufacturing overhead: $5 per unit
Fixed manufacturing overhead: $20,000 per month
Number of units produced: 1,000 per month
First, we need to determine the POAR:
POAR = (Fixed manufacturing overhead / Number of units produced)
POAR = ($20,000 / 1,000)
POAR = $20 per unit
Next, we can calculate the total cost of production:
Total cost of production = (Direct materials + Direct labor + Variable manufacturing overhead + Fixed manufacturing overhead)
Total cost of production = ($50 + $25 + $5 + $20)
Total cost of production = $100 per unit
Finally, we can calculate the cost per unit:
Cost per unit = Total cost of production / Number of units produced
Cost per unit = ($100 / 1,000)
Cost per unit = $0.10
Therefore, the cost of each unit produced using absorption costing is $0.10.
Conclusion
Businesses need to determine the cost of their products to make informed decisions about pricing and production levels. Absorption costing and marginal costing are two methods used to calculate the cost of production.
Absorption costing includes all costs associated with production, while marginal costing only considers variable costs. By understanding these methods, businesses can make accurate cost calculations and set competitive prices for their products.
Marginal Costing
Marginal costing is a cost accounting technique that calculates the cost of production by considering only the variable costs. Variable costs are costs which vary with the level of production.
Direct costs, such as direct material, direct labor, and direct expenses, are included in the calculation of variable costs. However, fixed costs, such as rent and salaries, are excluded.
One of the key concepts in marginal costing is contribution, which is the difference between sales revenue and variable costs. The contribution margin is the amount of money that can be used to cover fixed costs and generate profits.
Marginal costing helps businesses understand the additional costs of producing one more unit and make informed production decisions. Calculation example of
Marginal Costing
Let’s take an example to illustrate the process of calculating the contribution using marginal costing:
Direct material: $50 per unit
Direct labor: $25 per unit
Variable production overheads: $10 per unit
Number of units produced: 1,000 per month
Sales price per unit: $100
First, we need to determine the total variable cost:
Total variable cost = (Direct material + Direct labor + Variable production overheads)
Total variable cost = ($50 + $25 + $10)
Total variable cost = $85 per unit
Next, we can calculate the contribution:
Contribution = (Sales price per unit – Total variable cost)
Contribution = ($100 – $85)
Contribution = $15 per unit
Finally, we can calculate the total contribution:
Total contribution = (Contribution x Number of units produced)
Total contribution = ($15 x 1,000)
Total contribution = $15,000
Therefore, the total contribution for 1,000 units produced using marginal costing is $15,000.
Difference between
Absorption Costing and
Marginal Costing
Absorption costing and marginal costing are two popular methods used to calculate the cost of production. While absorption costing considers all costs associated with production, including fixed overheads, marginal costing only considers variable costs.
Here are the key differences between the two methods:
1. Definition of
Absorption Costing and
Marginal Costing
Absorption costing is a costing method that considers all costs associated with production, including fixed overheads.
Marginal costing is a costing method that considers only variable costs associated with production. 2.
Inventory Valuation under
Absorption Costing and
Marginal Costing
Under absorption costing, the valuation of inventory includes the total variable production cost and the full production cost, including fixed overheads. Under marginal costing, the valuation of inventory only includes the total variable production cost.
3. Effect on Profit under
Absorption Costing and
Marginal Costing
Absorption costing can lead to higher profits in periods of increased production, as fixed overheads are spread out over a larger number of units.
Marginal costing can lead to lower profits in periods of increased production, as fixed overheads are excluded from the cost calculation. 4.
Treatment of Fixed Cost Outcome under
Absorption Costing and
Marginal Costing
In absorption costing, fixed overheads are allocated to each unit of production using an overhead absorption rate. If actual fixed overheads are higher than allocated fixed overheads, this creates over-absorbed overheads.
If actual fixed overheads are lower than allocated fixed overheads, this creates under-absorbed overheads. Under marginal costing, fixed overheads are treated as a periodic cost and are not allocated to units of production.
5. Usefulness of the Technique under
Absorption Costing and
Marginal Costing
Both methods offer benefits and limitations and can be used for different decision making processes.
Absorption costing is useful for understanding the cost-volume-profit relationship, while marginal costing is useful for making incremental pricing decisions. 6.
Presentation in Financial Statements under
Absorption Costing and
Marginal Costing
Absorption costing is generally more acceptable for external financial reporting purposes as it provides a true and fair view of financial statements. Marginal costing is more suitable for internal management decision-making purposes.
Conclusion
In conclusion, absorption costing and marginal costing are two methods used to calculate the cost of production. Absorption costing considers all costs associated with production, while marginal costing only considers variable costs.
Each method has its advantages and limitations, and businesses should choose the method best suited to their needs. Understanding the differences between the two methods can help businesses make informed decisions about pricing, inventory valuation, and production levels.
In conclusion, determining the cost of production is essential for businesses to make informed decisions about pricing, inventory valuation, and production levels. Absorption costing considers all costs associated with production, including fixed overheads, while marginal costing only considers variable costs.
Each method has its advantages and limitations, and businesses should choose the method best suited to their needs. It is crucial to understand the differences between the two methods to make informed decisions.
By applying the concepts discussed in this article, businesses will be better equipped to determine the cost of production and make informed decisions for their operations.