KNUST SCHOOL OF BUSINESS.

COST ACCOUNTING

INDEX NUMBER:8133521

Difference between Absorption Costing and Marginal Costing

Absorption costing and marginal costing are two distinct methods used for cost accounting and decision-
making. While absorption costing considers all production costs, including fixed overheads, marginal
costing focuses solely on variable costs. This note provides a comparative analysis of these two
methods.Absorption Costing:

Definition: Absorption costing allocates all manufacturing costs, including direct materials, direct labor,
and both variable and fixed overheads, to units of production.

Treatment of Fixed Costs: Fixed costs are absorbed into the cost of units produced, meaning they are
spread across the units.

Reporting: Under absorption costing, fixed production costs are included in the cost of goods sold,
impacting reported profits.

Advantages:

Provides a comprehensive view of total production costs.

Suitable for external reporting as it aligns with generally accepted accounting principles (GAAP).

Disadvantages:

May distort profitability due to fluctuations in production levels.Fixed overheads can be inflated if
production levels are low.

Marginal Costing:

Definition: Marginal costing considers only variable costs (direct materials, direct labor, and variable
overheads) as the cost of production.

Treatment of Fixed Costs: Fixed costs are treated as period costs and are not assigned to units of
production.

Reporting: Fixed costs are deducted from contribution margin to determine the contribution to covering
fixed costs and profit.

Advantages:

Provides a clearer understanding of cost behavior and cost-volume-profit relationships.

Useful for decision-making, such as pricing and product mix, as it focuses on relevant costs.

Disadvantages:

May not comply with external reporting requirements, potentially leading to differences between
managerial and financial accounting reports.Ignores the importance of fixed costs in the long run.
Comparison:

Approach to Fixed Costs: Absorption costing includes fixed costs in product costs, while marginal costing
treats fixed costs as period costs.

Profit Measurement: Absorption costing may result in higher reported profits when production exceeds
sales, while marginal costing may show higher profits when sales exceed production.

Decision-making: Marginal costing provides more relevant information for short-term decision-making,
such as pricing and discontinuing products, due to its focus on variable costs.

External Reporting: Absorption costing is generally preferred for external reporting purposes as it
complies with GAAP and provides a more complete picture of costs.

Conclusion:

Both absorption costing and marginal costing offer unique advantages and are suitable for different
purposes. While absorption costing is better suited for external reporting and provides a comprehensive
view of total costs, marginal costing offers clearer insights into cost behavior and is valuable for short-
term decision-making. Organizations often use a combination of both methods to meet various
reporting and decision-making needs.