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Difference between Marginal Costing and Absorption Costing

We often buy several products from both online and offline platforms for the betterment of our family. In purchasing these things, we often come across some terms like marginal costing and absorption costing. Now, you must be wondering; what the meanings of these terms? Well, both the terms differ in their meaning and approach. So, let us discuss both the terms separately, finally looking at the difference between the two.

Marginal costing is also called the total cost, which undergoes a particular change when one unit of the product is increased. As the cost of producing the good increases, the total cost also increases, thereby changing the quantity. Marginal costing varies with the slightest change in production. One must not get confused between fixed cost and marginal cost. Both are different in their sense. For instance, when a company produces a particular product, the labour costs are already added. The marginal cost adds to every small charge incurred by the company.

Marginal Costing vs Absorption Costing

On the other hand, the fixed cost is the cost that is not dependent on the number of goods produced. Fixed costs are also known as indirect costs. Thus, both fixed and marginal costs are different.

Marginal costing includes both short-run and long-run cases. In the short-run, the marginal costing is cleared out, i.e., all costs become marginal. But in the long-run, marginal costs fail to cover the total cost sometimes. In such cases, the company requires a subsidy to support it. So, in layman's language, marginal costing is defined as the process of lowering the cost so that the company requires no subsidy. Marginal costing is applied by the companies so that their business can run smoothly and efficiently.

In the short-run marginal costing, the total cost is changed when an extra product is produced in the short run. The short-run marginal costing graph is 'U' in shape that depicts average variable costs and the total costs. The companies who apply this kind of marginal costing have a small and fixed number of assets. The increase and decrease in productivity are dependent upon the owner of the company.

On the other hand, there are no fixed costs or variable costs in the long-run marginal costing. This kind of costing is quite similar to short-run costing except that the fixed costs are applied in short-run marginal costing, unlike the long-run marginal costing. Now, let us look at two main formulas that are used for calculating the marginal costs.

  1. MC(Q) = dC /dQ
    Here, C is the continuous cost function, MC is the Marginal Cost, and Q depicts its quantity.
  2. MC = ^C/ ^Q
    This formula denotes the change in quantity when the cost function is non-linear. Here '^' denotes an increase in the number of goods.

These two formulae help us in determining the marginal cost of the company. There are two kinds of marginal costs, i.e., marginal private cost and marginal social cost. The marginal private cost is defined as the cost wherein the costs of the firm are listed. To maximize the profit yielded by the company; the private marginal cost is applied. On the other hand, in marginal social cost, the other charges/ expenses are not associated with any product purchase and sale. Both private and social costs have positive and negative benefits of production. Now, let us look at some of the benefits and disadvantages of marginal costing.

1. Advantages:

  • Marginal Cost remains constant. The marginal cost remains stable irrespective of the amount of production that takes place in the company.
  • In marginal costing, the fixed cost has been removed that result in cost control of the company. The company does not incur losses due to these costs.
  • Marginal Costing helps the company in determining whether it is good to start a new business or not. It also helps the company in determining the fact as to what will be more profitable for the company; buying, manufacturing, or selling.

2. Disadvantages:

  • Marginal Costs do not provide any particular reason for the increase in sales and production. No complete information is provided in this costing.
  • In marginal costing, fixed cost is not added that can prove to be dangerous for the company.

So, these are some of the advantages and disadvantages of marginal costing. Marginal costing is the change in the cost when one more unit is produced. No fixed costs are applied in this costing. Both small-scale ate large-scale companies use this costing technique. Thus, the marginal cost helps the company in yielding profits.

Having discussed so much about marginal costing, let us now discuss some points regarding absorption costing. Absorption cost is a kind of cost that includes all the external costs required to increase production. Both fixed and variable costs are included in the absorption costing. The costing can be direct or indirect. Direct costing can be recognized by the cost centres, whereas the cost centres cannot recognize indirect costing. Now, you must be wondering what cost centres are? Well, cost centres are particular departments in the company that directly or indirectly contribute to the company's profits. The distribution of business expenses is often called allotments or assignments.

There are two kinds of allotments, i.e., primary allotment and secondary allotment. There are three ways in which the primary allotment is handled in the company.

  • Primary allotment happens when the profits and expenses yielded by the company are measured. According to that, the departments are allocated accordingly.
  • The primary allotment is also done based on a survey. If the company does not measure the expenses, then allotment is done on a survey basis. For instance, if the manager gives 70% time to one department and 30% to the other; his allotment will be based on this survey.
  • In the third case, the allotment is based on the sale of the product. This is not considered a fair allotment as supervisors or managers might not know how much hard work a department has done to help the company yield profits.

Now, let us discuss some points about the secondary allotment. Unlike primary allotment, secondary allotment helps in transferring the expenses from production departments to the cost centres. Some key points regarding secondary allotment includes:

  • In secondary allotment, the process of absorption occurs, which is defined as the distribution of expenses in a company. There are various methods of absorption like prime cost percentage, labour rate, machine rate, etc. These all cost rates helps us in determining the second allotment.
  • In prime cost percentage, both material cost and labour cost serve as the base for calculating the business expenses. The formula is; (expenses/ prime expenses) x 100.
  • In the labour rate, the rate of labour per hour is calculated. The formula is; (expenses/ labour hour needed).

These are some of the points regarding the primary and secondary allotment in the absorption cost. The formula for absorption cost is:

  • Cost of product = Direct cost + Production Cost
  • Direct Cost = Material + Labour
  • Production Cost = Variable Expenses + Fixed Expenses (manufacturing)

These formulas will help us in calculating the absorption cost of the product. Now, let us look at the key differences between marginal costing and absorption costing.

  1. In marginal costing, only variable costs are included, whereas, in absorption costing, both variable and fixed costs are included.
  2. Marginal costing is divided into fixed and variable expenses, whereas absorption costing has distinguished categories like selling, purchasing, distribution, and administration.
  3. In marginal costing, the unit cost is not affected. On the other hand, in absorption costing, the unit cost is affected by an increase and decrease in production.
  4. Marginal cost is calculated by the profit volume ratio, whereas the net profit ratio calculates the absorption cost.

So, these are some key differences between the marginal cost and the absorption cost. Both marginal and absorption cost help in calculating the profits yielded by the company. The increase in sales and production are taken care of by these costs. Thus, both kinds of costs help the company in functioning smoothing and efficiently.

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