Marginal/Variable and absorption costing

• Marginal (Variable) Costing


  Also known as variable costing or direct costing, focuses on the variable costs associated with producing each unit of a product
• Variable costs


  • Costs that vary with the level of production and include direct materials, direct labor, and variable overhead
• Under marginal costing


  Only variable manufacturing costs are considered as product costs, while fixed manufacturing overhead costs are treated as period costs and are expensed in the period incurred
• The cost of a unit of product in inventory or in cost of goods sold under the variable costing method does not contain any fixed manufacturing overhead cost
• Advantages of marginal costing


  • Simplicity and ease of understanding
  • Provides a clear distinction between fixed and variable costs
  • Helps in assessing the impact of changes in production volumes on profitability
• Marginal costing


  Often used for internal decision-making, such as determining product pricing and evaluating the impact of changes in production levels on profit
• Absorption (Full) Costing


  Considers both variable and fixed manufacturing costs as product costs

  
• Under absorption costing


  Fixed manufacturing overhead costs are treated as an essential part of the cost of each unit and are absorbed into the product's cost, impacting the valuation of inventory

  
• The absorption costing approach is required for external financial reporting according to Generally Accepted Accounting Principles (GAAP)
• The absorption costing method may result in differences in reported profits compared to marginal costing, especially when there are variations in the production volume or the level of finished goods inventory
• Advocates of absorption costing argue that

  • It provides a more accurate reflection of the total cost of production, including both variable and fixed costs, and therefore is more suitable for external reporting purposes
• Reconciliation of Variable Costing with Absorption Costing Income

  1. When fixed manufacturing overhead cost is deferred in inventory, it is added to the variable costing income figure

  2. When fixed manufacturing cost is released from inventory, it is deducted from the variable costing income figure