Term of the Day - 8 February 2024

Today’s Term is “Absorption & Marginal Costing”.

Absorption Costing is a method of accounting for all production costs, both variable and fixed, as part of the cost of a product. This approach allocates direct materials, direct labour, variable manufacturing overhead, and fixed manufacturing overhead to each unit of output. Fixed manufacturing overhead is absorbed into the product cost using a predetermined overhead rate based on a production activity measure like machine hours or labour hours. The key feature is that fixed overhead costs become part of the product's inventory until the inventory is sold.

In contrast, Marginal Costing (also known as Variable Costing) only considers variable manufacturing costs (direct materials, direct labour, and variable overhead) as part of the product cost. Fixed manufacturing overhead is treated as a period cost and is expensed in the period incurred, regardless of production levels. This results in a clear distinction between fixed and variable costs on the income statement.

The primary difference lies in the treatment of fixed manufacturing overhead. Absorption costing includes fixed overhead in product costs and is used for external financial reporting, while marginal costing separates fixed and variable costs for internal decision-making and emphasizes contribution margin. The choice between absorption costing and marginal costing can impact reported profits and influence managerial decisions.