MARGINAL AND ABSORPTION COSTING

7.0 MEANING OF COSTING TECHNIQUE

This refers to the method used to determine the value of finished goods. Examples of costing techniques include:
a. Marginal costing
b. Absorption costing
7.1 MARGINAL COSTING
Marginal costing is the variable cost of one unit of a product or service. It is an alternative method of costing to
absorption costing. In marginal costing (MC), only the variable costs are charged as cost of sales and contribution
is calculated (sales revenue – variable cost of sales). The following apply to marginal costing:
 Closing stocks of Work In Progress (WIP) or finished goods are valued at marginal (variable) cost of
production.
 Fixed costs are treated as a period cost and are charged in full to the profit & loss of the accounting period
in which they are incurred.
 The marginal production cost/unit of an item consists of direct material, direct labour and variable
production overhead.
 The marginal cost of sales consists of:
i. Marginal cost of production adjusted for inventory movement
ii. Sales commission
iii. Variable distribution costs.

7.1.1 CONTRIBUTION
This is an important measure in marginal costing, and it is calculated as sales value – variable cost of sales.
Contribution is used instead of profit for decision making.
7.1.2 ADVANTAGES OF MARGINAL COSTING
i. It provides a ready source of data for solving decision making problem
ii. It assists in pricing decision making process i.e. identifying minimum selling prices
iii. It is simple to operate
iv. It encourages managers to concentrate on sales volume rather than production volume as surplus production
does not add to profit
v. It helps to make short tern decision such as whether to accept or reject a special order, to close down a line
of a product or business, to make or buy a product etc.
7.1.3 DISADVANTAGES OF MARGINAL COSTING
i. Cost analysis into fixed and variable may be subjective
ii. It places emphasis on the short run effect of cost whereas fixed cost will vary in the long run
iii. It fails to recognize that upward or downward trends in volume should eventually lead to increase or decrease
in fixed cost
iv. A business remains unprofitable unless fixed cost is covered by sufficient contribution

7.2 ABSORPTION COSTING

Absorption costing on the other hand is about costing a product or service with due regards to the entire cost
elements involved in the production process (i.e. variable and fixed cost of production). This implies that
appropriate apportionment is made for indirect costs to be incorporated into the total cost for each unit of goods
and services provided.

7.2.1 ADVANTAGES OF ABSORPTION COSTING

i. It does not ignore the importance of fixed cost
ii. It complies with Statement of Accounting Standards 4
iii. It assists in arriving at total cost of production which is a basis for selling price decision process
iv. It obeys matching concept as it matches costs with revenue in full
v. It capitalizes on the effect of higher production volume to reduce unit cost.

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7.2.2 DISADVANTAGES OF ABSORPTION COSTING
i. Apportionment and absorption of overhead may be subjective
ii. It is complicated when the organisation has many different manufacturing cost centres
iii. It may lead to excessive production in order to increase profit generated in the period
iv. Excess production may tie down capital
v. Calculation of over/under absorption of overhead may be problematic

7.3 COSTING CALCULATION OF PROFIT UNDER MARGINAL COSTING AND ABSORPTION

Basis Marginal Costing Absorption Costing

Stocks Valuation Valued at marginal Valued at full production cost (i.e. variable cost
production cost + fixed cost)
Treatment of Fixed Treated as a period cost Treated as a product cost (i.e. apportioned and
production cost absorbed into unit cost)
Component of Cost of Does not include a share of Include a share of fixed overhead
sales fixed overhead
Uses Internally. it is also used for Both internally and externally i.e. for the
decision making preparation of financial statement. It is also used
for routine purposes.

Illustration 7.1
Ayomide limited furnishes the following details for the year ended 31st December 2009 for preparing the income
statement of the year.
Sales 1,000 units @ N10 per unit
Fixed manufacturing costs N2,200
Variable manufacturing cost 1,100 units @ N6 per unit
Fixed selling & admin expenses N500
Variable selling & admin expenses N400
Inventory at close 100 units
Required: Prepare the income statement for the year using both marginal & absorption costing.

SUGGESTED SOLUTION:

Income Statement Using Marginal Costing

₦ ₦
Sales (1,000 x ₦10) 10,000
less cost of sales:
Variable manufacturing cost (1,100 x ₦6) 6,600
less closing inventory (₦6 x 100) (600)
Variable cost of goods sold 6,000

Add other variable costs:

Variable selling and admin expenses 400
Variable cost of sales (6,400)
Contribution 3,600
less period cost:
Manufacturing 2,200
Selling and admin expenses 500
(2,700)
Profit 300

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 Profit Statement Using Absorption Costing
₦ ₦
Sales (1,000 x ₦10) 10,000
less cost of sales:
Variable manufacturing cost (1,100 x ₦6) 6,600
Fixed manufacturing cost (₦2 x 1,100) 2,200
Manufacturing costs 8,800
less closing inventory (₦8 x 100) (800)
Cost of goods sold (8,000)
Gross profit 2,000
less non manufacturing cost:
Variable selling and admin expenses 400
Selling and admin expenses 500
(900)
Profit 1,100

Note: Overhead absorption rate = ₦2,200/1,100 = ₦2

Product cost/unit = manufacturing cost/units produced = ₦8,800/1,100 = ₦8

7.4 RECONCILIATION OF PROFIT

Reported profit figures using marginal costing or absorption costing will differ if there is any change in the level
of inventory in the period. If opening inventory = closing inventory, there will be no difference in calculated
profits using the two costing methods.
The difference in profits reported under the two costing methods is due to the different inventory valuation
method used (i.e. fixed overhead is included in closing stock when using absorption costing. The following can
be used as a guide for reconciliation;
 If inventory levels increase between the beginning and end of a period (i.e. closing stock > opening stocks),
absorption costing will report a higher profit
 If inventory levels decrease, absorption costing will report a lower profit
 Difference in profit = change in inventory level x overhead absorption rate
Illustration 7.2
The following information is available for a firm producing and selling a single product:
Budgeted cost at normal activity level ₦’000
Direct materials and labour 264,000
Variable production overhead 48,000
Fixed production overhead 144,000
Variable selling & admin overhead 24,000
Fixed selling & admin overhead 96,000
The overhead absorption rates are based upon normal activity level of 240,000 units per period. During the period
just ended, 260,000 units of product were produced and 230,000 units were sold @ ₦3,000 per unit. At the
beginning of the period, 40,000 units were in stock. These were valued at the budgeted costs shown above.
Actual costs incurred were as budget.
Require;
i. Calculate the fixed production overhead absorbed during the period and the extent of any over or under
absorption.
ii. Calculate profits for the period using absorption costing and marginal costing respectively.
iii. Reconcile the profit figures calculated in (ii) above.
iv. State the situation in which the profit figures calculated under both absorption costing and marginal
costing would be the same.

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SUGGESTED SOLUTION
i. fixed production overhead absorbed during the period:
Overhead absorption rate (OAR) = Budgeted Overhead/Normal activity level
= ₦144,000/240,000 = ₦0.6
Absorbed overhead = ₦0.6 x 260,000 = ₦156,000

Over or under absorption: using activity level:

Normal activity level – Actual production X OAR
= 240,000 – 260,000 = -20,000 X ₦0.6 = ₦12,000 Over absorbed overhead

ii. Profit statement:

Income Statement Using Marginal Costing

₦’000 ₦’000
Sales (230,000 x ₦3,000) 690,000
less cost of sales:
Direct materials and labour 264,000
Variable production overhead 48,000
Production cost 312,000
Add: opening inventory (40,000 x ₦1.2) 48,000
360,000
less closing inventory ( 70,000 x ₦1.2) (84,000)
Variable cost of goods sold 276,000

Add other variable costs:

Variable selling and admin overhead 24,000
Variable cost of sales (300,000)
Contribution 390,000
less period cost:
Manufacturing 144,000
Selling and admin overhead 96,000
(240,000)
Profit 150,000

*Note: Product cost/unit = ₦312,000/260,000 = ₦1.2

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 Profit Statement Using Absorption Costing

₦’000 ₦’000
Sales (230,000 x ₦3,000) 690,000
less cost of sales:
Direct materials and labour 264,000
Variable production overhead 48,000
Manufacturing overhead (0.6 x 260,000) 156,000
Production cost 468,000
Add: opening inventory (40,000 x ₦1.8) 72,000
540,000
less closing inventory ( 70,000 x ₦1.8) (126,000)
Cost of goods sold 414,000

less: Over absorbed overhead (0.6 x 20,000) (12,000)

Adjusted cost of goods sold (402,000)
Gross profit 288,000

Less Non-manufacturing costs:

Variable selling and admin overhead 24,000
Fixed Selling and admin overhead 96,000 (120,000)
Net Profit 168,000
*Note: OAR = ₦144,000/240,000 = ₦0.6
Product cost/unit = ₦468,000/260,000 = ₦1.8

iii. Reconcile the profit figures calculated

₦
Marginal profit 150,000
Add: absorbed overhead in closing inventory (0.6 x 70,000) 42,000
192,000
Less: absorbed overhead in opening inventory (0.6 x 40,000) (24,000)
Absorption profit 168,000
iv. Reported profit figures using marginal costing or absorption costing will differ if there is any change in the
level of inventory in the period. If opening inventory = closing inventory, there will be no difference in
calculated profits using the two costing methods. The difference in profits reported under the two costing
methods is due to the different inventory valuation method used (i.e. fixed overhead is included in closing
stock when using absorption costing

7.5 PRACTICE QUESTIONS

1. Double Star Limited is considering its plan for the year ending 31 December 2010. It makes and sells a single
product which has budgeted cost and selling price per unit as follows:
N
Selling price 50
Direct material 15
Direct labour 9
Variable production overhead 3
Fixed production overhead 5
Variable selling overhead 5
Fixed selling overhead 2
Fixed admin overhead 3

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 Fixed overheads cost per unit are based on a normal annual activity level of 96,000 units. These costs are
expected to be incurred at a constant rate throughout the year.
Activity levels during January and February 2010 are expected to be:

January February
Units Units
Sales 7,000 8,750
Production 8,500 7,750
Assume that there will be no stock held on 1st January 2010.
Required:
i. Prepare profit statement for each of the two months using Absorption and Marginal costing techniques
ii. Reconcile and explain the reasons for any difference between the marginal and absorption costing profits
for each of the month in your answer above

2. A firm manufactures and sells a single product called omega

Unit price of omega is as follows: N
Selling price 30
Direct costs 8
Details for the month of September and October are as follows:
September October
Production of omega 750 units 1,000 units
Sales of omega 600 units 1,150 units
Fixed production overhead N4,500 N4,500

Required:
a) Prepare for September and October profit statement showing stock valuation, based on the following
principles:
i. Absorption costing
ii. Marginal costing
b) Briefly comment on your result
3. RFSA Ltd. which manufactures packet sized calculators commenced business in June 2009. The company’s
budget for each four week period is as follows:
N N
Sales (20,000 units) 400,000
Manufacturing cost of goods sold:
Variable costs 240,000
Fixed overhead 60,000
(300,000)
Gross profit 100,000
Selling and distribution (fixed) (20,000)
Net profit 80,000
The following data relate to the first two periods
Periods 1 2
Production 24,000 18,000
Sales 18,000 21,000
Required:
Prepare operating statements for each of the periods on the following bases:
i. Where fixed manufacturing overhead is absorbed into production at the budgeted rate and selling and
distribution costs are treated as period cost
ii. Where all fixed costs are treated as period costs

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4. The normal annual level of operations of ABC Ltd is 96,000 bangles upon which the production overhead
absorption rate is calculated. At the end of the year, the records show the following:
Production 100,000 bangles
Sales 90,000 bangles
Selling price N12
Fixed overhead budgeted and incurred ₦201,600
Production costs: N
Direct materials 3
Direct labour 2
Variable overhead 2
Selling and distribution expenses:
Fixed ₦50,000
Variable 5% of sales revenue
There were no opening stocks of finished goods. Work-in-progress at the beginning and at the end of the period
were the same.
Required: Prepare statement for the year ended 30/06/2009 based on;
a) Marginal costing
b) Absorption costing
c) Comment on the difference in profit in (a) and (b) above and reconcile the profits

5. When opening stock were 8,500 litres and closing stock 6,750 litres, a firm had a profit of N62,100 using
marginal costing. Assuming that fixed overhead absorption rate was N3 per litre, what would be the profit
using absorption costing?

6. The OAR for product X is N10/machine hour. Each unit of product X requires 5 machine hours. Inventory of
product X on 1/1/09 was 150 units and on 31/12/09 it was 100 units. What is the difference in profit between
results reported using absorption costing and marginal costing.
7. Maryam makes a product, the gong, which has a variable production cost of ₦6 per unit and a sales price of
₦10 per unit. There were no opening inventory and production during the month of June 2009 was 20,000
units. Fixed costs were ₦45,000.
Required:
a. Calculate the contribution and profit for the month using marginal costing principles if sales were as
follows:
a) 10,000 gongs b) 15,000 gongs c) 20,000 gongs
b. Find the contribution and profit, if sales are:
a) 12,000 gongs b) 17,000 gongs c) 19,000 gongs

8. From the information given below, you are required to prepare profit statement for the year based on:
i. Marginal costing
ii. Absorption costing
iii. To comment on the difference in the profit figures you report in (i) and (ii) above.

Cosmos Ltd produces a single product which is bottled and sold in cases. The normal annual level of operations
on which the production fixed overhead absorption is based is 36,000 cases. Data for the last financial year were
as follows;
Production 40,000 cases
Sales 32,000 cases
Selling price ₦60/unit
Costs:
Direct material ₦14
Direct labour ₦12
Variable overhead ₦8

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Fixed overhead (budgeted & incurred) ₦216,000
Selling & admin cost:
Fixed ₦50,000
Variable: 15% of sales revenue.
There was no opening stock of finished goods and the WIP stock may be assumed to be the same at the end of
the year as it was at the beginning of the year.