Radhika G

Marginal costing is an alternative method of costing to absorption costing.

In marginal costing, only variable production costs are charged as a cost of sale.

Therefore, the cost of a unit =

Direct materials + direct labour + variable production overheads

Fixed costs are treated as a period cost, and are charged in full to the income statement of the accounting
period in which they are incurred.

Radhika G
Contribution is of fundamental importance in marginal costing, and the term
'contribution' is really short for 'contribution towards covering fixed overheads
and making a profit'.

Contribution = Sales price – ALL variable costs

Total contribution = contribution per unit x sales volume

Profit = Total contribution – Fixed overheads

Radhika G
Radhika G
Radhika G
Radhika G
 THE EFFECT OF ABSORPTION AND MARGINAL COSTING ON
INVENTORY VALUATION AND PROFIT

1. Marginal costing: values inventory at the total variable production cost of a product.

E.g. direct labour, direct material, direct expenses and variable production overheads

No FIXED overheads!

2. Absorption costing : values inventory at the full production cost (including

fixed production overheads) of a product.

3. Inventory values using absorption costing are therefore greater than those calculated using
marginal costing.

4. Since inventory values are different, profits reported in the SOPL will also be different.

Radhika G
The cost of Product A:

Direct materials $10

Direct labour $5
Direct expenses $2
Variable production overhead $6
Fixed production overhead $8

What will the inventory valuations be according

to marginal and absorption costing?

Radhika G
 Marginal costing:

Direct materials $10

Direct labour $5
Direct expenses $2
Variable production overhead $6

Value of 1 unit of Product A = 10 + 5 + 2 + 6 = $23

Absorption costing

Direct materials $10

Direct labour $5
Direct expenses $2
Variable production overhead $6
Fixed production overhead $8

Value of 1 unit of product A = 10 + 5 + 2 + 6 + 8 = $31

Radhika G
 In marginal costing, fixed production costs:

- are not included in the COS

- are treated as period costs (are written off as they are incurred)
In absorption costing, fixed production costs

- are absorbed into the cost of units

- are included in the COS

In the long run, total profit for a company will be the same whether marginal costing or
absorption costing is used.

Radhika G
Radhika G
Radhika G
Radhika G
Radhika G
Radhika G
Radhika G
1. If production (units) is equal to sales (units): there will be no difference in profits

2. If inventory levels increase between the beginning and end of a period, absorption costing will report the higher profit.

This is because some of the fixed production OH will be carried forward in closing inventory (which reduces cost of sales and
therefore reduces Expenses and therefore increases the Profit).

LESS expenses you have .... MORE Profit you get

3. If inventory levels decrease absorption costing will report the lower profit because as well as the fixed OH incurred, fixed
production overhead which had been carried forward in opening inventory is released and is also included in cost of sales.

MORE expenses you have .... LESS Profit you get

Therefore:
1. If inventory levels increase, absorption costing gives the higher profit
2. If inventory levels decrease, marginal costing gives the higher profit
3. If inventory levels are constant, both methods give the same profit

Radhika G
 ILLUSTRATION 1 - IF INVENTORY
LEVELS INCREASE
Production was 500 units and Sales 200 units.
No opening inventory.

OAR = $2 per unit

Calculate the difference in the Profit.

Radhika G
 Step 1: Calculate Closing Inventory (CL)
CL = Production - Sales = 500 - 200 = 300 units

Step 2: Change in Inventory

OP = 0 units
CL = 300 units

Change in Inventory = Closing - Opening = 300 - 0 = 300 units (Increase)

Increase in Inventory means AC > MC

Step 3: Difference in Profit

= change in inventory in units x OAR per unit
300 units x $2 per unit = $600

AC Profit > MC Profit by $600

Radhika G
Production was 500 units and Sales 800 units.
The opening inventory was 400 units.

OAR = $2 per unit

Calculate the difference in the Profit

Radhika G
Step 1: Calculate Closing Inventory

Sales = OP + Production - CL
800 = 400 + 500 - CL
CL = 900 - 800
CL = 100 units

Step 2: Change in Inventory

OP = 400 units
CL = 100 units

Change in Inventory = Closing - Opening = 100 - 400 = - 300 units decrease

OP 400 > CL 100, therefore, there was a decrease in the inventory level

Decrease in Inventory means MC > AC

Step 3: Difference in Profit

= change in inventory in units x OAR per unit

= 300 units x $2 per unit = $600

MC Profit > AC Profit by $600

Radhika G
Radhika G
Radhika G