Absorption and marginal costing

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Introduction
 Before we allocate all manufacturing costs
to products regardless of whether they are
fixed or variable. This approach is known
as absorption costing/full costing
 However, only variable costs are relevant
to decision-making. This is known as
marginal costing/variable costing

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Definition
 Absorption costing
 Marginal costing

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Absorption costing
 It is costing system which treats all
manufacturing costs including both the
fixed and variable costs as product costs

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Marginal costing
 It is a costing system which treats only the
variable manufacturing costs as product
costs. The fixed manufacturing overheads
are regarded as period cost

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 Absorption Costing
Cost
Manufacturing cost Non-manufacturing cost

Direct Direct Overheads

Materials Labour Period cost

Finished goods Cost of goods sold Profit and loss account

Marginal Costing
Cost
Manufacturing cost Non-manufacturing cost

Direct Direct Variable Fixed

Materials Labour Overheads overhead Period cost

Finished goods Cost of goods sold Profit and loss account

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Presentation of costs on income
statement

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 Trading and profit ans loss account
Absorption costing Marginal costing
$ $
Sales X Sales X
Less: Cost of goods sold X Less: Variable cost of
Goods sold X
Gross profit X Product contribution margin X

Less: Expenses Less: variable non- manufacturing

Selling expenses X expenses
Admin. expenses X Variable selling expenses X
Other expenses X X Variable admin. expenses X
Other variable expenses X
Total contribution expenses X
Variable and fixed manufacturing
Less: Expenses
Fixed selling expenses X
Fixed admin. expenses X
Other fixed expenses X
Net Profit X Net Profit X
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Example

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A company started its business in 2005. The following information
Was available for January to March 2005 for the company that produ
A single product:
$
Selling price pre unit 100

Direct materials per unit 20

Direct Labour per unit 10
Fixed factory overhead per month 30000(30
Variable factory overhead per unit 5

Fixed selling overheads 1000

Variable selling overheads per unit 4

Budgeted activity was expected to be 1000 units each month(UNITS

PRODUCED)
Production and sales for each month were as follows:
Jan Feb March
Unit sold 1000 800 1100 10
 Required:
 Prepare absorption and marginal costing
statements for the three months

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Absorption costing

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 January February March
$ $ $
Sales/REVENUE 100000 80000 110000
Less: cost of good sold ($65) 65000 52000 71500
Profit before adjustment 35000 28000 38500
Adjustment for Over-/(under)
Absorption of factory overhead (300*30)9000 (100*30)(3000)
Gross profit 35000 37000 35500
Less: Expenses
Fixed selling overheads 1000 1000 1000
Variable selling overheads 4000 3200 4400
Net profit 30000 32800 30100

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Marginal costing

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 January February March
$ $ $
Sales 100000 80000 110000
Less: Variable cost of good
sold ($35) 35000 28000 38500
Product contribution margin 65000 52000 71500
Less: Variable selling overhead4000 3200 4400
Total contribution margin 61000 48800 67100
Less: Fixed Expenses
Fixed factory overhead 30000 30000 30000
Fixed selling overheads 1000 1000 1000
Net profit 30000 17800 36100

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Wk1:
Standard fixed overhead rate
= Budgeted total fixed factory overheads
Budgeted number of units produced

= $30000
1000 units
= $30 units
Wk 2:
Production cost per unit under absorption costing:
$
Direct materials 20
Direct labour 10
Fixed factory overhead absorbed 30
Variable factory overheads 5
65
Back
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Wk 3:
(Under-)/Over-absorption of fixed factory overheads:
January February March
$ $ $
Actual Fixed overhead(30*1000)30000(30*1300)39000(30*900)2700
Bud Fixed overheads incurred30000 30000 30000
0 9000 (3000)
1000*$30 1300*$30 900*$30

Wk 4: No fixed factory overhead

Variable production cost per unit under marginal costing:
$
Direct materials 20
Direct labour 10
Variable factory overhead 5
Back 35 17
Difference between absorption
and marginal costing

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 Absorption costing Marginal costing
Treatment for Fixed Fixed manufacturing
fixed manufacturing overhead are treated
manufacturing overheads are as period costs. It is
overheads treated as product believed that only the
costing. It is variable costs are
believed that relevant to decision-
products cannot be making.
produced without Fixed manufacturing
the resources overheads will be
provided by fixed incurred regardless
manufacturing there is production or
overheads not
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 Absorption costing Marginal costing
Value of High value of Lower value of
closing stock closing stock will be closing stock that
obtained as some included the variable
factory overheads cost only
are included as
product costs and
carried forward as
closing stock

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 Absorption costing Marginal costing
Reported If the production = Sales, AC profit = MC Profit
profit
If Production > Sales, AC profit > MC profit
As some factory overhead will be deferred as
product costs under the absorption costing

If Production < Sales, AC profit < MC profit

As the previously deferred factory overhead
will be released and charged as cost of goods
sold

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Argument for absorption costing

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 Compliance with the generally accepted
accounting principles(GAAP)
 Importance of fixed overheads for production
 Avoidance of fictitious profit or loss
 During the period of high sales, the production is small
than the sales, a smaller number of fixed
manufacturing overheads are charged and a higher net
profit will be obtained under marginal costing
 Absorption costing is better in avoiding the fluctuation
of profit being reported in marginal costing

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Arguments for marginal costing

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 More relevance to decision-making
 Avoidance of profit manipulation
 Marginal costing can avoid profit manipulation by
adjusting the stock level
 Consideration given to fixed cost
 In fact, marginal costing does not ignore fixed costs
in setting the selling price. On the contrary, it
provides useful information for break-even analysis
that indicates whether fixed costs can be converted
with the change in sales volume

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