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CHAPTER 4
Marginal costing and
Absorption costing
MARGINAL COSTING
• Marginal Cost in economics is defined as the cost of producing one
additional item.
• Marginal Costing describes an approach to costing that excludes
fixed costs.
• Marginal Costing concentrates on Variable Costs.
• Marginal (Variable) Production Cost consists of:
• Direct Materials
• Direct Labour
• Variable production overheads
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Absorption Marginal
Costing Costing
Direct Materials
Product
Product Direct Labor
Costs
Costs Variable Manufacturing Overhead
Fixed Manufacturing Overhead
Period
Period Variable Selling and Administrative Expenses
Costs
Costs Fixed Selling and Administrative Expenses
MARGINAL COSTING
• A big advantage of marginal costing is how it helps with short-term
decision making.
• In the short-term many costs are assumed to be committed and
unavoidable (i.e. fixed production and non–production costs).
Therefore these costs should not be considered when making short
term decisions.
• A business may have a one-off order or spare capacity. The business
needs to decide:
• Should they accept the order?
• What is the minimum price to charge?
• How should the business use the spare capacity?
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CONTRIBUTION
Based on cost behaviour we have variable costs and fixed costs.
Total costs (TC) = Variable costs (VC) + Fixed costs (FC)
We also have profit formula:
Sales – Total Cost = Profit
Therefore
Sales – VC – FC = Profit
Fixed costs unchange in relevant activity level so we have
Contribution – Fixed Cost = Profit
Test your understanding 1
Terry Ltd has following standard cost card for cost unit aquarium.
Sales Price £80
Direct material £18
Direct labour £15
Variable production overhead £13
Variable selling overhead £14
Fixed production costs £25,000
Fixed selling and distribution costs £15,000
Calculate the total profit and profit per unit if Terry Ltd makes and sells:
0 units 1,000 units 2,000 units 3,500 units
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Test your understanding 2
Sparky sells an electrical good for £1,009.99. The variable material
cost per unit is £320, the variable labour cost per unit is £192 and the
variable production overhead cost per unit is £132 and the variable non
production cost per unit is £10. Fixed overheadsper annum are £100,000
and the budgeted production level is 1,000 units.
Calculate
(a) Contribution per unit
(b) Inventory value using marginal costing
CHARACTERISTIC OF CONTRIBUTION
• Contribution per unit is constant
• Total contribution rises as volume rises
• Profit per unit rises as activity rises. This is because total contribution
rises in line with activity whereas fixed costs are constant. Therefore
fixed costs are ‘spread’ over more units.
• The point, neither a profit nor a loss is made, is called the breakeven
point.
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Test your understanding 3
Sparky sells an electrical good for £1,009.99. The variable material
cost per unit is £320, the variable labour cost per unit is £192 and the
variable production overhead cost per unit is £132 and the variable non
production cost per unit is £10. Fixed overheadsper annum are £100,000
and the budgeted production level is 1,000 units.
Calculate
(a) No. of units at Breakeven point
(b) Revenue at Breakeven point
MARGINAL COSTING VS ABSOPTION COSTING
(Income statement)
• MC (Maginal Costing) and TAC (Traditional Absorption Costing)
profit or loss accounts may be presented in different formats.
• The value of opening and closing inventories will differ depending
on whether MC or TAC is adopted.
• MC values inventories at variable production cost.
• TAC values inventories at full production cost.
• Therefore, MC expenses all fixed costs in the period in which
they are incurred, whereas TAC will only expense fixed
production costs in the period in which the inventory is sold.
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ABSORPTION COST STATEMENT
Absorption Costing
Sales xxxx
Cost of sales:
Opening inventory xxxx
Add production cost xxxx
Less closing inventory (xxxx)
Under/ Over Absorption xxxx
(xxxx)
Gross Profit xxxx
Variable Non_Production OVH (xxxx)
Fixed Non_Production OVH (xxxx)
Net Profit xxxx
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MARGINAL COST STATEMENT
Marginal Costing
Sales xxxx
Cost of sales:
Opening inventory xxxx
Add production cost xxxx
Less closing inventory (xxxx)
(xxxx)
Variable Non_Production OVH (xxxx)
Contribution xxxx
Fixed Production OVH (xxxx)
Fixed Non_Production OVH (xxxx)
Net Profit xxxx
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Test your understanding 4
Selhurst plc commenced business on 1 March making only one
product. Its standard costs are:
Direct labour £5 Direct material £8
Variable production OVH £2 Fixed production OVH £5
The fixed production OVH figure has been calculated on the basis of a
budgeted normal output of 36,000 units per annum. The fixed production
OVH actually incurred in March and April was £15,000 each month.
Selling, distribution and administration expenses are:
Fixed £10,000 per month Variable 15% of the sales value
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Test your understanding 4
The selling price per unit is £35 and the number of units produced
and sold were:
March April
(Units) (Units)
Production 2,000 3,100
Sales 1,500 3,300
Required:
Prepare the Profit or Loss accounts for each of the months of March
and April using:
(a) Absorption costing.
(b) Marginal costing.
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PROFIT RECONCILIATION
Remember the ONLY difference between the reported profit figures
must be due to differences in opening and closing inventory valuations
because:
MC treats fixed production OVH as a period cost
TAC treats fixed production OVH as a product cost
Therefore the deduction of closing inventory from cost of sales carries
forward some of the fixed cost to the next period.
Formula:
Difference in Inventory OVH absorption rate
= x
profit level per unit
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ABSORPTION COSTING VS MARGINAL COSTING
Criteria Absorption Costing Marginal Costing
Separation of Costs Allocated Variable
Apportioned Fixed
Product costs
Variable Costs Included Included
Fixed Costs Included Excluded
(Fixed costs written off as
period costs)
Stock Valuation
Variable Costs Included Included
Fixed Costs Included Excluded
Recovery of Costs Attempts to recover all Uses only costs that can be
costs. traced to product. Avoids
over/under recovery
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ABSORPTION COSTING VS MARGINAL COSTING
Criteria Absorption Costing Marginal Costing
Profit Computed as Gross Profit Computed as
and Net Profit Contribution and Net
Profit
Reporting Advocated for external Advocated for internal
reporting by IAS2- management reporting
Inventory Valuation
Decision Making Unsuitable Suitable
Costs not considered really Eg. Break Even analysis,
accurate limiting factors etc.
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ABSORPTION COSTING VS MARGINAL COSTING
ADVANTAGES of TAC ADVANTAGES of MC
• Fixed production costs are • It is simple to operate.
incurred in order to make • There are no apportionments
output; it is therefore ‘fair’ to of fixed costs, which are
charge all output with a share frequently done on an arbitrary
of these costs. basis. Many costs, such as the
managing director’s salary, are
indivisible by nature.
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ABSORPTION COSTING VS MARGINAL COSTING
Advantages of TAC
• Closing inventory values, by including a share of fixed production
overhead, will be valued on the principle required by accounting
standards for the financial accounting valuation of inventories for
external reporting purposes.
Advantages of MC
• Fixed costs will be the same regardless of the volume of output, because
they relate to a period of time and are period costs. It makes sense,
therefore, to charge them in full as a cost to the period.
• The cost to produce an extra unit is the variable production cost. It is
realistic to value closing inventory items at this directly attributable cost.
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ABSORPTION COSTING VS MARGINAL COSTING
Advantages of TAC
• A problem with calculating the contribution of various products made by a
company is that it may not be clear whether the contribution earned by
each product is enough to cover fixed costs, whereas by charging fixed
overhead to a product it is possible to ascertain whether or not it is
profitable.
Advantages of MC
• Under or over absorption of overheads is avoided.
• Marginal costing information can be more useful for decision making since
it focuses on the variable costs that are most likely to be altered as the
result of a decision.
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Test your understanding 5
Present a reconciliation of the profit or loss figures in March and April
from TYU4.
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Test your understanding 6
• Feedman Ltd makes only one product, the standard cost card of which is:
Direct materials £3 Fixed production overhead £4
Direct labour £6 Variable selling cost £5
Variable production OVH £2 Selling price of one unit is £21.
• Budgeted fixed OVH are based on budgeted production of 5,000 units.
Opening inventory was 1,000 units and closing inventory was 4,000 units.
Sales during the period were 3,000 units and actual fixed production OVH
incurred were £25,000.
The amount of under/over absorption in an absorption costing system was:
A Under absorbed by £13,000 B Under absorbed by £5,000
C Under absorbed by £1,000 D Over absorbed by £2,000
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Test your understanding 7
Using the information in TYU6, what would be the contribution earned in
the period using a marginal costing system?
A. (£10,000)
B. £15,000
C. £18,000
D. £30,000
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Test your understanding 8
In a period where opening inventory was 5,000 units and closing inventory
was 3,000 units, a firm had a profit of £92,000 using absorption costing. If the
fixed overhead absorption rate was £9 per unit, the profit using marginal costing
would be:
A. £65,000
B. £74,000
C. £110,000
D. Impossible to calculate.
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Test your understanding 9
When comparing the profits reported under marginal and absorption
costing during a period when the level of inventory decreased:
A. Absorption costing profits will be higher and closing inventory
valuations lower than those under marginal costing.
B. Absorption costing profits will be higher and closing inventory
valuations higher than those under marginal costing.
C. Marginal costing profits will be higher and closing inventory
valuations lower than those under absorption costing.
D. Marginal costing profits will be lower and closing inventory
valuations higher than those under absorption costing.
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Test your understanding 10
• In a period, opening inventory was 12,600 units and closing inventory was
14,100 units.
• The profit based on marginal costing was £50,400 and profit using
absorption costing was £60,150. The fixed overhead absorption rate per unit
(to the nearest penny) is:
A. £4.00
B. £4.27
C. £4.77
D. £6.50
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Test your understanding 11
A business made 24,000 units of its product at a total cost of £40. The
product was sold at £55 and 55% of its costs were variable. The sales for the
period were 20,000 units.
If there were no opening inventory what will be the difference between the
profit calculated using absorption costing principles and marginal costing
principles?
A. Absorption costing profit will be higher by £72,000
B. Absorption costing profit will be lower by £72,000
C. Absorption costing profit will be higher by £88,000
D. Absorption costing profit will be lower by £88,000
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