MARGINAL AND ABSORPTION COSTING

INTRODUCTION
Welcome to this topic: Marginal and Absorption Costing. This topic covers
the cost accounting techniques where variable costs or marginal costs are
absorbed in the productionprocess leading to different product costing
and income determination

Differentiate between marginal and absorption costing techniques

Generally, there are two approaches used for internal & external
reporting, Marginal costing and Absorption costing. Marginal costing
approach is used for internal financial reporting and is also preferred by
most managers for internal decision making as it is simpler to understand
as compared with absorption costing. For external financial reporting,
absorptioncosting approach is generally used.

Variable or Marginal Costing:

Manufacturing costs that vary with output are treated as product costs
under this approach. These product costs include direct materials, direct
labor and variable part of manufacturing overhead. The remaining portion
of manufacturing overhead i.e. fixed overhead is treated as aperiod cost,
so it is charged against revenue each period. Period cost does also include
fixed portion of selling and administrative expenses. Unit cost under
marginal costing approach does not contain any fixed manufacturing
overhead; it does only contain those items mentioned earlier. It is also
known as marginal costing or direct costing.

When marginal costing is used the following are the consequences

i) Cost of production will be understated

ii) Cost of inventory will be understated
iii) The net profit will be understated
iv) The tax payable will be understated
v) The value of the statement of financial position will be understated
vi) The bargaining power of the business entity with the rest
of the world will beunderstated

Absorption Costing:
Manufacturing costs under absorption costing contain all manufacturing
cost as product cost (whether they are marginal or fixed). Under this
approach, unit cost of a product contains direct material, direct labor, &
manufacturing overheads (variable plus fixed). Fixed costs areallocated to
each unit of product along with other costs. As it includes all product costs,
it is sometimes referred as full allocated cost too.

In case of handling of selling and administrative expenses, selling and

administrative expenses are never treated as a product cost, so both
marginal and fixed selling and
administrative expenses are always treated as period costs in both approaches (marginal and
absorption) and deducted from revenues as incurred.

When the absorption costing is used, the following will be the consequences

vii) Cost of production will be overstated

viii) Cost of inventory will be overstated
ix) The net profit will be overstated
x) The tax payable will be overstated
xi) The value of the statement of financial position will be overstated
xii) The bargaining power of the business entity with the rest of the world will be
overstated

Comparison of The Two Approaches as to Impact on Profit:

(i) Impact of Marginal costing approach on profits:

Under marginal costing approach, any change in production does not make any effect
on profits. Operating income or profits would remain same for years under this
approach, whether production is more than sales or less than sales, a change in
production has no impact on profits when marginal costing is used.

(ii) Impact of Absorption costing approach on profits:

Under absorption costing, profits are affected by the changes in production. If production
goes up in a year, then profit would also increase, and if production goes down profit would
also decrease. The reason for this effect can be traced to fixed FOH costs that shift between
periods under absorption costing as a result of inventory Change.

(iii) Comparison of Profits-Absorption and Marginal Costing Approaches:

Increase in inventories means Absorption costing profit is higher than profit under Marginal
Costing and Decrease in inventories means Absorption costing profit is less than profit under
 Marginal Costing. There is no change in profits if No change in inventories.

Arguments in favor of Marginal costing:

When coming towards arguments in favor of marginal costing, income statements with
respect to marginal costing approach are clear and easy to understand. As it is used for
internal reporting so it makes easy for the internal personnel to understand organization's
performance easily. If sales remain constant over the years, then profits would also remain
unvarying. The statements are consistent with what the managers would expect to see under
the situation, so they tend to generate confidence instead of confusion.

Arguments in favor of Absorption costing:

Financial statements under absorption costing are relatively somewhat difficult, but more
helpful for external entities (if they understand it with great care and in deep study) as readers
of financial statements should be alert to changes in inventory levels to avoid mistakes when
this costing approach is used. Under this approach, if there is an increase in inventories, fixed
manufactured overhead costs are deferred in inventories and net operating income is
elevated. If inventories decrease, fixed manufactured overhead costs are released from
inventories and net operating income is depressed, so fluctuations in profits can be due to
changes in inventories rather than to changes in sales when absorption costing is used.

Prepare operating statements using marginal and absorption costing techniquesIllustration

A manufacturing company produces a single product. During the year ended 31 December
20X2, 10,000 units were produced and sold. There was no opening and closing inventory. All
the 10,000 units were sold at Kshs 200 each.

The costs of manufacturing in Kshs during the year were shown as follows:

Direct Materials 600,000

Direct Labour 200,000

Variable Manufacturing Overheads 40,000

Fixed Manufacturing Overheads 300,000

Variable Selling Overheads 187,500

Fixed Selling and Administrative Overheads 250,000

Required

Prepare operating Statement using Marginal and Absorption Costing

Solution

Operating Statement Marginal Costing

Sales (10,000 units at Kshs 200 each) 2,000,000

Less: Variable Cost of Sales (840,000)

Product Contribution Margin 1,160,000

Less: Variable Selling Overheads (187,500)

Total Contribution Margin 972,500

Less: Fixed Manufacturing Overheads (300,000)

Fixed Selling and Administrative Overheads (250,000)

Net Profit 422,500

Operating Statement Absorption Costing

Sales (10,000 units at Kshs 200 each) 2,000,000

Less: Cost of Sales (1,140,000)

Gross Profit 860,000

Less: Variable Selling Overheads (187,500)

Fixed Selling and Administrative Overheads (250,000)

Net Profit 422, 500

When production =Sales, the net profit under marginal and absorption costing will bethe
same

Scenario 2

Use the previous data except that there was closing inventory of 2,000 units, i.e. only 8,000
units were sold during the year and as a corollary the variable selling overheads would only
be Kshs 150,000 (Kshs187,500 x 8,000/10,000).
Solution

Operating Statement using Marginal Costing

Sales (8,000 units at Kshs 200 each) 1,600,000

Direct Materials 600,000

Direct Labour 200,000

Variable Manufacturing Overheads 40,000

Total Product Costs 840,000

Closing Inventory c/f to Next Year

(Kshs 840,000 x 2,000/10,000) Kshs 168,000

Variable Cost of Goods Sold for the Year

Kshs 672,000
(Kshs 840,000 x 8,000/10,000)

Product Contribution Margin 928,000

Less: Variable Selling Overheads (150,000)

Total Contribution Margin 778,000

Less: Fixed Manufacturing Overheads (300,000)

Fixed Selling and Administrative Overheads (250,000)

Net Profit 228,000

Operating Statement under Absorption Costing

Sales (8,000 units at Kshs 200 each) 1,600,000

Direct Materials 600,000

Direct Labour 200,000

Variable Manufacturing Overheads 40,000

Fixed Manufacturing Overheads 300,000

Total Product Costs 1,140,000

Closing Inventory c/f to Next Year

(Kshs 1,140,000 x 2,000/10,000) Kshs 228,000

Cost of Goods Sold for the Year

(Kshs 1,140,000 x 8,000/10,000) Kshs 912,000

Gross profit 688,000

Less: Variable Selling Overheads (150,000)

Fixed Selling and Administrative Overheads (250,000)

Net Profit 288,000

Reconciliation

Net Profit under Absorption Costing 288,000

Less: Fixed Manufacturing Overheads in Closing Inventory

(Kshs300, 000/10,000 x 2,000) (Kshs30 per unit) (60,000)

Net Profit under Marginal Costing 228,000

When Production is more than Sales the net profit under Absorption costing will behigher
than the net profit under marginal costing

Scenario 3

Fixed overhead in closing inventory less than opening inventory

Continue with previous data (with closing inventory of 2,000 units as at 31 December 20X2.
During the year ended 31 December 20X3, 9,000 units were produced and the costs of
manufacturing were:

Direct Materials Kshs70 per unit

Direct Labour Kshs25 per unit

Variable Manufacturing Overheads Kshs5 per unit

Variable Selling Overheads Kshs16 per unit

Fixed Manufacturing Overheads Kshs261, 000

Fixed Selling and Administrative Overheads Kshs280, 000

10,000 units were sold at Kshs210 each.

SOLUTION

Operating Statement using Marginal Costing

Sales (Kshs210 x 10,000) 2,100,000

Less: Cost of Goods Sold:

Opening Inventory (Kshs84 x 2,000) 168,000

Variable Cost of Goods Completed (Kshs100 x 9,000) 900,000

Less: Closing Inventory (assuming FIFO, Kshs100 x 1,000) (100,000) (968,000)

Product Contribution Margin 1,132,000

Less: Variable Selling Overheads (Kshs16 x 10,000)

(160,000)

Total Contribution Margin 972,000

Less: Fixed Manufacturing Overheads (261,000)

Fixed Selling and Administrative Overheads (280,000)

Net Profit 431,000

Operating Statement using Absorption Costing

Sales (Kshs210 x 10,000) 2,100,000

Less: Cost of Goods Sold:

Opening Inventory (Kshs114 x 2,000) 228,000

Cost of Goods Completed (Kshs100 x 9,000 + Kshs261,000) 1,161,000

Less: Closing Inventory [assuming FIFO,

[(Kshs100 + Kshs261,000/9,000) x 1,000] (129,000) (1,260,000)

Gross Profit 840,000

Less: Variable Selling Overheads (Kshs16 x 10,000) (160,000)

Fixed Selling and Administrative Overheads (280,000)

Net Profit 400,000

Reconciliation
 Net Profit under Absorption Costing 400,000

Add: Fixed Manufacturing Overheads in Opening Inventory

(Kshs300,000/10,000 x 2,000) (Kshs30 per unit) 60,000

Less: Fixed Manufacturing Overheads in Closing Inventory

(Kshs261,000/9,000 x 1,000) (Kshs29 per unit) (29,000)

Net Profit under Marginal Costing 431,000

When Production is less than Sales the net profit under marginal costingwill
be higher than the net profit under Absorption costing

Difference Between Marginal Costing and Absorption Costing

There are two alternative approaches for the valuation of inventory; they are Marginal Costing and Absorption
Costing. In marginal costing, marginal cost is determined by distinguishing fixed cost and variable cost. Only
variable costs are charged to operation, whereas the fixed costs are excluded from it and are charged to profit
and loss account for the period. Conversely, Absorption costing or otherwise known as full costing, is a costing
technique in which all costs, whether fixed or variable are absorbed by the total units produced. It is mainly used
for reporting purposes, i.e. for financial and tax reporting. There are many who say marginal costing is better,
while others prefer absorption costing. So, one should know the difference between marginal costing and
absorption costing to reach at conclusion, as to which one to be preferred over the other.

Content: Marginal Costing Vs Absorption Costing

BASIS FOR COMPARISON MARGINAL COSTING ABSORPTION COSTING

Meaning A decision making technique for Apportionment of total costs to the

ascertaining the total cost of cost center in order to determine
production is known as Marginal the total cost of production is
Costing. known as Absorption Costing.

Cost Recognition The variable cost is considered as Both fixed and variable cost is
product cost while fixed cost is considered as product cost.
considered as period costs.

Classification of Overheads Fixed and Variable Production, Administration and

Selling & Distribution

Profitability Profitability is measured by Profit Due to the inclusion of fixed cost,

Volume Ratio. profitability gets affected.

Cost per unit Variances in the opening and Variances in the opening and
closing stock does not influence closing stock affects the cost per
the cost per unit of output. unit.
 Highlights Contribution per unit Net Profit per unit

Cost data
Presented to outline total
contribution of each product.

Definition of Marginal Costing

Marginal Costing, also known as Variable Costing, is a costing method whereby decisions can be taken regarding
the ascertainment of total cost or the determination of fixed and variable cost to find out the best process and
product for production, etc.

It identifies the Marginal Cost of production and shows its impact on profit for the change in the output units.
Marginal cost refers to the movement in the total cost, due to the production of an additional unit of output.

In marginal costing, all the variable costs are regarded as product related costs while fixed costs are assumed as
period costs. Therefore, fixed cost of production is posted to the Profit & Loss Account. Moreover, fixed cost is
also not given relevance while determining the selling price of the product or at the time of valuation of closing
stock (whether it is finished goods or Work in Progress).

Absorption Costing is a method for inventory valuation whereby all the manufacturing expenses are allocated to
the cost centres to recognise the total cost of production. These manufacturing expenses include all fixed as well
as variable costs. It is the traditional method for cost ascertainment, also known by the name Full Absorption
Costing.

In an absorption costing system, both the fixed and variable costs are regarded as product related cost. In this
method, the objective of the assignment of the total cost to cost centre is to recover it from the selling price of
the product.

On the basis of function, the expenses are divided into Production, Administration and Selling & Distribution.
The following are the types of Absorption Costing:

• Activity Based Costing

• Job Costing
• Process Costing

Key Differences Between Marginal Costing and Absorption Costing

The following are the major differences between marginal costing and absorption costing.

1. The costing method in which variable cost is apportioned exclusively, to the products is known as
Marginal Costing. Absorption Costing is a costing system in which all the costs are absorbed and
apportioned to products.
 2. In Marginal Costing, Product related costs will include only variable cost while in the case of Absorption
costing, fixed cost is also included in product related cost apart from variable cost.
3. Marginal Costing divides overheads into two broad categories, i.e. Fixed Overheads and Variable
Overheads. Look at the other term Absorption costing, which classifies overheads in the following three
categories Production, Administration and Selling & Distribution.
4. In marginal costing profit can be ascertained through the help of Profit Volume Ratio [(Contribution /
Sales) * 100]. On the other hand, Net Profit shows the profit in case of Absorption Costing.
5. In Marginal Costing variances in the opening and closing stock will not influence the per unit cost. Unlike
Absorption Costing, where the variances between the stock at the beginning and the end will show its
effect by increasing/decreasing per unit cost.
6. In marginal costing, the cost data is presented to outline total cost of each product. On the contrary, in
absorption costing, the cost data is presented in traditional way, net profit of each product is ascertained
after deducting fixed cost along with their variable cost.

Conclusion

You can see the differences in the profits generated in the income statement by the two costing system because
the absorption costing procedure, apportions fixed cost of production to the output whereas the marginal
costing system ignores it. Moreover, the absorption costing is based on budgeted levels of output, but because
fixed overheads remain same irrespective of the levels of output, it creates variances in the actual and the
budgeted levels at the time of its recovery.

E – RESOURCES

https://www.wallstreetmojo.com/absorption-costing/

SUMMARY
 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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