Marginal costing and absorption costing

Marginal costing and
absorption costing
Introduction
The main principles underlying the content of this chapter should be familiar to
you from your earlier studies. You should already be able to apply a system of
marginal costing and understand how it differs from absorption costing.
Whereas absorption costing recognises fixed costs (usually fixed production
costs) as part of the cost of a unit of output and hence as product costs,
marginal costing treats all fixed costs as period costs.
The emphasis in your Management Accounting Performance Evaluation
syllabus is on a comparison between the two systems and their effect on
reported profit and inventory valuation, and on their application in different
learning environments.
Topic list
Learning outcomes Syllabus references
Ability required
1 The principles of marginal costing
A(i)
A 1
Analysis
2 The principles of absorption costing
A(i)
A 2
Analysis
3 The effect of marginal costing and absorption
A(i)
A 1, 2
Analysis
costing on reported profit and inventory
valuation
4 Marginal costing and absorption costing
A(i)
A 1, 2
Analysis
compared
5 Job costing and batch costing
A(ii)
A 1, 2
Application


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PART A COST ACCOUNTING SYSTEMS
Knowledge brought forward from earlier studies

Terminology
•
Absorption costing 'Assigns direct costs, and all or part of overhead to cost units using one or
more overhead absorption rates'.
•
Marginal cost is 'Part of the cost of one unit of product or service that would be avoided if the unit
were not produced, or that would increase if one extra unit were produced'.
•
Contribution is 'Sales value less variable cost of sales'.
CIMA Official Terminology
•
Marginal costing is an alternative method of costing to absorption costing. In marginal costing,
only variable costs are charged as a cost of sale and a contribution is calculated which is sales
revenue minus the variable cost of sales. Closing inventories of work in progress or finished goods
are valued at marginal (variable) production cost. Fixed costs are treated as a period cost, and are
charged in full to the income statement in the accounting period in which they are incurred.
1 The principles of marginal costing
The principles of marginal costing (also known as variable costing) are as follows.
(a)
Period fixed costs are the same for any volume of sales and production (provided that the
level of activity is within the 'relevant range'). Therefore, by selling an extra item of product
or service the following will happen.
•
Revenue will increase by the sales value of the item sold
•
Costs will increase by the variable cost per unit
•
Profit will increase by the amount of contribution earned from the extra item.
(b)
Similarly, if the volume of sales falls by one item, the profit will fall by the amount of
contribution earned from the item.
FAST FORWARD
The marginal costing philosophy is that profit measurement should be based on an analysis of total
contribution, that is sales value less the variable cost of sales.
(c)
Since fixed costs relate to a period of time, and do not change with increases or decreases
in sales volume, it is misleading to charge units of sale with a share of fixed costs.
Absorption costing is therefore misleading, and it is more appropriate to deduct fixed costs
from total contribution for the period to derive a profit figure.
(d)
When a unit of product is made, the extra costs incurred in its manufacture are the variable
production costs. Fixed costs are unaffected, and no extra fixed costs are incurred when
output is increased.
FAST FORWARD
Supporters of marginal costing argue that the valuation of closing inventories should be at variable
production cost (direct materials, direct labour, direct expenses (if any) and variable production overhead)
because these are the only costs properly attributable to the product.
Before reviewing marginal costing principles any further, it will be helpful to remind yourself of the basics
by looking at a numerical example.
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1: MARGINAL COSTING AND ABSORPTION COSTING
1.1 Example: marginal costing
Water and Sons makes a product, the Splash, which has a variable production cost of £6 per unit and a
sales price of £10 per unit. At the beginning of September 20X0, there were no opening inventories and
production during the month was 20,000 units. Fixed costs for the month were £30,000 for production
and £15,000 for administration, sales and distribution. There were no variable marketing costs.
Required
Calculate the contribution and profit for September, using marginal costing principles, if sales were as
follows.
(a) 10,000
Splashes
(b) 15,000
Splashes
(c) 20,000
Splashes
Solution
The first stage in the profit calculation must be to identify the variable costs, and then the contribution.
Fixed costs are deducted from the total contribution to derive the profit. All closing inventories are valued
at marginal production cost (£6 per unit). Production during the month in all three cases is 20,000 units.

10,000 Splashes
15,000 Splashes
20,000 Splashes

£
£
£
£
£
£
Sales (at £10)
100,000
150,000
200,000
Opening inventory
0

0

0

Variable production cost
120,000
120,000
120,000


120,000
120,000
120,000

Less value of closing






inventory (at marginal cost)
60,000

30,000
0

Variable cost of sales

60,000

90,000
120,000
Contribution

40,000

60,000

80,000
Less fixed costs

45,000

45,000

45,000
Profit/(loss)

(5,000)
15,000
35,000
Profit/(loss) per unit

£(0.50)

£1

£1.75
Contribution per unit

£4

£4

£4
The conclusions which may be drawn from this example are as follows.
(a) The
profit per unit varies at differing levels of sales, because the average fixed overhead cost per
unit changes with the volume of output and sales.
(b) The
contribution per unit is constant at all levels of output and sales. Total contribution, which is
the contribution per unit multiplied by the number of units sold, increases in direct proportion to
the volume of sales.
(c) Since
the
contribution per unit does not change, the most effective way of calculating the expected
profit at any level of output and sales would be as follows.
(i)
Calculate the total contribution
(ii)
Deduct fixed costs as a period charge in order to find the profit
(d)
In our example the expected profit from the sale of 17,000 Splashes would be as follows.

£
Total contribution (17,000 × £4)
68,000
Less fixed costs
45,000
Profit
23,000

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PART A COST ACCOUNTING SYSTEMS
2 The principles of absorption costing
The principles of absorption costing are as follows.
(a)
Fixed production costs are an integral part of the production cost of an item and so should
be absorbed into product costs.
FAST FORWARD
With absorption costing, fixed production costs are absorbed into product unit costs using a
predetermined overhead absorption rate, based on the normal level of production for the period.
(b)
Inventories are valued at their full production cost including absorbed fixed production costs.
FAST FORWARD
If the actual production is different from the normal level, or actual expenditure on fixed production costs
is different from that budgeted, there may be an under or over absorption of fixed production costs for the
period. This amount is written off against the absorption costing profit for the period.
2.1 Example: absorption costing
Using the earlier example of Water and Sons, assume that the normal level of activity is 15,000 Splashes
per month and that budgeted fixed production costs were £30,000 for the month.
Required
Prepare profit statements for September, using absorption costing, for the three sales levels given.
Solution
The fixed production cost per unit, based on the normal level of activity, is £30,000/15,000 = £2 per unit.
The full production cost per unit = £6 + £2 = £8 per unit
With production of 20,000 Splashes the fixed overhead will be over-absorbed.

£
Fixed production costs absorbed (20,000 units × £2)
40,000
Fixed production costs incurred
30,000
Over-absorbed fixed production cost
10,000


10,000 Splashes
15,000 Splashes
20,000 Splashes

£
£
£
£
£
£
Sales

100,000

150,000

200,000
Opening inventory
0

0

0

Full production costs
160,000

160,000

160,000


160,000

160,000

160,000

Less closing inventory






(at full production cost)
80,000

40,000

0

Full production of sales
80,000

120,000

160,000

Adjustment for over-






absorbed overhead
10,000

10,000

10,000

Full production costs

70,000

110,000

150,000
Gross profit

30,000

40,000

50,000
Administration, sales and






distribution costs

15,000

15,000

15,000
Net profit

15,000

25,000

35,000
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1: MARGINAL COSTING AND ABSORPTION COSTING
3 The effect of marginal costing and absorption costing
on reported profit and inventory valuation


5/05 (OT), 11/05 (OT)
The results of the last two examples can be compared as follows.

Sales volume (Splashes)

10,000 15,000 20,000
Marginal costing profit/(loss) £(5,000)
£15,000
£35,000
Absorption costing profit
£15,000 £25,000 £35,000
Increase in inventory units
10,000
5,000
0
An important conclusion can be drawn from these results.
FAST FORWARD
If there are changes in inventories during a period, marginal costing and absorption costing systems will
report different profit figures.
In this example the inventory levels increased with the two lower sales volume figures and the reported
profit figure was higher with absorption costing than with marginal costing.
FAST FORWARD
If inventory levels increase, absorption costing will report a higher profit than marginal costing.
This is because some of the fixed production overhead incurred during the period will be carried forward
in closing inventory (which reduces cost of sales) to be set against sales revenue in the following period
instead of being written off in full against profit in the period concerned.
FAST FORWARD
If inventory levels decrease, absorption costing will report the lower profit.
This is because as well as the fixed overhead incurred, fixed production overhead which had been brought
forward in opening inventory is released and is included in cost of sales.
In our example the two reported profit figures were the same when sales volume was 20,000 Splashes, ie
when production and sales volumes were equal and there was no change in inventory.
FAST FORWARD
If the opening and closing inventory volumes and values are the same, marginal costing and absorption
costing will report the same profit figure.
It is important to appreciate that the differences in reported profits occur only in the short run, ie in
reporting the profit of individual accounting periods.
FAST FORWARD
In the long run, the total reported profit will be the same whether marginal or absorption costing is used.
This is because in the long run, total costs will be the same by either method of accounting. Short term
differences are the result of changes in the level of inventory.
3.1 Calculating the difference in reported profit
The difference in the profit reported by the two systems therefore results from the fixed production
overhead that is carried forward in inventory in an absorption costing system.
FAST FORWARD
The difference in reported profit is equal to the change in inventory volume multiplied by the fixed
production overhead rate per unit.

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PART A COST ACCOUNTING SYSTEMS
In our example the profit figures can be reconciled as follows.


Sales volume (Splashes)


10,000

15,000


£

£
Marginal costing profit/(loss)

(5,000)

15,000
Increase in inventory units @ £2 per unit
(10,000 × £2)
20,000
(5,000 × £2)
10,000
Absorption costing profit

15,000

25,000
In both cases the absorption costing profit was higher because the inventory level increased and fixed
production overhead was carried forward to next month in the absorption costing valuation.
Exam focus
The calculation of the difference between reported profits and inventory valuation in the two costing
point
systems is a subject that lends itself well to objective testing questions and has been examined in several
papers, including the November 2006 exam.

Question
Marginal versus Absorption costing – effect on profit

Learning outcome: A(i)
The overhead absorption rate for product X is £10 per machine hour. Each unit of product X requires five
machine hours. Opening inventory of product X on 1 January was 150 units and closing inventory on 31
December it was 100 units. What is the difference in profit between results reported using absorption
costing and results reported using marginal costing?
A
The absorption costing profit would be £2,500 less
B
The absorption costing profit would be £2,500 greater
C
The absorption costing profit would be £5,000 less
D
The absorption costing profit would be £5,000 greater

Answer


Difference in profit = change in inventory levels × fixed overhead absorption per unit = (150 – 100) × £10
× 5 = £2,500 lower profit, because stock levels decreased. The correct answer is therefore option A.
The key is the change in the volume of inventory. Inventory levels have decreased therefore absorption
costing will report a lower profit. This eliminates options B and D.
Option C is incorrect because it is based on the closing inventory only (100 units × £10 × 5 hours).

4 Marginal costing and absorption costing compared
FAST FORWARD
There are arguments in favour of each costing method.
4.1 Arguments in favour of absorption costing
(a)
Fixed production costs are incurred in order to make output; it is therefore 'fair' to charge all
output with a share of these costs.
(b)
Closing inventory values, include a share of fixed production overhead, and therefore follow
the requirements of the international accounting standard on inventory valuation (IAS 2).
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1: MARGINAL COSTING AND ABSORPTION COSTING
(c)
Absorption costing is consistent with the accruals concept as a proportion of the costs of
production are carried forward to be matched against future sales.
(d)
A problem with calculating the contribution of various products made by an enterprise 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 it is profitable or not. This is particularly important where fixed production
overheads are a large proportion of total production costs. Not absorbing production would
mean that a large portion of expenditure is not accounted for in unit costs.
(e)
In a job or batch costing environment (see section 5 below), absorption costing is
particularly useful in the pricing decision to ensure that the profit markup is sufficient to
cover fixed costs.
4.2 Arguments in favour of marginal costing
(a)
It is simple to operate.
(b)
There are no apportionments, which are frequently done on an arbitrary basis, of fixed
costs. Many costs, such as the marketing director's salary, are indivisible by nature.
(c)
Fixed costs will be the same regardless of the volume of output, because they are period costs. It
makes sense, therefore, to charge them in full as a cost to the period.
(d)
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.
(e)
Under or over absorption of overheads is avoided.
(f)
Marginal costing provides the best information for decision making.
(g)
Fixed costs (such as depreciation, rent and salaries) relate to a period of time and should be
charged against the revenues of the period in which they are incurred.
(h)
Absorption costing may encourage over-production since reported profits can be increased
by increasing inventory levels.
Exam focus
Part of a Section B question in November 2006 asked for a profit calculation using absorption costing and
point
an explanation of why marginal costing may be more useful than absorption costing. Make sure you are
completely happy with the pros and cons and calculations for each method.
4.3 Example: absorption costing encouraging over-production
To demonstrate the last argument in favour of marginal costing, consider an organisation that produces a
product that sells for £60 per unit.
Variable production costs are £35 per unit and the fixed production costs of £30,000 per period are
absorbed on the basis of the normal capacity of 5,000 units per period.
Fixed administration, selling and distribution overheads are £19,000 per period. There was no opening
inventory for the latest period.
Required
Calculate the profit reported for sales of 5,000 units last period for production volumes of 5,000 units,
6,000 units and 7,000 units, using:
(a) Absorption
costing
(b) Marginal
costing

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PART A COST ACCOUNTING SYSTEMS
Solution: absorption costing
Fixed production cost per unit = £30,000/5,000 = £6 per unit
Full production cost per unit = £35 + £6 = £41 per unit

Production

5,000 units
6,000 units
7,000 units

£'000
£'000
£'000
£'000
£'000
£'000
Sales (5,000 units × £60)

300

300

300
Production cost @ £41 per unit
205

246

287

Less closing inventory
–

41

82


205

205

205

Less over-absorbed fixed production cost
–

6

12

Total production cost of sales

205

199

193
Gross profit

95

101

107
Administration costs

19

19

19
Net profit

76

82

88
Solution: marginal costing

Production

5,000 units
6,000 units
7,000 units

£'000
£'000
£'000
£'000
£'000
£'000
Sales

300

300

300
Variable cost of production @ £35 per unit
175

210

245

Less closing inventory
–

35

70

Variable production cost of sales
175
175

175
Contribution

125

125

125
Fixed production costs

30

30

30
Administration costs

19

19

19
Net profit

76

76

76
This example demonstrates an important point when considering the impact on profit reporting of
marginal and absorption costing methods.
FAST FORWARD
For a given level of sales, marginal costing will report the same level of profit whatever the level of
production. In contrast, absorption costing will report higher levels of profit for the same level of sales, if
production levels are higher.

Question
Shortcomings of absorption costing

Learning outcome: A(i)
A criticism of the use of absorption costing for the internal reporting of profit is that, if a manager's reward
is based on the profit for the period, the manager will be encouraged to increase production even if the
resulting output cannot be sold. Explain why absorption costing can have this effect.

(5 marks)
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1: MARGINAL COSTING AND ABSORPTION COSTING

Answer


If a manager's reward is based on the profit for the period then the manager will be encouraged to take
actions which will increase the reported profit in the short term.
With absorption costing, all production costs are absorbed into product unit costs. Any inventory
remaining at the end of the period would include absorbed fixed production costs. The higher production
for the period, the greater the amount of fixed production cost that will be carried forward in inventory to
be charged against the revenues of future periods. Furthermore, the higher the production level for the
period, the lower will be the full unit cost of production because the same amount of fixed production cost
will be shared out over a higher number of units.
Thus, the higher the production for the period, the higher will be the reported profit for the period, for a
given level of sales, when an absorption costing system is used.

4.4 Marginal costing – concluding remarks
In spite of the arguments in favour of marginal costing as a decision making tool, absorption costing is
widely used for general accounting purposes and inventory valuation. Fixed production costs should
ultimately be charged to cost units in a fair and meaningful way. A central problem in cost accounting is to
identify the best method of attributing these costs.
In the following few chapters we shall look at new approaches developed to address the weaknesses of
both marginal and absorption costing.
Activity based costing (ABC), discussed in Chapter 6, is a form of absorption costing. It is a relatively
modern costing approach seeking to address certain weaknesses of traditional absorption costing and
identify the most appropriate way of attributing overhead costs to units of production.
5 Job costing and batch costing
Knowledge brought forward from earlier studies

Job costing
•
Job costing is a costing method applied to work undertaken to customers' special requirements;
each job is of comparatively short duration and is a continuously identifiable unit.
•
Each job is given a unique number and the cost of a job is collected and summarised on a job cost
sheet or job card, which may be simply a separate file in a computerised system.
Batch costing
•
The procedures for costing batches are very similar to those for costing jobs.
•
The batch is treated as a job during production and costs are collected in the same manner as for
job costing.
•
Once the batch has been completed, the cost per unit can be calculated as the total batch cost
divided by the number of units in the batch
So far in this chapter all of the examples of the application of absorption costing and marginal costing
have related to a situation where a number of identical units have been produced and sold in a period.

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PART A COST ACCOUNTING SYSTEMS
FAST FORWARD
Marginal and absorption costing approaches can also be applied in job and batch environments.
5.1 Absorption costing in a job costing environment
Since each job is different from any other it would not usually be equitable to absorb fixed production
overheads using a pre-determined rate per job, since the same amount of fixed production overhead
would then be absorbed by each job. This is unlikely to result in a fair absorption of overheads since some
jobs would place a greater load on the organisation’s facilities than other jobs.
An overhead absorption rate based upon machine hours or labour hours would usually be more
appropriate but it would be very important to ensure that the absorption base reflected the incidence of
fixed overheads. For example in a machine intensive environment a machine hour rate would be most
appropriate and in a labour intensive environment a labour hour rate is likely to lead to fairer overhead
absorption.
The absorption base selected should result in the fairest distribution of overhead costs between jobs.
5.2 Example: the effect of the overhead absorption base in job costing
Fixit uses the job costing method and currently absorbs fixed production overhead into job costs using a
pre-determined rate per labour hour. The general manager is considering changing the absorption base to
a pre-determined rate per machine hour.
Information for the latest period is as follows.

$
Budgeted fixed production overhead
350,000
Budgeted machine hours
70,000
Budgeted labour hours
87,500
Extracts from data concerning two jobs completed during the period are as follows.

Job 876
Job 890
Direct labour hours
24
9
Machine hours
11
15
Required
Calculate the fixed production overhead to be absorbed by each job using:
(a)
A direct labour hour rate of overhead absorption
(b)
A machine hour rate of overhead absorption
Solution
Direct labour hour rate = $350,000/87,500 = $4 per direct labour hour
Machine hour rate = $350,000/70,000 = $5 per machine hour
Fixed production overhead absorbed:


Job 876

Job 890


$
$
(a)
Direct labour hour rate
($4 × 24)
96
($4 × 9)
36
(b) Machine
hour
rate
($5 × 11)
55
($5 × 15)
75
The alteration in overhead absorption basis would thus have a significant impact on the amount of
production overhead absorbed by each of these jobs. If Fixit uses cost plus pricing this could lead to
under or over pricing of the jobs to the customer.
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