Chapter 9 Marginal Costing and Absorption Costing

Contents:

1. Full cost and marginal cost

2. Contribution

3. Profit statements under absorption and marginal costing

4. Advantages of marginal costing

5. Advantages of absorption costing

I. Full Cost and Marginal Cost

Absorption costing:

- Fixed manufacturing overheads are absorbed into costs units. Hence, inventory is

valued at total production cost.

- Fixed manufacturing/production overheads are charged in the SOPL of the period in

which the units are sold.

Marginal costing:

- Fixed overheads are not absorbed into cost units. Inventory is valued at marginal or

variable production cost.

- All fixed overheads, including fixed manufacturing overheads are treated as period

costs and are charged in the SOPL of the period in which the overheads are incurred.

II. Contribution

𝑪𝒐𝒏𝒕𝒓𝒊𝒃𝒖𝒕𝒊𝒐𝒏 = 𝑺𝒂𝒍𝒆𝒔 − 𝑻𝒐𝒕𝒂𝒍 𝑽𝒂𝒓𝒊𝒂𝒃𝒍 𝑪𝒐𝒔𝒕 𝒐𝒇 𝑺𝒂𝒍𝒆𝒔

Contribution is the difference between sales and the variable cost of sales. Contribution

is short for ‘contribution to fixed costs and profits’. The idea is that after deducting the variable

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costs from sales, the figure remaining is the amount that contributes to the fixed costs and, once

fixed costs are covered, to profits.

1. Contribution and Profit (calculation)

Marginal costing values goods at variable cost of production (or marginal cost)

and contribution can be shown as follows:

Marginal Costing

Sales X

Less: all variable costs (X)

Contribution X

Less: fixed production costs (X)

Less: all other fixed costs (X)

Net Profit X

Note: they may be variable non-production costs which must also be deducted from

sales to arrive at contribution.

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 In absorption costing profit is effectively calculated in one stage as the cost of

sales already includes all overheads.

Absorption costing: profit calculation

Sales X

Less: absorption cost (X)

Gross profit X

Less: non-production costs (X)

Net Profit X

Why is contribution significant?

Contribution is an important concept in marginal costing. Changes in the volume of

sales or in sales prices, or in variable costs will all affect profit by altering the total contribution.

Marginal costing techniques can be used to help management to assess the likely effect on

profits of higher or lower sales volume or the likely consequences of reducing the sales price

of a product in order to increase demand, and so on. The approach to any such analysis should

be to calculate the effect on total contribution. The arithmetic is quite straightforward.

Tips: When calculating the impact of changes to sales price, variable cost and sales volume,

it is often quicker to calculate unit contribution configures. This approach also focuses on

the key information which is important to managers when making a decision.

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III. Profit Statements Under Absorption and Marginal Costing

Absorption costing must be used to provide inventory valuation for statutory financial

statements. However, either marginal or absorption costing can be useful for internal

management reporting. The choice made will affect:

- The way in which the profit information is presented and,

- The level of reported profit, but only if sales volumes do not exactly equal production

volumes (so that there is a difference between opening and closing inventory values).

Notes: How variable selling costs are debuted in the calculation of contribution in the

marginal costing statement.

1. Explanation of The Difference in Profit

The difference in profit between two costing methods is due to the difference in

inventory levels between the beginning and the end of the period.

Difference in profit between MC and AC

= 𝑭𝒊𝒙𝒆𝒅 𝒑𝒓𝒐𝒅𝒖𝒄𝒕𝒊𝒐𝒏 𝒐𝒗𝒆𝒓𝒉𝒆𝒂𝒅 × 𝑰𝒏𝒄𝒓𝒆𝒂𝒔𝒆 𝒐𝒓 𝑫𝒆𝒄𝒓𝒆𝒂𝒔𝒆 𝒊𝒏 𝒊𝒏𝒗𝒆𝒏𝒕𝒐𝒓𝒚

 If inventory levels are rising or falling, absorption costing will give a different profit

figure from marginal costing.

 If sales equal production, the fixed overheads absorbed into cost of sales under

absorption costing will be the same as the period costs charged under marginal

costing and thus the profit figure will be the same.

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 The basic rule:

 If inventory levels are rising, AC profit > MC profit

 If inventory levels are falling, AC profit > MC profit

 If opening and closing inventory levels are the same, AC profit = MC profit

2. Under and Over Absorption of Fixed Overheads

Under and over absorption of fixed overheads arises if the actual expenditure and

production level are not as estimated in the predetermined overhead absorption rate. Such

difference between budgeted and actual expenditure and production cause under or over

absorption but have no effect on different profit figures reported under absorption and

marginal costing, which is due to the different inventory valuations. The next example

illustrates this.

IV. Advantages of Marginal Costing

Preparation of routine operating statements using marginal costing is considered more

informative for the following reasons:

 Marginal costing emphasizes variable costs per unit and treats fixed costs in total as

period costs, whereas absorption costing includes all production costs in unit costs,

including a share of fixed production costs. Marginal costing therefore reflects the

behavior of costs in relation to activity. Since most decision-making problems involve

changes to activity, marginal costing information is more relevant and appropriate

for short-run decision making than absorption costing.

 Profit per unit with absorption costing can be a misleading figure. This is because

profitability might be distorted by increases or decreases in inventory levels in the

period, which has no relevance for sales.

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  Comparison between products using absorption costing can be misleading because of

the effect of the arbitrary apportionment of fixed costs. Where two or more products

are manufactured in a factory and share all production facilities, the fixed overhead can

only be apportioned on an arbitrary basis.

V. Advantages of Absorption Costing

In spite of its weaknesses as a system for providing information to management absorption

costing is widely used. The only difference between using absorption costing and marginal

costing as the basis of inventory valuation is the treatment of fixed production costs.

The argument used in favor of absorption costing are as follows:

 Fixed costs are incurred within the production function, and without those facilities

production would not be possible. Consequently such costs can be related to production

and should be included in inventory valuation.

 Absorption costing follows the matching concept by carring forward a proportion of

the production cost in the inventory valuation to be matched against the sales value

when the items are sold.

 It is necessary to include fixed overhead in inventory values for financial statements;

routine cost accounting using absorption costing produces inventory values which

include a share of fixed overhead.

 Overhead allotment is the only practicable way of obtaining job costs for estimating

prices and profit analysis.

 Analysis of under-/over-absorbed overhead is useful to identify inefficient utilization

of production resources.

 It is quite common to price jobs or contracts by adding a profit margin to the estimated

fully-absorbed cost of the work.

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o Absorption costing can provide misleading information to management whenever a

decision has to be made.

o Marginal costing is consistent with the concept of relevant costs of management decision-

making. It’s also useful for forward planning, for example in forecasting and budgeting.