Marginal Costing & Absorption costing

Chapter 4
Learning Objective 1

Explain how variable costing

differs from absorption
costing and compute unit
product costs under each
method.
Marginal Costing
 Marginal Cost is the variable cost of one
unit of product or service
 A cost would be avoided if the unit was
not produced or provided

• Marginal cost = variable

production costs
 Marginal costing and Contribution

Contribution = Sales Revenue – Variable cost (both production and non-production cost)

Profit = Contribution – Fixed cost (both fixed production and non-production cost)
Marginal Costing

The principles of marginal costing:

1) Period fixed costs are the same (unchanged) for
any volume of sales and production.
 By selling an extra item of product/ service, then
- Revenue will increase
- Costs (variable costs) will increase
- Profit will increase by the amount of contribution
earned from the extra item sold
Marginal Costing

The principles of marginal costing:

2) Profit measurement should be based on an
analysis of total contribution
- Fixed costs are unchanged whatever sales volume
increase or decrease
- -> Mislead if charge unit of sale with a share of fixed
cost
- -> appropriate to deduct fixed costs from total
contribution
Marginal Costing

The principles of marginal costing:

3)When a unit of product is made, the extra costs
incurred are variable costs only (fixed costs are
unaffected), and no extra fixed costs are incurred
when output is increased
-> Valuation of closing inventories should be at
variable production costs (include: materials, direct
labor and variable production overhead)
Example of Marginal costing and contribution
ABC company makes 2 products: The Loo and the Wash. Information relating to each of these
products for April 20X1 is as follows:

Loo Wash
Opening inventory Nil Nil
Production (units) 15,000 6,000
Sale units 10,000 5,000
$ $
Unit price 20 30
Unit costs
- Variable materials 8 14
- Variable labor 4 2
- Variable production Overhead 2 1
- Variable Sales overhead 2 3

Fixed Costs for the month $

- Production costs 40,000
- Administration costs 15,000
- Sales and distribution costs 25,000

Required: Caculate the profit in April using Marginal

costing
Overview of Absorption and Marginal Costing
Absorption costing Vs. Marginal costing

Product cost: Refers to the costs used to create a product. These costs
include: direct materials, direct labor, consumable production supplies, and
factory overhead

Period costs: are not a necessary part of the manufacturing process.

They can not be assigned to the products or to the cost of inventory,
including: Selling and Administrative Expenses
Absorption and Marginal costing
Absorption Marginal
costing Costing
Valuing units Total production Marginal
cost (Variable)
production cost
Valuing inventory Opening and Opening and
closing inventory closing inventory
valued at total valued at
production cost marginal cost
Fixed production Carried forward Fixed costs
Overheads from one period charged in full
to the next as part against profit in
of the the period in
closing/opening which they are
inventory incurred
valuation. Only hit
profit when units
are sold
Absorption and Marginal costing

Absorption costing Marginal costing

Adjusting for over-or under- Yes- in the income None is needed
absorption statement
Impact of increase in inventory Gives higher profit Gives lower profit
levels
Impact of decrease in inventory Gives lower profit Gives higher profit
levels
Inventory level constant Same profit under both systems
Absorption and Marginal costing

Profit Statement
Sale revenues Sale revenues
- -
Cost of Sales Cost of sales
- +/-
Variable non-production costs Over/under absorption
= =
CONTRIBUTION GROSS PROFIT
- -
Fixed costs Variable non-production costs
-
=
Fixed non-production costs
NET PROFIT/LOSS =
NET PROFIT/LOSS
Absorption and Marginal Costing
RECONCILIATION

MARGINAL COSTING PROFIT

+/-

Change in inventory x Fixed OAR

ABSORPTION COSTING PROFIT

Absorption vs. Marginal costing

Advantages of marginal costing Advantages of Absorption costing

Contribution per unit is constant Absorption costing includes an
unlike profit per unit which varies with element of fixed overheads in
changes in sales volumes inventory values (in accordance with
accounting standards)
There is no under or over absorption Analyzing under/over absorption of
of overheads (hence, no adjustment overheads is a useful exercise in
is required in the income statement) controlling costs of an organization
Fixed costs are period cost and are In small organizations, absorbing
charged in full to the period under overheads into the costs of products
consideration is the best way of estimating job
costs and profits on jobs
Marginal costing is useful in the
decision- making process
Simple to operate
 Example
A company commenced business on 1 Mar produces one product only, the cost
card of product is as follows

$
Direct Materials 8
Direct Labor 5
Variable production overhead 2
Fixed production overhead 5
Standard production cost 20
OAR = 15.000 * 12/36.000 = 5

Fixed production overhead figure has been calculated on the basis of a budget
normal output of 36,000 units per annum. The fixed production overhead incurred
in Mar was $15.000 each month
Example
Selling, distribution and Administration expenses are
Fixed: $ 10,000 per month
Variable: 15% of the sales value

The selling price per unit is $35 and the number of units produced and sold was
March (units)
Production: 2,000
Sales: 1,500 * 35 = 52,500

Required:
- Prepare the absorption costing profit statement for Mar
- Prepare the marginal costing profit statement for Mar
- Comparison of the profits
- Reconcile the profits/loss between the 2 methods:
Absorption and Marginal costing
Absorption cost in favor:
1. Fixed overhead incurred in order to make output, so it is FAIR to charge all
output with a share of fixed overhead
2. Absorption cost is used in inventory valuation under IAS 02 “Inventory”
3. Pricing can be misled when contribution is insufficient to cover fixed costs
4. In the long-run, all costs are variable, Absorption cost will give recognition to
these long-run variable costs

Marginal cost in favor:

1. It is simple to operate
2. Help to make short-run pricing decision because it focuses on the variable
costs
3. There would be now apportionments of fixed costs
4. Fixed costs relate to a period of time should be periodic expenses
5. Under/over absorption of overhead is avoided
Absorption and Marginal costing:

Interactive Question: Reconciling the difference in reported profits:

The overhead absorption rate for product X is $10 per machine hour. Each
unit of product X requires 5 machine hours.
Production of product X last period was 4,800 units and the sales volume
achieved was 4,750 units
Requirement:
1. The absorption costing profit would be :
a. Greater than
b. The same as
c. Less than the marginal costing profit
2. The differences between the reported profits would be: $?
Absorption and Marginal costing
Example: Comparison of total profits:
Company ABC produces and sells a single product X. At the beginning
of period 1, there are no opening inventories of the product for which the
variable production cost is $4 per unit and the sales price is $6 per unit.
Fixed costs are $2,000 per period, of which $1,500 are fixed production
costs

Period 1 Period 2
Sales 1,200 units 1,800 units
Production 1,500 units 1,500 units
Requirement:
What profit would be reported in each period and in total using the following
costing systems?
1. Absorption costing. Assume normal output is 1,500 units per period
2. Marginal costing
Quick Check 

Which method will produce the highest values for

work in process and finished goods inventories?
a. Absorption costing.
b. Marginal costing.
c. They produce the same values for these
inventories.
d. It depends. . .
Unit Cost Computations
Harvey Company produces a single product
with the following information available:
Unit Cost Computations
Unit product cost is determined as follows:

Under absorption costing, all production costs, variable

and fixed, are included when determining unit product
cost. Under variable costing, only the variable
production costs are included in product costs.
Learning Objective 2

Prepare income statements

using both variable and
absorption costing.
Income Comparison of
Absorption and Variable Costing

Let’s assume the following additional information

for Harvey Company.
 20,000 units were sold during the year at a price
of $30 each.
 There is no beginning inventory.

Now, let’s compute net operating

income using both absorption
and variable costing.
Absorption Costing

Fixed manufacturing overhead deferred in

inventory is 5,000 units × $6 = $30,000.
Variable Costing
Variable
manufacturing
Variable Costing
costs only.
Sales (20,000 × $30) $ 600,000
Less variable expenses:
Beginning inventory $ -
All fixed
Add COGM (25,000 × $10) 250,000
manufacturing
Goods available for sale 250,000
Less ending inventory (5,000 × $10) 50,000
overhead is
Variable cost of goods sold 200,000
expensed.
Variable selling & administrative
expenses (20,000 × $3) 60,000 260,000
Contribution margin 340,000
Less fixed expenses:
Manufacturing overhead $ 150,000
Selling & administrative expenses 100,000 250,000
Net operating income $ 90,000
Learning Objective 3

Reconcile variable costing

and absorption costing net
operating incomes and
explain why the two
amounts differ.
Comparing the Two Methods
Comparing the Two Methods
We can reconcile the difference between
absorption and variable income as follows:

Variable costing net operating income $ 90,000

Add: Fixed mfg. overhead costs
deferred in inventory
(5,000 units × $6 per unit) 30,000
Absorption costing net operating income $ 120,000

Fixed mfg. overhead $150,000

= = $6 per unit
Units produced 25,000 units
Extended Comparisons of Income Data
Harvey Company – Year Two
Unit Cost Computations

Since the variable costs per unit, total fixed costs,

and the number of units produced remained
unchanged, the unit cost computations also
remain unchanged.
Absorption Costing Unit product
cost.
Absorption Costing
Sales (30,000 × $30) $ 900,000
Less cost of goods sold:
Beg. inventory (5,000 × $16) $ 80,000
Add COGM (25,000 × $16) 400,000
Goods available for sale 480,000
Less ending inventory - 480,000
Gross margin 420,000
Less selling & admin. exp.
Variable (30,000 × $3) $ 90,000
Fixed 100,000 190,000
Net operating income $ 230,000

Fixed manufacturing overhead released from

inventory is 5,000 units × $6 = $30,000.
Variable Costing Variable
manufacturing
costs only.

All fixed
manufacturing
overhead is
expensed.
Comparing the Two Methods
We can reconcile the difference between
absorption and variable income as follows:

Variable costing net operating income $ 260,000

Deduct: Fixed manufacturing overhead
costs released from inventory
(5,000 units × $6 per unit) 30,000
Absorption costing net operating income $ 230,000

Fixed mfg. overhead $150,000

= = $6 per unit
Units produced 25,000 units
Comparing the Two Methods
Summary of Key Insights
Learning Objective 4

Understand the
advantages and
disadvantages of both
variable and absorption
costing.
Impact on the Manager
Opponents of absorption costing argue that
shifting fixed manufacturing overhead costs
between periods can lead to faulty decisions.

These opponents argue that variable costing income

statements are easier to understand because net operating
income is only affected by changes in unit sales. This
produces net operating income figures that are
consistent with managers’ expectations.
CVP Analysis, Decision Making
and Absorption costing
Absorption costing does not dovetail with CVP analysis,
nor does it support decision making. It treats fixed
manufacturing overhead as a variable cost. It assigns per
unit fixed manufacturing overhead costs to production.
Treating fixed manufacturing overhead as a
variable cost can:
• Lead to faulty pricing decisions and faulty
keep-or-drop decisions.

Assigning per unit fixed manufacturing overhead

costs to production can:
• Potentially produce positive net operating income
even when the number of units sold is less than
the breakeven point.
 External Reporting and Income Taxes
To conform to
IFRS and US GAAP
requirements, absorption costing In many countries,
must be used for including US,
external financial reports. absorption costing must be
used when filling out
income tax returns.
Since top executives
are typically evaluated based on
earnings reported to shareholders
in external reports, they may feel that
decisions should be based on
absorption costing data.
Advantages of Variable Costing
and the Contribution Approach
Consistent with
CVP analysis.
Management finds Net operating income
it more useful. is closer to
net cash flow.
Consistent with standard
costs and flexible budgeting.
Advantages
Easier to estimate profitability
of products and segments.
Impact of fixed
costs on profits Profit is not affected by
emphasized. changes in inventories.
Variable versus Absorption Costing

Fixed manufacturing
costs must be assigned Fixed manufacturing
to products to properly costs are capacity costs
match revenues and and will be incurred
costs. even if nothing is
produced.

Absorption Variable
Costing Costing
Variable Costing and the Theory of
Constraints (TOC)
Companies involved in TOC use a form of variable
costing. However, one difference of the TOC approach
is that it treats direct labor as a fixed cost for three
reasons:
 Many companies have a commitment to guarantee
workers a minimum number of paid hours.
 Direct labor is usually not the constraint.
 TOC emphasizes the role direct laborers play in driving
continuous improvement. Since layoffs often devastate
morale, managers involved in TOC are extremely
reluctant to lay off employees.
Impact of Lean Production

When companies use Lean Production . . .

Production
tends to equal
sales . . .

So, the difference between variable and

absorption income tends to disappear.
Learning Objective 8

Explain the potential

problems of using
absorption costing.
 Creating Extra Profit Without Increase In Sales
Continue with the Harvey Fresh example (slides 54, and 58 to 64).
Assume the company had the same sales, revenue and cost structure
but produced 35,000 units (instead of 25,000 units) to increase ending
inventory by 10,000 units.
Overapplied adjustments required
 Harvey Fresh’s actual fixed manufacturing overhead
= $120,000
 Based on the original scenario, the applied overhead
was based on actual production of 25,000 units at $6
each (slide 19), giving rise $150,000 being applied to
the items produced. Therefore, it was overapplied
by $30,000 ($150,000 applied - $120,000 actual).
 Based on the new scenario, the applied overhead
was based on actual production of 35,000 units at $6
each (slide 19), giving rise $210,000 being applied to
the production. Therefore, it was overapplied by
$90,000 ($210,000 applied - $120,000 actual).
Profit Arising from Ending Inventory Value

 The additional profit ($60,000) is the same amount as the

additional overapplied adjustment ($90,000 - $30,000).
 The overapplied adjustment is to make good of the applied
fixed overhead to match with the actual overhead spent.
 The additional profit actually arises from the additional fixed
overhead (based on the predetermined overhead rate,
POHR) carried forward through the change in ending
inventory, amounting the same as the over/underapplied
fixed overhead adjustment if the adjustment is written off
directly to cost of goods sold.
 If the adjustment is done through the proportional method
shown in slides 61– 64, then the increased profit will not
match the overapplied adjustment.
Value of Ending Inventory
 Use of Variable Costing
Continue with the Harvey Fresh example but presenting the results
using the variable costing format.

Profits remain the same despite of changing quantity in production and ending inventory
Use of Variable Costing can avoid Profit inflation through producing more inventories
Overapplied and Underapplied Manufacturing
Overhead - Summary
Harvey Fresh’s
Method
Alternative 1 Alternative 2
If Manufacturing Close to Cost Proportional
Overhead is . . . of Goods Sold Allocation

UNDERAPPLIED INCREASE INCREASE

Cost of Goods Sold Work in Process
(Applied OH is less Finished Goods
than actual OH) Cost of Goods Sold

OVERAPPLIED DECREASE DECREASE

Cost of Goods Sold Work in Process
(Applied OH is greater Finished Goods
than actual OH) Cost of Goods Sold

More accurate but more complex to compute.

Quick Check 
What effect will the overapplied overhead have
on Harvey’s net operating income?
a. Net operating income will increase.
b. Net operating income will be unaffected.
c. Net operating income will decrease.
Quick Check 

What effect will the overapplied overhead have

on Harvey’s net operating income?
a. Net operating income will increase.
b. Net operating income will be unaffected.
c. Net operating income will decrease.
Multiple Predetermined Overhead Rates
To this point, we have assumed that there is a single
predetermined overhead rate called a plantwide
overhead rate.

Large companies May be more complex

often use multiple but . . .
predetermined
overhead rates.
May be more accurate because
it reflects differences across
departments.
End of Chapter 5