TOPIC 2: MARGINAL AND ABSORPTION COSTING

1. Marginal and Absorption Costing

• Distinction between marginal and absorption costing
• Valuation of products under marginal and absorption
costing
Class Assignments
Prepare • Preparation of marginal and absorption statements;
marginal and cost of production and profit determination Question & Answer

absorption cost • Reconciliation of marginal profits and absorption Demonstrations

statements profits
Group discussions
• Make or buy decisions
• Preparation of manufacturing cost statements

Marginal Costing

Definition: Marginal Costing is a costing technique wherein the marginal cost, i.e. variable
cost is charged to units of cost, while the fixed cost for the period is completely written off
against the contribution.

The term marginal cost implies the additional cost involved in producing an extra unit of
output, which can be reckoned by total variable cost assigned to one unit. It can be calculated
as:

Marginal Cost = Direct Material + Direct Labor + Direct Expenses + Variable Overhead

Marginal cost is the change in the total cost when the quantity produced is incremented by
one. That is, it is the cost of producing one more unit of a good. For example, let us suppose:

Variable cost per unit = Ksh. 25

Fixed cost = Ksh. 100,000
Cost of 10,000 units = 25 × 10,000 = Ksh. 250,000
Total Cost of 10,000 units = Fixed Cost + Variable Cost

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 = 100,000 + 250,000 = Ksh. 350,000
Total cost of 10,001 units = 100,000 + 250,025
= Ksh. 350,025
Marginal Cost = 350,025 – 3,50,000
= Ksh. 25

Need for Marginal Costing

Let us see why marginal costing is required:

• Variable cost per unit remains constant; any increase or decrease in production changes
the total cost of output.

• Total fixed cost remains unchanged up to a certain level of production and does not
vary with increase or decrease in production. It means the fixed cost remains constant
in terms of total cost.

• Fixed expenses exclude from the total cost in marginal costing technique and provide
us the same cost per unit up to a certain level of production.

Features of Marginal Costing

Features of marginal costing are as follows:

• Marginal costing is used to know the impact of variable cost on the volume of
production or output.

• Break-even analysis is an integral and important part of marginal costing.

• Contribution of each product or department is a foundation to know the profitability of

the product or department.

• Addition of variable cost and profit to contribution is equal to selling price.

• Marginal costing is the base of valuation of stock of finished product and work in
progress.

• Fixed cost is recovered from contribution and variable cost is charged to production.

• Costs are classified on the basis of fixed and variable costs only. Semi-fixed prices are
also converted either as fixed cost or as variable cost.

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Ascertainment of Profit under Marginal Cost

‘Contribution’ is a fund that is equal to the selling price of a product less marginal cost.
Contribution may be described as follows:

Contribution = Selling Price – Marginal Cost

Contribution = Fixed Expenses + Profit
Contribution – Fixed Expenses = Profit

Income Statement under Marginal Costing

Income Statement
For the year ended 31-03-2014

Particulars Amount Total

Sales 2,500,000

Less: Variable Cost:

Cost of goods manufactured 1,200,000

Variable Selling Expenses 300,000

Variable Administration Expenses 50,000

1,550,000

Contribution 950,000

Less: Fixed Cost:

Fixed Administration Expenses 70,000

Fixed Selling Expenses 130,000 200,000

750,000

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Advantages of Marginal Costing
The advantages of marginal costing are as follows:

• Easy to operate and simple to understand.

• Marginal costing is useful in profit planning; it is helpful to determine profitability at

different level of production and sale.

• It is useful in decision making about fixation of selling price, export decision and make
or buy decision.

• Break even analysis and P/V ratio are useful techniques of marginal costing.

• Evaluation of different departments is possible through marginal costing.

• By avoiding arbitrary allocation of fixed cost, it provides control over variable cost.

• Fixed overhead recovery rate is easy.

• Under marginal costing, valuation of inventory done at marginal cost. Therefore, it is

not possible to carry forward illogical fixed overheads from one accounting period to
the next period.

• Since fixed cost is not controllable in short period, it helps to concentrate in control
over variable cost.

Key Differences
• Marginal costing doesn’t take fixed costs into account under product costing or
inventory valuation. Absorption costing, on the other hand, takes both fixed costs and
variable costs into account.
• Marginal costing can be classified as fixed costs and variable costs. Absorption costing
can be classified as production, distribution, and selling & administration.
• The purpose of marginal costing is to show forth the contribution of the product cost.
The purpose of absorption costing is to provide a fair and accurate picture of the profits.
• Marginal costing can be expressed as a contribution per unit. Absorption costing can
be expressed as net profit per unit.
• Marginal costing is a method of costing and it isn’t a conventional way of looking at
costing method. Absorption costing, on the other hand, is used for financial and tax
reporting and it is the most convenient method of costing.

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Absorption Costing
Absorption costing, also called full costing is what you are used to under Generally Accepted
Accounting Principles. Under absorption costing, companies treat all manufacturing costs,
including both fixed and variable manufacturing costs, as product costs. Remember, total
variable costs change proportionately with changes in total activity, while fixed costs do not
change as activity levels change. These variable manufacturing costs are usually made up of
direct materials, variable manufacturing overhead and direct labor. The product costs (or cost
of goods sold) would include direct materials, direct labor and overhead. The period costs
would include selling, general and administrative costs

The product cost, under absorption costing, would be calculated as:

Direct Materials
+ Direct Labor
+ Variable Overhead
+ Fixed Overhead
= Total Product Cost

You can calculate a cost per unit by taking the total product costs / total units
PRODUCED. Yes, you will calculate a fixed overhead cost per unit as well even though we
know fixed costs do not change in total but they do change per unit. We will assign a cost
per unit for accounting reasons. When we prepare the income statement, we will use the
multi-step income statement format.

For our purpose, the absorption income statement will contain:

Sales

– Cost of Goods Sold

= Gross Profit

Operating Expenses:

Selling Expenses

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 + General and Admin. Expenses

= Total Expenses

= Net Operating Income

Gross Profit is also referred to as gross margin. Net operating income is Gross Profit – Total
Operating Expenses and is also called Income before taxes. Let’s look at an example:

Bradley Company had the following information for May:

• Direct materials Ksh. 13,000

• Direct labor Ksh.15,000

• Variable overhead Ksh.5,000

• Fixed overhead Ksh.6,000

• Fixed selling expenses Ksh.15,000

• Variable selling expenses Ksh.0.20 per unit

• Administrative expenses Ksh.12,000

• 10,000 units produced

• 9,000 units sold (1,000 remain in ending finished goods inventory)

• Sales price Ksh.8 per unit

First, we need to calculate the absorption product cost per unit:

Direct Materials Ksh. 13,000

+ Direct Labor Ksh. 15,000

+ Variable Overhead Ksh. 5,000

+ Fixed Overhead Ksh. 6,000

= Total Product Cost Ksh.39,000

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 ÷ Total Units Produced ÷ 10,000

= Product cost per unit Ksh. 3.90

Next, we can use the product cost per unit to create the absorption income statement. We will
use the UNITS SOLD on the income statement (and not units produced) to determine sales,
cost of goods sold and any other variable period costs.

Bradley Company

Income Statement (absorption)

For Month Ended May

Ksh. Ksh.

Sales (9,000 x Ksh.8 per unit) 72,000

– Cost of Goods Sold (9,000 x $3.90 per unit) 35,100

= Gross Profit 36,900

Operating Expenses:

Selling Expenses (15,000 fixed + variable 0.20 x 9,000

16,800
units sold)

+ General and Admin. Expenses 12,000

= Total Expenses 28,800

= Net Operating Income 8,100

Illustration
The following information was extracted from the book of Happy Ltd for the year ended
31/12/2018
Output 100000 units
Production costs
Direct labour cost Shs 5 Million

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Direct material cost Shs 2 million
Variable overheads Shs 2 million
Fixed overheads Shs 4 million
Units sold 90,000
Selling price per unit Shs 100.00
Assume closing stocks at the end of the previous period were nil.

Required
Using both absorption and marginal costing determine
i. Cost per unit
ii. Prepare the income statement under marginal and Absorption costing

Solution
Marginal costing
(5 + 2 + 2)
million = Shs.90
i. Cost per unit = 100 ,000
Note:
Only variable costs are considered. Fixed overheads are not included in the cost per unit.

∴Total units sold = 90,000 x 90 = Shs 8100,000

∴Closing stock value = 10,000 x 90 = Shs 900,000

Total costs (variable) for the goods produced
= 100,00 x 90 = shs.9,000,000 = cost of finished goods

Absorption costing
Cost per unit = 5,000,000 + 2,000,000 +2,000,000 + 4,000,000 = Shs 13,000,000

Note
All costs (fixed and variable) are considered in arriving at the cost per unit.
∴Total cost of units sold = 130 x 90000 = Shs 11,700,000
Closing stock = 10,000 x 130 = 1,300,000
Total costs for goods produced = Shs 1,300,000 = cost of finished goods

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ii. Income statement for the year ended 31.12.208

Using MARGINAL ABSORPTION

COSTING COSTING
Shs Shs
Sales 90,000 x 100 9,000,000 9,000,000
Cost of sales
Opening stock Nil Nil
Cost of finished goods 9,000,000 13,000,000
Cost of goods available for sale 9,000,000 13,000,000
Less closing stock (900,000) (13,000,000
)
Cost of goods sold (8,100,000) 11,700,00
GROSS PROFIT/LOSS 900,000 (2,700,000
)
Period costs
Fixed overheads (400,000) -________
Net loss 500,000 (2,700,000
)

How can the above differences in net losses be explained?

Note that they are caused chiefly by the differences in cost of goods sold, which is in turn
caused by the differences in the cost per unit for finished goods and closing stock

Reconciliation of marginal costing and absorption costing profits

As at 31/12/2018

Net loss as per absorption costing (2,700,000)

Net profit as per marginal costing 500,000
Difference 2,200,000
Value of closing stock as per absorption costing 1,300,000
Value of closing stock as per marginal costing (900,000)

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 400,000

Make or buy decisions (No Limiting Factors)

The choice between making or buying a given component is one which is likely to face all
businesses at some time. It is often one of the most important decisions for management for
the critical effect on profits that may ensue. The choice is critical, too, for the management
accountant who provides the cost data on which the decision is ultimately based.

A make or buy problem involves a decision by an organisation about whether it should make
a product or carry out an activity with its own internal resources or whether it should pay
another organisation to carry out the activity. The make option gives management more direct
control over the work, but the buy option may have benefits in that the external organisation
has expertise and special skills in the work making it cheaper.

There are certain situations where the make or buy decision is not really a choice at all. There
can be no alternative to making, where product design is confidential or the methods of
processing are kept secret. On the other hand, patents held by suppliers may preclude the use
of certain techniques and then there is no choice other than buying or going without. The
supplier who has developed a special expertise or who uses highly specialized equipment may
produce better-quality work which suggests buying rather than making. In other cases, the
special qualities demanded in the product may not be available outside and so making becomes
necessary.

Where technical considerations do not influence the make or buy decision, the choice becomes
one of selecting the least-cost alternative in each decision situation. Comparative cost data are
necessary, therefore, to determine whether it is cheaper to make or to buy. In general this
requires a comparison of the respective marginal costs or, in some cases, the incremental costs
of each alternative. Incremental costs are relevant in decisions which include capacity changes.
For example, a certain component has always been bought out because the plant and equipment
for its manufacture has not been installed in the factory. When considering the alternative to
buying, the cost of making comprises all the incremental costs (including additional fixed
expenditure) arising from the decision. The incremental cost also includes the opportunity cost
of the investment in capital equipment, that is, the expected return from an alternative
investment opportunity. A decision to buy a part which has previously been manufactured may
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release capacity for other uses or for disposal so that the incremental cost of the decision also
includes the relevant fixed-cost savings.

Illustration
Assume that ABC Ltd makes four components with the following information:
W X Y
Z
Production (units) 1000 2000 4000
3000
Unit marginal costs
Direct material 4 5 2
4
Direct labour 8 9 4
6
Variable O/H 2 3 1
2
14 17 7 12

Attribute Fixed Cost sub contractor price

Sh. Sh.
TO W 1000 W 12
X 5000 X 21
Y 6000 Y 10
Z 8000 Z 14
Committed Fixed Costs are Sh.30000
Required
Advice the company on the components to buy or make if any.

Solution
W X Y Z
Cost of buying per unit 12 21 10 14
Variable Cost of making 14 17 7 12
Extra variable cost of buying(2) 4 3 2
No. of units 1 000 2 000 4000 3000
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Total extra costs VC of buying(2000) 8000 12000 6000
Less attributable FC (1000) (5000) (6000) (8000)
Net extra costs of buying (3000) 3000 6000 (2000)

The decision is to Buy W and Z and Make X and Y

Make or buy decisions under limiting factors.

One reason for buying products/services from another organization is the scarcity of resources,
so that the company may be unable to make all its components. In such a case the company
should combine internal resources with buying externally to increase profitability. In situations
where a company must sub-contract work to make up short fall in its in-house capability, then
its cost will be minimized where the marginal cost of buying is least for each unit of scarce
resource saved by buying externally.

Illustration
Assume that ABC Ltd makes four components with the following information:
W X Y Z
Production (units) 1000 2000 4000 3000
Unit marginal costs
Direct material 4 5 2 4
Direct labour 8 9 4 6
Variable O/H 2 3 1 2
14 17 7 12

Attribute Fixed Cost sub contractor price

Sh. Sh.
TO W 1000 W 16
X 5000 X 21
Y 6000 Y 10
Z 8000 Z 18
Committed Fixed Costs are Sh.30000
Assume that machine hours per unit required to produce the components are:
Machine Hours
W 4
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X 5
Y 3
Z 6
The total machine hour available is 27000 hours during the budget period.

Required:
Advice the company on which products to make and the ones to buy externally.
Solution
Required machine hours
W 4X1000 = 4000
X 5X2000 = 10000
Y 3X4000 = 12000
Z 6X3000 = 18000
I 44000
Available hours 27000
Shortfall 17000
Machine hours is therefore a limited resource
W X Y Z
Cost of buying per unit 16 21 10 18
Cost of making VC 14 17 7 12_
Extra variable cost of buying 2 4 3 6
No. of units 1000 2000 4000 3000
Total extra V. Cost of buying 2000 8000 12000 18000
Less attributable F C (1000) (5000) (6000) (8000)
Net extra cost of buying 1000 3000 6000 10000
Divide the no. of mhrs saved 4000 10000 12000 18000
Net extra costs of buying per
Machine hours saved 0.25 0.30 0.5 0.56
Priority for buying 1 2 3 4
Priority for making 4 3 2 1

Attempt the following Questions

1.In a period, Mwangaza ltd produced 200,000 units. The followings information is also

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available for the same period.
Sh.
Units sold 175,000
Production cost
Variable cost 3,500,000
Fixed cost 1,500,000
Selling & administrative cost
Variable 1,000,000
Fixed 2,500,000
Selling price per unit 500
Required:
Prepare operating statements based on:
i. Absorption costing. (7 marks)
ii. Marginal costing. (7 marks)

2.Fakenot cosmetics produced 200,000 combs year 2013 but only 18,000 of them were sold
the production costs during the year were:
Ksh. (’000’)
Direct materials 56,000
Direct labour 16,000
Production overheads 20,000
92,000
Additional informational
i. Sales price is ₤ 500 per comb
ii. 60% of production overhead is fixed
iii. Sales distribution and administrative overheads amount to ₤ 4,000,000 in the year of
which 40% were fixed iv.
No stocks of W.I.P
Required:
i) Profit and loss account using direct costing method (8 marks)
ii) Profit and loss A/c using full costing method (8 marks)

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3.The following information was provided for Chuma Ltd. The company provides for the
manufacture and sales of 12,000 units per month. The standard cost is Kshs 70, made up of
the following:
Direct materials Ksh. 40
Direct labour Ksh. 10
Fixed overheads Ksh. 20
Ksh.70

The selling price of each unit is Ksh. 110

Production and sales quantities for the first and second quarter were as follows:

1st quarter 2nd quarter

Production 12,000 12,000
Sales 8,000 10,000
Required:
i)Operating profit using marginal and absorption costing methods. (16marks)
ii)Reconcile the two profits (4marks)

References:

1. Finnerty, J.D. (2013). Project financing: asset-based financial engineering (3rd ed.). New
Jersey, USA: John Wiley & Sons Inc.
2. Gatti, S. (2013). Project finance in theory and practice: designing, structuring, and
financing private and public projects (2nd ed.). Oxford, England: Academic Press/Elsevier
Inc.
3. Meredith, J. R. and Mantel, S.J. (2012). Project Management: a managerial approach (8th
ed.). New Jersey, USA: John Wiley & Sons Ltd.
4. Prassana, C. (2009). Projects: Planning, Analysis, Selection, Financing, Implementation
and Review, (7th ed.). New Delhi, India: Tata McGraw-Hill Education Private Limited.
5. Van Horne C. J. & Wanchowcz J. M. (2009). Fundamentals of Financial Management
(13th ed.). Harlow, England: Financial Times Press/Pearson Education Ltd.
6. Yescombe, E.R. (2014). Principles of project finance (2nd ed.). Oxford, England: Academic
Press/Elsevier Inc.

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