Dpa30073 COST AND MANAGEMENT ACCOUNTING 1

TOPIC 4 : MARGINAL COSTING AND ABSORPTION

COSTING
General Objective : To understand the marginal costing and absorption
costing.
To illustrate income statement using marginal and
absorption costing.

Specific Objectives : At the end of the unit you will be able to

➢ Define the meaning of marginal costing and
absorption costing.
➢ Distinguish the differences between marginal costing
and absorption costing
➢ Explain benefits and limitations of marginal and
absorption costing.
➢ Evaluate product cost per unit under both method.
➢ Prepare income statements under marginal costing &
absorption costing.
➢ Calculate over or under absorption of overheads
➢ Produce a reconciliation report for income gathered
from both costing method.

DEFINITION OF MARGINAL COSTING

Marginal (variable) costing is an accounting technique which differentiates between fixed
and variable costs and ascertains their effects on profit of changes in volume or
production.
An important feature of marginal costing is the calculation of what is termed
CONTRIBUTION. This is simply the difference between sales value and the variable cost
of sales. For inventory valuation, stocks are valued at variable costs. Fixed cost are treated
as period costs and written off to the profit and loss.
Variable cost is taken to be : direct material, direct labour, direct expenses and the
variable portion of overheads. Marginal costing emphasises the behavioral aspect of
cost where costs are classified for example into variable and fixed costs.

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DEFINITION OF ABSORPTION COSTING

Under absorption costing, variable and fixed cost are charged to the stocks. Absorption
costing emphasises the functional classification of cost such as manufacturing, selling,
administration and financial costs.

DIFFERENCES BETWEEN MARGINAL COSTING AND ABSORPTION COSTING

MARGINAL ABSORPTION
Stock value Lower stock value because fixed cost Higher stock value because all fixed
are excluded and variable costs are absorb.
Profit When production fluctuates but Will show fluctuating profits
sales remain constant, it will show a because profits will effected by
constant profit because profit is not stock changes.
affected by changes of stock.
Format in Fixed cost are not absorbed into the All costs are absorbed into
costing cost of production. They treat as production and thus operating
statement period costs and written off each statement do not distinguish
period in the profit and loss account. between fixed and variable costs.

BENEFIT OF MARGINAL COSTING

▪ It does not apply fixed costs to product

▪ It shows the relationship between cost, price and volume.
▪ Under or over absorption do not arise in marginal costing
▪ It is useful in managerial decision-making as it provides better information
▪ It is simple to understand.
▪ Marginal costing shows contribution which enables management, for instance to
decide where to concentrate its sales effort.
▪ During trade recessions orders are accepted as long as it covers marginal costs and
contributes towards fixed costs so that losses are kept to a minimum.

DISADVANTAGES OF MARGINAL COSTING

▪ By not applying fixed cost to products it creates a belief that fixed costs have nothing
to do with production.
▪ Marginal costing method of stock valuation is not accepted by the Inland Revenue
because the stock value do not contain fixed cost.
▪ It is difficult to classify costs into fixed and variable costs.
▪ In determining a reasonable price reference must be made to the effects of fixed
costs otherwise prices will be set too low. Short term pricing may be based on
contribution but long term pricing should include total cost.

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▪ Marginal costing use of historical data. Since decisions by management relate to

future events, the use of historical costs will limit the usefulness of such decisions.

BENEFIT OF ABSORPTION COSTING

• Since fixed cost are necessary to produce goods it should be applied to products. It
recognizes the importance of fixed costs in production.
• It is accepted by Inland Revenue because fixed costs are included in stock values.
• Prices are set by reference to fixed costs. This does not lead under pricing.
• The absorption costing approach is almost always used to prepare financial account.

DISADVANTAGES OF ABSORPTION COSTING

• It is not useful in planning, control and managerial decision making as costs are not
differentiated into fixed and variable costs
• Some costs are ignored especially administration, selling and distribution.

COST CLASSIFICATIONS- ABSORPTION VS MARGINAL COSTING

ABSORPTION MARGINAL
COSTING COSTING
Direct material
Direct labor product cost
Product cost Variable manufacturing O/H

Fixed manufacturing O/H

Period cost
Period cost Selling & admin Exp.

PRODUCT COST PER UNIT

EXAMPLE 1

Production (units) 6,000

Variable cost per unit:
Direct material RM 2
Direct labor RM 4
Variable manufacturing O/H RM 1
Variable selling & admin expenses RM 3

Fixed cost per year:

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Fixed manufacturing o/h RM 30,000

Fixed selling & admin o/h RM 10,000

Compute product cost per unit under marginal and absorption costing

Absorption Marginal
Direct material
Direct labor
Variable manufacturing o/h
Fixed manufacturing o/h

Product cost per unit

ABSORPTION OF FIXED MANUFACTURING OVERHEAD

• The absorption of fixed manufacturing overhead is usually based on normal

activity
• Predetermined overhead rate is calculate by:
• In reality the actual units and the normal units is not the same, there will be under
or over absorbed amount overhead.
• Example
Total manufacturing overhead RM 30,000
Total units at normal activity 15,000 units
Actual production units 12,000 units
• Solution:
Fixed overhead rate : RM 30,000 / 15,000 units = RM 2
Overhead absorb = RM 2 x 12,000 units = RM 24,000
Since the actual unit is less than the normal units, there will under absorption.
The under absorb overhead is RM 30,000 – RM24,000 = RM 6,000
The difference is due to lower volume of actual production which is multiplied by
overhead rate. (15,000 units – 12,000 units) X RM 2 per unit = RM 6000
This under absorbed overhead cost of RM 6000 is deducted from the profit
because profit is overstated.

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PREPARING INCOME STATEMENT USING ABSORPTION AND MARGINAL COSTING.

EXAMPLE :
Milina Manufacturing sells its special car accessories with selling price RM 25 per unit.
The total fixed factory overhead is RM 36,000 which is based on a production of 18,000
units per annum. The information for the financial year 2011 is as follows:
Production units 22,000
Sales units 18,900
Beginning inventory units 3,300
Direct material per unit RM 8
Direct labor per unit RM 6
Variable factory overhead per unit RM 4
Variable Selling & administrative expenses per unit RM 2
Fixed selling and administrative expenses RM 20,000

Prepare Da Di Du Manufacturing income statement for 2011 using absorption costing

and marginal costing.

SOLUTION: find the product cost per unit

ABSORPTION COSTING MARGINAL COSTING

Direct material
Direct labor
Variable overhead
Fixed factory overhead

Total product cost per unit

ABSORPTION COSTING
RM RM
Sales

Less: cost of goods sold

Beginning inventory
Cost of goods manufactured:
Direct material
Direct labor
Variable overhead
Fixed overhead
Ending inventory

COST OF GOOD SOLD

GROSS MARGIN

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Less: variable selling and admin exp

Fixed selling and admin exp

OPERATING PROFIT

Add/ (less): over absorb / (under

absorb)

NET PROFIT

Computation of over absorb of overhead:

Actual overhead RM
Absorb overhead RM
Over Absorb RM
OR

Normal production 18000 units

Actual production 22000 units
Difference 4,000 units
Actual production > normal production =
Over absorb =

MARGINAL COSTING
RM RM
Sales

Less: cost of goods sold

Beginning inventory
Cost of goods manufactured:
Direct material
Direct labor
Variable overhead
Ending inventory

COST OF GOOD SOLD

Less: variable selling and admin exp

CONTRIBUTION MARGIN

LESS: fixed manufacturing overhead

Fixed selling and admin exp

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NET PROFIT

Based on the income statement, there is difference in profit between absorption and
marginal costing.
We can reconcile the profit under both method. How?

RECONCILING PROFIT UNDER ABSORPTION AND MARGINAL COSTING

a) If cost for opening and closing inventory is same

Difference in profit = difference in inventory X fixed

production overhead per unit

Refer to Amirina Manufacturing, the difference profit from both method is

It can be explain by the changes in inventory level.

Solution :
Beginning inv. Units =
Ending inv. Units =
Increase =

Reconciling profits:
Profit absorption costing is higher by

b) If cost for opening inventory and closing inventory is difference

To find rate is
based on
difference cost of
opening inv.

[ (fixed overhead rate for opening inv.) X opening stocks units] –

[(fixed overhead rate for closing inv. ) X closing stocks units]

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DIFFERENCES IN PROFIT BETWEEN ABSORPTION COSTING AND

MARGINAL COSTING

Production & sales Net changes in Profit relationship

relationship (units) inventory
Production = sales No changes Absorption = marginal
Production > sales Increase Absorption > marginal
Production < sales decrease Absorption < marginal

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