Chapter 8 Absorption and Marginal Costing (Part 2)

Concept of contribution
• Contribution − The difference between a product or service’s selling price and marginal
cost.
• Contribution is the amount that contributes towards the recovery of the overheads of an
organisation.
• If contribution in total is greater than fixed overheads, the company will profit.
• Contribution formula

Contribution = Selling price − Marginal cost (also known as total variable cost)

• For example, if Product P sells for $30 per unit and its marginal cost is $17 per unit, the
contribution earned per unit sold is $13 ($30 - $17)
• Contribution per unit is the same for all levels of sales and production. This means it is
straightforward to calculate total contribution and profit.

Total contribution = contribution per unit × number of units sold

• Period costs (Fixed overheads)

Fixed overheads are treated as period costs when marginal costing is used. Period cost
means that the expense is incurred over a period and is unrelated to production levels.
• Marginal costing collects the fixed production overheads in the production overheads
account and debits them to the statement of profit or loss (as an expense) at the end of
an accounting period.
• Contribution Graph

Marginal costing
• Marginal costing is a costing method used for short-term decision-making. It facilitates
this by recognising costs according to their behaviour.
• Fixed Costs
o Marginal costing expenses fixed costs against profit for the period, not retaining
any fixed costs in the inventory valuation. This is because fixed costs do not
 change in the short-term and are irrelevant to short-term decision-making (they
would be incurred regardless of the decision).
o Compare this to absorption costing, where fixed costs are allocated, apportioned,
and absorbed into inventory. Any unsold inventory would carry a portion of
these fixed costs into the next period.
• Variable Costs
o Under marginal costing, only variable (marginal) costs are included in inventory
valuation.
o This is because the marginal cost of a product is the increase in expenses
required to produce an additional unit, which is usually its variable cost.
o For example, if it costs $60,000 to make 10,000 units and $60,003 to produce
10,001 units, the marginal cost of the additional unit is $3.

• The marginal cost of a product usually consists of the following:

o Prime costs:
▪ Direct materials
▪ Direct labour
▪ Direct expenses
o Variable production overheads

Activity 1
Classify the statements as relating to either marginal costing or absorption costing.

Classification
(Marginal costing or
Statement Absorption costing)

Fixed costs are written off in total in the period

they relate to

Costing is based on the cost of producing one

more unit

Fixed costs relating to the previous period could

be carried forward in the cost of the opening
inventory

Fixed costs are included in the cost of inventory

Costing is based on the variable costs of

production

If there is closing inventory, a portion of the

fixed costs are carried forward into the next
period
Absorption and Marginal Costing Inventory Valuation
• Absorption and marginal costing are two different methods of dealing with production
overheads. As a result, they may produce profit figures for an accounting period that
differ from each other.
Absorption Costing Marginal Costing

Variable production costs

Valuation of
All production costs only.
production
(including production Fixed production overheads
(finished goods)
overheads) are not included.

Treatment of fixed Absorbed into cost units

production (included in the value of Expensed off for the period
overheads finished goods) as a cost (period cost).

Relationship with Selling price – absorption cost Selling price – marginal

the selling price = profit cost = contribution.

The marginal cost of

production is the cost of
Description The total cost of production; making one additional unit.
helps set a selling price that Useful for decision-
covers all production costs. making.
• Marginal costing values inventory at marginal cost (variable production costs only).
• Absorption costing cost card
$ per unit
Direct materials [x]
Direct labour [x]
Direct expenses [x]
Variable production overheads [x]
Fixed production overheads [x]

Unit cost under absorption costing [x]

• Absorption costing values inventory at the full absorption cost (including overheads
absorbed). The full absorption cost is sometimes called the full production cost.
• Marginal costing cost card
$ per unit
Direct materials [x]
Direct labour [x]
Direct expenses [x]
Variable production overheads [x]

Unit cost under marginal costing [x]

• Note that the total unit cost on the marginal cost card is also the total variable production
cost.
Example 1
A company makes Product P, which sells for $30 per unit. Product P’s cost card is as below:
$ per unit

Direct materials 5

Direct labour 10

Direct expenses 1

Variable production overheads 1

Fixed production overheads 3

What are Product P’s absorption and marginal cost and profit per unit?

Activity 2
BKU Co is in the process of valuing one of its products, Product XB. Product XB has a
marginal cost of $15 per unit and an absorption cost of $18 per unit. At the end of September,
there were 2,500 units left in inventory.
1. What is the value of this inventory at the end of September if BKU Co uses marginal
costing to value its products?
2. If BKU Co uses absorption costing instead to value its products, what would the value
of BKU Co’s inventory of Product XB be at the end of September?
3. Why is the valuation of inventory under absorption costing higher than under marginal
costing?

Activity 3
Production data for one grommet:
Materials: 2.4 kg @ $3 per kg

Direct labour: 1.5 hours @ $5 per hour

The variable overhead rate is $4 per direct labour hour. The fixed overhead absorption rate is
$7 per direct labour hour. The budgeted production is 5,000 grommets.
Budgeted fixed overheads:
Units × no of hours per unit × hourly rate = 5,000 × 1.5 hours × $7 = $52,500

Determine the cost of a grommet for inventory valuation purposes on:

(a) a marginal costing basis; and
(b) an absorption costing basis.
Activity 4
The information in the table relates to Product YT for June.
$ per unit

Direct materials 8

Direct labour 12

Direct expenses 3

Variable production overheads 2

Fixed production overheads 5

Fixed selling costs 1

At the end of June, 1,750 units of Product YT were left in inventory.
1. What is the full absorption cost of one unit of Product YT?
2. If Product YT sells for $38 per unit, how much contribution is earned for each unit sold?
3. If Product YT sells for $38 per unit, how much is the profit per unit under absorption
costing?
4. How much was the value of inventory at the end of June under absorption costing?
5. How much was the value of inventory at the end of June under marginal costing?

Absorption and Marginal Costing profit difference

Because units of inventory are valued differently under absorption and marginal costing, this
will affect the following:
• The value of opening inventory at the beginning of an accounting period
• The value of closing inventory at the end of an accounting period.

Absorption costing: statement of profit or loss format

$ $
Sales revenue X
Cost of sales
Opening inventory X
Production costs X
Closing inventory (X)
Production cost of sales (X)
Gross profit X
Non-production overheads (X)
Absorption profit X
Marginal Costing: Statement Of Profit Or Loss Format
$ $
Sales revenue X
Cost of sales
Opening inventory X
Variable production costs X
Closing inventory (X)
Variable production cost of sales (X)
Variable non-production costs (X)
Contribution X
Fixed production overheads (X)
Fixed non-production overheads (X)
Marginal profit X

Example 2
The following information relating to Product Z for January 20X4 is available: Sales in January
were 8,500 units of Product Z at $30 per unit = $255,000
• The full absorption cost per unit of Product Z is $10 per unit. This comprises a marginal
cost of $8 per unit and absorbed production fixed overhead of $2 per unit.
• 1 January inventory of 2,000 units of Product Z was held. This inventory was valued at
2,000 × $10 per unit = $20,000
• 9,000 units of Product Z were produced in January at a total production cost of 9,000 ×
$10 = $90,000
• On 31 January, inventory of 2,500 units of Product Z was held. This inventory was
valued at 2,500 × $10 = $25,000.
Prepare statements of profit or loss for Product Z for Jan 20X4, using:
a) Absorption costing
b) Marginal costing

Activity 5
Furniture Co has a product with the following budgeted price and costs for a month:
• Direct labour cost per unit of $7.00
• Direct material cost per unit of $3.00
• Variable production overhead cost per unit of $5.00
• Each unit requires one hour of direct labour
• The sales price is $40.00
• There are no opening inventories
• Budgeted production in the month is 500 units
• Fixed production costs are $2,000
1. Calculate Furniture Co’s monthly marginal profit if 400 units were sold.
2. Calculate Furniture Co’s monthly absorption profit if 400 units were sold.
Activity 6
Baller Co produces 1,000 units of product X per month.
On February 1, there were 80 units in the opening inventory.
Each Product X requires 2 hours of labour and 2 square metres of material. Labour costs are
$10 per hour, while material costs $5 per square metre.
Fixed production overheads are $2,000 per month.
Each Product X sells for $50.
February sales were 1,000 units. In March, sales were 900 units.
Calculate absorption and marginal costing profit for February and March.

Reconciling Absorption and Marginal Costing profit

• Absorption and marginal costing will report different profits if there is a change in the
number of units of opening and closing inventory.
• The difference between absorption and marginal profit may be expressed as:
$
Marginal profit X
+([closing inv. − opening inv.] × overhead absorption rate) X / (X)
Absorption profit X
• This means the difference between absorption and marginal costing profit is the
overheads absorbed into inventory multiplied by the change in inventory.
• Absorption and marginal profit are the same if there is no change in inventory levels.

Example 3
The answers from the previous example of Product Z for January 20X4 are summarised as
follows:
Opening inventory on 1 January 20 X 4 = 2,000 units of Product Z
Closing inventory on 30 January 20 X 4 = 2,500 units of Product Z
Full production cost = $10 per unit
Marginal cost = $8 per unit
Absorption costing profit = $170,000
Marginal costing profit = $169,000
Reconcile Product Z’s absorption and marginal profit for January 20X4.
Determining whether absorption or marginal cost profit will be higher

Opening vs Closing Absorption costing (AC) profit vs Marginal costing

Inventory (MC) profit

Opening = Closing AC profit = MC profit

Opening > Closing AC profit < MC profit

Opening < Closing AC profit > MC profit

The difference in profits can be calculated as follows:
Change in inventory × fixed production overhead cost per unit

Activity 7
Baller has supplied the following information for February and March:
February March
Absorption costing profit ($) 18,000 16,200
Marginal costing profit ($) 18,000 16,000

Opening inventory (units) 80 80

Closing inventory (units) 80 180
The fixed production overhead absorbed per unit is calculated as $2.
Reconcile Baller Co’s absorption and marginal costing profit for February and March.

Activity 8
Opening inventory is 1,000 units, and closing inventory is 500 units. Absorption costing profit
is $27,000, and the fixed production overheads are absorbed at $2.50 per unit.
What is the marginal costing profit?

Opening inventory is 8,000 units, and closing is 9,500 units. Marginal costing profit is
$842,000, and the fixed production overheads are absorbed at $17 per unit.
What is the absorption costing profit?

Opening inventory is 12,000 units, and closing is 12,000 units. Absorption costing profit is
$98,000, and the fixed production overheads are absorbed at $4.50 per unit.
What is the marginal costing profit?