MARGINAL AND Topic 6

ABSORPTION Prepared By CPA James

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COSTING 1
TOPIC OUTLINE
 Historical Perspective of the methods
 Definitions of Important terminologies
 Marginal Costing method
 Preparation of Income statement by using Marginal
Costing
 Absorption Costing method
 Preparation of Income statement by using Absorption
Costing
 Comparison of the two Approaches
 Arguments for and against each method.

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HISTORICAL
PERSPECTIVE OF THE
METHODS
 The History of the two Costing Method is traced back to the
History of Cost Accounting i.e. back in 1900`s.
 The use of marginal costing is traced back in the 1900`s,
however the term was first used by Harris in 1936 (Harris,
1936)
 Where as the history of Absorption costing is as old as Cost
Accounting. ( Cunagin and Stancil,1992).
 Both method ware developed with the following aim
 Inventory Valuation for Manufacturing Firms.
 Cost Control and Cost Analysis.

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IMPORTANT
TERMINOLOGIES
 Variable Cost and Fixed Cost
 Cost are Classified based on their behavior to changes in output.
 Variable costs are costs that changes in total to the changes in the level of
output, while Fixed Cost are costs that don’t change in total to the
changes in the level of output.
Classification of Cost based on their function
 Production Cost – material cost, labour cost, factory overheads
 Non-Production Cost – selling expenses, distribution costs,
administration costs, transport costs etc.
Product Cost and Periodic Cost
 Product Cost – Cost that are used to value inventory and are included in
the balance sheet.
 Periodic Cost – Cost that are not used to value inventory and are
expensed to income statement as they are incurred.
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MARGINAL COSTING
METHOD
 Marginal Costing is an inventory valuation method that
uses variable production cost to value inventory, and all
other costs are treated as periodic cost.
Variable production cost including direct material, direct
labour, variable factory overhead are used to value
inventory.
 While fixed production cost are treated as periodic cost,
as well as other non-production cost.
The method is also called Variable Costing, Direct
Costing or Contribution Margin Statement.

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MARGINAL COSTING

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MARGINAL COSTING
INCOME STATEMENT
ABC Ltd.'s Income Statement for the period ending XXX by using
Marginal Costing (TZS)
Sales XXX
Less Cost of Sales
Opening stock XXX
Add: Variable production cost XXX
Less: Closing Stock (XX) (XXX)
Production Contribution Margin XXX
Less: Other Variable costs (XX)
Total Contribution XXX
Less Fixed Costs i.e. all Fixed Costs (XXX)
Profit for the Period XXX

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CLASS EXAMPLE
Class Question.pdf

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SOLUTION TO CLASS
EXAMPLE
Tannian Ltd.`s
Profit Statement for the months ending ---by using Marginal Costing
Month 1 Month 2 Month 3
Sales 270,000 255,000 315,000
Less Cost of Sales
Opening stock - - 11,500
Add: Variable Production Cost 207,000 207,000 230,000
Less: Closing stock - (11,500) -
Cost of Sales (207,000) (195,500) (241,500)
Production Contribution 63,000 59,500 73,500
Less Other variable cost
Marketing cost (18,000) (17,000) (21,000)
Total Contribution 45,000 42,500 52,500
Less: Fixed Cost
Fixed Production Cost (27,000) (27,000) (27,000)
Fixed Sellinh and Admn (13,000) (13,000) (13,000)
Profit for the month 5,000 2,500 12,500

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ABSORPTION COSTING
METHOD
 Absorption Costing method is an inventory valuation
method that uses variable production cost and fixed
production cost to value an inventory, and all other costs
are treated as periodic cost.
 The Challenge is how to assign fixed production cost to a
unit of an inventory, therefore the system decided to use the
following formula:
Fixed production cost per unit

The inclusion of fixed production method lead to the

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CLASS QUESTION
Class Question.pdf

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SOLUTION TO CLASS
EXAMPLE
Tannian Ltd.`s
Profit Statement for the months ending ---by using Absorption Costing
Month 1 Month 2 Month 3
Sales 270,000 255,000 315,000
Less Cost of Sales
Opening stock - - 13,000
Add: Production Cost 234,000 234,000 260,000
Less: Closing stock - (13,000) -
Cost of Sales 234,000 221,000 273,000
Add/Less Over or Under absorption - - (3,000)
Adjusted Cost of Sales (234,000) (221,000) (270,000)
Gross Profit 36,000 34,000 45,000
Less: Non-Production Cost
Marketing cost (18,000) (17,000) (21,000)
Fixed Sellinh and Admn (13,000) (13,000) (13,000)
Profit for the month 5,000 4,000 11,000

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OVER OR UNDER
ABSORPTION
 In Absorption costing, there are adjustments for over or under
absorption.
 Over or Under absorption occurs when Actual Fixed Overhead are
not equal to Absorbed Fixed Overhead.
 Over absorption occurs when Absorbed Fixed Overhead are more
than Actual Fixed Overhead.
 Under Absorption occurs when Absorbed Fixed Overhead is less
than Actual Fixed Overhead.
The above adjustments arise due to the following reasons:
 Expenditure Variance
 Volume Variance
 Both Expenditure and Volume Variance

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CALCULATION OF
OVER/UNDER
ABSORPTION
 Identify Fixed Production Cost per Unit €3
Compare Actual Fixed Overhead and Absorbed FOH
 Actual Fixed Production Cost 27,000 27,000 27,000
Allocated Fixed production Cost
 Units produced x Fixed pdn cost per unit.
27,000
 Month 1 = 9000 x 3
 Month 2 = 9000x3 27,000
 Month 3 = 10000 x 3 30,000
Under or Over absorption NIL NIL 3,000
Adjustments are as follows; under-absorption is added to cost of goods
sold while over-absorption is deducted.
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COMPARISON OF THE
TWO METHODS
Criteria Marginal Costing Absorption Costing
Variable production Cost Product Cost Product Cost
Fixed Production Cost Periodic Cost Product Cost
Non-Production Cost Periodic Cost Periodic Cost
Production = Sales Same profit Same Profit
Production > Sales Lower Profit Higher Profit
Production < Sales Higher Profit Lower Profit

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RECONCILIATION OF
PROFITS
 Based on the above comparison, the following are the reasons for
having different profits:-
1. When Production is not equal to sales
2. Treatment of fixed production cost
 Marginal – Periodic Cost
 Absorption – Product Cost
 Therefore when reconciling the two profits prepared under Marginal
and absorption costing:-
 The reconciling item should involve
 Difference between Production and Sales
 Fixed Production cost per unit.

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RECONCILIATION
STATEMENT
Month 1 Month 2 Month 3
Marginal Costing Profit 5,000 2500 12500
Reconciling item:
(Production – Sales ) x FOAR* - +1500 -1500
Absorption Costing Profit 5,000 4,000 11,000
*Fixed Overhead Absorption Rate = Fixed Production Cost per unit.

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ARGUMENTS FOR AND
AGAINST MARGINAL
COSTING
Advantages Disadvantages
1 Good for controlling cost Difficult to classify cost into fixed and
variable
2 Used for short-run decisions Only applicable in short run
3 Uses only variable cost to Ignores fixed production cost that are
value inventory i.e. relevant part and parcel of production process
cost
4 It is used in setting prices for Prices established by using marginal
special order costing can not be applied in long-run
5 It is used for internal purposes It is not suitable for external reporting
as per IFRS.
6 It doesn’t need over or under
absorption adjustments

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ARGUMENTS FOR AND
AGAINST ABSORPTION
COSTING
Advantages Disadvantages
1 It is used for external reporting as It is not useful for internal
per IFRS standards – IAS 2 purposes
2 It value inventory by using both It includes irrelevant cost,
fixed and variable pdn cost. therefore not useful for short-run
decisions
3 It is used in long-run pricing It needs adjustments of over or
under absorption
4 It follows the matching principle Its profit is affected by production
and level of sales – therefore
managers can manipulate the
profits.

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 THANKS FOR LISTENING
have a good night!!!!!

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