Management Accounting

Marginal and absorption costing

Rabiatu Kamil
 Session Overview

By the end of this session students should be able to :

1 Explain the purpose of costing technique and describe the constituents of
costing techniques.
2. Explain absorption and variable costing techniques and their importance to
management in organizations.
3. Compare and identify the differences between absorption and variable
costing techniques.
4. Value inventory and prepare income statements using absorption and
variable costing techniques.
5. Discuss the effect of production on absorption and variable costing income.
6. Reconcile the profit obtained from absorption costing with profit from variable
costing.
 Costing Techniques
• Costing technique refers to the various approaches organizations use to
determine the product cost of their goods or services.
• Aids decision-making and assists in cost reduction and control.
• Costing technique entails both cost accumulation and cost presentation
approaches to product costing.
– Cost accumulation approach to product costing is concern with determining
which manufacturing costs to be recorded and included as part of the product
cost.
– Cost presentation approach to product costing focuses on how costs are shown
on external financial statements and internal management reports.
Costing Techniques
Absorption (Full) costing: Cost of product is made up of both fixed and
variable cost.

Marginal costing: production cost is made of only variable cost.

Absorption (or full) costing and variable (or marginal) costing are the
common product costing techniques used by organisations to provide
external and internal product cost information.

• The timing of when fixed manufacturing overhead is expensed is the main

distinction between variable and absorption costing .
 Absorption costing
• Absorption (or full or total) costing charges products with all manufacturing
(or production) costs, regardless of whether the costs are fixed or variable.
• Absorption costing classify and presents costs by management function.
• Expenses are presented on income statement according to their functional
classification
• Functional classification is a group of costs that were all incurred for the same
principal purpose
• e.g. cost of sales, selling expense administrative expense, production, selling,
general and
• administrative expenses etc.
 Arguments for absorption costing
• Conforms with accrual concept.
• Inventory valuation complies with accounting standards, IAS 2.
• Avoids the illusion that fixed cost has nothing to do with production
– avoid the separation of product cost into fixed and variable.

• Inefficient utilization of production cost are revealed through the

• analysis of over or under absorbed (applied) overheads.
• Cost plus pricing ensures all costs are covered.
 Marginal Costing
• Variable (or marginal or direct) costing technique charges only variable
• manufacturing costs to cost units.
• – Fixed manufacturing overhead costs are excluded from inventory or product
costs and
• are treated as period cost, expensed as they are incurred, i.e., fixed costs of the
period
• are written off in full against the aggregate contributions.
Cost of a unit of product or service consists of the three variable
manufacturing costs direct material, direct labor, and variable manufacturing
overhead costs.
• It’s the basis for providing information to management for planning and decision
• making.
 Arguments for variable costing

• It prevents arbitrary allocation of indirect cost.

• Under or over absorption of overhead cannot arise or entirely avoided.
• No attempt is made to relate fixed cost to the product or service.
• No fictitious profit arise as a result of fixed cost being capitalized on
inventory.
Benefits of Absorption and Variable Costing
• Cost control decisions
– Variable costing reports are normally more useful than absorption
costing reports for controlling costs, because fixed cost are presented
separately in variable costing.
• Product pricing decisions
– Variable costing is often more useful than absorption costing for
setting short-run prices because variable costing reports variable and
fixed costs and expenses separately, and because absorption costing is
often more useful for setting long-term prices because it includes fixed
and variable costs in the cost of manufacturing a product.
 Benefits of Absorption and Variable Costing
• Planning production
– Variable costing is often more useful than absorption costing in short-term
production decisions because it reports contribution margin, whereas for
analysis and evaluation of long term sales and operating decisions, absorption
costing is more useful because it considers fixed and variable costs.

• Market Segment Analysis

– Absorption costing is often used for long term analysis of market segments
while variable costing is usually useful for short term market segments
analysis.
 Absorption and Marginal Costing Profit
• Product cost under variable costing is always lower than under absorption
costing but profit determined under both costing systems may differ.

• The difference between variable and absorption costing profits depends on

the relationship between the volume of sales and the volume of production.
– Net profit is not affected by changes in production using variable costing, but
net income under absorption costing is affected by changes in production.
Absorption and Marginal Costing Profit

• The effects of the relationships between sales and production volume

are
• based on these assumptions:
– unit costs are constant over time; and
– any fixed cost variances from standard are written off when
incurred rather than being prorated to inventory balances.
Absorption and Marginal Costing Profit
• If production units equal to sales units in the period
• • Net operating profit under absorption costing is the same as that
under
• variable costing.
• – Inventory will neither increase nor decrease, i.e., there is no beginning
or ending
• inventory.
• – Same fixed cost carried forward as expense in beginning inventory
valuation will
• be deducted in closing inventory valuation in the cost of production.
Absorption costing income statement
Marginal Costing income statement
Absorption and Marginal Costing
Reconciliation of Profits
Example 1
1. Prepare the income statement for ABF at the end of 2016 using:
i. Absorption costing
ii. Variable costing

2. Reconcile the profits determined from both approaches.

 Example 1
A Ltd manufactures products Ms, and has provided this information for the year end
2020. Assuming that 20,000 units of the product were sold during the year at a price
of GH¢30 each had no units in beginning inventory,

Determine the product cost per a using

(a) absorption costing
(b) (b) variable costing, .
(c) Prepare the income statement for ABF at the end of 2016 using:
i. Absorption costing
ii. Variable costing

(d) Reconcile the profits determined from both approaches.

Solution