Marginal and absorption costing Techniques

Marginal Costing
Definition of marginal costing
CIMA defines marginal costing as a decision making technique used to determine the effect of cost on changes in the
volume of time and output in a multi-product firm especially in the short run. It is a technique which emphasizes the
variable cost of a product, that is, the direct material, direct labour, direct expenses and other variable overheads. It
demands that fixed costs of the relevant period are written off in full against the contribution. The contribution is the
difference between the sales value and the variable or marginal cost of a product in a given period of time. It is however
instructive to note that alternative names for marginal costing are contribution approach and direct costing.
Arguments for the use of marginal costing in routine costing include:
1) Simple to operate.
2) It ignores arbitrary apportionment of fixed cost, which in some cases are indivisible by nature.
3) Accounts prepared using marginal costing is more likely an approach based on the actual cash flow.
4) Under or over absorption of overhead is completely eliminated because of non-inclusion of fixed production
overhead in product costing.
5) Where sales are constant but production fluctuates, marginal costing shows a constant net profit, whereas absorption
costing shows variable amount of profit.
Demerits of marginal costing
1) The analysis of costs into fixed and variable costs may be subjective for the purpose of costs classification.
2) It places emphasis on the short run effects of costs, whereas fixed costs will vary in the medium and long term.
3) It is impossible to determine strategic or long term decision given a product total cost data without considering fixed
costs
4) It focuses attention on the contribution level. The tendency to exclude fixed costs by the management may be
disastrous
Absorption costing
Under the absorption costing concept, all costs which include fixed and variable costs are ultimately charged or allocated
to cost unit and total overheads are then absorbed according to a given level of activity in order to ascertain the total cost
of each unit. Fixed production overheads are absorbed into products by establishing overhead absorption rate. This may
result in over or under absorbed overhead, which is less or more than recovery of fixed overheads at planned or
predetermined activity level.
Advantages of Absorption costing
1) It recognizes the importance of fixed cost
2) It assists in arriving at total cost of production which is a basis for selling price decision process.
3) It matches costs with revenues since fixed production cost are considered in the product cost.
4) It represents current market trends and therefore, it is widely accepted especially for tax purposes.
5) The computation of marginal cost and emphasis on contribution may lead to under pricing of product where the
quoted prices are below total cost of production.
Disadvantages of Absorption costing
1) It does not help in decision making
2) Production may be very difficult since there is element of fixed cost in the product cost.
3) Calculation of under or over absorbed overhead may be problematic
4) It overbears the product cost with management administrative inefficiency which may be partly represented in fixed
cost.
Over/Under Absorption of Overhead
Where actual overheads is greater than budgeted overheads, that will give rise to over absorption. This is either deducted
from total cost or added to the profit.
Under absorption on the other hand arises where the actual overhead is less than the budgeted overhead. This is either
added to total cost or deducted from the profit.

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Differences between Marginal costing technique and Absorption costing technique
Marginal costing Absorption costing
a) Fixed overheads are written off in a period. Fixed overheads are absorbed into production, such that
Treated as period cost. part of fixed cost is carried to subsequent year by way
of its inclusion in closing stock.
b) Only variable costs are regarded as product Fixed production overheads form part of the product
cost. cost.
c) Contribution is the main feature of the Contributions are treated as funds into which fixed
operating statement costs are absorbed to arrive at profit.
d) Distinction is made between fixed and No distinction is made between fixed and variable costs.
Variable costs
e) Stocks are valued at variable costs which Stocks are valued at total production cost including
exclude fixed costs. Fixed production overhead costs.
f) It is used for decision making purposes. It is used for routine purposes.

Question 1
The budget of Universal Plc for the manufacture and sale of 10,000 plastics per month. The unit standard cost being N6
made up of the following:
N
Direct material 2.50
Direct labour 1.00
Variable overhead 0.50
Fixed overheads 2.00
6.00
The selling price of plastic being N8. Production and sales for periods 1,2 and 3 were as follows:
Period I II III
Production 10,000 8,000 11,000
Sales 8,000 9,000 12,000
You are required to:
1) Prepare operating statements for the 3 periods.
i. Assuming the company uses asorption costing
ii. Assuming the company uses marginal costing
2) Comment on the differences of the two systems as regards as regards stock valuation and period profit.
Question 2
Dadani Limited produces Cola wine which is bottled and sold in cases. The normal annual level of production on which
the fixed production overhead absorption is based is 80,000 cases. Data for the last financial year ended 31 st December,
2011 were as follows:
Production 90,000 cases
Sales 75,000 cases
Per cases
N
Sales 1,500
Cost:
Direct material 500
Direct labour 400
Variable overhead 200
2
Fixed production overhead 1,560,000
Variable selling and distribution cost 10% of sales revenue.
Fixed selling and distribution cost 150,000
Required
Prepare profit statements for the year ended 31st December 2011 based on:
i. Marginal costing
ii. Absorption costing.
Question 3
The information below was extracted from the books of a company engaged in the manufacture of utility products.
Sales 10,000units at N5 each
Production 15,000 units
Cost of production: N
Direct materials 15,000
Direct labour 30,000
Variable expenses 6,000
Fixed expenses 12,000
The company has in its employment two accountants, one heading the management accounting department while the
other heads the financial accounting department. The two accountants produced statements showing their calculations of
the company’s profit for the period and the value of its closing stock, their results were different.
While one of the accountants used absorption costing, the other used marginal costing as a basis for the statement.
Required:
a) The two statements presented by the accountants in a tabular form and
b) Explain why these two methods give different results and briefly provide arguments for and against these two
approaches.
Question 4
The following data were taken from the records of a company.
Period 1 2 3
Production 30,000 38,000 27,000
Sales 30,000 27,000 38,000
Opening stock - - 11,000
Closing stock - 11,000 -
All the above are in kgs.
The firm makes a single product the financial details of which are as follows (based on a normal activity level of 30,000
kgs).
Cost/kg
N
Direct material 1.50
Direct labour 1.00
Production overhead (300% of labour) 3.00
5.50
Selling price per kg is N9.
Admin overheads are fixed at N25,000 and 1/3 of the production overheads are fixed.
Prepare separate operating statements on marginal costing and absorption costing principles.
Question 5
Time na money Ltd has the following budgeted marginal costing operating statement for the month ended 31 st December
2012.
N N
Sales 48,000
Cost of sales:
Opening stock 3,000
3
Production cost 36,000
Closing stock (7,000) 32,000
16,000
Other variable costs:
Selling (3,200)
Contribution 12,800
Fixed costs:
Production overhead 4,0000
Admin 3,600
Selling 1,200 8,800
profit 4,000
The standard cost per unit is N
Direct material (1 kg) 8
Direct labour (3 hrs) 9
Variable overheads (3 hrs) 3
Budgeted selling price per units is N30
The normal level of activity is 2,000 units per month. Fixed production costs are budgeted at N4,000 per month and
absorbed on the normal level of activity of units produced.
Required:
a) Prepare a budgeted operating statement under absorption costing for the month ended 31st December 2012.
b) Reconcile the profits under these two methods and explain why the business may prefer to use marginal costing
rather than absorption costing.