Marginal & Absorption

Costing.
Areas to be covered:

• Product and Period cost

• Marginal costing

• Absorption costing

• Comparison between absorption & marginal costing

• Reconciliation of profit between absorption & marginal costing

• Arguments regarding Absorption and Marginal Costing

• Accounting entries of overheads

Product & Period cost

• Product cost: “The cost of making a product is known as product cost”. It includes direct

material, direct labour, direct expense and production overheads.

• Period cost: “A fixed cost which is to be paid after a specific time period, irrespective of the

production volume is called period cost”. It includes selling, distribution, research, finance

and administration costs.

Marginal Costing:

• Marginal Cost: The cost of a unit of a product or service which would be avoided if that

unit were not produced or provided. Normally variable cost is considered as marginal

costing.

• Marginal Costing: It is the accounting system in which variable production costs are

charged to cost units and fixed costs of the period are written off in full against the

aggregate contribution.
Absorption Costing:

• Absorption: In absorption costing fixed manufacturing overheads are absorbed into cost

units.

• Definition of Absorption Costing: The accounting system in which variable and fixed

production cost are charged to cost units and fixed non production costs and variable

non production cost of the period are written off in full against the aggregate gross profit.
 Absorption and Marginal Costing.

• Support financial records . Decision making

• Application of IAS2

Production cost per unit:

Absorption costing Marginal costing
Direct materials 10 10
Direct labour 8 8
Direct expense 6 6
Variable production overheads 4 4
Fixed production overheads/ OAR 2 x
Production cost per unit 30 28
Basics:
Overhead Absorption Rate (OAR):
Budgeted Production Overheads
=
Budgeted Activity Level

Under/Over Absorption:
Absorbed overheads: Actual activity level x OAR =X
Actual overheads =X
Under/Over-Absorbed =X

Closing stock equation:

= Opening stock units + Production units – Sales units
✓ Absorption Costing
$ $
Sales XXX
Cost of goods sold:
Opening stock X
Production XX
Closing stock (X)
(XX)
Unadjusted Gross Profit X
(Under)/Over absorption (X)/X
Adjusted Gross Profit X
Variable selling overheads (X)
Variable distribution overheads (X)
Fixed selling overheads (X)
Fixed distribution overheads (X)
Fixed administration overheads (X)
(X)
Net Profit XX
✓ Marginal Costing
$ $
Sales XXX
Variable cost of goods sold:
Opening stock X
Production XX
Closing stock (X)
(XX)
Gross contribution XX
Variable selling overheads (X)
Variable distribution overheads (X)
Contribution X
Fixed production overheads (actual) (X)
Fixed selling overheads (X)
Fixed distribution overheads (X)
Fixed administration overheads (X)
(X)
Net Profit XX
Example 1
Anita Ltd manufactures the only product Mitt. Information is given below:
Normal production 30,000 units
$ per unit
Selling Price 40
Direct Material 10
Direct Labour 8
Variable production overheads 4
Variable selling overheads 3

Production 31,000 units

Sales 25,000 units
Fixed production overheads $60,000
Fixed selling overheads $25,000
Fixed Administration overheads $20,000
There is no opening stock. Assume that budgeted fixed costs are equal to actual fixed costs for
all activity levels.

Calculate the profits using both absorption and marginal costing?

Solution:
Solution: (Absorption Costing)
$ $
Sales
Cost of goods sold:
Opening stock
Production
Closing stock

Unadjusted Gross Profit

(Under)/Over absorption

Adjusted Gross Profit

Variable selling overheads

Fixed selling overheads
Fixed administration overheads

Net Profit
Solution (Marginal Costing)
$ $
Sales
Variable cost of goods sold:
Opening stock
Production
Closing stock

Gross contribution
Variable selling overheads

Contribution
Fixed production overheads (actual)
Fixed selling overheads
Fixed administration overheads

Net Profit
Example 1 (Part b & c): Home Assignment
Solution:
Solution: (Absorption Costing)
$ $
Sales
Cost of goods sold:
Opening stock
Production
Closing stock

Unadjusted Gross Profit

(Under)/Over absorption

Adjusted Gross Profit

Variable selling overheads

Fixed selling overheads
Fixed administration overheads

Net Profit
Solution (Marginal Costing)
$ $
Sales
Variable cost of goods sold:
Opening stock
Production
Closing stock

Gross contribution
Variable selling overheads

Contribution
Fixed production overheads (actual)
Fixed selling overheads
Fixed administration overheads

Net Profit
Solution:
Solution: (Absorption Costing)
$ $
Sales
Cost of goods sold:
Opening stock
Production
Closing stock

Unadjusted Gross Profit

(Under)/Over absorption

Adjusted Gross Profit

Variable selling overheads

Fixed selling overheads
Fixed administration overheads

Net Profit
Solution (Marginal Costing)
$ $
Sales
Variable cost of goods sold:
Opening stock
Production
Closing stock

Gross contribution
Variable selling overheads

Contribution
Fixed production overheads (actual)
Fixed selling overheads
Fixed administration overheads

Net Profit
Important Points:

• Profit differences are temporary; they are settled in the future.

• Profit differences do not arise due to Under / Over absorption.

• Stock values are always greater under Absorption Costing (due to high cost per unit)

• Net stock values difference is always equal to the profit difference.

• Profit differences arise due to the treatment of fixed production overheads in opening and

closing stock values using absorption costing.

Cases:
• Opening stock units < Closing stock units ; High profit under Absorption costing

• Opening stock units > Closing stock units ; High profit under Marginal costing

• Opening stock units = Closing stock units ; Same profit under Both
Another way to calculate profit using marginal costing:

$
Selling price XX
Direct Material (X)
Direct Labour (X)
Direct Expense (X)
Variable Prod. overheads (X)
Variable non-Prod. overheads (X)
Contribution per unit X

$
Total contribution: Actual sales units x Contribution per unit: XX
Fixed production overheads (actual/ budgeted) : (X)
Fixed Non-production overheads (actual/ budgeted) : (X)
Net Profit: : X

*Now we can calculate Absorption’s profit through profit reconciliation.

Arguments Regarding Absorption and Marginal
Costing
Arguments in favour of Absorption Costing:

• Fixed production costs are incurred in order to make output, it is therefore fair to charge all

outputs with a share of these costs.

• Closing stock values, by including a share of fixed production overhead, will be valued on

the principle of IAS 2, as required by financial accounting purpose.

• Including fixed cost in the value of closing stock allows the fixed cost to be charged only in

the period of which revenue is earned, thus following the cost - revenue matching concept.
Arguments Regarding Absorption and Marginal
Costing
Arguments in favour of Marginal Costing:

• It is simple to operate as we do not have to determine fixed overhead absorption rate.

• Writing off fixed cost immediately in the period it is incurred follows the prudence concept of

accounting.

• Fixed cost are irrelevant cost for decision making, thus highlighting contribution in profit

statement provides better information for decision making purposes.

• Profit will not be distorted through fluctuation in stock level and production level as the

contribution calculated is based on sales volume.

Accounting Entries of Overheads

1. Debit Work in progress account

Credit Production overheads account (With the amount of overheads absorbed)

2. Over absorption of overheads

Debit Production overheads account

Credit Over absorbed account (With the balancing figure of production

overheads a/c)
Accounting Entries of Overheads

3. Under absorption of overheads

Debit Under absorbed account

Credit Production overheads account (With the balancing figure of production

overheads a/c)

4. Closing entry of work in progress account

Debit Finished goods account

Credit Work in progress account (With the balancing figure of work in progress a/c)
Accounting Entries of Overheads

5. Closing entry of under absorbed account

Debit Profit and loss account

Credit Under absorbed account (With the balancing figure of under absorbed a/c)

6. Closing entry of over absorbed account

Debit Over absorbed account

Credit Profit and loss account (With the balancing figure of over absorbed a/c)
Practice Questions: Home Assignment