VERTEX LEARNING SOLUTIONS - https://vls-online.

com
Marginal Costing

• Marginal costing is an alternative method of costing to absorption costing.

• In marginal costing, only variable costs are charged as a cost of sale.

Cost of a Unit = Direct materials + direct labor + variable production OH

• Fixed costs are treated as a period cost and are charged in full to the income
statement of the accounting period in which they are incurred.

VERTEX LEARNING SOLUTIONS - https://vls-online.com

Overview of Absorption and Variable Costing
▪ Marginal is good for decision making.
▪ Absorption is for reporting

Absorption Marginal / Variable

Costing Costing

Direct Materials
Product
Direct Labor
Product Costs
Costs
Variable Manufacturing Overhead

Fixed Manufacturing Overhead

Period
Variable Selling and Administrative Expenses
Period Costs
Costs
Fixed Selling and Administrative Expenses
Cost Card – Marginal Costing

$/unit
Direct materials X
Direct labour X
Variable overhead X Used to value stock
Marginal cost X under Marginal costing

Fixed overheads X
Used to value stock under
Full product cost X Absorption costing
 Absorption and Marginal Costings
The effect of absorption and marginal costing on inventory valuation and profit

Absorption Costing - values inventory

at the full production cost (including
fixed production overheads) of a
Marginal Costing - values inventory at product.
the total variable production cost of a • Inventory values using absorption
product. E.g. direct labor, direct costing are therefore greater than
material, direct expenses and variable those calculated using marginal
production overheads costing.
• No FIXED overheads! • Since inventory values are
different, profits reported in the
Income statement (I/S) will also be
different.

VERTEX LEARNING SOLUTIONS - https://vls-online.com

The Concept of Contribution

How Do We Calculate Contribution?

Contribution = Sales price – variable costs

Contribution is of fundamental importance in marginal costing, and the term 'contribution' is

short for 'contribution towards covering fixed overheads and making a profit’.

Total contribution = contribution per unit x sales volume

Profit = Total contribution – Fixed overheads

VERTEX LEARNING SOLUTIONS - https://vls-online.com
 Absorption Versus Marginal Costing Profit Statements

A company manufactures and sell tables. Date for the period is given below.
Prepare income statement using Absorption Costing as well as Marginal Costing Method

Direct Materials $20 Overheads

Direct Labor $10 Factory Rent $2,000
Overhead cost $ 5/ unit Factory Insurance $2,000
Factory Depreciation $1,000
Total Overheads $5,000
Production 1000 units
Sales 700 units OAR per unit = $5 / unit
Selling Price $ 50
 Absorption Versus Marginal Costing Profit Statements
Marginal Costing Method
Absorption Costing Method

Sales 700 * 50 35,000 Sales 700 * 50 35,000

COS COS
Opening Inv 0 Opening Inv 0
Add Purchases 1000 (20+10+5) 35,000 Add Purchases 1000 (20+10) 30,000
Less Closing. Inv 300 (20+10+5) (10,500) (24,500) Less Closing. Inv 300 (20+10) (9,000) (21,000)
Gross Profit 10,500 Contribution 14,000
Less Fixed Costs (5,000)
Profit 9,000

Absorption Costing Profit $10,500 Difference in Profit is due to the difference in opening and
Marginal Costing Profit $9,000 closing inventories.
Difference in Profit $1,500 Difference in Opening and Closing Inv. * Overhead in each unit
300 units * $ 5 = $1,500
 Absorption Versus Marginal Costing Profit Statements

Absorption costing allows you to add overheads in the inventory, and if any
units are unsold then units are transferred to the next period and they also
take their fixed overheads to the the next period. Fixed cost in unsold units
is transferred to the next period.
In previous example the value of closing inventory was $10,500

Marginal costing on the other hand says that fixed costs are period costs
and can not be transferred to next period.
Whether you sell more or less full years fixed costs for the period must be
deducted in full from the income statement.
In previous example the value of closing inventory was $9,000
 Absorption Versus Marginal Costing

▪ Absorption costing is used for routine profit reporting and must be used for
financial accounting purposes under IAS 2 Inventories

▪ Marginal costing provides better management information for planning and

decision making and is used for internal reporting and decision making.
Profit Or Loss Under Absorption and Marginal Costing

In marginal costing, fixed production costs:

• are not included in the COS

• are treated as period costs (are written off as they are incurred)

In absorption costing, fixed production costs

• are absorbed into the cost of units

• are included in the COS

In the long run, total profit for a company will be the same whether marginal
costing or absorption costing is used.

Note that inventories are valued at variable production costs only

VERTEX LEARNING SOLUTIONS - https://vls-online.com

Reconciling profits

Difference in profit = Change in stock X OAR/unit

But which profit is higher

AC profit Or MC Profit?

Production < = > Sales

Closing stock < = > Opening stock

AC Profit < = > MC Profit

Reconcile The Profits or Losses

If Inventory Levels Increase

• Between the beginning and end of a period, absorption costing will report the higher profit.

• This is because some of the fixed production OH will be carried forward in closing inventory (which
reduces cost of sales and therefore reduces Expenses and therefore increases the Profit).

• LESS expenses you have .... MORE Profit you get

VERTEX LEARNING SOLUTIONS - https://vls-online.com

Reconcile The Profits or Losses

If Inventory Levels Decrease

• absorption costing will report the lower profit because as well as the fixed OH incurred, fixed production
overhead which had been carried forward in opening inventory is released and is also included in cost of
sales.

• MORE expenses you have .... LESS Profit you get

VERTEX LEARNING SOLUTIONS - https://vls-online.com

Reconcile The Profits or Losses

Therefore:
1. If inventory levels increase, absorption costing gives the higher profit
2. If inventory levels decrease, marginal costing gives the higher profit
3. If inventory levels are constant, both methods give the same profit

Profits generated using absorption & marginal costing can also be reconciled as follows:

Difference in the profit = change in inventory in units x OAR per unit

VERTEX LEARNING SOLUTIONS - https://vls-online.com

Advantages and Disadvantages of Marginal Costing

Advantages of Marginal Costing

• Contribution per unit is constant over different sales volumes

• No over- or under- absorption
• Highlights contribution so appropriate for decision-making
• Profit depends on sales and efficiency not on production levels
• Simple to operate

Disadvantages of Marginal Costing

• Contribution may not cover fixed costs

• Does not comply with IAS 2
• Fixed production overheads are not shared between units of production but written off
in full

VERTEX LEARNING SOLUTIONS - https://vls-online.com

Advantages and Disadvantages of Absorption Costing

Advantages of Absorption Costing

• Complies with IAS 2 “inventories”

• Better cost control due to analysing under-/over- absorption
• Recognises that selling price must cover all costs

Disadvantages of Absorption Costing

• Profits can be manipulated by changing production levels

• It is based on the assumption that overheads are volume-related

VERTEX LEARNING SOLUTIONS - https://vls-online.com

Profit under Marginal Costing

VERTEX LEARNING SOLUTIONS - https://vls-online.com

Profit under Absorption Costing

VERTEX LEARNING SOLUTIONS - https://vls-online.com