ACC1003

Week 4 – Marginal vs Absorption

Costing
Lecture Outcomes
After studying this chapter, you should be able to:
• explain the differences between an absorption costing and a variable costing system;
• prepare profit statements based on a variable costing and an absorption costing system;
• explain the difference in reported profits between variable and absorption costing profit calculations;
• explain the arguments for and against variable and absorption costing;
• describe the various denominator levels that can be used with an absorption costing system;
• explain why the choice of an appropriate denominator level is important
Overview of Absorption and Variable Costing

The only costs of driving my car

on a 200-mile trip today are
£12 for petrol.

Variable
Costing
Overview of Absorption and Variable Costing

No! You must consider these costs too!

Cost Per month Per day
Car payment £ 300 £ 10
Insurance 60.00 2.00

Absorption
Costing
Overview of Absorption and Variable Costing

Who’s right?
How should we treat the car
payment and the insurance?
Overview of Absorption and Variable Costing
1.Absorption costing (full costing) traces all
manufacturing costs to products.

2.Variable costing (direct or marginal costing) traces

all variable costs to products.

Different treatment of fixed manufacturing costs:

Which
one is better?
Overview of Absorption and Variable Costing

Absorption Variable
Costing Costing

Direct materials
Direct labour Product costs
Product costs Variable mfg. overhead

Fixed mfg. overhead

Period costs
Period costs Selling & admin. exp.
Overview of Absorption and Variable Costing

Let’s put some numbers to the

issue and see if it will
sharpen our understanding.
Unit Cost Computations
Harvey Co. produces a single product with the
following information available:
Unit Cost Computations
Unit product cost is determined as follows:

Absorption Variable
Costing Costing
Direct materials, direct labour,
and variable mfg. overhead £ 10 £ 10
Fixed mfg. overhead
(£150,000 ÷ 25,000 units) 6 -
Unit product cost £ 16 £ 10

Selling and administrative expenses are

always treated as period expenses and
deducted from revenue.
Profit Comparison of Absorption and Variable
Costing
Harvey Co. had no beginning inventory, produced 25,000 units and sold 20,000 units this year.
:
Absorption Costing
Sales (20,000 × £30) £600,000
Less cost of goods sold:
Beginning inventory £ -
Add COGM (25,000 × £16) 400,000
Goods available for sale 400,000
Ending inventory (5,000 × £16) 80,000 320,000
Gross margin 280,000
Less selling & admin. exp.
Variable
Fixed
Operating profit
Profit Comparison of Absorption and Variable
Costing
Harvey Co. had no beginning inventory, produced 25,000 units and sold 20,000 units this year.
:

Absorption Costing
Sales (20,000 × £30) £600,000
Less cost of goods sold:
Beginning inventory £ -
Add COGM (25,000 × £16) 400,000
Goods available for sale 400,000
Ending inventory (5,000 × £16) 80,000 320,000
Gross margin 280,000
Less selling & admin. exp.
Variable (20,000 × £3) £ 60,000
Fixed 100,000 160,000
Operating profit £120,000
 Profit Comparison of Absorption and
Variable Costing
Now let’s look at variable costing by Harvey Co.
Variable
costs
only.
All fixed
manufacturing
overhead is
expensed.

McGraw-Hill Education | 13
 Profit Comparison of Absorption and
Variable Costing

Let’s compare the methods.

McGraw-Hill Education | 14
 Profit Comparison of Absorption and
Variable Costing

Let’s compare the methods.

McGraw-Hill Education | 15
 Reconciliation

We can reconcile the difference between

absorption and variable profit as follows:

Variable costing operating profit £ 90,000

Add: Fixed mfg. overhead costs
deferred in inventory
(5,000 units × £6 per unit) 30,000
Absorption costing operating profit £ 120,000

Fixed mfg. overhead £150,000

= = £6.00 per unit
Units produced 25,000
McGraw-Hill Education | 16
 Extending the Example

Let’s look at the

second year
of operations
for Harvey
Company.

McGraw-Hill Education |
 Harvey Co. Year 2
In its second year of operations, Harvey Co. started with an inventory of 5,000 units, produced 25,000
units and sold 30,000 units.

Number of units produced annually 25,000

Variable costs per unit:
Direct materials, direct labour
variable mfg. overhead £ 10
Selling & administrative
expenses £ 3
Fixed costs per year:
Manufacturing overhead £150,000
Selling & administrative
expenses £100,000

McGraw-Hill Education | 18
 Harvey Co. Year 2

Unit product cost is determined as follows:

Absorption Variable
Costing Costing
Direct materials, direct labour,
and variable mfg. overhead £ 10 £ 10
Fixed mfg. overhead
(£150,000 ÷ 25,000 units) 6 -
Unit product cost £ 6 £ 10

No change in Harvey’s
cost structure.

McGraw-Hill Education | 19
 Harvey Co. Year 2

Now let’s look at Harvey’s statement of profit or

loss assuming absorption costing is used.

McGraw-Hill Education |
 Harvey Co. Year 2

Absorption Costing
Sales (30,000 × £30) £900,000
Less cost of goods sold:
Beginning inventory (5,000 × £16)£ 80,000
Add COGM (25,000 × £16) 400,000
Goods available for sale 480,000
Ending inventory - 480,000
Gross margin 420,000
Less selling & admin. exp.
Variable (30,000 × £3) £ 90,000
Fixed 100,000 190,000
These are the 25,000 units
produced in the current period.

McGraw-Hill Education |
 Harvey Co. Year 2

Next, we’ll look at Harvey’s statement of profit or

loss assuming is used.

McGraw-Hill Education |
 Harvey Co. Year 2
Variable
costs Variable Costing
Sales (30,000 × £30) only. £900,000
Less variable expenses:
Beginning inventory (5,000 × £10) £ 50,000 All fixed
Add COGM (25,000 × £10) 250,000 manufacturing
Goods available for sale 300,000
overhead is
Ending inventory -
expensed.
Variable cost of goods sold 300,000
Variable selling & administrative
expenses (30,000 × £3) 90,000 390,000
Contribution margin 510,000
Less fixed expenses:
Manufacturing overhead £150,000
Selling & administrative expenses 100,000 250,000
Operating profit £260,000

McGraw-Hill Education |
 Summary

Income
Income Comparison
Comparison

Costing
CostingMethod
Method 1st
1st Period
Period 2nd
2ndPeriod
Period Total
Total
Absorption
Absorption ££120,000
120,000 ££ 230,000
230,000 ££350,000
350,000
Variable
Variable 90,000
90,000 260,000
260,000 350,000
350,000

McGraw-Hill Education |
 Summary

McGraw-Hill Education | Seal & Rohde Management Accounting 6th edition © 2018
 Lecture Example: IM 6.5

McGraw-Hill Education |
 Advantages of Variable Costing and the
Contribution Approach

Consistent with
CVP analysis.
Management finds it
easy to understand. Operating profit is
closer
to net cash flow.
Consistent with standard
Advantages costs and flexible budgeting.

Easier to estimate profitability

of products and segments.
Impact of fixed
costs on profits Profit is not affected by
emphasized. changes in inventory.
McGraw-Hill Education |
 Variable versus Absorption Costing

Absorption Variable
Costing Costing

All manufacturing costs Fixed costs are

must be assigned to not really the costs
products to properly of any particular
match revenues and costs. product.

McGraw-Hill Education |
 Variable versus Absorption Costing

Absorption Variable
Costing Costing

Depreciation, taxes, These are capacity

insurance and salaries costs and will be
are just as essential to incurred if nothing
products as variable costs. is produced.

McGraw-Hill Education |
 Choosing a Costing Method

A basic problem with absorption costing is that fixed

manufacturing overhead costs appear to be variable
with respect to the number of units sold.

A company that attempts to use variable costing on its

external financial reports runs the risk that its auditors
may not accept the financial statements as conforming
to internationally accepted accounting principles.
The issue of performance evaluation.

McGraw-Hill Education | 30
 Impact of JIT Inventory Methods

In a JIT inventory system . . .

Production
tends to equal
sales . . .

So, the difference between variable and

absorption profit tends to disappear.

McGraw-Hill Education |
Conclusions
1. Choice depends on the circumstances:

• Volatile sales and changing stock levels favour variable costing for
internal monthly or quarterly profit measurement.

• Seasonal sales where stocks are built up in advance favours

absorption costing.

2. Debate only applies to internal reporting – SSAP 9 requires that

absorption costing is used for external reporting.
Alternative denominator level measures
• Absorption costing systems require the computation of estimated fixed
overhead rates.

• The fixed overhead rate will be significantly influenced by the choice of

the denominator level.
Alternative denominator level measures
 Alternative denominator level measures
There are four different denominator activity levels available:
• Theoretical maximum capacity of 6,000 hours
• Practical capacity of 5,000 hours
• Normal average long-run activity of 4,800 hours
• Budgeted activity of 4,000 hours.
Alternative denominator level measures
 Alternative denominator level measures
• The choice of activity level can have a significant
effect on the inventory valuation and profit
computation.
RECAP
• Explain the differences between an absorption costing and a variable
costing system
• Prepare profit statements based on a variable costing and an absorption
costing system
• Explain the differences in reported profits between the systems
• Explain the arguments for and against the systems
References
• Drury, C. (2023), Management and Cost Accounting, 12th edition, Andover:
Cengage Learning.- Chapter 6 [E]
• Seal, W., C. Rohde, R.H. Garrison and E.W. Noreen (2019), Management
Accounting, 6th edition, Maidenhead: McGraw-Hill Education. Chapter 7
[U]