ACMB213 Cost Accounting

TOPIC 10: ABSORPTION AND VARIABLE COSTING

Learning Objectives
After studying this topic, students should be able to:
1. Differentiate between absorption costing and marginal costing systems
2. Prepare cost statement and income statement for manufacturing companies under absorption
costing and marginal costing systems
3. Discuss the advantages and disadvantages of the absorption & marginal costing systems

INTRODUCTION
 Absorption costing (also known as full costing) traces all manufacturing costs to products and treats
non-manufacturing overheads as a period cost.
 Marginal costing (also known as direct or variable costing) traces all variable manufacturing costs to
products and treats fixed manufacturing overheads and fixed non-manufacturing overheads as period
cost.
 Therefore, variable and absorption costing differ in the treatment of fixed manufacturing costs.

Differences between Absorption Costing & Marginal costing

Absorption costing Marginal costing

Product cost All production costs consisting of direct
material, direct labour, direct expenses
and production overhead.
Fixed Treated as part of product cost
production
overhead
Usage External reporting as required by
MFRS102
Under/over  Result in under or over absorbed
absorption overhead since production overhead
is charged to product based on
predetermined OAR, which will be
different from the actual production
overhead incurred.
 Under/over absorption is treated as
the period cost adjustment
Profit Gross profit = Sales - COGS
calculation
Include variable production cost only -
direct material, direct labour, direct
expenses and variable production
overhead
Treated as expenses for the period
Internal reporting for decision-making
purposes.
No under/over absorption since the
actual fixed production, overhead is
treated as expense for the period.
Contribution = Sales – Total variable
costs (both manufacturing & non-
manufacturing)

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 Income Statement Format

ABSORPTION COSTING STATEMENT

<Company Name>
Income statement for the year ended xx/xx/xxx

RM RM
Sales Revenue xxxxx
Less: COGS
Opening Stock xxx
Add Production Cost xxxx
Less Closing Stock (xxx)
xxxx
Adjustment for under/(over) absorbed overhead xxx or (xxx)
Total costs xxxx
Gross profit xxxxx
Less: Non-manufacturing cost xxxx
Net Profit xxxx

MARGINAL COSTING STATEMENT

<Company Name>
Income statement for the year ended xx/xx/xxx

RM RM
Sales Revenue xxxxx
Less: COGS
Opening Stock xxxx
Add Variable Production Cost xxxx
Less Closing Stock (xxx)
Variable cost of goods sold xxx
Add Variable Non-manufacturing costs xxx (xxx)
Contribution xxxx
Less: Fixed cost (xxx)
Fixed Production cost xxxx
Fixed Non manufacturing cost xxxx
Net Profit Xxxx

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 Computation of profit using Absorption Costing and Variable Costing

Illustration
Cool Day Sdn Bhd (CDSB) manufactures and sells electric blankets. The selling price is RM100 per unit.
Each blanket has the following unit cost:
RM
Direct material 15
Direct labour 10
Variable production overhead 4
Fixed production overhead 5

The fixed production overhead per unit is calculated based on normal activity of 10,000 units of
production. Variable selling and administrative cost is RM3 per unit and fixed selling and administrative
cost is RM20,000 per annum.

CDSB sales and productions are as follows:

Sales units Production units
January 9,000 11,000
February 10,000 9,500

There is no opening stock in January.

Required:
(a) Calculate the unit product costs under absorption costing and marginal costing.
(b) Prepare the income statement for January and February under absorption costing and marginal
costing.
(c) Reconcile the profit figures you have calculated in (b) above.

Answer:
(a) Calculate the unit product costs under absorption costing and marginal costing.

Absorption Costing Marginal Costing

RM RM
Direct material
Direct labour
Variable production overhead
Fixed production overhead
Total product cost per unit

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(b) Prepare the income statement for January and February under absorption costing and marginal
costing.

 Absorption Costing
Cool Day Sdn Bhd
Income Statement for the months of
January February
RM RM
Sales
Less COGS
Opening stock
+ Production cost
- Closing stocks

Adjustment for under/(over)

absorbed overhead
Total costs
Gross profit
Less expenses:
Variable selling &
administrative cost
Fixed selling &
administrative cost
Net profit

 Marginal Costing
Cool Day Sdn Bhd
Income Statement for the months of
January February
RM RM
Sales
Less COGS
Opening stock
+ Production cost
- Closing stocks
Total variable costs of sales
Add: Variable selling &
administrative cost
Total costs
Contribution
Less fixed costs:
Fixed production overhead
Fixed selling &
administrative cost
Net profit

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(c) Reconcile the profit figures you have calculated in (b) above

January February
RM RM
Net profit under AC
Add: Fixed overhead included opening
stock carried down from previous period
Less: Fixed overhead included in closing
stock carried forward to next period
Net profit under MC

Impact on profit

Marginal costing values inventory at the total variable production cost whereas Absorption
costing values inventory at the full production cost. Therefore:
 Inventory values will therefore be different at the beginning and end of a period under marginal
and absorption costing.
 If inventory values are different, then this will have an effect on profits reported in the income
statement in a period. Profits determined using marginal costing principles will therefore be different
to those using absorption costing principles.

Reconciling profits reported under the different methods

When inventory levels increase or decrease during a period then profits differ under absorption
and marginal costing.
 If inventory levels increase (ie opening inventory < closing inventory OR sales > production), absorption
costing gives the higher profit. This is because fixed overheads held in closing inventory are carried
forward (thereby reducing cost of sales) to the next accounting period instead of being written off in
the current accounting period (as a period cost, as in marginal costing).
 If inventory levels decrease (ie opening inventory > closing inventory OR sales < production), marginal
costing gives the higher profit. This is because fixed overhead brought forward in opening inventory is
released, thereby increasing cost of sales and reducing profits.
 If inventory levels are constant, both methods give the same profit.

 The profit difference due to difference in stock valuation is summarized as follows:

Inventory Sales & Production PROFIT ADDITIONAL INFO

Opening = Closing Sales = Production Same provided the FC element in opening &
closing stocks are of the same amount
Opening < Closing Sales > Production MC < AC Greater portion of FC is included in closing
stock & carried over to next period.
Opening > Closing Sales < Production MC > AC Higher amount of FC contained in opening
stock is deducted as COGS during the
current period.

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 ADVANTAGES AND DISADVANTAGES OF THE ABSORPTION & MARGINAL COSTING

Advantages of marginal costing Advantages of absorption costing

 Contribution per unit is constant unlike profit
per unit which varies with changes in sales
volumes
 There is no under or over absorption of
overheads (and hence no adjustment is required
in the income statement).
 Marginal costing is useful in the decision-
making process
 It is simple to operate
 Marginal costing removes from profit the effect
of inventory changes
 Avoid fixed overhead being capitalized in
unsaleable stocks
 Absorption costing includes an element of
fixed overheads in inventory values (in
accordance with MFRS102). Therefore
consistent with external reporting
requirement
 Analysing under/over absorption of overheads
is a useful exercise in controlling costs of an
organisation
 In small organisations, absorbing overheads
into the costs of products is the best way of
estimating job costs and profits on jobs
 Does not understate the importance of fixed
costs especially in modern industry
 Avoids fictitious losses being reported
 Fixed overhead are essential for production

Disadvantages of marginal costing Disadvantages of absorption costing

 The separation of costs into fixed and  A portion of FC is carried over to the subsequent
variable is difficult & sometimes
gives misleading results.
 Stocks and work in progress are
understated. The exclusion of fixed
costs from inventories affect profit
and true and fair view of financial
affairs of an organization may not be
clearly transparent.
 Volume variance in standard costing
also discloses the effect of
fluctuating output on fixed overhead.
Marginal cost data becomes
unrealistic in case of highly
fluctuating levels of production, e.g.,
in case of seasonal factors.
accounting period as part of closing stock.
 This is an unsound practice because costs pertaining to a
period should not be allowed to be vitiated by the
inclusion of costs pertaining to the previous period and
vice versa.
 Cost per unit is dependent on the levels of output which
may vary from period to period, & consequently cost per
unit changes due to the existence of fixed overhead.
 Unless fixed overhead rate is based on normal capacity,
such changed costs are not helpful for the purposes of
comparison and control.
 Application of fixed overhead depends on estimates and
not on the actual and as such there may be under or over
absorption of the overhead.

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