Chapter 6:

Accounting for Overheads – Marginal Costing and Total Absorption Costing

Introduction
This sub-topic looks at two approaches to calculating profits: marginal costing (MC) and total absorption
costing (TAC).
Marginal costing accounts for variable costs only in the cost of production.
Total absorption cost tries to take all production costs into account. i.e. both variable production + fixed
production costs.
Different profits are likely to be calculated under each method.

Some Definitions
1. Marginal cost (MC): the additional cost incurred when one more unit is made. Marginal cost per unit will
be the sum of ALL variable costs per unit.
2. Total absorption cost (TAC): the total cost of manufacturing a unit. This is the sum of the marginal cost
and a fair share of the fixed production costs. i.e. TAC = MC + FC
3. Fixed overhead absorption rate (FOAR): budgeted fixed production costs divided by budgeted output in
units.
4. Profit per unit: selling price per unit less total absorption cost per unit i.e. Profit = SP – TAC or SP – MC –
FC or Contribution - FC
5. Contribution per unit: selling price per unit less marginal cost per unit. i.e. SP - MC

Profit statements and their preparation in absorption and marginal costing formats:
Illustration 1
Here is a cost card showing selling price and costs per unit:

Total absorption cost(TAC) per unit = $65 (i.e. $40 marginal cost + $25 fixed cost per unit)
Let us say that in a month, 1,000 units were made and 900 of those were sold.
This means that there must be 100 items left in inventory. i.e. the closing inventory.
Required: Prepare the profit statement using:
a) Marginal costing approach
b) Absorption costing approach
Solution
a)
Marginal costing approach:
Sales or revenue: 900u*100 = 90,000
Less marginal cost of production
Opening inventory 0
Marginal cost of production: 1,000u*40 = 40,000
Less: Closing inventory: 100u*40 = (4,000) (36,000)
Contribution 54,000
Less expenses
Fixed production cost (25,000)
Marginal costing profit $29,000

NB: Closing inventory is valued at marginal cost i.e. $40 per unit.
Marginal cost of production for goods that were sold = $36,000

b)
Absorption costing approach:
Sales or revenue: 900u*100 = 90,000
Less absorption cost of production
Opening inventory 0
Absorption cost of production: 1,000u*65 = 65,000
Less: Closing inventory: 100u*65 = (6,500) (58,500)
Absorption costing profit $31,500

NB: Closing inventory is valued at absorption cost i.e. $65 per unit.
Absorption cost of production for goods that were sold = $58,500

Comments on the two methods of calculating profits:

Both methods are correct. It’s simply if inventories are valued differently then profits will be different.

Under marginal costing closing inventory is valued at its marginal cost of production.
However, because MC does not take into account all production costs, it can be argued that the cost of
production and the value of inventory is understated. Hence, MC is not good for valuation of inventory; but it is
good for decision making.

Under TAC closing inventory is valued at its total absorption cost of production. i.e. all production costs are
taken into account and arguable TAC is better for inventory valuation.

Either method can be used in internal cost accounting, but for external reporting in the
financial statements TAC has to be used for inventory valuation.

Illustration 2
What is the contribution and profit if 500 units are made and sold where the selling price is $20 per unit and
the marginal cost is $8 per unit? Fixed overheads are expected to be $4,000 for the period.
Solution:
Contribution (i.e. total) = Sales – Marginal cost
= ($20*500u) – ($8*500u) = $6,000

Profit = Contribution (i.e. total) – Fixed overheads

= 6,000 – 4,000 = $2,000

Reconciling MC profit and TAC profit

A quick way to establish the difference in profits without going through the whole process of drawing up the
statements of profit or loss is as follows:
Difference in profits = change in inventory level × overhead absorption rate per unit.
From illustration 1 above:
Difference in profits = (100 - 0) * 25 = $2,500
N/B: Overhead absorption rate(OAR) = budgeted fixed cost per unit
Closing inventory = 100 units
Opening inventory = 0 units

Remarks:
If inventory levels have gone up (i.e., closing inventory > opening inventory) then absorption costing profit
will be greater than marginal costing profit.

If inventory levels have gone down (i.e., closing inventory < opening inventory) then absorption costing profit
will be less than marginal costing profit.

Conclusion: Where CI > OI, TAC Profit will be more than MC profit. And vice versa.

Illustration 3

Solution
Units sold = 56,000u
Units produced = 56,000+4,000 = 60,000u
Fixed production per unit = 258,000/60,000 = 4.3
MC = 3.6
TAC = 3.6+4.3 = 7.9

Sales or revenue: 700,000

Less absorption cost of production
Opening inventory 0
Absorption cost of production: 60,000u*7.9 = 474,000
Less: Closing inventory: 4,000u*7.9 = (31,600) (442,400)
257,600
Less expenses
Fixed non-production expense (144,000)
Absorption costing profit = $113,600

NB:
Difference in profits = Change in inventory * Fixed production cost per unit
= 4,000u * 4.3 = $17,200
Since CI > OI, absorption costing profit should be greater than marginal costing profit.
Marginal costing profit = 113,600 – 17,200 = $96,400

Illustration 4
Solution
NB: Gross profit = Sales or revenue – cost of goods sold
Total production = 6,700u, but 6,500u were sold
Variable costs per unit = 93,130/6,700 = 13.9
Fixed costs per unit = 41,540/6,700 = 6.2
TAC = 13.9+6.2 = 20.1

Gross profit = Sales or revenue – cost of goods sold

= 169,000 – (6,500u*20.1) = $38,350

Illustration 5

Solution
Difference in profits = Change in inventory * Fixed production cost per unit
10,000 = 2,000u * Fixed production cost per unit
Fixed production cost per unit = 10,000/2,000 = $5 per unit

Question 6

Solution
Opening inventory = 1,700u
Closing inventory = 1,700 + 33,300 – 33,950 = 1,050u
Change in inventory = difference in inventory = 1,700 – 1,050 = 650u
Total absorption cost of production = 16.30+11.60 = 27.90
Change in the value of inventory = 650u * 27.90 = $18,135

Question 7
Required:
a) The profit using marginal costing system
b) The profit made under an absorption costing system
Solution
a)
Marginal cost of production per unit = 2+3+3 = 8
Profit statement:
Sales or revenue: 9,000u * 20 = 180,000
Less marginal cost of production for goods sold: 9,000u*8 = (72,000)
Less variable selling cost: 9,000u*1 = (9,000)
Less fixed production overhead: 10,000u*4 = (40,000)
Less fixed selling overhead: 10,000u*2 = (20,000)
Marginal costing profit = $39,000

b)
Opening inventory = 0
Closing inventory = 11,000 – 9,000 = 2,000u
Change in inventory level = 2,000-0 = 2,000u
Difference in profits = change in inventory level * Fixed production cost per unit
= 2,000 * 4 = 8,000
NB: Closing inventory > opening inventory. Hence, absorption costing profit > marginal costing profit.
Absorption costing profit = 39,000 + 8,000 = $47,000

Cost Allocation and Cost Apportionment

Typically, as units are produced they pass through a number of departments such as component manufacturing,
assembly, finishing and testing.
The first challenge is to calculate the fixed production costs relating to each production department.
There are two general ways in which costs can be traced to or identified with production departments:
Cost allocation: where the whole of a cost can be traced to a single department.
Cost apportionment: where a cost has to be divided over several departments.
Example: Cost apportionment would have to be carried out if a rent invoice were received for the whole
business, so relating to all manufacturing departments, apportionment is carried out.
Apportionments (dividing-up the total cost) are done on a common sense basis. For example:
 Heating costs - apportioned on the basis of volume occupied or floor area of the departments.
 Insurance cost of machines - apportioned on the basis of machine value
 Rent - apportioned on the basis of floor area
 Canteen costs - apportioned on the basis of the number of people employed per department.

Illustration 8
A factory has two production departments: preparation and assembly, and one canteen for the labour force.
Statistics about the departments are:

Fixed overhead costs are: rent $45,000, insurance $5,400, canteen costs $12,000, electricity $40,000.
Required: Show how the costs would be apportioned to each department.
Solution

Illustration 9

Solution
For packing = 8,960 + (3/21 * 8,400) = $10,160

Absorption Rates:
The costs now have to be traced into (or charged) to items being produced.
If there is only one type of item being produced, then the costs per item would simply be the total costs spread
over the items. This would be known as a fixed overhead absorption rate per unit.
i.e. Overhead absorption rate (OAR) per unit = Budgeted fixed production costs
Budgeted production in units

However, often a mix of items is produced, and the normal approach is to charge overheads on the basis of the
amount of time that the items spend in each department.
It is assumed that there is a correlation between spending time in a department and benefitting from what goes
on there.
The time can be estimated using:
 Labour hours: this will give a fixed overhead absorption rate per labour hour
 Machine hours: this will give a fixed overhead absorption rate per machine hour
i.e. Overhead absorption rate (OAR) per labour hour = Budgeted fixed production costs
Budgeted labour hours
Or
i.e. Overhead absorption rate (OAR) per machine hr. = Budgeted fixed production costs
Budgeted machine hours

Under-absorption and Over-absorption of Overheads

Under-absorption where not enough fixed costs have been accounted for.
Under-absorption occurs when absorbed overheads < actual overheads.
Under-absorption means that the costs have been understated. Hence, profits are overstated.
Correction: Subtract the under-absorption from the reported (or the overstated) profit.

Over-absorption where too many fixed costs have been accounted for.
Over-absorption occurs when absorbed overheads > actual overheads.
Over-absorption means that the costs are overstated. Hence, the profits are understated.
Correction: Add the over absorption to the reported profit.

NB: Absorbed overheads = OAR * Actual units produced or actual labour hours or actual machine hours.

Illustration 10
Budgeted overheads = $12,000; budgeted production = 2,000 units
Actual overheads = $13,000; actual production = 1,900 units.
Find the OAR, and overheads under or over absorbed.
Solution:
OAR per unit = Budgeted fixed overheads/Budgeted production = 12,000/2,000 = $6 per unit

Absorbed overheads = OAR * Actual production = 6 * 1,900 = $11,400

Actual overheads = $13,000
Under absorption = $1,600

NB: The benchmark is the actual overheads. Below actual overheads = under absorption
Above actual overheads = over absorption

Illustration 11
Budgeted overheads = $50,000; budgeted production = 20,000 units
Actual overheads = $46,000; actual production = 19,000 units.
Find the OAR, and overheads under or over absorbed.
Solution:
OAR per unit = Budgeted fixed overheads/Budgeted production = 50,000/20,000 = $2.5 per unit

Absorbed overheads = OAR * Actual production = 2.5 * 19,000 = $47,500

Actual overheads = $46,000
Over absorption = $1,500
Illustration 12

Solution
OAR per labour hour = Budgeted fixed overheads/Budgeted labour hrs = 164,000/10,000 = $16.4

Absorbed overheads = OAR * Actual labour hrs = 16.4 * 9,800 = $160,720

Actual overheads = $158,000
Over absorption = $2,720

Illustration 13

Solution
Direct material cost = 7.15
Direct labour cost = 8.25
Absorbed overheads = (3hrs*1.76)+(1.5hrs*3.28) = 10.20
Full production cost = $25.60

Illustration 14

Solution
Absorbed overheads = 86,920 – 2,496 = 84,424
But absorbed overheads = OAR * Actual labour hrs
i.e. 84,424 = OAR * 9,760
OAR = 84,424/9,760 = $8.65 per labour hr.

Illustration 15

Solution
Absorbed overheads = 640,150 + 35,000 = 675,150
But absorbed overheads = OAR * Actual labour hrs
i.e. 675,150 = OAR * 48,225
OAR = 675,150/48,225 = $14 per labour hr.