Cost Accounting Techniques

Absorption and marginal costing

Facilitator:
Dr Irfan Sahibzada
Contact Details:
Irfan.sahibzada@nbs.nust.edu.pk
Ph. Office: 051 90853154
Mob: 0342 5093739
Office: Room 311
 Chapter Scope
• This chapter defines marginal costing and compares it with
absorption costing.
• Whereas absorption costing recognises fixed costs (usually
fixed production costs) as part of the cost of a unit of output
and hence as product costs, marginal costing treats all fixed
costs as period costs.
• Two such different costing methods obviously each have their
supporters and so we will be looking at the arguments both in
favour of and against each method.
• Each costing method, because of the different inventory
valuation used, produces a different profit figure and we will
be looking at this particular point in detail.
 Marginal Costing
• Marginal costing— a costing system in which only
variable production costs are charged to cost units.
• Fixed costs are expensed in full in the period in which
they are incurred.
 Marginal Cost
• When referring to “Marginal Cost" it is necessary to
distinguish between marginal cost of production and
marginal cost of sale (i.e. total marginal cost which includes
variable selling and distribution costs, etc.).
• For inventory valuation, only marginal production cost is relevant.
• The marginal cost of production is the increase in cost of
inputs if one additional unit of output is produced. These are
the costs generated solely by the production of a given cost
unit, i.e. all unit direct production costs + variable production
overhead per unit.
• The marginal cost of sale is the increase in total cost of
producing and selling one additional unit.
 Contribution
• Contribution is an important measure in marginal
costing, and it is calculated as the difference between
sales value and marginal or variable cost of sales.
• The term 'contribution' is really short for 'contribution
towards covering fixed overheads and making a profit'.
• Total contribution is total revenue less total variable cost
incurred.
• Unit contribution is the amount by which profit is increased
when one more unit is made and sold and it is the unit
selling price less marginal cost of sales per unit.
The Principles of Marginal Costing
1. Period fixed costs are the same, for any volume of sales and
production (provided that the level of activity is within the
'relevant range'). Therefore, by selling an extra item of
product or service the following will happen.
a. Revenue will increase by the sales value of the item sold.
b. Costs will increase by the variable cost per unit.
c. Profit will increase by the amount of contribution earned from
the extra item.
2. Similarly, if the volume of sales falls by one item, the profit
will fall by the amount of contribution earned from the item.
The Principles of Marginal Costing
3. Profit measurement should therefore be based on an
analysis of total contribution. Since fixed costs relate to
a period of time, and do not change with increases or
decreases in sales volume, it is misleading to charge
units of sale with a share of fixed costs.
• Absorption costing is therefore misleading, and it is
more appropriate to deduct fixed costs from total
contribution for the period to derive a profit figure.
The Principles of Marginal Costing
4. When a unit of product is made, the extra costs
incurred in its manufacture are the variable production
costs. Fixed costs are unaffected, and no extra fixed
costs are incurred when output is increased.
• It is therefore argued that the valuation of closing
inventories should be at variable production cost (direct
materials, direct labour, direct expenses (if any) and
variable production overhead) because these are the only
costs properly attributable to the product.
 Example
Marginal Costing Principles
• Diana & Co makes a product, the Splash, which has a variable
production cost of $6 per unit and a sales price of $10 per
unit. At the beginning of September 2018, there were no
opening inventories and production during the month was
20,000 units. Fixed costs for the month were $45,000
(production, administration, sales and distribution). There
were no variable marketing costs.
• Calculate the contribution and profit for September 2018,
using marginal costing principles, if sales were as follows:
a. 10,000 Splashes
b. 15,000 Splashes
c. 20,000 Splashes
 Solution Steps
• The stages in the profit calculation are as follows:
• Identify the variable cost of sales, and then the
contribution.
• Deduct fixed costs from the total contribution to
derive the profit.
• Value all closing inventories at marginal production
cost ($6 per unit).
 Marginal vs Absorption Costing
• In marginal costing, fixed production costs are treated as
period costs and are written off as they are incurred.
• In absorption costing, fixed production costs are
absorbed into the cost of units and are carried forward in
inventory to be charged against sales for the next period.
• Inventory values using absorption costing are therefore
greater than those calculated using marginal costing.
 Example
Marginal vs Absorption Costing
• The example in a word file is used to lead you through
the various steps in calculating marginal and absorption
costing profits, and will highlight the differences
between the two techniques.
 No Changes in Inventory
• You will notice from the calculations in the example that there
are differences between marginal and absorption costing
profits.
• Before we go on to reconcile the profits, how would the
profits for the two different techniques differ if there were no
changes between opening and closing inventory (that is, if
production = sales)?
• For the first quarter you should now assume that sales is
280,000 units and then calculate the profits.
 Reconciling Profit – A Short Cut
• Therefore, the difference in profits reported under the
two costing systems is due to the different inventory
valuation methods used.
• Difference in profits = change in inventory level ×
overhead absorption rate per unit.
• If inventory levels have gone up (that is, closing inventory
> opening inventory), then absorption costing profit will
be greater than marginal costing profit.
• If inventory levels have gone down (that is, closing
inventory < opening inventory) then absorption costing
profit will be less than marginal costing profit.
Profit or Contribution Information
• The main advantage of contribution information (rather
than profit information) is that it allows an easy
calculation of profit if sales increase or decrease from a
certain level.
• By comparing total contribution with fixed overheads, it
is possible to determine whether profits or losses will be
made at certain sales levels.
• Therefore, contribution information looks more useful
for decision making than profit information.
 Example
• The overhead absorption rate for product X is $10 per
machine hour.
• Each unit of product X requires 5 machine hours. Inventory of
product X on 1st January 2018 was 150 units and on 31st
December 2018 it was 100 units.
• What is the difference in profit between results reported
using absorption costing and results reported using marginal
costing?
 Example
• When opening inventories were 8,500 litres and closing
inventories 6,750 litres, a firm had a profit of $62,100 using
marginal costing.
• Assuming that the fixed overhead absorption rate was $3 per
litre, what would be the profit using absorption costing?
 Example
• Last month a manufacturing company's profit was $2,000,
calculated using absorption costing principles.
• If marginal costing principles have been used, a loss of $3,000
would have occurred.
• The company's fixed production overhead cost is $2 per unit.
Sales last month were 10,000 units.
• What was last month's production (in units)?
 Marginal vs Absorption Costing
• Absorption costing is most often used for routine profit
reporting and must be used for financial accounting purposes.
• Marginal costing provides better management information for
planning and decision making.
• There are a number of arguments both for and against each of
the costing systems.
Arguments for Absorption Costing
• It is 'fair' to share fixed production cost between units of
production as such costs are incurred in order to make output.
• Closing inventories valued in accordance with IAS 2 principles.
• It is easier to determine the profitability of several products by
charging a share of fixed overheads to them (rather than
working out if the total contribution from several products will
cover fixed costs)
• Where building up inventory is necessary (e.g. fireworks
manufacture) fixed costs should be included in inventory
valuations in order to prevent a series of losses (e.g. in periods
before Bonfire Night) from occurring.
 Arguments for Marginal Costing
• Simple to operate
• No apportionments of fixed costs
• Fixed costs = period costs unchanged at all output volumes
• Closing inventory realistically valued at variable production
cost per unit
• Size of contribution provides management with useful
information about expected profits
• Absorption costing encourages management to produce goods
in order to absorb allocated overheads instead of meeting
market demands
• Under/over absorption of overheads is avoided
• It is a great aid to decision making (unlike absorption costing)
as we have seen in some of the examples.