ABSORPTION COSTING AND MARGINAL COSTING

Learning Objectives

By the end of this chapter you should be able to:

 Prepare profit statements using absorption costing method

 Explain and illustrate the concept of contribution

 Discuss the usefulness of profit and contribution information

respectively

 Prepare profit statements using the marginal costing method

 Compare and contrast the use of marginal costing for period profit
reporting and inventory valuation

 Reconcile the profits reported by absorption and marginal costing

ABSORPTION COSTING AND MARGINAL COSTING

Absorption Costing
 Absorption costing sometimes known as full or total costing, which is the basis of
all financial statements for routine profit reporting.
 All inventories are valued at full production cost, which include a share of fixed
production overheads absorbed using any of the bases available.
 Fixed production costs (both the fixed and variable costs) are absorbed into
production and inventories valuation.
 The operating (profit/income) statement does not distinguish between fixed and
variable production costs.
 Fixed production overheads are absorbed on the basis of normal capacity, which
is often the same as the budgeted capacity.
 If the production level is not equal to the normal capacity there will be over or
under absorbed fixed production overhead.
 Absorption costing income statement:
$ $
Revenue/ Sales X
Production costs of sales
Opening inventory (valued at full production costs) X
Production (valued at full production costs) X
Closing inventory (valued at full production costs) (X) (X)
Gross profit X
Adjustment: Over or (under) fixed production overhead X
X
Less: Non-production overhead X
Variable selling overhead X
Fixed selling overhead X
Variable administration overhead X
Fixed administration overhead X
Variable distribution overhead X
Fixed distribution overheads X (X)
Net profit X

Marginal Costing
 Marginal costing is defined as “ the accounting system in which variable costs
are charged to cost units and the fixed costs of the period are written off against the
aggregated contribution.
 Contribution is a term given to the difference between sales value and marginal
cost of sales.
 Contribution information allows an easy calculation of profit if sales increase or
decrease from a certain activity level by comparing total contribution with fixed
overheads. (however, profit information does not lend itself to easy manipulation)
 This costing method distinguishes fixed and variable costs as conventionally
classified.
 The marginal cost of a product or service is its variable costs, which would be
avoided if that unit were not produced or provided.
 Its special value is on decision-making.
  The basic principles are:
1. Period fixed costs are constant for any volume of sales and production
provided that the level of activity is within the “ relevant range”.
2. Profit measurement should be based on an analysis of total contribution.
(Fixed costs relate to a period of time and do not change with increases of
decreases in sales volume)
3. The extra costs incurred in manufacture a unit of product is the variable
production costs.
Marginal/ costing income statement:
$ $
Revenue/Sales X
Production costs of sales
Opening inventory (valued at variable production costs) X
Production (valued at variable production costs) X
Closing inventory (valued at variable production costs) (X) (X)
Gross margin X
Less: Variable selling overhead X
Contribution X
Less: Fixed non-production overhead X
Fixed selling overhead X
Fixed administration overhead X
Fixed distribution overheads X (x)
Net profit X

Compare the profit calculation of absorption costing and marginal costing

Absorption costing Marginal costing

o A technique to assess profit in a o A technique to assess profit in a
period period
o Not necessary to distinguish variable o Necessary to identify: variable costs,
costs from fixed costs contribution and fixed costs
o Inventories and production are o Inventories and production are valued
valued at full production cost at marginal (variable) production cost
Inventory values are greater Inventory values are lower
o Fixed production costs are absorbed o All fixed costs are treated as period
into unit costs costs and write off against total
contribution.

Arguments for absorption costing

 Closing inventory valued in accordance with accounting principles (IAS 2)
 It is fair to share fixed production costs between units of production as
such costs are incurred in order to make output – less likely in setting selling prices
which are below total costs.
 It is easier to determine the profitability of several products by charging a
share of fixed overheads to them rather than working out the total contribution from
several products will cover fixed costs.
 Arguments for marginal costing
 Simple to operate
 No apportionment of fixed costs, which are frequently on an arbitrary basis.
 Over or under absorption of overheads is avoided.
 Fixed costs are written off in the period they are incurred because do not relate to
activity level.
 Closing inventory realistically valued at variable production cost per unit, which
avoid fixed costs being capitalized in unsaleable inventories.
 Contribution provides management with useful information about expected profits
and short term decision making.

Reconciling the profit figures

Reported profit figures using absorption costing and marginal costing will differ if there
are any changes in the level of inventories in the period. If production is equal to sales or
if opening and closing inventories are the same, there will be no difference in calculated
profits using these costing methods.

The profit differences are caused by the different valuations given to the closing
inventories in each period. With absorption costing, an amount of fixed production
overhead is carried forward in inventories to be charged against sales of later period.

If inventory increases, absorption costing profit will be higher than marginal costing
profit. This is because some of the fixed production overhead is carried forward in
inventory instead of being written off against sales for the period.

If inventory reduces, marginal costing profit will be higher than absorption costing profits.
This is because the fixed production overhead, which had been carried forward in
inventory with absorption costing is now being released to be charged against the sales
for the period.

However, the two different costing methods produce profit differences only in the short
run when inventories fluctuate. If inventories remain constant then there will be no profit
differences between the two methods.

In the long run, the total profit will be the same whichever method is used. This is
because all of the costs incurred will eventually be charged against sales. It is merely the
timing of the sales that causes the profit differences from period to period.

Should absorption costing or marginal costing be used?

There is no absolute correct answer as to when absorption costing or marginal costing is
preferable. However, it is generally accepted that marginal costing statements provide
the best information for the purposes of management decision making.

Supporters of absorption costing argue that fixed production overheads are a necessary
cost of production and they should be included in the unit cost used for inventory
valuation. IAS 2 requires the use of absorption costing for external reporting purposes.
Supporters or marginal costing argue that management attention is concentrated on the
more controllable measure of contribution. They say that the apportionment of fixed
production overheads to individual units is carried out on a purely arbitrary basis, is of
little use for decision making and can be misleading.