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Topic list Syllabus reference 1 Marginal cost and marginal costing D4 (a) 2 The principles of marginal costing D4 (a) 3 Marginal costing and absorption costing and the calculation of profit
D4 (b), (c)
4 Reconciling profits D4 (d) 5 Marginal costing versus absorption costing D4 (e)
Marginal and
absorption costing
Introduction
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.
PART D COST ACCOUNTING TECHNIQUES
Study guide
Intellectual level D4 Marginal and absorption costing (a) Explain the importance and apply the concept of contribution^1 (b) Demonstrate and discuss the effect of absorption and marginal costing on inventory valuation and profit determination
(c) Calculate profit or loss under absorption and marginal costing^2 (d) Reconcile the profits or losses calculated under absorption and marginal costing 2 (e) Describe the advantages and disadvantages of absorption and marginal costing 1
Exam guide
Look out for questions in your examination which require you to calculate profit or losses using absorption and marginal costing.
1 Marginal cost and marginal costing
1.1 Introduction
Marginal cost is the variable cost of one unit of product or service.
Marginal costing is an alternative method of costing to absorption costing. In marginal costing, only variable costs are charged as a cost of sale and a contribution is calculated (sales revenue minus variable cost of sales). Closing inventories of work in progress or finished goods are valued at marginal (variable) production cost. Fixed costs are treated as a period cost, and are charged in full to the profit and loss account of the accounting period in which they are incurred.
The marginal production cost per unit of an item usually consists of the following.
- Direct materials
- Direct labour
- Variable production overheads Direct labour costs might be excluded from marginal costs when the work force is a given number of employees on a fixed wage or salary. Even so, it is not uncommon for direct labour to be treated as a variable cost, even when employees are paid a basic wage for a fixed working week. If in doubt, you should treat direct labour as a variable cost unless given clear indications to the contrary. Direct labour is often a step cost, with sufficiently short steps to make labour costs act in a variable fashion. The marginal cost of sales usually consists of the marginal cost of production adjusted for inventory movements plus the variable selling costs, which would include items such as sales commission, and possibly some variable distribution costs.
1.2 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.
Contribution is of fundamental importance in marginal costing, and the term 'contribution' is really short for 'contribution towards covering fixed overheads and making a profit'.
Key term
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PART D COST ACCOUNTING TECHNIQUES
10,000 Splashes 15,000 Splashes 20,000 Splashes $ $ $ $ $ $ Sales (at $10) 100,000 150,000 200, Opening inventory 0 0 0 Variable production cost 120,000 120, 120, 120,000 120,000 120, Less value of closing inventory (at marginal cost) 60,000 30,000 – Variable cost of sales 60,000 90,000 120, Contribution 40,000 60,000 80, Less fixed costs 45,000 45,000 45, Profit/(loss) (5,000) 15,000 35,
Profit (loss) per unit $(0.50) $1 $1. Contribution per unit $4 $4 $
The conclusions which may be drawn from this example are as follows.
(a) The profit per unit varies at differing levels of sales, because the average fixed overhead cost per unit changes with the volume of output and sales. (b) The contribution per unit is constant at all levels of output and sales. Total contribution, which is the contribution per unit multiplied by the number of units sold, increases in direct proportion to the volume of sales. (c) Since the contribution per unit does not change , the most effective way of calculating the expected profit at any level of output and sales would be as follows.
- First calculate the total contribution.
- Then deduct fixed costs as a period charge in order to find the profit. (d) In our example the expected profit from the sale of 17,000 Splashes would be as follows. $ Total contribution (17,000 × $4) 68, Less fixed costs 45, Profit 23,
- If total contribution exceeds fixed costs , a profit is made
- If total contribution exactly equals fixed costs , no profit or loss is made
- If total contribution is less than fixed costs , there will be a loss
Question Marginal costing principles
Mill Stream makes two products, the Mill and the Stream. Information relating to each of these products for April 20X1 is as follows. Mill Stream Opening inventory nil nil Production (units) 15,000 6, Sales (units) 10,000 5,
Sales price per unit (^) $$20 $ Unit costs (^) $ $ Direct materials 8 14 Direct labour 4 2 Variable production overhead 2 1 Variable sales overhead 2 3
9: MARGINAL AND ABSORPTION COSTING
Fixed costs for the month $ Production costs 40, Administration costs 15, Sales and distribution costs 25,
Required (a) Using marginal costing principles and the method in 2.1(d) above, calculate the profit in April 20X1. (b) Calculate the profit if sales had been 15,000 units of Mill and 6,000 units of Stream.
Answer
(a) $ Contribution from Mills (unit contribution = $20 – $16 = $4 × 10,000) 40, Contribution from Streams (unit contribution = $30 – $20 = $10 × 5,000) 50, Total contribution 90, Fixed costs for the period 80, Profit 10,
(b) At a higher volume of sales, profit would be as follows. $ Contribution from sales of 15,000 Mills (× $4) 60, Contribution from sales of 6,000 Streams (× $10) 60, Total contribution 120, Less fixed costs 80, Profit 40,
2.2 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. Profit information , on the other hand, does not lend itself to easy manipulation but note how easy it was to calculate profits using contribution information in the question entitled Marginal costing principles. Contribution information is more useful for decision making than profit information, as we shall see when we go on to study decision making in Section F of this Study Text.
3 Marginal costing and absorption costing and the
calculation of profit
3.1 Introduction
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.
Marginal costing as a cost accounting system is significantly different from absorption costing. It is an alternative method of accounting for costs and profit, which rejects the principles of absorbing fixed overheads into unit costs.
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9: MARGINAL AND ABSORPTION COSTING
(a) If sales are 10,000 units of Mill and 5,000 units of Stream, profit would be as follows.
Absorption costing Mills Streams Total $ $ $ Costs of production Direct materials 120,000 84,000 204, Direct labour 60,000 12,000 72, Overhead (105.56% of labour) 63,333 12,667 76, 243,333 108,667 352, Less closing stocks (W1) 81,111 18,111 99, Production cost of sales 162,222 90,556 252, Administration costs 15, Sales and distribution costs Variable (W2) 35, Fixed 25, Total cost of sales 327, Sales 200,000 150,000 350, Profit 22,
Note. There is no under-/over-absorption of overhead, since actual production is the same as budgeted production. The profit derived using absorption costing techniques is different from the profit ($10,000) using marginal costing techniques at this volume of sales (see earlier question).
(b) If production and sales are exactly the same, (15,000 units of Mill and 6,000 units of Stream) profit would be $40,000. $ Sales (300,000 + 180,000) 480, Cost of sales (W3) 440, Profit 40,
- No closing inventory if sales and production are equal.
Workings
1 Closing inventories
(a) If 15,000 units of Mills are produced and only 10,000 units are sold, there will be closing inventories of 5,000 units (15,000 – 10,000). Therefore, of the production costs of $243,333, 5,000 units of the 15,000 units produced (5,000/15,000 = 1/3) will be carried forward in closing inventory ie 1/3 × $243,333 = $81,111. (b) Similarly, if 6,000 units of Streams are produced and only 5,000 units are sold there will be closing inventories of 1,000 units (6,000– 5,000). Therefore, of the production cost of $108,667, 1,000 units of the 6,000 units produced (1,000/6,000 = 1/6) will be carried forward in closing inventory ie 1/6 × $108,667 = $8,111.
2 Variable sales and distribution costs
Mills Variable sales and distribution costs = $2 (from Question entitled 'marginal costing principles') × 10,000 units = $20, Streams Variable sales and distribution costs = $3 (from Question entitled 'marginal costing principles') × 5,000 units
PART D COST ACCOUNTING TECHNIQUES
∴Total sales and distribution costs = $20,000 + $15, = $35, 3 Cost of sales $ $ Costs of production (from part (a)) 352, Administration costs (from Question entitled 'marginal costing principles') 15, Fixed sales and distribution costs (from Question entitled 'marginal costing principles') 25, Variable sales overhead Mills (15,000 × $2) 30, Streams (6,000 × $3) 18, 48, 440,
This is the same as the profit calculated by marginal costing techniques in the earlier question. We can draw a number of conclusions from this example. (a) Marginal costing and absorption costing are different techniques for assessing profit in a period.
(b) If there are changes in inventories during a period , so that opening inventory or closing inventory values are different, marginal costing and absorption costing give different results for profit obtained.
(c) If the opening and closing inventory volumes and values are the same, marginal costing and absorption costing will give the same profit figure. This is because the total cost of sales during the period would be the same, no matter how calculated.
3.3 The long-run effect on profit
In the long run, total profit for a company will be the same whether marginal costing or absorption costing is used. Different accounting conventions merely affect the profit of individual accounting periods.
3.4 Example: Comparison of total profits
To illustrate this point, let us suppose that a company makes and sells a single product. At the beginning of period 1, there are no opening inventories of the product, for which the variable production cost is $ and the sales price $6 per unit. Fixed costs are $2,000 per period, of which $1,500 are fixed production costs. Period 1 Period 2 Sales 1,200 units 1,800 units Production 1,500 units 1,500 units Required Determine the profit in each period using the following methods of costing. (a) Absorption costing. Assume normal output is 1,500 units per period. (b) Marginal costing.
PART D COST ACCOUNTING TECHNIQUES
∴Closing inventory valuation = 300 units × $ = $1, Notes
(a) The total profit over the two periods is the same for each method of costing, but the profit in each period is different.
(b) In absorption costing, fixed production overhead of $300 is carried forward from period 1 into period 2 in inventory values, and becomes a charge to profit in period 2. In marginal costing all fixed costs are charged in the period they are incurred, therefore the profit in period 1 is $ lower and in period 2 is $300 higher than the absorption costing profit.
Question AC versus MC
The overhead absorption rate for product X is $10 per machine hour. Each unit of product X requires five machine hours. Inventory of product X on 1.1.X1 was 150 units and on 31.12.X1 it was 100 units. What is the difference in profit between results reported using absorption costing and results reported using marginal costing?
A The absorption costing profit would be $2,500 less B The absorption costing profit would be $2,500 greater C The absorption costing profit would be $5,000 less D The absorption costing profit would be $5,000 greater
Answer
Difference in profit = change in inventory levels × fixed overhead absorption per unit = (150 – 100) × $ × 5 = $2,500 lower profit, because inventory levels decreased. The correct answer is therefore option A.
The key is the change in the volume of inventory. Inventory levels have decreased therefore absorption costing will report a lower profit. This eliminates options B and D.
Option C is incorrect because it is based on the closing inventory only (100 units × $10 × 5 hours).
4 Reconciling profits
4.1 Introduction
Reported profit figures using marginal costing or absorption costing will differ if there is any change in the level of inventories in the period. If production is equal to sales, there will be no difference in calculated profits using the costing methods.
The difference in profits reported under the two costing systems is due to the different inventory valuation methods used.
If inventory levels increase between the beginning and end of a period, absorption costing will report the higher profit. This is because some of the fixed production overhead incurred during the period will be carried forward in closing inventory (which reduces cost of sales) to be set against sales revenue in the following period instead of being written off in full against profit in the period concerned.
If inventory levels decrease , absorption costing will report the lower profit because as well as the fixed overhead incurred, fixed production overhead which had been carried forward in opening inventory is released and is also included in cost of sales.
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9: MARGINAL AND ABSORPTION COSTING
4.2 Example: Reconciling profits
The profits reported under absorption costing and marginal costing for period 1 in the example in Paragraph 3.4 would be reconciled as follows. $ Marginal costing profit 400 Adjust for fixed overhead in inventory: Inventory increase of 300 units × $1 per unit 300 Absorption costing profit 700
Question Absorption costing profit
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? A $41,850 B $56,850 C $67,350 D $82,
Answer
Difference in profit = (8,500 – 6,750) × $3 = $5, Absorption costing profit = $62,100 – $5,250 = $56, The correct answer is B. Since inventory levels reduced, the absorption costing profit will be lower than the marginal costing profit. You can therefore eliminate options C and D.
The effect on profit of using the two different costing methods can be confusing. You must get it straight in your mind before the examination. Remember that if opening inventory values are greater than closing inventory values, marginal costing shows the greater profit.
5 Marginal costing versus absorption costing
In your examination you may be asked to calculate the profit for an accounting period using either of the two methods of accounting. 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.
Exam focus
point
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9: MARGINAL AND ABSORPTION COSTING
Chapter roundup
- Marginal cost is the variable cost of one unit of product or service.
- 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.
- 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.
- Reported profit figures using marginal costing or absorption costing will differ if there is any change in the level of inventories in the period. If production is equal to sales, there will be no difference in calculated profits using these costing methods.
- In your examination you may be asked to calculate the profit for an accounting period using either of the two methods of accounting. 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.
Quick quiz
1 What is marginal costing?
2 What is a period cost in marginal costing?
3 Sales value – marginal cost of sales = ………………….
4 What is a breakeven point?
5 Marginal costing and absorption costing are different techniques for assessing profit in a period. If there are changes in inventory during a period, marginal costing and absorption costing give different results for profit obtained. Which of the following statements are true?
I If inventory levels increase, marginal costing will report the higher profit. II If inventory levels decrease, marginal costing will report the lower profit. III If inventory levels decrease, marginal costing will report the higher profit. IV If the opening and closing inventory volumes are the same, marginal costing and absorption costing will give the same profit figure. A All of the above B I, II and IV C I and IV D III and IV
6 Which of the following are arguments in favour of marginal costing?
(a) Closing stock (inventory) is valued in accordance with IAS 2. (b) It is simple to operate. (c) There is no under or over absorption of overheads. (d) Fixed costs are the same regardless of activity levels. (e) The information from this costing method may be used for decision making.
PART D COST ACCOUNTING TECHNIQUES
Answers to quick quiz
1 Marginal costing is an alternative method of costing to absorption costing. In marginal costing, only variable costs are charged as a cost of sale and a contribution is calculated (sales revenue – variable cost of sales). 2 A fixed cost
3 Contribution 4 The point at which total contribution exactly equals fixed costs (no profit or loss is made) 5 D
6 (b), (c), (d), (e)
Now try the questions below from the Exam Question Bank
Number Level Marks Time Q9 MCQ/OTQ n/a n/a
