Marginal and Absorption Costing: An Overview of Key Concepts

Marginal Costing Principles

Marginal costing includes only variable production costs with fixed costs are charged against the period in which they were incurred regardless of the level of output. Closing stocks of work in progress or finished goods are valued at marginal (or variable) production cost.

Fixed costs are treated as period costs and are charged in full to the profit and loss account of the accounting period in which they were incurred. Marginal cost is the cost of a unit of a product or service which would be avoided if that unit was not produced or the service provided. Marginal production cost per unit consists of direct materials, direct labour and variable production overhead.

NB direct labour costs might be excluded from marginal costing when workforce is a given number of employees on a fixed wage or salary. Direct labour cost is treated as variable cost unless given indications to the contrary.Inventory valuation using absorption costing and marginal costing

Marginal costing 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.

A principle whereby variable production costs only are charged to cost units and the fixed costs attributable to the relevant period are written off in full against the contribution for the period.

Inventory is valued at the variable cost of production.

Marginal Costing Inventory Valuation

In marginal costing Closing inventories are valued at marginal production cost.

(Fixed costs are charged in full against the profit of the period in which they are incurred.Principles of Marginal Costing

Period fixed costs are the same for any volume of sales and production. If volume of sales falls by one item the profit will fall by the amount of contribution earned from the item. Profit measurement should be based on analysis of total contribution since fixed costs relate to a period of time and do not change with increase or decrease in volume. When a unit of product is made the extra cost incurred in its manufacture are the variable production costs.Contribution towards fixed costs is represented by:

• Selling price per unit less all variable costs per unit (whether production, admin or selling etc)
• Fixed costs + profitFormat: Marginal Costing

Marginal Costing Format

Sales XX Less Cost of Sales Opening stock Direct materials XX XX Direct labour XX Variable Overheads XX Less Closing Stock (XX) Cost of Sales (XX) Less other variable costs XX (XX) ( XX) CONTRIBUTION Less Expenses: Fixed Production Overheads XX Selling and distribution X X Administration Overheads (XX) Net Profit XX

Advantages of Marginal Costing

• Most appropriate for decision making as it highlights contribution
• Fixed costs are treated in accordance with their nature, ie as period costs
• Profit depends on sales and efficiency not on production levels
• Slightly simpler variance analysis

Disadvantages of Marginal Costing

• There is a danger that products will be sold on an ongoing basis at a marginal contribution which fails to cover fixed costs
• Does not comply with IAS 2, so year end adjustments are needed for the preparation of published accounts
• Requires analysis of mixed costs between fixed and variable
• Seasonal variations in a year can cause unnecessary profit variances

Absorption Costing Principles

In absorption costing Closing inventories are valued at full production cost, and include a share of fixed production costs.

This means that the cost of sales in a period will include some fixed overhead incurred in a previous period (in opening inventory values) and will exclude some fixed overhead incurred in the current period but carried forward in closing inventory values as a charge to a subsequent accounting period.Format: Absorption costing

Absorption Costing Format

Sales XX Less Cost of Sales Opening stock Direct materials Direct labour X X Variable Overheads XX Fixed Production Overheads XX XX Less Closing Stock (XX) Cost of Sales Gross Profit Over absorption Less Expenses (XX) XX XX Selling and distribution Administration Overheads Under absorption (XX) XX

Arguments for Absorption Costing

Arguments in favour of absorption costing (AC) When sales fluctuate because of seasonality of demand but production is constant, AC avoids large fluctuations in profit. Marginal costing fails to recognise the importance of working to full capacity. Marginal costing does not recognise the effects on pricing decisions if cost plus method of pricing is used. Prices based on marginal cost (minimum prices) do not guarantee that contribution will cover fixed costs. In the long run all costs are variable, and absorption costing recognises these long-run variable costs. It is consistent with the requirements of accounting standards.Effect of inventory valuation on profit

Inventory Valuation and Profit Impact

• Production = sales (so inventory is constant) AC profit = MC profit
• Production < sales (so inventory is falling) AC profit < MC profit
• Production > sales (so inventory is climbing) AC profit > MC profitProfit statements using absorption costing and marginal costing

Profit Statement Differences

The different treatment of overheads in the two methods are reflected in the profit statements produced. In a marginal costing system, all variable costs are deducted from the sales figure to give a contribution figure. All fixed costs are then deducted from this figure to give a net profit figure.

In absorption costing, all production costs are deducted from sales to give a gross profit figure. Selling and distribution and administration overheads are then deducted from this figure to give a net profit figure.Reconciliation of profit

Profit Reconciliation

Change in inventory X OAR Inventory Increase Absorption profit is MoreAccounting Entries

Accounting Entries for Production Costs

When production costs are incurred. Dr Production overhead account. Cr Cash/bank Absorption of production overheads Dr Work in progress control account Cr Production overhead control account For an over absorption Dr Production overhead account Cr Costing profit and loss account For an under absorption Dr Costing Profit and Loss account Cr Production Overhead control account.Illustration 1

Illustration 1: Income Statement Preparation

Selling price per unit Variable costs per unit $10 direct materials $2 direct labour $3 production overhead selling and distribution $1 Fixed costs: Production: budgeted $8,000 actual $8,500 Selling and distribution: (budgeted and actual) $2,000 Activity levels: Year 1 Units Budgeted production 4,000 Actual sales 4,200 Actual production 4,400 There is no opening inventory in Year 1. $1Required

Required for Illustration 1

Prepare an income statement: Under absorption costing. Under Marginal Costing. Reconcile the profit under the two methodsIllustration 2

Illustration 2: Income Statement for Year 2

Selling price per unit Variable costs per unit $10 direct materials $2 direct labour $3 production overhead selling and distribution $1 $1 Fixed costs: r Production: budgeted $8,000 each year actual $8,500 Selling and distribution: (budgeted and actual) $2,000 Activity levels: Year 1 Year 2 Units Budgeted production 4,000 Actual sales 4,200 Actual production 4,400 There is no opening inventory in Year 1.Required

Required for Illustration 2

Prepare an income statement for Year 2: Under absorption costing Under Marginal Costing Reconcile the profit under the two methods