Income effects of alternative

Inventory Valuation Methods

MARGINAL AND ABSORPTION COSTING


Contents:
Meaning of Marginal Costing and Contribution
 Difference between Marginal and Absorption

Costing
 Calculation of stock values using Marginal

 and Absorption Costing

 Preparation of multi-period Marginal and

Absorption Costing
 TRADITIONAL COSTING METHODS

Traditional costing methods are

(i) Marginal Costing (ii) Absorption Costing
Under marginal costing, Only the Variable Costs of Production
are considered to be product costs and the inventory is valued
accordingly. Fixed Costs of production are not absorbed into
the cost of production.
Fixed costs of production as well as all non-manufacturing
costs (both variable and f ixed) are considered to be period
costs, hence they are not considered in determining the
product costs or for valuation of inventories.
Under absorption costing, the entire costs of
production, whether variable or f ix ed, are
considered to be the product costs and only the
non-manufacturing costs (both variable and
fixed) are considered to be period costs.
Non-manufacturing costs (i.e. administration
costs, research and development costs and
selling and distribution costs) are not allocated
to the products; instead, they are charged as an
expense to the period in which they are incurred.
This means, under absorption costing, for
product costing and valuation of inventory, all
the costs that are incurred in order to produce
an item are considered.
 Under absorption
Under marginal
costing
costing
(Cost per unit)
(Cost per unit)
(Tshs‟000)
(Tshs‟000)

Direct material 27.50 27.50

Direct labour 7.50 7.50
Direct expenses 2.50 2.50

Prime cost 37.50 37.50

- Fixed overhead 2.00 -
- Variable overhead 6.00 6.00

Production Cost 45.50 43.50

MARGINAL COSTING
Marginal Costing is formally def in ed as the accounting
system in which Variable Costs are charged to Cost Units
and the Fixed Costs are treated as Period Costs and are
written-off in full against the aggregate Contribution for that
period.

Marginal costing method recognizes cost behavior and divides

cost into those which vary with production and which are fixed
for a period. According to this method, ONLY Variable Costs of
production are included in inventory calculation .

Marginal cost is the cost of one unit of product or service which

would be avoided if that unit were not produced or provided
Marginal costing distinguishes between Fixed Costs and
Variable Costs as conventionally classif ied. The marginal
cost of a product is its variable cost. This is normally
taken to be
Direct Labour………………………………XX
Direct Materials,,,,,,,,,,,,,,,,,,,,,,,,,,,,,,,XX
Direct Expenses and……………………XX
Variable part of Overheads…………..XX …………..XX

The product costs under marginal costing only include

Direct Materials, Direct Labour, Direct expenses and
Manufacturing Variable Overheads. It recognizes cost
behaviour and hence is useful in decision-making.
Kn o w l e d g e o f m a r g i n a l c o s t i s f u n d a m e n t a l t o
understanding the concept of marginal costing. Marginal
cost is defined a
MARGINAL COSTING
Contribution is the term given to the difference
between Sales and Marginal Costs (MC).
MC = VC = D Labour + D Material + D Expenses +
Variable Manufacturing Overheads
Contribution = Sales – Marginal Costs

Profit
Less
Contrib
ution Fixed
Cost
Sales
Less Marginal
Cost
Alternative names for Marginal Costing are
Contribution Approach, Variable Costing and
Direct Costing
Under Marginal Costing, ONLY VARIABLE
Manufacturing/Production Costs become
Product Costs.
The product costs under marginal costing
only include direct materials, direct labour,
direct expenses and variable overheads. It
recognises cost behaviour and hence is
useful in decision-making.
 Fixed Manufacturing Costs together with Non-
Manufacturing Costs (Period Costs) are written-
off in the period in which they are incurred.

Alternative concepts of marginal costs

To the economist, Marginal Cost is the Additional
Cost incurred by the production of one extra unit.
To the accountant, marginal cost is the Average
Variable Cost which is conventionally presumed
to act in a linear fashion i.e. marginal cost per unit
is assumed to be constant in the short run, over
the activity range being considered
 USES OF MARGINAL COSTING
There are two (2) main uses for the concept of
marginal costing:
1. As a basis for providing information to the
man agemen t for decis ion makin g an d
planning. It is particularly appropriate for
short run decisions involving changes in
volume or activity and the resulting cost
changes.
2. It is used in the routine cost accounting
system for the calculations of costs and the
valuation of stocks. In this use it becomes an
alternative method to Total Absorption
Costing
MARGINAL COSTING INCOME STATEMENT
Format Of Marginal Cost Income Statement
Marginal Cost Income (Costing) Statement as at 31 Dec. 2023
Tshs
Sales Revenue
xxx
Less: Marginal Cost of Sales:
Opening Stock (Valued @ Marginal Cost) xxx
Add: Production Cost (Valued @ Marginal Cost) xxx
Total Production Cost xxx
Less: Closing Stock (Valued @ Marginal Cost) xxx
Marginal Cost of Production xxx
Add: Variable Selling, Admin & Distribution Cost xxx
Marginal Cost of Sales xxx

Contribution xxx

Less: Fixed Cost (based on normal production) xxx

Marginal Costing Profit /Loss
XXX
ARGUMENTS FOR THE USE OF MARGINAL
COSTING


Arguments (importance) for the use of Marginal Costing
Simple to operate
No apportionments which are frequently on an arbitrary basis, of
fixed costs to products or departments.
Where sales are constant, but production f luctuates (possibly and
unlikely circumstance) marginal costing shows a constant net-
prof it where as absorption costing shows variable amounts of
profit.
Under or over absorption of overheads is almost entirely avoided.
The usual reason for under/over absorption is the inclusion of fixed
costs into overhead absorption rates and the level of activity
being different to that planned.
Fixed costs are incurred on time basis, e.g. salaries, rates, etc and
do not relate to activity. Therefore it is logical to write them off in
the period they are incurred and this is done using marginal costing.
Accounts prepared using marginal costing more nearly approach
the actual cash flow position.
 ABSORPTION COSTING
Absorption Costing, sometimes known as Total
Absorption Costing, is the basis of all Financial
Accounting Statements. Using absorption costing, all
costs are absorbed into production and thus Operating
Statements do not distinguish between f ix ed and
variable costs. Consequently the valuation of stocks
and work in progress contains both f ixed and variable
elements.
Under Absorption Costing, the entire costs of
production, whether variable or f ixed are considered
to be the product costs and only the Non-
manufacturing costs (both variable and f ixed) are
considered to be Period Costs
In Absorption Costing, the cost of a product or
service is established by adding a share of Fixed
Production Overheads to Direct Costs. It is consistent
with the requirements for stock valuation in f inancial
reporting. It is usual to absorb Production Overheads
ONLY into Product Costs. Other Overheads are
written off as an expense when they arise.
Production Overhead Costs are f irst allocated, then
apportioned and f in ally absorbed into Production
Costs or service
 ABSORPTION COSTING
Factory overhead costs are incurred in three main centers:
Production centers costs arising in production departments such as the
costs of fuel, protective clothing, depreciation and supervision.
Service centers the costs of operating support departments or sections
within the factory, for example, the costs of materials handling, production
control and canteen.
General costs centers general production overhead such as factory
rent/taxes, heating and lighting and production management salaries

Overhead Allocation. Indirect Production Costs are allocated to Cost

Centres or codes. Allocation is the process of charging a cost directly to the
source of the expenditure.
Overhead apportionment. The overhead costs that have been allocated to
cost centres and codes other than Direct Production Departments are then
apportioned to Direct Production Departments. Apportionment is the
process of sharing on a fair basis.
 Overhead absorption. An absorption rate is
calculated for each production department as
follows:
Total Production Overhead Costs (allocated and apportioned)
Production volume

Wh ere th e depar tmen t produ ces a sin gle

product, production volume can be measured as
the number of units produced, and the
ab sorp t ion rat e w ou ld b e a rat e p e r u n it
produced.
 ABSORPTION COSTING
Where organisations produce different products or carry out non-standard
jobs for customers production volume may then be measured as one of the
following:
•Direct labour hours worked – the absorption rate is a rate per direct
labour hour worked
•Machine hours worked – the absorption rate is a rate per machine hour
operated
•The cost of direct labour – the absorption rate is a percentage of direct
labour cost.
It is possible to calculate absorption rates using actual overhead costs and
actual production volume but the normal practice is to absorb based on
budgeted overhead expenditure and budgeted production volume.
An Absorption Costing System might distinguish between fixed and variable
overheads.
–Variable overhead costs – where the total expenditure is expected to rise
in direct proportion to the volume of output.
–Fixed overhead costs – where total expenditure is a constant amount in a
given period, regardless of the output volume.
ABSORPTION COSTING
In absorption costing, inventories of work-in-
progress and f inished goods are valued at their full
production cost.
On the other hand, using marginal costing, f ix ed
costs are not absorbed into the costs of production.
They are treated as period costs and written off each
period in the Costing Profit or Loss Account.
The effect of this is that f inished goods and work in
progress are valued at marginal costs only; i.e. the
variable elements of cost, usually prime cost plus
variable overhead. At the end of a period the
marginal cost of sales is deducted from sales
revenue to show the contribution, from which f ixed
costs are deducted to show less net prof it in mc as
compared to absorption.
 DIFFERENCES BETWEEN MARGINAL & ABSORPTION
COSTING

Marginal Costing (MC): Absorption Costing (AC):

 Not accepted for external Accepted for external reporting
reporting
Relevant for decision making Not conducive for decision making
Fixed production cost is period
Fixed production cost is part of product
cost
cost
Costs are classified by cost Costs are classified by functions
behaviour
Valuation of stock is less than Valuation of stock is greater than under
AC MC
There is under/over absorption of
No under/over absorption of overheads
overheads
 ABSORPTION COSTING
The Basic Rule
The basic rules for reconciling Absorption Costing Profit to
Marginal Costing Profit are (AC = Absorption Costing, MC =
Marginal Costing):
–If closing inventory is more than opening inventory, AC profit >
MC profit.

–If closing inventory is less than opening inventory, AC

profit < MC profit.

–If opening and closing inventory are the same, AC profit =

MC profit.
Under- or Over-absorbed Overhead
–Under- and Over-absorption of fixed overheads occur in
absorption costing, and are reported in the income statement.
 RECONCILIATION
T shs
M arginal C osting Profit XXX
A D D : F uC i (closing – opening stock ) XXX
A b sor p tion costin g p r ofit XXX

T he difference betw een the reported operating profits for an absorption costing and a
v ariable costing sy stem can be deriv ed by ;

Pa – Pm = F uC i

W here Pa = Profit com puted under absorption costing m ethod

Pm = Profit com puted under m arginal costing m ethod
F u = F ix ed factory ov erhead per unit
C i = C hange in inv entory (E nding – B eginning I nv entory ).
ABSORPTION COSTING
Under- or Over-Absorbed Overhead
–Under- and Over-absorption of f ixed overheads occur in absorption costing and are
reported in the Income Statement.
It occurs because the Absorption Rate is a predetermined rate. The amount of under
- or over-absorbed overhead is:

Over-Absorption.
When the overhead absorbed (X) is more than the overhead expenditure incurred,
there is over-
Budgeted fixed production overhead IS GREATER THAN Budgeted fixed production
overhead


Budgeted levels of activities ACTUAL levels of activities

under-absorption
–When the overhead absorbed (X) is less than the overhead expenditure incurred,
there is . under-
. Budgeted fixed production overhead IS LESS THAN Budgeted fixed production overhead


Budgeted levels of activities ACTUAL levels of activities

Over and Under absorption needs to be adjusted against cost of sales (DEDUCT
over absorption and ADD under absorption )
ARGUMENTS FOR THE USE OF ABSORPTION
COSTING
Arguments for the use of Absorption Costing
Fixed costs are substantial and increasing proportion of
costs in modern industry.
Where production is constant but sales f luctuate, net prof it
f lu ctuations are less with absorption costing than with
marginal costing
Where stock building is necessary
The calculation of marginal cost and the concentration
upon contribution may lead to the f irm setting prices which
are below total cost although producing some contribution.
The statement of standard accounting practice on stocks
and work in progress recommends the use of absorption
costing for f in ancial accounts because the costs and
revenues must be matched in the period when the revenue
arises not when the costs are incurred.
FORMAT ABSORPTION INCOME STATEMENT
TOTOISE PLC
Absorption Income (Costing) Statement as at 31 Dec. 2018

Sales Revenue
xxx
Less: Absorption Cost of Sales:
Opening Stock (Valued @ absorption cost) xxx
Add: Production Cost (Valued @ absorption cost) xxx
Total Production Cost xxx
Less: Closing Stock (Valued @ absorption cost) xxx
Absorption Cost of Sales xxx
Adjustment for over/(under) absorbed overhead (A-B)FOAR xxx
Adjusted cost of sales
xxx
Gross Profit xxx
Less: Selling, Admin & Distribution Cost xxx
Net Profit xxx
 EXAMPLE 1
Galway Plc manufactures and sells a single product .The following budgeted/ actual
information is provided in relation to the production of this product:
Selling price per unit 50.00
Direct materials per unit 8.00
Direct labour per unit 5.00
Variable production overheads per unit 3.00

Details for the months of May and June 2010 are as follows:
May June
Production of Product A 500 380
Sales of Product A (units) 300 500

Fixed production overheads are budgeted at €4,000 per month and are absorbed on a unit
basis. The normal level of production is budgeted at 400 units per month.
Other costs
Fixed selling €4,000 per month
Fixed Administration €2,000 per month
Variable sales commission 5% of sales revenue
there was no opening inventory of Product A at the start of May.
Required: Produce Operating Statements based upon Marginal Costing and absorption
costing principles and reconcile profit
SOLUTION TO EXAMPLE ONE
Galway Plc
Absorption income (Costing) statement as at may &June. 2010
May June
Sales Revenue 15,000 25,000
Less: Absorption Cost of Sales:
Opening Stock (Valued @ absorption cost) 0 5,200
Add: Production Cost (Valued @ absorption cost) 13,000 9,880
Total Production Cost 13,000 15080
Less: Closing Stock (Valued @ absorption cost) 5,200 2080
Absorption Cost of Sales 7,800 13,000
over/(under) absorbed overhead (A-B)FOAR (1,000 ) 200
Adjusted cost of sales (6,800 ) (13,200)

Gross Profit 8,200 11,800

Less: Variable Selling commission 750 1,250
Fixed Administration 2,000 2,000
Fixed selling 4,000 6,750 4,000 7,250
Net Profit 1450 4550
 SOLUTION TO EXAMPLE ONE
Galway Plc
Marginal cost income (Costing) statement for May & June 2010
may June
Tshs
Sales Revenue 15,000 25,000

Less: Marginal Cost of Sales:

Opening Stock (Valued @ marginal cost) 0 3,200
Add: Production Cost (Valued @ marginal cost) 8,000 6,080
Total Production Cost 8,000 9,280
Less: Closing Stock (Valued @ marginal cost) 3,200 1,280
Marginal Cost of Production 4,800 8,000
Add: Variable Selling, Admin & Distribution Cost 750 1,250
Marginal Cost of Sales 5,550 9,250
Contribution 9,450 15,750
Less: Fixed Cost (based on normal production)
Fixed production 4,000 4,000
Fixed administration 2,000 2,000
Fixed selling 4,000 10,000 4,000 10,000
Marginal Costing Profit /loss (650) 5,750
xx
RECONCILIATION OF PROFIT FIGURES MAY
JUNE 2010
Statement of Reconciliation of profit
may june
Profit under absorption 1,450 4,550
Less Profit under marginal costing (550) 5,750
(Closing stock – opening stock)foar (200-0)10= 2,000 (80 -200)10= (1,200)

Not e t he m ain re ason for t he

de fe re nce is f ix e d product ion
overhead (FOAR) absorption rate
carried in closing stock to the next
year
Example 2
Stock production and sales data for the single product of Industrial
Detergents Limited are given here below:
Yr 1 Yr Yr 3 Yr 4
Production (litres) 60,000 70,000 55,000 65,000
Sales (litres) 60,000 55,000 65,000 70,000
Opening stock (litres) - - 15,000 5,000
Closing stock (litres) - 15,000 5,000 -
The f inancial data for an activity level of 60,000 litres per period are as
follows: Cost per litre (Tshs)
Direct material 2.50
Direct labour 3.00
Production overhead = 200% of direct labour 6.00
Total cost/litre 11.50
Selling price 18.00
Administrative overheads are f ixed at Tshs 100,000 per period and half of
the production overhead are fixed.
Required:
From the above given information, prepare operating statements on
marginal costing and absorption costing principles.
Example 3
Zain Company Limited supplies you with the following
data:
Tshs
Direct Material cost 48,000
Direct wages 22,000
Variable overhead - factory 13,000
- admn and selling 2,000
Fixed overhead - factory 20,000
- admn and selling 8,000
Sales 125,000
Re q u i r e d: pr e pa r e s ta te me n ts o f
income under marginal and absorption
costing methods
 EXAMPLE 4
Chimwaga Limited produces and sells a single product. The company
prepares its f in ancial statements using absorption costing method. Recently
the company’s production manager attended a short course on Cost and
Management Accounting for Non Accountants and one of the issues
discussed during the course was the application of variable costing and its
usefulness in decision making. He has approached you as the company’s
Cost Accountant with the following data extracted from the company’s records
for the years 2005 and 2006:
2005 2006
Sales (units) 200,000 300,000
Opening stock (units) 50,000 100,000
Closing stock (units) 100,000 40,000
Selling price per unit (Tshs) 250 250
Variable manufacturing unit cost (Tshs) 120 120
Fixed manufacturing costs (Tshs) 13,200,000 13,200,000
Normal volume (units) 240,000 240,000
Fixed selling and administration costs 5,000,000 5,000,000

Required: prepare absorption and variable costing statements for the years
2005 and 2006. Reconcile the reported prof it f igures. Explain to him why the
two approaches result in different profit figures.
the behavior
 EXAMPLE 5
Richmond Limited provided the following information for three
months:
January February March
Sales (units) 1,000 900 1,100
Production (units) 1,200 800 1,000
Costs incurred during the three months are as follows:
Variable production overhead cost per unit is Tshs 960
Variable administration and distribution cost per unit is Tshs
120
Fixed production overhead per month is Tshs 864,000
Fixed administration and distribution cost per month is Tshs
360,000
Unit selling price is Tshs 2,400
Required: prepare income statement under Absorption Costing
based on normal production of 1,200 units per month and
Marginal Costing
 EXAMPLE 6
Kagoda Investment Limited has made the following projections for Year 2004, 2005
and 2006.
Yr 2004 Yr 2005 Yr 2006
Production (units) 10,000 11,000 9,000
Sales (units) 8,000 12,000 10,000
Kagoda Investment Limited does not expect to have any work in progress (for all years)
or f inished goods at the beginning of year 2004 and at the end of Year 2006. However,
the normal capacity of the company is 10,000 units.
Total f ixed costs per year were as follows: Production Tshs 172,000 Administration
Tshs 200,000 Research and Development Tshs 30,000 and Selling & Distribution Tshs
138,000.
Variable cost per unit:
Direct Material Tshs 20
Direct Labour Tshs 30
Variable Overhead Tshs 25
Selling & Distribution Tshs 5
Selling price per unit Tshs 150
Required:
Prepare income statement by using Absorption and Marginal Costing methods
Comment on the differences of their profits