Lecture 5 and 6 - Marginal Absorption Costing

Lecture 5 & 6
Marginal Costing
and
Absorption Costing
Absorption Costing: Concept

Also known as Total Absorption Costing
All costs are absorbed into production and
operating statements.
Do not distinguish between fixed and variable
costs.
It classifies costs by function, where it
allocates/apportions a share of costs to its
products
Profit reported will be influenced by the level
of production and level of sales
Absorption Costing:
Operating Statement
Example 1:
In a period, 20,000 units of Z were produced and sold. Costs
and revenues were:
Sales
Production Costs:
Variable
Fixed
Administrative + Selling overheads:
Fixed
RM100,000
RM 35,000
RM 15,000
RM 25,000
Prepare operating statement based on Absorption Costing.
Absorption Costing:
Operati g State e t Co t
Solution:
Operating Statements
Absorption Costing Approach (RM)
Sales
Less: Production Cost of Sales (35,000+15,000)
= Gross Profit
Less: Administrative + Selling Overheads
= Net Profit
100,000
(50,000)
50,000
(25,000)
25,000
Marginal Costing
also known as
Contribution Approach
or
Direct Costing
What is Marginal Costing ?

Definition:
The a ou ti g syste i hi h aria le osts
are charged to cost units and fixed costs of the
period are written off in full against the
aggregate contribution. Its special value is in
recognising cost behaviour, and hence assisting
in decision- aki g
~ Terminology
Marginal Costing: Concept

Distinguish fixed costs and variable costs.
Marginal cost of a product is its variable cost.
Marginal Cost= Variable Cost= Direct Labour +
Direct Material +
Direct Expense +
Variable Overheads
Contribution is the difference between Sales

and Marginal Cost
Contribution = Sales - Marginal Cost
Margi al Costi g o t
Fixed cost are not absorbed into the cost of
production
Fixed cost are treated as period costs and
written off each period in the Costing Profit
and Loss account.
Finished goods and work in progress are
valued at marginal cost only.
At the end of a period, marginal cost of sales is
deducted from sales revenue to show the
contribution, from which fixed costs are
deducted to show net profit.
Marginal Costing: Main Uses

i. To provide information to management for
planning and decision making
- short run decisions involving changes in
volume/activity and resulting cost changes.
ii. Can be used in routine cost accounting system
for the calculation of costs and valuation of

stock.
Marginal Costing:
Operating Statement
Example 1:
In a period, 20,000 units of Z were produced and sold. Costs
and revenues were:
Sales
Production Costs:
Variable
Fixed
Administrative + Selling overheads:
Fixed
RM100,000
RM 35,000
RM 15,000
RM 25,000
Prepare operating statements based on Marginal Costing.
Marginal Costing:
Operati g State e t o t
Solution:
Marginal Costing Approach (RM)
Sales
Less: Marginal Cost (Variable elements)
= Contribution
Less: Fixed Costs
Production
Administrative + Selling Overheads
= Net Profit
100,000
(35,000)
65,000
15,000
25,000 (40,000)
25,000
Marginal Costing and

Absorption Costing
Solution:
Absorption Costing Approach (RM)
Marginal Costing Approach (RM)
Sales
100,000
Sales
Less: Production Cost of Sales (50,000) Less: Marginal Cost
= Gross Profit
50,000
= Contribution
Less: Admin + Selling Overheads (25,000) Less: Fixed Costs
Production
15,000
Admin + Selling O/H 25,000
= Net Profit
25,000
= Net Profit
100,000
(35,000)
65,000
(40,000)
25,000
Changes In The Level of Activity

When changes occur in the level of activity, the
absorption costing approach may cause some
confusion.
In Example 1, the activity level was 20,000 units.
Using absorption approach, profit per unit and cost
per unit can be calculated as follows:
Selling Price per unit
less: Total cost per unit = RM75,000
20,000
Profit per unit
RM5.00
(RM3.75)
RM1.25
Cha ges I The Level of A tivit
o t
If the figures were used as a guide for any activity level other
than 20,000, then it may be misleading.
Example, if level of activity changes to 25,000 units, it might
be assumed that total profits would be:
25,000 x RM1.25 = RM31,250
However, results are likely to be as follows:
Operating Statement (Absorption Approach)
Sales (25,000 x RM5)
RM125,000
Less: Production Cost (RM35,000 x 125% + RM15,000) (RM 58,750)
= Gross Profit
RM 66,250
Less: Admin + Selling overheads
(RM 25,000)
= Net Profit
RM 41,250
Therefore causing a difference of RM10,000 (RM41,250 RM31,250)

due to incorrect treatment of fixed cost.
o t
In such situation, marginal approach presents a clearer

picture. For example, using the same scenario but based on
Marginal approach
Marginal cost per unit = Marginal Cost = RM35,000
Quantity
20,000 units
= RM1.75 per unit
Thus, Contribution per unit = Selling price - Marginal cost per unit
= RM5.00 RM1.75
= RM3.25 per unit
Hence,
Expected profit for 25,000 units
= (25,000 units x Contribution per unit) Fixed Costs
= (25,000 units x RM3.25 per unit) (RM15,000 + RM25,000)
= RM41,250
o t
Operating Statement on Marginal Costing

Sales
Less: Marginal cost (25,000 x RM1.75)
= Contribution
Less: Fixed cost
Net profit
RM125,000
RM 43,750
RM 81,250
RM 40,000
RM 41,250
Marginal cost and contribution per unit have been

assumed to be constant and that fixed costs
remain unchanged.
Inventories and Marginal Costing

Both marginal and absorption costing
produces the same net profit in the earlier
example because there was no inventories at
the beginning or end of the period.
This two methods will produce different profit
figures when inventories arise because of
different valuation method on inventories.
I ve tories a d Margi al Costi g Co t

Example 2:
Using the same data from Example 1 except only
18,000 of the 20,000 units produced were sold.
2,000 unit is being carried forward as inventories
to the next period.
Prepare the operating statements based on both
marginal costing and absorption costing.

Solution:
OPERATING STATEMENTS
ABSORPTION COSTING (RM)
MARGINAL COSTING (RM)
Sales (18,000 x RM5)

90,000
Sales
Less: Production Cost of
Less: Marginal cost
35,000
Sales (35,000+15,000) 50,000
(-) Closing inventories
(2,000 x RM1.75)
(3,500)
(2,000 x RM2.50)
5,000) (45,000)
= Contribution
= Gross profit
45,000 Less: Fixed costs
Less: Admin + Selling overheads (25,000)
Production
15,000
Admin + Selling O/H 25,000
= Net profit
20,000
= Net profit
Closing Stock:
Absorption Costing = Average Production Cost
= RM50,000 = RM2.50
20,000
90,000
(31,500)
58,500
(40,000)
18,500
Marginal Costing= Marginal cost

= RM35,000 = RM1.75
20,000

Absorption costing transfers some of this
periods osts i to e t period i ludi g
fixed costs in inventories valuation
Marginal costing always writes off all fixed
costs in the period they are incurred
In a period with increasing inventories (as
shown in the example), absorption costing will
show higher profits than marginal costing and
vice versa
Lecture Exercise 1
ABC Ltd manufactures a single product which has a standard selling
price of RM15 per unit. It operates a standard absorption costing
system.
The total standard production cost is RM9 per unit of which RM4
per unit represents the variable cost element.
Non-production costs of RM44,000 per month are all fixed.
The following data relate to the month just ended:
Budget
Actual
(units)
(units)
Production
48,000
47,000
Sales
45,000
46,000
The actual total sales revenue for the month just ended was
RM678,500.
Calculate the BUDGETED profit for the month just ended under:
(i) absorption costing;
(ii) marginal costing.
Solution: Absorption Costing

Sales (45,000 x RM15)
Less: Production cost
(RM9 x 48,000)
(3,000 x RM9)
Gross profit
Less: Non production costs
Net Profit
675,000
432,000
27,000
405,000
270,000
44,000
226,000
Solution: Marginal Costing

Sales (45,000 x RM15)
Less: Production cost
Variable (RM4 x 48,000)
(3,000 x RM4)
Contribution
Less: Fixed production costs
(RM5 x 48,000)
Non production costs
Net Profit
675,000
192,000
12,000
180,000
495,000
240,000
44,000
284,000
211,000

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Lecture 5 & 6

Absorption Costing: Concept

Prepare operating statement based on Absorption Costing.

What is Marginal Costing ?

Marginal Costing: Concept

Contribution is the difference between Sales

Marginal Costing: Main Uses

ii. Can be used in routine cost accounting system

for the calculation of costs and valuation of

Prepare operating statements based on Marginal Costing.

Marginal Costing and

Marginal Costing Approach (RM)

Changes In The Level of Activity

Cha ges I The Level of A tivit

Therefore causing a difference of RM10,000 (RM41,250 RM31,250)

Cha ges I The Level of A tivit

In such situation, marginal approach presents a clearer

Cha ges I The Level of A tivit

Operating Statement on Marginal Costing

Marginal cost and contribution per unit have been

Inventories and Marginal Costing

I ve tories a d Margi al Costi g Co t

I ve tories a d Margi al Costi g Co t

ABSORPTION COSTING (RM)

MARGINAL COSTING (RM)

Sales (18,000 x RM5)

Marginal Costing= Marginal cost

I ve tories a d Margi al Costi g Co t

Solution: Absorption Costing

Solution: Marginal Costing

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