1.

0 Introduction
2.0 Absorption Costing
2.1 Under – and – 0ver absorption
2.2 Advantages of Absorption Costing
2.3 Disadvantages of Absorption Costing
3.0 Marginal Costing
3.1 Assumptions of Marginal Costing
3.2 Advantages of Marginal Costing
3.3 Disadvantages of Marginal Costing
4.0 Difference between MCT and ACT
5.0 Practice questions.
1. Introduction

Absorption costing and marginal costing represent

distinct approaches in managerial accounting, each
offering unique insights for decision-making.
Absorption costing incorporates all production
costs, both variable and fixed, into the unit cost of a
product. This method provides a comprehensive
view of total expenses associated with production,
aiding in long-term strategic decisions and external
financial reporting. On the other hand, marginal
costing focuses solely on variable costs, treating fixed
overhead as a period cost.

This approach is particularly valuable for short-term decision-making, as it highlights the contribution
margin and helps assess the impact of varying production levels on profitability. Managers can leverage
absorption costing for a holistic understanding of overall costs and profitability, while marginal costing
offers a more focused perspective for short-term tactical decisions in dynamic business environments. The
choice between these methods depends on the specific context and time horizon of the decision at hand.
2. Absorption Costing:
In an absorption costing system, the fixed production costs for a period are shared across the output for that
period. Therefore, a product's cost will consist of its variable costs, (direct materials, direct labour, direct
expenses, and variable production overheads) plus a share of fixed production overheads. Closing stocks and
work in progress will therefore include a share of the current period's overheads.
As a result, some of the current period's fixed costs will be carried into the next period's production cost of
sales. This is because the production cost of sales, i.e. absorption costing cost of sales figure is made up of:

 The opening stock (including work in progress), valued at the PREVIOUS

period's production costs per unit;
 plus the total of the current period's direct material and labour costs;
 plus the variable and fixed production overheads;
 less the closing stock (including work in progress); valued at the CURRENT
period's production costs per unit:

Note: the above definition assumes that stocks are valued on a first in first out
(FIFO)basis.
Absorption costing measures cost of a product or a service as:
 its direct costs (direct materials, direct labour and sometimes direct expenses and variable production
overheads); plus

 a share of fixed production overhead costs.

It is a system of costing in which a share of fixed overhead costs is added to direct costs and variable production
overheads, to obtain a full cost. This might be:
 a full production cost, or

 a full cost of sale

This was covered in an earlier chapter but a brief revision is provided here for your convenience.
 Production overheads are indirect costs. This means that the costs (unlike direct costs) cannot be attributed
directly to specific items (products) for which a cost is calculated.

 A ‘fair’ share of overhead costs is added to the direct costs of the product, using an absorption rate.

 A suitable absorption rate is selected. This is usually a rate per direct labour hour, a rate per machine hour, a
rate per amount of material or possibly a rate per unit of product.

 Production overheads may be calculated for the factory as a whole; alternatively, separate absorption rates may
be calculated for each different production department. (However, it is much more likely that a question
involving absorption costing will give a factory-wide absorption rate rather than separate departmental
absorption rates.)
The overhead absorption rate (or rates) is determined in advance for the financial year. It is calculated as follows:

Formula: Overhead absorption rate

Total allocated and apportioned overheads

Volume of activity in the period

Which is:
Budgeted production overhead expenditure for the period
Budgeted activity in the period

The ‘activity’ is the number of labour hours in the year, the number of machine hours, or the number of units produced,
depending on the basis of absorption (labour hour rate, machine hour rate, or rate per unit) that is selected.

2.1 Under- and over-absorption

Overhead absorption rates are decided in advance (before the period under review).
Actual overhead expenditure and actual production volume might differ from the estimates used in the budget to work
out the absorption rate.
As a consequence, the amount of overheads added to the cost of products manufactured is likely to be different from
2.2 Advantages of Absorption Costing

 It complies with the stock and work-in-progress valuation criteria set out in International Accounting Standard
2 (1AS 2). However, for firms which use JIT manufacturing, this particular advantage is of historical
significance only.
 The alternative technique, marginal costing, fails to recognize the importance of working to full capacity. With
absorption costing, the effect of higher production volume is to reduce unit cost (because the unit cost is lower)
and if sales prices are based on the 'cost-plus' method, the relevance of output capacity to
cost/price/sales/demand should be clear.
 Selling prices based on marginal costing input enable the firm to make a contribution on each unit of product it
sells, but the total contribution earned might be insufficient to cover all fixed costs.
 In the long run, all costs are variable, and inventory values based on absorption costs will give recognition to
these long-run variable costs.

 Inventory values include an element of fixed production overheads. This is consistent with the requirement in
financial accounting that (for the purpose of financial reporting) inventory should include production overhead
costs.
 Calculating under/over absorption of overheads may be useful in controlling fixed overhead expenditure.
 By calculating the full cost of sale for a product and comparing it will the selling price, it should be possible to
identify which products are profitable and which are being sold at a loss.
2.3 Disadvantages of Absorption Costing

 The apportionment and absorption bases used are arbitrary and subjective. This can production managers to
spend time arguing for alternative apportionment or absorption bases, in an attempt to reduce the perceived
costs of 'their’ products or activities.
 The process of building up absorption costs in firm a with many different overhead and manufacturing cost
centres is extremely complicated.
 Production managers may manufacture excess output in an attempt to bring down unit costs.
 Stock valuations bear no relation the real cost of producing the stock, i.e. the cash cost, avoidable cost or
opportunity cost.

 Absorption costing is a more complex costing system than marginal costing.

 Absorption costing does not provide information that is useful for decision-making (like marginal costing
does).
The consequences of these drawbacks are that, since the 1980’s, many manufacturers (especially in the
advanced economies) have abandoned absorption costing in favour of a new system called activity-based
costing. Activity-based costing (ABC) attempts to deal with the problems caused by uncritical use of absorption,
costing, by focusing managers' attention on overhead costs that are CAUSED by a product.
3. Marginal Costing:
Marginal costing is an alternative to absorption costing. In marginal costing, fixed production
overheads are not absorbed into product costs but expensed in the period. Marginal costing is
useful in decision-making as it focuses on the change in total costs brought about by an increase or
decrease in a level of activity. This is covered in more detail in later chapters of this text. Marginal
costing extends the contribution idea that is used for CVP analysis through to the routine operating
statements that are prepared to assist management control.
In a marginal costing system, a product's production cost is its variable production cost. Therefore, any unsold production, i.e. closing
stocks or work in progress, will also be valued at its variable production cost. Contribution will be revenue less the variable cost of
sales. The variable cost of sales to the variable production cost of the goods or services sold in a period plus any variable selling and
distribution costs. All the fixed costs for a period will be charged to that period's profit and loss account as period costs.
The CIMA Official Terminology defines marginal costing as 'The accounting system in which variable costs 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-making.
Marginal costing might be used for decision-making. For example, marginal costing is used for limiting factor analysis and linear
programming.
It is appropriate to use marginal costing for decision-making when it can be assumed that future fixed costs will be the same, no
matter what decision is taken, and that all variable costs represent future cash flows that will be incurred as a consequence of any
decision that is taken.
These assumptions about fixed and variable costs are not always valid. When they are not valid, relevant costs should be used to
evaluate the economic/financial consequences of a decision.
3.1 Assumptions
It is often assumed that marginal costs are relevant costs for the purpose of decision-making.
• The marginal cost of a product is the extra cost that would be incurred by making and selling one extra unit of
the product.
• Similarly, the marginal cost of an extra hour of direct labour work is the additional cost that would be
incurred if a direct labour employee worked one extra hour. When direct labour is a variable cost, paid by the
hour, the marginal cost is the variable cost of the direct labour wages plus any variable overhead cost related
to direct labour hours.
3.2 Marginal costing has some distinct advantages:

• It uses the same cost logic as CVP, so is consistent with short-term decision-making techniques. Therefore, a
marginal costing system will provide a ready source of data for solving decision problems.
• It is easy for managers to understand the distinction between variable (or marginal) costs and fixed costs.
• Highlighting contribution encourages managers to concentrate on sales volume, rather than production
volume, as surplus production does not add to profits. This may seem obvious, but, as we shall see in some of
the questions involving absorption costing, a costing system can encourage production managers to produce
goods for stock without too much concern for eventual sales.
• A marginal costing system is simple to operate. Materials costs, direct labour costs and sales commissions are
the main variable costs - and they are all comparatively easy to trace to individual products. Almost all other
costs are period costs, i.e. fixed, and can be collected from the routine financial accounting records.
• Marginal costs are useful for identifying minimum selling prices.

• It is easy to account for fixed overheads using marginal costing. Instead of being apportioned, they are treated
as period costs and written off in full as an expense the income statement for the period when they occur.

• There is no under/over-absorption of overheads with marginal costing, and therefore no adjustment is

necessary in the income statement at the end of an accounting period.

• Marginal costing provides useful information for decision-making.

• Contribution per unit is constant, unlike profit per unit which varies as the volume of activity varies.
3.3 The limitations of a marginal costing system are:

• As more and more production costs become fixed (a salaried workforce, vastly reduced production cost.
Consequently, alternative systems, such as activity-based costing are being introduced. Marginal costing is
not invalidated, but its range of applicability, particularly in manufacturing, is decreasing.
• Marginal costing can encourage managers to concentrate on maximizing contribution per unit, by increasing
selling prices and /or reducing variable costs. As a result, fixed costs may be ignored until there is a
reduction in sales volume and panic cuts ensure.
• It is a simplistic system, which fails to recognize that upward, or downward trends in volume should
eventually lead to increased or reduced 'fixed' costs, (Activity-based costing, which is covered elsewhere in
this book, recognizes this and works to encourage managers to cut "fixed' overhead costs when volume falls
and to extract the maximum value from 'fixed' overhead costs when volume increases).
• Using marginal costs as a basis for determining selling prices can be dangerous, except for peripheral
activities or jobs. A business will be unprofitable unless sufficient contribution is earned to cover all its fixed
costs.
• Marginal costing does not value inventory in accordance with the requirements of financial reporting.
(However, for the purpose of cost accounting and providing management information, there is no reason
why inventory values should include fixed production overhead, other than consistency with the financial
accounts.)
• Marginal costing can be used to measure the contribution per unit of product or the total contribution earned
by a product, but this is not sufficient to decide whether the product is profitable enough. Total contribution
has to be big enough to cover fixed costs and make a profit.
Despite the apparent disadvantages of marginal costing, it is a powerful costing system that works well,
provided its limitations are understood.
4. The difference in profit between marginal costing and absorption costing
• The profit for an accounting period calculated with marginal costing is different from the profit calculated with
absorption costing.
• The difference in profit is due entirely to the differences in inventory valuation.
• The main difference between absorption costing and marginal costing is that in absorption costing, inventory
cost includes a share of fixed production overhead costs.
 The opening inventory contains fixed production overhead that was incurred last period. Opening inventory is
written off against profit in the current period. Therefore, part of the previous period’s costs are written off in
the current period income statement.

 The closing inventory contains fixed production overhead that was incurred in this period. Therefore, this
amount is not written off in the current period income statement but carried forward to be written off in the next
period income statement.
• The implication of this is as follows (assume costs per unit remain constant):
 When there is no change in the opening or closing inventory, exactly the same profit will be reported using
marginal costing and absorption costing.

 If inventory increases in the period (closing inventory is greater than opening inventory),
o the increase is a credit to the income statement reducing the cost of sales and increasing profit;
o increase will be bigger under total absorption valuation than under marginal costing valuation (because the
absorption costing inventory includes fixed production overhead); therefore
o the total absorption profit will be higher.
 If inventory decreases in the period (closing inventory is less than opening inventory),
 the decrease is a debit to the income statement;

 the decrease will be bigger under total absorption valuation than under marginal costing valuation (because
the absorption costing inventory includes fixed production overhead); therefore

• the total absorption profit will be lower.

QUESTIONS

Walk-talk manufactures a cordless telephone system. At the beginning of the financial year ending November
2016, the firm planned to make and sell 50,000 units of its only product, the Nova, at a selling price of N3,000
per unit. Information on standard costs used in the preparation of the budget is as follows: N

Direct materials 400 per unit

Direct labour 600 per unit

• Fixed production overheads for the year were estimated at N80,000,000; to be absorbed on the basis of the
number of units produced. There are no variable overheads.

• Fixed selling and administration expenses were estimated at N10,000,000; to be absorbed on the basis of the
number of units sold.

• At the beginning of the year (1 December 2015) there were no units in stock and no units were budgeted to be
in stock at the end of the year (30 November 2016).

• Situation as at 1 December 2016.

The market for cordless telephones has changed rapidly over the course of the past year. In response to competitive
pressures, Walk-talk has had to make a number of changes both to the operating programmes within the Nova model and
the range of colours available. There are now three different versions of the Nova available in a choice of eight different
colours.

During the year the cost of materials and direct labour per unit has been incurred in line with standard costs, although
production overheads incurred during the year have risen to - N83,000,000; due to a higher-than-expected rent review for
the factory. Selling and administration costs were as budget. Production exceeded budget with 52,000 units being made.
However, despite the changes in product specification, sales have only reached 45,000 units with 7,000 units of finished
systems remaining ni stock on 30 November 2016. There was no stock of work-in-progress at the year-end.

Stocks of finished goods are to be valued on the basis of the standard cost of production.

Required:

a. Prepare a budgeted Profit and Loss Account for Walk-talk for the year ending 30 November 2016 using an
absorption costing basis.
b. Prepare the actual Profit and Loss Account for the year ended 30 November 2016, using following two methods:

i). absorption costing; ii) marginal costing

c. Compare the budgeted profit with the actual profit and explain the reasons for any difference occurring. Your
answer should include reference to the effect of sales and overhead variance;
i. Between the budget and the actual profits on the absorption costing basis;
ii. Between the budget and the actual profits on the marginal costing basis.
d. State any concerns you may have about valuing the finished stock of telephone at the end (November 2016).
SOLUTION:

a). The first step is to calculate overhead absorption rates

Per unit

Production: N80,000,000 / 50,000 units = 1,600

Selling & Admin: N10,000,000 / 50,000 units = 200

Budgeted Profit and Loss Account

N’000 N’000

Sales (50,000 x N3,000) 150,000

Less cost of sales
 DL (50,000 x N600) 30,000

Prime cost 50,000

Fixed (50,000 x N1,600) 80,000

Production cost 130,000

Fixed SAOH (50,000 x N200) 10,000

Total cost 140,000

Profit 10,000

b). The first step is to determine the overhead over (under) absorption

FPOH FSAOH

Quantity produced/sold 52,000 45,000*

Absorption rate N1,600 N200

Absorbed (N’000) 83,200 9,000

Less actual cost (83,000) 10,000

Over/(under) absorption 200 (1,000)

i.) Actual-profit and Loss Account for the year ended 30 November 2016 – Absorption costing

N’000 N’000

Sales (45,000 x N3,000) 135,000

Less cost of sales

DM (52,000 x N400) 20,800

DL (52,000 x N600) 31,200

Prime cost 52,000

Add: FPOH (52,000 x N1,600) 83,200

Production cost 135,200

Less stock of finished goods [(52,000 – 45,000) x N2,600*] 18,200

Production cost of sales 117,000

Selling & admin expenses (45,000 x N200) 9,000

Total cost of sales 126,000

Standard profit on actual sales 9,000

 Add FPOH over-recorded 200

Less selling, etc. overhead under recovered (1,000)

Net under-recovery of overheads (800)

Profit 8,200

* Production cost per unit made up of: N

DM 400

DL 600

Prime cost (variable) 1,000

FPOH 1,600

2,600

ii). Actual Profit & Loss Account for the year ended 30 November 2016 – Marginal Costing

N’000 N’000

Sales 135,000

Less variable costs: 52,000 x N1,000 52,000

 Less stock of finished goods at variable cost (7,000 x N1,000) 7,000 45,000

Contribution 90,000

Less fixed costs

- Production 83,000

- Selling and admin 10,000 93,000

Loss (3,000)

c. i.) First, we analyze the total fixed production overhead over-absorption

N’000

Absorbed (a) 83,200

Budgeted (b) 80,000

Actual (c) 83,000

Volume variance (a – b) 3,200 (F)

Expenditure (b – c) 3,000 (A)

Total variance (a – c) 200 (F)

Reconciliation of budgeted profit to actual profit – absorption costing basis

N’000 N’000

Budgeted profit 10,000

Sales volume variance (5000 units x N200*) (1,000)

FPOH expenditure variance (3,000)

(200 units x 1600) FPOH volume variance 3,200

Under-recovery of selling overheads (1,000) (1,800)

8,200

(*budgeted profit per unit)

Comment: Profitability has reduced as a consequence of the rise in the rent of the factory expenditure

variance (N,3000,000). However this has been offset temporarily by the effect of increased production,

Leading to a favourable volume of N3,200,000.

Profit has been further reduced by selling 5,000 units less than budget (45,000 Vs 50,000) resulting
in adverse sales volume variance of N1,000,000 and under-recovery of selling and admin overhead of
 ii.) Budgeted Profit to Actual Profit – marginal costing basis

N’000

Budgeted profit 10,000

Less FPOH expenditure variance (3,000)

Less reduction in contribution due to reduced sales unit

= 5,000 x N (3,000 – 1,000) `(10,000)

Actual loss (3,000)

Comment: Again we see the detrimental effect of the N3,000,000.00 increase in factory rent, but this time

the full effect of the reduction in sales volume is felt. The lower sales volume means that contribution of

N10,000,000 (5000 units x N2000 per unit) is not earned in this period, resulting in an overall loss for the

of N3,000,000.00 compared with a budgeted profit of N10,000,000.

d.) Valuation of the stock of finished goods: The valuation of the stock of finished goods under the absorption costing
basis

should be viewed cautiously. Production has exceeded the budgeted level, despite the reduced sales volume. This

might indicate that unpopular programme options and colours variations, which have not sold as planned during
 Under the marginal costing regime this potential problem is greatly reduced. Stock is only valued at variable cost and

management may feel that this cost should be recoverable, even if the telephones were disposed of quickly to discount

retailer.

QUESTION 2

P Ltd manufactures a specialist photocopier. Increased competition from a new manufacturer has meant that P
Ltd been operating below full capacity for the last two years.

The budgeted information for the last two years was as follows:
Year 1 Year 2

• Annual sales demand (units) 70 70

• Annual production(units) 70 70

• Selling price (for each photocopier) N50,000 N50,000

• Direct costs (for each photocopier) N20,000 N20,000

• Variable production overheads (for Each photocopier) N11,000 N12,000
Fixed production overhead N525,000N525,000
Actual results for the last two years were as follows:
Annual sales demand (units) 30 60
Annual production(units) 40 60
Selling price (for each photocopier) N50,000 N50,000
Direct costs (for each photocopier) N20,000 N20,000
Variable production overheads (for each photocopier) N12,000 N12,000
Fixed production overheads N500,000 N500,000
There was no opening stock at the beginning of year 1.
Required:
a) Prepare the actual profit and loss statements for each of the two years using:
i. absorption costing ii. marginal costing.
a) Calculate the budgeted breakeven point in units and the budgeted margin of safety as a percentage
of sales for year 1 and then again for year 2.
b) Provide a reconciliation of the profit of absorption costing with that of marginal costing.
a) i) Profit and Loss statement using absorption costing

Year 1 Year 2

N’000 N’000 N’000 N’000

Sales (W1) 1,500 3,000

Cost of sales:

Opening stock Nil 385

Total production cost (W2) 1,540 2,370

Less: closing stock (W3) (385) (1,155) (395) (2,360)

Gross Profit 345 640

(Under)/over absorption adjustment(W4) (200) (80)

Profit 145 560

ii) Profit and lost statement using marginal costing

Sales (W1) 1,500 3,000

Cost of sales:
 Year 1 Year 2

N’000 N’000 N’000 N’000

Variable production cost (W5) 1,240 1,920

Less closing stock (W6) (310) (930) (320) (1,910)

Contribution 570 1,090

Less: Fixed cost

Production (500) (530)

Profit 70 560

Workings

(W1) Sales

Year 1

N50,000 x 30 = N1,500,000

Year 2
N50,000 x 60 = N3,000,000
(W2) Total production cost

Cost per unit

Year 1 Year 2

N N

Direct Cost 20,000 20,000

Variable production overheads 11,000 12,000

Fixed production overheads* 7,500 7,500

Total production cost per unit 38,500 39,500

*OAR

N525,000 / 70 = N7500 per photocopier.

Total Production cost – year 1

N38,500 x 40 = 1,540,000

Total production cost – year 2

N39,500 x 60 = 2,370,000
(W3) Closing stock adjustment

Year 1: N1,240,000 / 40 x 10 = N385,000

Year 2: N1,920, 000 / 60 x 10 = N395,000

(W4) Under/over absorption adjustment

Year 1 N’000

Absorbed N7,500 x 40 300

Incurred 500

Under absorbed 200

Year 1 N’000

Absorbed N7,500 x 60 450

Incurred 530

Under absorbed 80

(W5) Variable production cost

Cost per unit

 Year 1 Year 2

N’000 N’000

Direct costs 20 20

Variable production overheads 11 12

Variable production cost per unit 31 32

Total variable production cost – year 1: N31,000 x 40 = N1,240,000

Total variable production cost – year 2: N32,000 x 60 = N1,920,000

(W6) Closing stock - marginal

Year 1: N1,240,000 x 10 = N320,000

Year 2: N1,920,000 X 10 = N320,000

b) Budgeted break-even units = Fixed costs / contribution per unit

Budgeted margin of safety = Budgeted sales units – break-even sales units

Year 1

Break-even units N525,000 / N19,000 = 27.63 photocopiers = 28 photocopiers

 Year 2

Break-even units = N525,000 / N19,000 = 29.16 photocopiers = 30 photocopiers

Margin of safety = 70 – 30 = 40 photocopiers = 57.14%

c) The budgeted break-even point in year 2 is higher than in year 1. This is due to the increase in variable over-

head per photocopier from N11,000 in year 1 to N12,000 in year 2 causing a decrease in contribution. The

selling price, other variable costs and fixed costs have remained constant and therefore the increase in the

budgeted number of units to break-even can only be attributed to the increase in variable overheads.

The margin of safety indicates the percentage by which forecast turnover exceeds or fall short of that requi-

red to break-even. In year 1, the budgeted margin of safety is 60% and in year 257.14%.