ABSORPTION AND MARGINAL COSTING Course Lecturer: Dr. O.J. Akinyomi Absorption and Marginal Costing by Dr. Oladele John AKINYOMI is licensed under a Creative Commons Attribution-NonCommercial 4.0 International License.

Introduction Previously, we allocate all manufacturing costs to products regardless of whether they are fixed or variable. This approach is known as absorption costing/full costing However, only variable costs are relevant to decision-making. This is known as marginal costing/variable costing

Definition Absorption costing Marginal costing

Absorption costing It is costing system which treats all manufacturing costs including both the fixed and variable costs as product costs

Marginal costing It is a costing system which treats only the variable manufacturing costs as product costs. The fixed manufacturing overheads are regarded as period cost

Absorption Costing Cost Manufacturing cost Non-manufacturing cost Direct Materials Direct Labour Overheads Period cost Finished goods Cost of goods sold Profit and loss account Marginal Costing Cost Manufacturing cost Non-manufacturing cost Direct Materials Direct Labour Variable Overheads Fixed overhead Period cost Finished goods Cost of goods sold Profit and loss account

Presentation of costs on income statement

Trading, Profit or Loss Account Absorption costing Marginal costing N N Sales X Sales X Less: Cost of goods sold X Less: Variable cost of Goods sold X Gross profit X Product contribution margin X Less: Expenses Less: variable non- manufacturing Selling expenses X expenses Admin. expenses X Variable selling expenses X Other expenses X X Variable admin. expenses X Other variable expenses X Total contribution expenses X Less: Expenses Fixed selling expenses X Fixed admin. expenses X Other fixed expenses X Net Profit X Net Profit X Variable and fixed manufacturing

Example

A company started its business in 2015. The following information was available for January to March 2015 for the company that produced A single product: N Selling price per unit 100 Direct materials per unit 20 Direct Labour per unit 10 Fixed factory overhead per month 30,000 Variable factory overhead per unit 5 Fixed selling overheads 1,000 Variable selling overheads per unit 4 Budgeted activity was expected to be 1,000 units each month Production and sales for each month were as follows: Jan Feb March Unit sold 1,000 800 1,100 Unit produced 1,000 1,300 900

Required: Prepare absorption and marginal costing statements for the three months

Absorption Costing

January February March N N N Sales 100000 80000 110000 Less: cost of good sold (N 65) 65000 52000 71500 28000 38500 Adjustment for Over-/(under) absorption of factory overhead 9000 (3000) Gross profit 35000 37000 35500 Less: Expenses Fixed selling overheads 1000 1000 1000 Variable selling overheads 4000 3200 4400 Net profit 30000 32800 30100

Marginal Costing

January February March N N N Sales 100000 80000 110000 Less: Variable cost of good sold (N35) 35000 28000 385500 Product contribution margin 65000 52000 71500 Less: Variable selling overhead 4000 3200 4400 Total contribution margin 61000 48800 67100 Less: Fixed Expenses Fixed factory overhead 30000 30000 30000 Fixed selling overheads 1000 1000 1000 Net profit 30000 32800 30100

Wk1: Standard fixed overhead rate = Budgeted total fixed factory overheads Budgeted number of units produced = N30000 1000 units = N30 units Wk 2: Production cost per unit under absorption costing: N Direct materials 20 Direct labour 10 Fixed factory overhead absorbed 30 Variable factory overheads 5 65 Back

Wk 3: (Under-)/Over-absorption of fixed factory overheads: January February March N N N Fixed overhead 30000 39000 27000 Fixed overheads incurred 30000 30000 30000 0 9000 (3000) 1000*N30 1300*N30 900*N30 No fixed factory overhead Wk 4: Variable production cost per unit under marginal costing: N Direct materials 20 Direct labour 10 Variable factory overhead 5 35 Back

Difference between absorption and marginal costing

Absorption costing Marginal costing Treatment for fixed manufacturing overheads Fixed manufacturing overheads are treated as product cost. It is believed that products cannot be produced without the resources provided by fixed manufacturing overheads Fixed manufacturing overhead are treated as period costs. It is believed that only the variable costs are relevant to decision-making. Fixed manufacturing overheads will be incurred regardless there is production or not

Absorption costing Marginal costing Value of closing stock High value of closing stock will be obtained as some factory overheads are included as product costs and carried forward as closing stock Lower value of closing stock that included the variable cost only

Absorption costing Marginal costing Reported profit If the production = Sales, AC profit = MC Profit If Production > Sales, AC profit > MC profit As some factory overhead will be deferred as product costs under the absorption costing If Production < Sales, AC profit < MC profit As the previously deferred factory overhead will be released and charged as cost of goods sold

Argument for absorption costing

Compliance with the generally accepted accounting principles Importance of fixed overheads for production Avoidance of fictitious profit or loss During the period of high sales, the production is small than the sales, a smaller number of fixed manufacturing overheads are charged and a higher net profit will be obtained under marginal costing Absorption costing is better in avoiding the fluctuation of profit being reported in marginal costing

Arguments for marginal costing

More relevance to decision-making Avoidance of profit manipulation Marginal costing can avoid profit manipulation by adjusting the stock level Consideration given to fixed cost In fact, marginal costing does not ignore fixed costs in setting the selling price. On the contrary, it provides useful information for break-even analysis that indicates whether fixed costs can be converted with the change in sales volume

Bibliography Adeniji, A. (2009). Cost accounting: A managerial approach Lagos, El-Toda Ventures Limited http://202.82.16.155/bss/account/notes2/Absorption%20and%20marginal%20costing.ppt. http://www.blackhallpublishing.com/webresources/html/Slides/ma_ch04_slides.ppt. Absorption and Marginal Costing by Dr. Oladele John AKINYOMI is licensed under a Creative Commons Attribution-NonCommercial 4.0 International License.