Absorption and marginal costing

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Definition
 Absorption costing
 Marginal costing

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

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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

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 Absorption Costing
Cost
Manufacturing cost Non-manufacturing cost

Direct Direct Overheads

Materials Labour Period cost

Finished goods Cost of goods sold Profit and loss account

Marginal Costing
Cost
Manufacturing cost Non-manufacturing cost

Direct Direct Variable Fixed

Materials Labour Overheads overhead Period cost

Finished goods Cost of goods sold Profit and loss account

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Today’s Objectives
 Yesterday we looked at absorption and
marginal costing
 Today we will look at the presentation of
income statement using both absorption
and marginal costing.
 We will also look at theoretical differences
between marginal and absorption costing.

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Presentation of costs on income
statement

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 Trading and profit ans loss account
Absorption costing Marginal costing
$ $
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
Variable and fixed manufacturing
Less: Expenses
Fixed selling expenses X
Fixed admin. expenses X
Other fixed expenses X
Net Profit X Net Profit X
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Example

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A company started its business in 2005. The following information
Was available for January to March 2005 for the company that produced
A single product:
$
Selling price pre unit 100
Direct materials per unit 20
Direct Labour per unit 10
Fixed factory overhead per month 30000
Variable factory overhead per unit 5
Fixed selling overheads 1000
Variable selling overheads per unit 4

Budgeted activity was expected to be 1000 units each month

Production and sales for each month were as follows:
Jan Feb March
Unit sold 1000 800 1100
Unit produced 1000 1300 900
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 Required:
 Prepare absorption and marginal costing
statements for the three months

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Absorption costing

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 January February March
$ $ $
Sales 100000 80000 110000
Less: cost of good sold ($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

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Marginal costing

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 January February March
$ $ $
Sales 100000 80000 110000
Less: Variable cost of good
sold ($35) 35000 28000 385500
Product contribution margin 65000 52000 71500
Less: Variable selling overhead4000 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

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Wk1:
Standard fixed overhead rate
= Budgeted total fixed factory overheads
Budgeted number of units produced

= $30000
1000 units
= $30 units
Wk 2:
Production cost per unit under absorption costing:
$
Direct materials 20
Direct labour 10
Fixed factory overhead absorbed 30
Variable factory overheads 5
65
Back
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Wk 3:
(Under-)/Over-absorption of fixed factory overheads:
January February March
$ $ $
Fixed overhead 30000 39000 27000
Fixed overheads incurred 30000 30000 30000
0 9000 (3000)
1000*$30 1300*$30 900*$30

Wk 4: No fixed factory overhead

Variable production cost per unit under marginal costing:
$
Direct materials 20
Direct labour 10
Variable factory overhead 5
Back 35 17
Difference between absorption
and marginal costing

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 Absorption costing Marginal costing
Treatment for Fixed Fixed manufacturing
fixed manufacturing overhead are treated
manufacturing overheads are as period costs. It is
overheads treated as product believed that only the
costing. It is variable costs are
believed that relevant to decision-
products cannot be making.
produced without Fixed manufacturing
the resources overheads will be
provided by fixed incurred regardless
manufacturing there is production or
overheads not
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 Absorption costing Marginal costing
Value of High value of Lower value of
closing stock closing stock will be closing stock that
obtained as some included the variable
factory overheads cost only
are included as
product costs and
carried forward as
closing stock

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 Absorption costing Marginal costing
Reported If the production = Sales, AC profit = MC Profit
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

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Argument for absorption costing

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 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

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Arguments for marginal costing

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 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

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 PROCESS COSTING
 Outcomes
 Describe the characteristics of process costing
 Situations for use of process costing
 Calculate cost per unit of process outputs
 Explain the concepts of normal and abnormal
costs
 Prepare accounts involving normal and
abnormal losses
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 Calculate and explain the concept of equivalent
unit
 Absorption process cost between work remaining
in process and transfers out of a process using
weighted average and FIFO methods
 Prepare process accounts in situations where
work remains incomplete and where losses and
gain at different stages.

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 THE BASIC PROCESS OF
PROCESS COSTING
 Process costing is a costing method used
where it is not possible to identify separate
units of production, or jobs usually because
of continues nature of the production
process involved.
 Examples. Oil refining, food and drinks,
chemical and paper.

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 Features of process costing
 The output of one process becomes the input
of the other until the finished product is
made in the final process.
 The continues nature of production means
that there will usually be closing work in
progress which must be valued.
 There are often losses in the process due to
spoilage, waste, evaporation etc
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 Features of process costing
cont’d
 The output from production may be a
single product , but there may also be by-
product or joint products

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Process accounts
 Where a series of separate processes is
required to manufacture the finished
product, the output of one process become
the input to the next until the final output is
made in the final process. If two processes
are required the accounts will look like the
one below.

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Process accounts example
Process 1 accounts
units $ units $
Direct materials 1000 50,000 output to process 2 1000 90000
Direct labour 20,000
Production overhead 20,000
1000 90,000 1000 90000
Process 2
Units $ units $
Materials from process 1 1000 90000 Output finished 1000 150000
Added materials 30000
Direct labour 15000
Production overhead 15000
1000 150000 1000 150000

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 Framework for dealing with
process costing
 Step 1. determine the output and losses
 Step 2 Calculate cost per unit of output,
losses and WIP
 Step 3. calculate total cost of output, losses
and WIP
 Step 4. complete accounts

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Losses in process costing
 Normal losses –Loss expected during the
process. It is not given a cost
 Abnormal losses-Extra loss resulting when
actual loss is greater than normal or
expected loss and is given a cost
 Abnormal gain- Is the gain resulting when
actual loss is less than the normal or
expected loss and is given a negative cost.
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Example of abnormal losses and
gains
 Suppose that input is 1000 units at a cost of
$4500. Normal loss is 10% and there are no
opening or closing stock. Determine the
accounting entries for the cost of output and
cost of the loss if the actual output were as
follows
 (a) 860 units( so actual loss is 140 units)
 (b)920 units (so actual loss is 80 units)
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Output is 860 units solution
 Step 1 Determine output and losses
units
Actual loss 140
Normal loss 10%of 1000 100
Abnormal loss 40

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 Step 2.calculate cost per unit of output and
losses
The cost per unit of output and cost per unit
of abnormal losses are based on expected
output.
Cost incurred/Expected output
=$4500/900=$5 per unit

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 Step 3. calculate total cost of output and losses
Normal loss is not assigned any cost
$
Cost of output (850*$5) 4300
Normal loss 0
Abnormal loss(40*$5) 200
4500

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Step 4 complete the accounts
 PROCESS ACCCOUNTS

 units $ units $

Cost incurred 1000 4500 normal loss 100 0

output 860 (*$5) 4300
abnormal loss 40 (*$5) 200
1000 4500 1000 4500

abnormal loss account

units $ units $
Process a/c 40 200 40 200

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Exercise
 Now complete for 920 units

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Question
 Shiny Inc has two processes Y and Z . There
is an expected loss of 5% of input in process
Y and 7% of input in process Z. Activity
during a four week period is as follows
Y Z
Materials input(kg) 20000 28000
Output(kg) 18500 26100
Is there an abnormal gain or abnormal loss for each
process?

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Solution
 Y Z
 Input(kg) 20000 28000
 Normal loss(kg) 1000 1960
 Expected output 19000 26040
 Actual output 18500 26100
 Abnormal loss/gain 500(loss) 60(gain)

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