Course Title: Marginal and Absorption Costing

ProfessionalDevelopmentProgramme onEnriching KnowledgeoftheBusiness,AccountingandFinancialStudies (BAFS)Curriculum<ElectivePart>

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LearningOutcomes
Uponcompletionofthiscourse,teacher participantsshouldbeableto: compareand contrast betweenmarginal costingandabsorptioncosting; calculateandpresent netprofitundermarginal costingandabsorptioncosting;and explainand evaluate theusesofmarginal costingandabsorptioncosting.
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SyllabusinHKDSEExamination
Comparetheuse ofmarginalandabsorption costinginpreparing:
(i)Manufacturingaccounts (ii)Incomestatements OperatingStatements

Comparetheadvantages anddisadvantages ofadoptingmarginalandabsorptioncosting

Contents
Segregationofcostintovariableandfixedelements (Illustration1) Marginalcostingvs.absorptioncosting(Illustrations25) Normalabsorptioncosting(Illustration6) Overheadabsorptionrate(Illustration6) Calculationandtreatmentofoverheadover absorbed/underabsorbed(Illustration6) Advantagesanddisadvantagesofmarginalcostingand absorptioncosting Casestudy integratedillustrativequestion
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PriorKnowledgeRequired

SegregationofCostintoVariableandFixedElements

Illustration1 SegregationofCostintoVariableandFixedElements

Themanufacturingcostvarieswithproduction volumesasfollows:
ProductionVolume 1,000units 1,800units TotalManufacturingCost $400,000 $600,000

Illustration1 SegregationofCostintoVariableandFixedElements

Totalfixedcost= $400,000 $250x1,000=$150,000 or $600,000 $250x1,800=$150,000

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MarginalCosting (alsoknownasVariableCosting)

TotalCost

ProductCost

PeriodCost

DirectMaterials DirectLabour DirectExpenses VariableManufacturingOverheads

FixedManufacturingOverheads VariableNonManufacturingOverheads FixedNonManufacturingOverheads

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AbsorptionCosting (alsoknownasFullCosting)

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TotalCost

ProductCost

PeriodCost

DirectMaterials DirectLabour DirectExpenses VariableManufacturingOverheads FixedManufacturingOverheads

VariableNonManufacturingOverheads FixedNonManufacturingOverheads

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Illustration2 MarginalCostingvs.AbsorptionCosting
Amanufacturingcompanyproducesasingleproduct.Duringthe yearended31December2009,10,000unitswereproducedand sold.Therewasnoopeninginventory.Thecostsofmanufacturing duringtheyearwereshownasfollows:

Costs
DirectMaterials DirectLabour VariableManufacturingOverheads FixedManufacturingOverheads VariableSellingOverheads FixedSellingandAdministrativeOverheads
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$ 600,000 200,000 40,000 300,000 187,500 250,000

Allthe10,000unitsweresoldat$200each.

Illustration2 MarginalCosting
ProductCostunderMarginalCosting
DirectMaterials DirectLabour VariableManufacturingOverheads TotalProductCosts

$ 600,000 200,000 40,000 840,000

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Illustration2 MarginalCosting
PeriodCostunderMarginalCosting
FixedManufacturingOverheads VariableSellingOverheads FixedSellingandAdministrativeOverheads TotalPeriodCostchargedtoIncomeStatement

$ 300,000 187,500 250,000 737,500

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Illustration2 MarginalCosting
OperatingStatementunderMarginalCosting fortheyearended31December2009
Sales(10,000unitsat$200each) Less:VariableCostofSales ProductContributionMargin Less:VariableSellingOverheads TotalContributionMargin Less: FixedManufacturingOverheads FixedSellingandAdministrativeOverheads NetProfit
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$ 2,000,000 (840,000) 1,160,000 (187,500) 972,500 (300,000) (250,000) 422,500

Illustration2 AbsorptionCosting
ProductCostunderAbsorptionCosting
DirectMaterials DirectLabour VariableManufacturingOverheads FixedManufacturingOverheads TotalProductCosts

$ 600,000 200,000 40,000 300,000 1,140,000

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Illustration2 AbsorptionCosting
PeriodCostunderAbsorptionCosting
VariableSellingOverheads FixedSellingandAdministrativeOverheads TotalPeriodCostchargedtoIncomeStatement

$ 187,500 250,000 437,500

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Illustration2 AbsorptionCosting
OperatingStatementunderAbsorption Costing for the yearended 31 December Sales (10,000 unitsat $200 each) 2009
Less:CostofSales GrossProfit Less: VariableSellingOverheads FixedSellingandAdministrativeOverheads NetProfit

$ 2,000,000 (1,140,000) 860,000 (187,500) (250,000) 422,500

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Illustration2 MarginalCostingandAbsorptionCosting:Implications

Hence,profitsundermarginalcostingand absorptioncostingwillbethesamewhen thereisnoopeninginventoryand thereisnoclosinginventory.

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ComparisononImpactsofInventoryonNetProfit
Inventory Noopeninginventory andnoclosinginventory (Illustration2above) ImpactonProfit Nodifferencein profitbetween absorptioncosting andmarginalcosting Nodifferencein profitbetween absorptioncosting andmarginalcosting Reason Allthefixedmanufacturing overheadsarecharged againstthecurrentyear profit(eitherasproduct costorperiodcost) Fixedcostelement broughtforwardfromlast periodandabsorbedin openinginventoryisfully compensatedbyfixedcost elementcarriedforwardto nextperiodandabsorbed inclosinginventory

Fixedmanufacturing overheadsinopening andclosinginventories areofsameamount (notnecessarily productionvolume= salesvolume)

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ComparisononImpactsofInventoryonNetProfit
Inventory Fixedmanufacturing overheadinclosing inventoryisgreaterthan thatinopeninginventory (alwaysbutnot necessarily productionvolume>sales volume) Fixedmanufacturing overheadinclosing inventoryissmallerthan thatinopeninginventory (alwaysbutnot necessarily productionvolume<sales volume)
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ImpactonProfit Profitunder absorptioncosting willbehigherthan thatunder marginalcosting

Reason Agreateramountoffixed manufacturingoverheadis includedinclosing inventoryandcarried forwardtonextaccounting period Agreateramountoffixed manufacturingoverheadin openinginventoryis chargedagainstthe currentyearprofit

Profitunder absorptioncosting willbelowerthan thatunder marginalcosting

ImpactsofInventoryonNetProfit Summary

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Illustration3 WhenthereisClosingInventory

Usethedataofillustration2(slide13)exceptthat therewasclosinginventoryof2,000units,i.e. only8,000unitsweresoldduringtheyearandas acorollarythevariablesellingoverheadswould onlybe$150,000($187,500x8,000/10,000).

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Illustration3 MarginalCosting
ProductCostunderMarginalCosting
DirectMaterials DirectLabour VariableManufacturingOverheads TotalProductCosts VariableCostofGoodsSoldfortheYear ($840,000x8,000/10,000) ClosingInventoryc/ftoNextYear ($840,000x2,000/10,000)

$ 600,000 200,000 40,000 840,000

$672,000 $168,000

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Illustration3 MarginalCosting
PeriodCostunderMarginalCosting
FixedManufacturingOverheads VariableSellingOverheads FixedSellingOverheads TotalPeriodCostchargedtoIncomeStatement

$ 300,000 150,000 250,000 700,000

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Illustration3 MarginalCosting
OperatingStatementunderMarginalCosting fortheyearended31December2009
Sales(8,000unitsat$200each) Less:VariableCostofGoodsSold ProductContributionMargin Less:VariableSellingOverheads TotalContributionMargin Less: FixedManufacturingOverheads FixedSellingandAdministrativeOverheads NetProfit
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$ 1,600,000 (672,000) 928,000 (150,000) 778,000 (300,000) (250,000) 228,000

Illustration3 AbsorptionCosting
ProductCostunderAbsorptionCosting
DirectMaterials DirectLabour VariableManufacturingOverheads FixedManufacturingOverheads TotalProductCosts CostofGoodsSoldfortheYear ($1,140,000x8,000/10,000) ClosingInventoryc/ftoNextYear ($1,140,000x2,000/10,000)
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$ 600,000 200,000 40,000 300,000 1,140,000

$912,000 $228,000

Illustration3 AbsorptionCosting
PeriodCostunderAbsorptionCosting
VariableSellingOverheads FixedSellingandAdministrativeOverheads TotalPeriodCostchargedtoIncomeStatement

$ 150,000 250,000 400,000

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Illustration3 AbsorptionCosting
OperatingStatementunderAbsorption Costing for the year ended 31December 2009 Sales (8,000 units at$200 each)
Less:CostofGoodsSold GrossProfit Less: VariableSellingOverheads FixedSellingandAdministrativeOverheads NetProfit

$ 1,600,000 (912,000) 688,000 (150,000) (250,000) 288,000

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Illustration3 Reconciliation:MarginalCostingandAbsorptionCosting
NetProfitunderAbsorptionCosting(slide31) Less:FixedManufacturingOverheadsinClosingInventory ($300,000/10,000x2,000)($30perunit) NetProfitunderMarginalCosting(slide28)

$ 288,00 0 (60,000) 228,00 0

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Illustration4
FixedOverheadinClosingInventoryLessThanOpeningInventory
Continuewithillustration3(withclosinginventoryof2,000unitsas at31December2009).Duringtheyearended31December2010, 9,000unitswereproducedandthecostsofmanufacturingwere:

Costs
DirectMaterials DirectLabour VariableManufacturingOverheads VariableSellingOverheads FixedManufacturingOverheads FixedSellingandAdministrativeOverheads 10,000unitsweresoldat$210each.
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$70perunit $25perunit $5perunit $16perunit $261,000 $280,000

Illustration4 MarginalCosting
OperatingStatementunderMarginalCosting fortheyearended31December2010
Sales($210x10,000) Less: CostofGoodsSold: OpeningInventory($84x2,000)(slide26) VariableCostofGoodsCompleted($100x9,000) Less:ClosingInventory(assumingFIFO,$100x1,000) ProductContributionMargin Less:VariableSellingOverheads($16x10,000) TotalContributionMargin Less: FixedManufacturingOverheads FixedSellingandAdministrativeOverheads NetProfit
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$
2,100,000

168,000 900,000 (100,000) (968,000) 1,132,000 (160,000) 972,000 (261,000) (280,000) 431,000

Illustration4 AbsorptionCosting
OperatingStatementunderAbsorptionCosting fortheyearended31December2010
Sales($210x10,000) Less: CostofGoodsSold: OpeningInventory($114x2,000)(slide29) CostofGoodsCompleted($100x9,000+$261,000) Less:ClosingInventory[assumingFIFO, [($100+$261,000/9,000)x1,000] GrossProfit Less: VariableSellingOverheads($16x10,000) FixedSellingandAdministrativeOverheads NetProfit 228,000 1,161,000 (129,000) (1,260,000) 840,000 (160,000) (280,000) 400,000

$
2,100,000

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Illustration4 Reconciliation:MarginalCostingandAbsorptionCosting
$
NetProfitunderAbsorptionCosting Add:FixedManufacturingOverheadsinOpeningInventory ($300,000/10,000x2,000)($30perunit) Less:FixedManufacturingOverheadsinClosingInventory ($261,000/9,000x1,000)($29perunit) NetProfitunderMarginalCosting 400,000 60,000 (29,000) 431,000

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Illustration5
ProductionVolume=SalesVolumebutFixedOverheadsAbsorbedin OpeningInventoryandClosingInventoryDifferent

Usethedataofillustration4(slide33)except thatonly9,000unitsweresoldduringtheyear, i.e.productionvolumewasequaltothesales volumeandasaresulttherewasclosing inventoryof2,000units.

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Illustration5 MarginalCosting
OperatingStatementunderMarginalCosting fortheyearended31December2010
Sales($210x9,000) Less: CostofGoodsSold: OpeningInventory($84x2,000)(slide26) VariableCostofGoodsCompleted($100x9,000) Less:ClosingInventory(assumingFIFO,$100x2,000) ProductContributionMargin Less:VariableSellingOverheads($16x9,000) TotalContributionMargin Less: FixedManufacturingOverheads FixedSellingandAdministrativeOverheads NetProfit
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$
1,890,000

168,000 900,000 (200,000) (868,000) 1,022,000 (144,000) 878,000 (261,000) (280,000) 337,000

Illustration5 AbsorptionCosting
OperatingStatementunderAbsorptionCosting fortheyearended31December2010
Sales($210x9,000) Less: CostofGoodsSold: OpeningInventory($114x2,000)(slide29) CostofGoodsCompleted($100x9,000+$261,000) Less:ClosingInventory[assumingFIFO, [($100+$261,000/9,000)x2,000] GrossProfit Less: VariableSellingOverheads($16x9,000) FixedSellingandAdministrativeOverheads NetProfit 228,000 1,161,000 (258,000) (1,131,000) 759,000 (144,000) (280,000) 335,000

$
1,890,000

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Illustration5 DifferenceinProfit

Hence,evenifproductionvolumeisequalto thesalesvolume,itdoesnotnecessarilymean thattheprofitsundermarginalcostingand absorptioncostingarethesame. Italldependsonhowmuchfixed manufacturingoverheadisabsorbedina singleunitofopeninginventoryandclosing inventoryrespectively.

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Illustration5 Reconciliation:MarginalCostingandAbsorptionCosting
$
NetProfitunderAbsorptionCosting(slide39) Add:FixedManufacturingOverheadsinOpeningInventory ($300,000/10,000x2,000)($30perunit) Less:FixedManufacturingOverheadsinClosingInventory ($261,000/9,000x2,000)($29perunit) NetProfitunderMarginalCosting(slide38) 335,000 60,000 (58,000) 337,000

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Format Reconciliation:MarginalCostingandAbsorptionCosting
$
NetProfitunderAbsorptionCosting Add:FixedManufacturingOverheadinOpeningInventory Less:FixedManufacturingOverheadinClosingInventory NetProfitunderMarginalCosting X X (X) X

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Whyaretheretwosystems? Absorption Costing Marginal Costing

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Uses Externalreporting (HKAS2Inventories) Planningand decisionmaking

TwoApproachestoAbsorptionCosting
ActualAbsorptionCosting Absorbedonactualbasis (Asillustrations25butitis impracticalbecause overheadabsorptionhasto bewaiteduntilexpiryofthe accountingperiod) NormalAbsorptionCosting Absorbedonpre determinedoverhead absorption (Thisistheusualpractice andisimpliedunlessstated otherwise)

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IssuesforNormalAbsorptionCosting

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CalculationofFixedManufacturing OverheadAbsorptionRate(OAR)

Normallevelofproductionactivitycanbe: Productionunits Labourhours Machinehours Materialusage

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Overabsorption/Underabsorption ofOverhead

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TreatmentofOverorUnder AbsorptionofOverheads

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Illustration6 NormalAbsorptionCosting

Refertoillustration4(slide33).Assumeforthe yearended31December2010,thebudgeted fixedmanufacturingoverheadwas$300,000 andthenormallevelofproductionactivitywas 10,000units.

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Illustration6 OverheadAbsorptionRate

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Illustration6 Overabsorption/UnderabsorptionofOverheads

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Illustration6 NormalAbsorptionCosting
OperatingStatementunderNormalAbsorption Costingfortheyearended31December2010
Sales($210x100,000) Less: CostofGoodsSold: OpeningInventory($114x2,000) CostofGoodsCompleted[($100+$30)x9,000) Less:ClosingInventory[assumingFIFO, ($100+$30)x1,000] Less:FixedManufacturingOverheadsOverabsorbed GrossProfit Less: VariableSellingOverheads FixedSellingandAdministrativeOverheads NetProfit
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$
2,100,000

228,000 1,170,000 (130,000) 1,268,000 (9,000) (1,259,000) 841,000 (160,000) (280,000) 401,000

Illustration6 ActualAbsorptionCostingandNormalAbsorptionCosting

NetProfitunderNormalAbsorption Costingisgreaterthanthatunder ActualAbsorptionCosting

because

Portionofoverabsorbedoverheadis includedintheclosinginventoryand carriedtonextperiod

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Illustration6 Reconciliation:ActualAbsorptionCostingand NormalAbsorptionCosting

$
NetProfitunderNormalAbsorptionCosting(slide52) Less:OverabsorbedFixedManufacturingOverheadsin ClosingInventory($9,000/9,000x1,000) NetProfitunderActualAbsorptionCosting(slide35) 401,000 (1,000) 400,000

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Illustration6 Reconciliation:NormalAbsorptionCostingand MarginalCosting

$
NetProfitunderNormalAbsorptionCosting(slide52) Add:FixedManufacturingOverheadsinOpeningInventory ($300,000/10,000x2,000) Less:FixedManufacturingOverheadsinClosingInventory ($300,000/10,000x1,000) NetProfitunderMarginalCosting(slide34) 401,000 60,000 (30,000) 431,000

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Summary Similarities
MarginalCosting AbsorptionCosting Variablemanufacturingcostsaretreatedas productcosts. Nonmanufacturingcosts(whethervariableor fixed)aretreatedasperiodcosts.

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Summary Differences
MarginalCosting Fixedmanufacturingcostsaretreatedas periodcosts. AbsorptionCosting Fixedmanufacturingcostsaretreatedas productcosts. Noproblemofoverabsorptionorunder Actualabsorptioncosting:Noproblemofover absorptionoffixedmanufacturingoverheads. absorptionorunderabsorptionoffixed manufacturingoverheads. Normalabsorptioncosting:Thereisproblemof overabsorptionorunderabsorptionoffixed manufacturingoverheads. Operatingstatementshowscontribution margin(salesrevenuelessvariablecosts). Netprofitistheexcessofcontribution marginoverfixedcosts. Distinctionbetweenvariablecostsandfixed costsisrelativelyimportant. Particularlyusefulforshorttermdecision making. Operatingstatementshowsgrossprofit(sales revenuelesscostofgoodssold). Netprofitistheexcessofgrossprofitovernon manufacturingcosts. Distinctionbetweenmanufacturingcostsand nonmanufacturingcostsisrelativelyimportant. Requiredforexternalreporting.

OperatingStatementFormat MarginalCosting
$ Salesrevenue Less: Variablecostofgoodssold Openinginventory Variablecostofgoodscompleted Less:Closinginventory Productcontributionmargin Less: Variablenonmanufacturingoverheads Totalcontributionmargin Less:Fixedcosts Netprofit X X (X) (X) X (X) X (X) (X) $ X

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OperatingStatementFormat AbsorptionCosting
$ Salesrevenue Less: Costofgoodssold Openinginventory Manufacturingcostofgoodscompleted Less:Closinginventory Add/Less:Overheadsunderabsorbed/(overabsorbed) GrossProfit Less:Nonmanufacturingcosts Netprofit X X (X) X X X X (X) (X) $ X

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Activity IntegratedIllustrativeQuestion

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Question(1)
Amanufacturingcompanyproducesandsellsa singleproduct.Thefollowingbudgeteddatahad beenpreparedforaoneyearperiod:
LevelofActivity 100% $000 Salesrevenue Totalmanufacturingcosts Totalsellingandadministrativecosts (Variablepartvarieswithsalesvolume)
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60% $000 8,640 7,320 2,520

14,400 10,200 3,000

Question(2)
Incompilingtheabovebudgeteddata,ithad beenassumedthatsalesvolumewasequalto theproductionvolume.Inaddition,thenormal levelofactivity was100%atwhichitwas estimatedthat60,000unitscouldbeproduced intheperiod.

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Question(3)
Theactualresultsfortheperiodareexhibitedas follows: 1.66,000unitswereproducedand62,000units weresold. 2.Unitsellingprice,unitvariablecostsandfixed overheadsarethesameasbudgeted. 3.Therewasnoopeninginventory.

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Question(4)
Required a) Calculatethemanufacturingoverheadabsorptionrate. b) Calculatetheamountoffixedmanufacturingoverhead absorbedintheproducts. c) Calculatetheamountoffixedmanufacturingoverheadover absorbedorunderabsorbed. d) Preparetheoperatingstatementunderabsorptioncosting. e) Preparetheoperatingstatementundermarginalcosting. f) Reconciletheprofitsunderabsorptioncostingandmarginal costing.
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Answers
a) Manufacturingoverheadabsorptionrate=$50perunit b) Fixedmanufacturingoverheadabsorbed=$3,300,000 c) Fixedmanufacturingoverheadoverabsorbedorunder absorbed=$300,000 d) Profitunderabsorptioncosting=$1,600,000 e) Profitundermarginalcosting=$1,400,000 f) Differenceinprofitsisduetofixedmanufacturingoverhead absorbedinclosinginventoryamountingto$200,000

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AdvantagesofAbsorptionCosting
Itisconsistentwiththematchingconceptin whichmanufacturingcostsofsalesare matchedwiththesalesrevenue.Thisiswhy financialreportingstandardrequires absorptioncosting. Itfacilitatescostpluspricingstrategy.Inthe longrunforsurvivalandprofitability,prices mustcoverfixedcosts.
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DisadvantagesofAbsorptionCosting
Absorptionofmanufacturingfixedoverheads toproductunitsbymeansofoverhead absorptionratecansometimesbearbitrary. Reportedprofitscanbemanipulatedby adjustinginventorylevelintheshortrun.For example,reportedprofitcanbeboostedby inventorypilingattheyearend.

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AdvantagesofMarginalCosting
Itfacilitatesvariousshorttermdecisions making,e.g.breakevenanalysis. Itisrelativelysimpleinthesensethatitavoids overheadapportionmentandabsorption problems.

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DisadvantagesofMarginalCosting
Segregationofmanufacturingoverheadsinto fixedandvariableelementscansometimesbe difficultandimpracticable. Itgivesthewrongimpressionthatfixed manufacturingoverheadshaveno relationshipwiththemanufacturingbecause itisexcludedfromproductcosts.

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FurtherReadings
Burgstahler,D.,Horngren,C.,Schatzberg,J.,Stratton,W.,&Sundem, G.(2008).IntroductiontoManagementAccounting,14thed. UpperSaddleRiver:PrenticeHall.Chapters4&13. Drury,C.(2008).ManagementandCostAccounting,7thed.London: SouthWesternCengage Learning.Chapters7&10. Horngren,C.T.,Datar,S.M.,Foster,G.,Raian,M.&Ittner,C.(2009). CostAccounting:AManagerialEmphasis,13thed.UpperSaddle River:PrenticeHall.Chapters5&9. Lucey,T.(2009).Costing,7thed.London:SouthWesternCengage Learning.Chapter19.
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