Chapter 6: Marginal Costing and Absorption Costing
Marginal costing and absorption costing are two fundamentally different approaches to product costing. They differ in how fixed manufacturing overheads are treated, leading to different profit figures when inventory levels change. Understanding both methods and their implications is crucial for financial reporting and managerial decision-making.
6.1 Marginal Costing
Definition: Marginal costing (also called variable costing or direct costing) treats only variable costs as product costs. All fixed costs are treated as period costs and charged entirely to the income statement in the period incurred.
Product Cost = Direct Material + Direct Labor + Variable Overheads
6.2 Absorption Costing
Definition: Absorption costing (also called full costing) treats both variable and fixed manufacturing costs as product costs. Fixed overheads are absorbed into product cost using a predetermined rate.
Product Cost = Direct Material + Direct Labor + Variable Overheads + Fixed Manufacturing Overheads
6.3 Comparison
| Basis | Marginal Costing | Absorption Costing |
|---|---|---|
| Fixed OH Treatment | Period cost (P&L entirely) | Product cost (part goes to inventory) |
| Inventory Valuation | Variable cost only (lower value) | Full cost (higher value) |
| Income Statement | Contribution format | Traditional format |
| Profit when Production > Sales | Lower profit | Higher profit (fixed OH in closing stock) |
| Profit when Production < Sales | Higher profit | Lower profit (fixed OH released from opening stock) |
| Profit when Production = Sales | Same profit | Same profit |
| Decision Making | Better (focuses on relevant costs) | Less suitable for short-term decisions |
| External Reporting | Not allowed (NAS/NFRS) | Required for financial statements |
Profit Reconciliation Formula
Absorption Profit = Marginal Profit + (Closing Stock - Opening Stock) × Fixed OH per unit
6.4 Worked Example
Data: Production = 1,000 units, Sales = 800 units, SP = NPR 500/unit, Variable cost = NPR 200/unit, Fixed manufacturing OH = NPR 1,50,000, Fixed selling & admin = NPR 50,000
Absorption Costing Income Statement:
| Sales (800 × 500) | 4,00,000 |
| Less: COGS (800 × (200+150)) = 800 × 350 | (2,80,000) |
| Gross Profit | 1,20,000 |
| Less: Selling & Admin | (50,000) |
| Net Profit (Absorption) | 70,000 |
Marginal Costing Income Statement:
| Sales (800 × 500) | 4,00,000 |
| Less: Variable costs (800 × 200) | (1,60,000) |
| Contribution | 2,40,000 |
| Less: Fixed manufacturing OH | (1,50,000) |
| Less: Fixed selling & admin | (50,000) |
| Net Profit (Marginal) | 40,000 |
Reconciliation: Difference = 70,000 - 40,000 = 30,000 = Closing stock (200 units) × Fixed OH/unit (150) = 200 × 150 = 30,000 ✓
6.5 Decision-Making Applications of Marginal Costing
| Decision | Rule | Example |
|---|---|---|
| Accept/Reject Special Order | Accept if price > variable cost (spare capacity) | Export order at NPR 250 when VC=200 → accept (NPR 50 contribution) |
| Make or Buy | Make if variable cost < buy price (+ consider qualitative factors) | Make cost NPR 180 vs buy at NPR 220 → make in-house |
| Continue or Shutdown | Continue if contribution > 0 (covers some fixed costs) | Department with loss but positive contribution should continue |
| Product Mix (Limiting Factor) | Rank by CM per unit of limiting factor | If machine hours limited, produce product with highest CM/machine hour |
6.6 Three-Period Comparison — Impact of Inventory Changes
Data: SP = NPR 100, VC = NPR 55, Fixed Mfg OH = NPR 90,000, Fixed Admin = NPR 30,000. Capacity = 3,000 units.
| Period 1 | Period 2 | Period 3 | |
|---|---|---|---|
| Production | 3,000 | 3,000 | 3,000 |
| Sales | 2,500 | 3,000 | 3,500 |
| Opening Stock | 0 | 500 | 500 |
| Closing Stock | 500 | 500 | 0 |
| Stock Change | +500 (build up) | 0 (same) | -500 (rundown) |
Fixed OH per unit (absorption) = 90,000/3,000 = NPR 30/unit
Absorption Costing Profit:
| Period 1 | Period 2 | Period 3 | |
|---|---|---|---|
| Sales | 2,50,000 | 3,00,000 | 3,50,000 |
| COGS (units sold × 85) | (2,12,500) | (2,55,000) | (2,97,500) |
| Gross Profit | 37,500 | 45,000 | 52,500 |
| Admin OH | (30,000) | (30,000) | (30,000) |
| Net Profit (Absorption) | 7,500 | 15,000 | 22,500 |
Marginal Costing Profit:
| Period 1 | Period 2 | Period 3 | |
|---|---|---|---|
| Sales | 2,50,000 | 3,00,000 | 3,50,000 |
| Variable costs (sold × 55) | (1,37,500) | (1,65,000) | (1,92,500) |
| Contribution | 1,12,500 | 1,35,000 | 1,57,500 |
| Fixed Mfg OH | (90,000) | (90,000) | (90,000) |
| Fixed Admin OH | (30,000) | (30,000) | (30,000) |
| Net Profit (Marginal) | -7,500 | 15,000 | 37,500 |
Reconciliation:
| Period 1 | Period 2 | Period 3 | |
|---|---|---|---|
| Absorption Profit | 7,500 | 15,000 | 22,500 |
| Marginal Profit | -7,500 | 15,000 | 37,500 |
| Difference | 15,000 | 0 | -15,000 |
| Stock change × FOH/unit | 500×30=15,000 | 0×30=0 | -500×30=-15,000 |
| Match? | ✓ | ✓ | ✓ |
Critical Observations:
1. Period 1 (stock build-up): Absorption shows PROFIT (7,500), Marginal shows LOSS (-7,500). Absorption "hides" fixed costs in inventory.
2. Period 2 (stable stock): Both profits identical (15,000). When stock doesn't change, methods agree.
3. Period 3 (stock rundown): Marginal profit (37,500) > Absorption (22,500). Stock reduction releases previously hidden fixed costs in absorption.
4. Over 3 periods combined: Absorption total = 45,000, Marginal total = 45,000. Over the long run, total profits are identical.
6.7 Limiting Factor Analysis — Detailed Example
Scenario: A factory has 8,000 machine hours available. Three products:
| Product | SP | VC | CM | Machine hrs/unit | CM per machine hr | Rank | Max Demand |
|---|---|---|---|---|---|---|---|
| X | 500 | 300 | 200 | 4 | 50 | 2nd | 1,000 |
| Y | 400 | 280 | 120 | 2 | 60 | 1st | 1,500 |
| Z | 600 | 420 | 180 | 5 | 36 | 3rd | 800 |
Optimal Production Plan:
1st: Produce Y to max demand: 1,500 × 2 = 3,000 hrs used
2nd: Produce X to max demand: 1,000 × 4 = 4,000 hrs used. Total = 7,000 hrs.
3rd: Remaining hours for Z: (8,000-7,000)/5 = 200 units of Z
Maximum Contribution:
Y: 1,500 × 120 = 1,80,000
X: 1,000 × 200 = 2,00,000
Z: 200 × 180 = 36,000
Total = NPR 4,16,000
Note: Product Z has the highest total CM (180) but lowest CM per machine hour (36). If we produced Z first (wrong approach), we'd only generate: 800×180 + remaining hrs products = less than 4,16,000. Always rank by CM per unit of scarce resource, not total CM.
6.8 Shutdown Decision — Comprehensive Example
A company has three departments:
| Dept A | Dept B | Dept C | Total | |
|---|---|---|---|---|
| Sales | 5,00,000 | 3,00,000 | 2,00,000 | 10,00,000 |
| Variable Costs | (3,00,000) | (2,00,000) | (1,60,000) | (6,60,000) |
| Contribution | 2,00,000 | 1,00,000 | 40,000 | 3,40,000 |
| Avoidable Fixed | (80,000) | (60,000) | (50,000) | (1,90,000) |
| Allocated Fixed | (60,000) | (40,000) | (30,000) | (1,30,000) |
| Net Profit/(Loss) | 60,000 | 0 | (40,000) | 20,000 |
Should Dept C be shut down?
Contribution (40,000) < Avoidable Fixed (50,000) → Yes, shut down Dept C
Savings = Avoidable Fixed 50,000 - Lost Contribution 40,000 = NPR 10,000 improvement
New total profit = 20,000 + 10,000 = 30,000
Note: Allocated fixed costs of 30,000 continue even after shutdown — they must be redistributed to A and B.
Practice Questions
Short Answer:
1. Distinguish marginal costing from absorption costing.
2. Why do profits differ under the two methods?
3. State the profit reconciliation formula.
4. Why is marginal costing preferred for decision-making?
5. What is a limiting factor? How does it affect product mix decisions?
Long Answer:
6. Production 5,000 units, Sales 4,000, SP=NPR 100, VC=NPR 55, Fixed manufacturing=NPR 90,000, Fixed admin=NPR 30,000. Prepare income statements under both methods. Reconcile profits. (15 marks)
7. A company receives a special export order for 500 units at NPR 180 when normal SP=NPR 250 and VC=NPR 160. Fixed costs won't change. Should the order be accepted? Show analysis. (15 marks)
8. Compare marginal and absorption costing. Which method should be used for: (a) external reporting, (b) internal decisions, (c) performance evaluation? (15 marks)
9. A company produces three products. Machine hours are limited to 10,000. Product A: CM=NPR 40, machine hrs=2. Product B: CM=NPR 60, machine hrs=4. Product C: CM=NPR 30, machine hrs=1. Determine optimal product mix. (15 marks)
10. Discuss applications of marginal costing in make-or-buy, shutdown, and pricing decisions with examples. (15 marks)
Exam Tips: ✓ Both income statements almost always asked — know both formats ✓ Reconciliation is key — always verify the difference ✓ Marginal costing decisions: focus on contribution ✓ Limiting factor: rank by CM per unit of scarce resource ✓ Remember: absorption required for external reports, marginal for decisions