Marginal and Absorption Costing
Cost Fundamentals
Marginal and Absorption Costing
Syllabus tag: KASNEB CPA | Intermediate Level | CA25 Management Accounting | Topic 3 Marginal and Absorption Costing
Lesson objectives
By the end of this topic, you will be able to:
- Compute a marginal and an absorption cost per unit
- Prepare a profit statement under each method
- Reconcile the two profit figures
- Compute under- and over-absorption of fixed overhead
- Say which method is required for reporting and which is better for decisions
Why this matters
Two accountants, same company, same month, different profit. Neither has made an error. The whole of this topic is understanding why, and being able to reconcile the two figures to the shilling.
One company throughout
Nyati Ltd, one product. Selling price KES 900. Direct materials 220, direct labour 180, variable production overhead 100, variable selling overhead 40. Fixed production overhead KES 3,600,000 on budgeted output of 30,000 units. Fixed selling costs KES 900,000. It produced 30,000 units and sold 26,000.
Words to know
- Marginal cost — the variable production cost of one more unit.
- Absorption cost — marginal cost plus a share of fixed production overhead.
- Overhead absorption rate (OAR) — budgeted fixed overhead divided by budgeted activity.
- Under-absorption — less overhead absorbed than actually incurred.
- Period cost — charged in full in the period; never held in inventory.
The two unit costs
Marginal production cost = 220 + 180 + 100 = KES 500
OAR = 3,600,000 / 30,000 = KES 120 per unit
Absorption cost = 500 + 120 = KES 620
Note what is excluded. Variable selling overhead of 40 appears in neither unit cost — it is not a production cost, so it never enters inventory under either method.
Profit under marginal costing
| KES | |
|---|---|
| Sales (26,000 × 900) | 23,400,000 |
| Marginal cost of sales (26,000 × 500) | (13,000,000) |
| Variable selling (26,000 × 40) | (1,040,000) |
| Contribution | 9,360,000 |
| Fixed production overhead | (3,600,000) |
| Fixed selling | (900,000) |
| Profit | 4,860,000 |
Fixed production overhead is charged in full, all 3,600,000 of it, whether or not the units were sold.
Profit under absorption costing
| KES | |
|---|---|
| Sales | 23,400,000 |
| Cost of sales (26,000 × 620) | (16,120,000) |
| Gross profit | 7,280,000 |
| Variable selling | (1,040,000) |
| Fixed selling | (900,000) |
| Profit | 5,340,000 |
Only 26,000 units' worth of fixed overhead reaches the income statement. The rest is sitting in inventory.
The reconciliation
| KES | |
|---|---|
| Absorption profit | 5,340,000 |
| Marginal profit | 4,860,000 |
| Difference | 480,000 |
Fixed overhead in closing inventory = 4,000 units × 120 = 480,000
The difference is never a coincidence and never an error. It is always the fixed production overhead carried in the movement in inventory.
The rule that follows:
| Situation | Result |
|---|---|
| Production exceeds sales (inventory rises) | Absorption profit is higher |
| Sales exceed production (inventory falls) | Marginal profit is higher |
| Production equals sales | The two are identical |
:::checkpoint A divisional manager is paid a bonus on absorption profit. Explain how producing 40,000 units instead of 30,000, while still selling 26,000, would affect the reported profit and the bonus — and say what is wrong with that. :::
Under- and over-absorption
The OAR is set on budgeted figures before the year begins. Actual output almost never matches.
Suppose actual output is 28,000 units rather than the budgeted 30,000:
Overhead absorbed = 28,000 × 120 = 3,360,000 Overhead incurred = 3,600,000 Under-absorbed = 240,000
That 240,000 is charged as an extra expense in the income statement. Had output exceeded budget, the over-absorption would be credited instead.
Under-absorption is not a loss of cash. It is the correction of an estimate that was made before the year started.
Which method, and when
Absorption costing is required for external reporting under IAS 2, because inventory must be valued at full production cost.
Marginal costing is better for decisions, for two reasons. It reports contribution, which is what actually changes when volume changes. And it removes the incentive to build inventory in order to flatter profit — an incentive absorption costing creates, as the checkpoint above shows.
Most companies run marginal costing internally and convert to absorption for the published accounts.
:::checkpoint Sales are steady but a company's absorption profit rises sharply this year while its cash balance falls. Give the most likely explanation, and name the figure you would check first. :::