Business, Accounting and Financial Studies | Marginal and Absorption Costing

BAFS Study Notes: Marginal and Absorption Costing

Hey everyone! Welcome to your study guide for one of the most important topics in cost accounting: Marginal and Absorption Costing. Don't worry if the names sound a bit intimidating. Think of them as two different 'recipes' for calculating profit. By the end of these notes, you'll understand both recipes, know when to use them, and be able to prepare professional-looking income statements for any business.

Why is this important? How a company calculates its costs can change the profit it reports and affect major decisions, like setting prices or deciding whether to keep making a product. Understanding these two methods is a key skill for any future business leader or accountant!

Part 1: The Building Blocks - A Quick Cost Refresher

Before we dive into the two costing methods, let's quickly review the basic types of costs. Getting this straight makes everything else MUCH easier!

Variable Costs vs. Fixed Costs

• Variable Costs: These costs change in total as your activity level changes. Think of them as 'per-unit' costs.
  Analogy: Imagine you're selling bubble tea. The more cups you sell, the more you spend on tea, milk, pearls, and cups. These are your variable costs. The cost per cup stays the same, but the total cost goes up with every sale.

• Fixed Costs: These costs stay the same in total, no matter how many units you produce or sell (within a certain range).
  Analogy: The rent for your bubble tea shop is $10,000 a month. It doesn't matter if you sell one cup or a thousand cups – you still have to pay $10,000. That's a fixed cost.

Product Costs vs. Period Costs

• Product Costs: These are the costs directly related to making a product. They 'attach' to the inventory and are only expensed (as Cost of Goods Sold) when the product is sold. They include:
  - Direct Materials
  - Direct Labour
  - Manufacturing Overheads (e.g., factory rent, factory electricity)

• Period Costs: These are costs that are not related to production. They are expensed in the period they happen. They are usually non-manufacturing costs, like:
  - Selling expenses (e.g., advertising)
  - Administrative expenses (e.g., office staff salaries)

Quick Review Box

The BIG question that separates Marginal and Absorption costing is this:
Are FIXED manufacturing overheads (like factory rent) a PRODUCT cost or a PERIOD cost?
Their different answers to this one question create two completely different ways of calculating profit!

Part 2: Absorption Costing (The 'Full Cost' Method)

Absorption Costing is the traditional method. Its main idea is that products should 'absorb' ALL manufacturing costs, both variable and fixed.

The Core Idea

Under absorption costing, fixed manufacturing overheads are treated as a product cost. This means a little piece of the factory rent, the supervisor's salary, and factory insurance is included in the cost of every single unit produced.

Analogy: Think of baking a big cake. You wouldn't just say the cost is the flour and sugar (variable costs). You'd also include a small fraction of the cost of the oven you used and the electricity it consumed (fixed costs) in the total cost of the cake.

Calculating the Product Cost

The formula for the cost of one unit is:

$$Product \ Cost_{AC} = Direct \ Materials + Direct \ Labour + Variable \ MOH + Fixed \ MOH$$

Hold on! How do we know how much fixed cost to assign to each unit? We use a Predetermined Fixed Overhead Absorption Rate (FOAR).

$$FOAR = \frac{Budgeted \ Fixed \ Manufacturing \ Overheads}{Budgeted \ Production \ Units}$$

We use 'budgeted' (estimated) figures because we need to calculate the cost per unit during the year, before we know the actual final costs.

Dealing with Over or Under-Absorption

Because we use an estimated rate (FOAR), the amount of overhead we 'absorb' into our products might be different from what we actually paid.

• Under-absorption: Actual overheads > Absorbed overheads. (We didn't charge enough cost to our products).
• Over-absorption: Actual overheads < Absorbed overheads. (We charged too much cost to our products).

HKDSE Syllabus Rule: Any over or under-absorbed overhead is adjusted in the Cost of Goods Sold (COGS) in the income statement.
- You ADD under-absorbed overheads to COGS.
- You SUBTRACT over-absorbed overheads from COGS.

Income Statement Format: Absorption Costing

This format focuses on calculating Gross Profit first.

Sales
Less: Cost of Goods Sold:
    Opening Inventory
    Add: Cost of Goods Manufactured
    Less: Closing Inventory
    Add/Less: Under/Over-absorbed Overheads
= Gross Profit
Less: Period Costs (All Selling & Admin Expenses)
    Variable S&A Expenses
    Fixed S&A Expenses
= Net Profit

Key Takeaway for Absorption Costing

Remember A for All. Absorption costing includes ALL manufacturing costs (variable and fixed) in the product cost. Fixed manufacturing overheads are PRODUCT costs.

Part 3: Marginal Costing (The 'Variable Cost' Method)

Marginal Costing is often used for internal decision-making. Its main idea is that the cost of a product should only include its variable costs.

The Core Idea

Under marginal costing, fixed manufacturing overheads are treated as a period cost. This means they are expensed completely in the period they are incurred, just like rent for the head office. They are NOT included in the cost of inventory.

Analogy: Back to the bubble tea shop. The 'marginal cost' of one more cup of tea is just the cost of the ingredients (tea, milk, pearls). The shop's rent is a separate monthly expense; you don't try to attach a piece of it to every cup sold.

Calculating the Product Cost

The formula for the cost of one unit is much simpler:

$$Product \ Cost_{MC} = Direct \ Materials + Direct \ Labour + Variable \ MOH$$

Income Statement Format: Marginal Costing

This format is very different. It focuses on calculating Contribution.

Sales
Less: Variable Costs:
    Variable Cost of Goods Sold
    Variable Selling & Admin Expenses
= Contribution
Less: Fixed Costs (All of them!)
    Fixed Manufacturing Overheads
    Fixed Selling & Admin Expenses
= Net Profit

What is Contribution? It's a very important concept! Contribution (Sales - All Variable Costs) is the amount of money generated from sales that is available to 'contribute' towards paying for all the fixed costs. Once fixed costs are covered, any extra contribution becomes profit!

Key Takeaway for Marginal Costing

Remember M for Move it. Marginal costing moves the fixed manufacturing overheads out of the product cost and treats them as a PERIOD cost.

Part 4: The Showdown - Comparing the Two Methods

So... Why is the Profit Different?

The net profit under the two methods can be different. The reason is all about inventory.

• Under absorption costing, when you produce more than you sell, some of the period's fixed manufacturing overheads get "stored" in the closing inventory on the balance sheet. They don't appear on the income statement yet.
• Under marginal costing, ALL fixed manufacturing overheads for the period go directly to the income statement, no matter how much is produced or sold.

This leads to a simple rule:

• If Production > Sales (inventory levels increase) → Absorption Profit > Marginal Profit.
• If Production < Sales (inventory levels decrease) → Absorption Profit < Marginal Profit.
• If Production = Sales (inventory levels are constant) → Absorption Profit = Marginal Profit.

Important Note: The HKDSE syllabus does NOT require you to do a mathematical "reconciliation" of the two profits. You just need to understand WHY they are different!

Advantages vs. Disadvantages

Absorption Costing

Advantages:

• It follows the 'matching principle' and is required for external financial reporting (like annual reports).
• It ensures all production costs are included when setting long-term selling prices.

Disadvantages:

• It can be misleading for short-term decision making.
• Net profit can be manipulated by simply producing more units, even if they aren't sold.

Marginal Costing

Advantages:

• Excellent for internal, short-term decision making (e.g., accepting a special order, cost-volume-profit analysis).
• Profit is not affected by changes in production levels; it's driven by sales. This gives a clearer picture of performance.

Disadvantages:

• It is NOT allowed for external financial reporting.
• If used for long-term pricing, it might lead to setting prices too low because it ignores fixed costs.

Part 5: Worked Example - Let's See It in Action!

Don't worry, we'll take this step-by-step. Let's use the weighted average cost method for inventory, as required by the syllabus.

The Data

Company ABC provides the following data for the year:

• Selling Price per unit: $50
• Units Produced: 10,000 units
• Units Sold: 8,000 units
• Opening Inventory: 0 units
• Costs per unit:
  • Direct Materials: $10
  • Direct Labour: $8
  • Variable Manufacturing Overhead: $2
• Total Costs for the year:
  • Fixed Manufacturing Overhead: $60,000
  • Variable Selling & Admin Expense: $3 per unit sold
  • Fixed Selling & Admin Expense: $40,000
• Budgeted production was also 10,000 units.

Step 1: Calculations for Absorption Costing

Fixed Overhead Absorption Rate (FOAR):

$$FOAR = \frac{\$60,000}{10,000 \ units} = \$6 \ per \ unit$$

Product Cost per unit (AC):

$$Product \ Cost_{AC} = \$10 (DM) + \$8 (DL) + \$2 (Var \ MOH) + \$6 (Fixed \ MOH) = \mathbf{\$26}$$

Check for Over/Under Absorption:

• Absorbed Overhead = $6 per unit × 10,000 units produced = $60,000
• Actual Overhead = $60,000
• Difference = $0. (There is no over or under-absorption in this case because actual production matched the budget).

Step 2: Income Statement (Absorption Costing)

Sales (8,000 units × $50) ........................................ $400,000
Less: Cost of Goods Sold
    Opening Inventory ...................... $0
    Cost of Goods Manufactured
    (10,000 units × $26) ........ $260,000
    Less: Closing Inventory
    (2,000 units × $26) ......... ($52,000) ............ ($208,000)
Gross Profit ............................................................ $192,000
Less: Selling & Admin Expenses
    Variable (8,000 units × $3) ......... $24,000
    Fixed .......................................... $40,000 ............... ($64,000)
Net Profit ............................................................... $128,000

Step 3: Calculations for Marginal Costing

Product Cost per unit (MC):

$$Product \ Cost_{MC} = \$10 (DM) + \$8 (DL) + \$2 (Var \ MOH) = \mathbf{\$20}$$

Step 4: Income Statement (Marginal Costing)

Sales (8,000 units × $50) ........................................ $400,000
Less: Variable Costs
    Variable COGS:
        Opening Inv .................... $0
        Var. Cost of Goods Manuf.
        (10,000 units × $20) .... $200,000
        Less: Closing Inv
        (2,000 units × $20) ..... ($40,000) ........ $160,000
    Variable S&A (8,000 × $3) ............................ $24,000 ........ ($184,000)
Contribution ......................................................... $216,000
Less: Fixed Costs
    Fixed Manufacturing Overheads .................... $60,000
    Fixed Selling & Admin Expenses .................. $40,000 ........ ($100,000)
Net Profit ............................................................... $116,000

Why the difference?

The Absorption Costing profit ($128,000) is higher than the Marginal Costing profit ($116,000). This is because production (10,000 units) was greater than sales (8,000 units).
The 2,000 units in closing inventory under absorption costing hold onto their share of fixed overheads (2,000 units × $6 = $12,000), keeping those costs off the income statement for now. This $12,000 difference is exactly the difference between the two profits!

Final Summary

You've made it! It might seem like a lot, but it all boils down to one simple difference.

The Ultimate Cheat Sheet

When you see a question, ask yourself: "Where does the Fixed Manufacturing Overhead go?"

• Absorption Costing: It's a PRODUCT COST. It gets absorbed into inventory.
• Marginal Costing: It's a PERIOD COST. It gets expensed immediately.

That's it! That's the core concept. Practice preparing the two different income statement formats, and you'll be an expert in no time. Keep up the great work!