Introduction: Unlocking the Secrets of Product Costing
Hello future accountants! This chapter, Margosing and Absorption Costing, is incredibly important because it changes how a business reports its profits. It's the difference between seeing one profit figure and seeing a completely different one, depending on the method you choose!
We are moving away from simply tracking transactions and into Management Accounting, where the goal is to provide useful information for decision-making. Don't worry if this seems tricky at first—we will break down these two different approaches step-by-step. Let’s get started!
Section 1: Revisiting Cost Classification (The Foundation)
Before we tackle the two main methods, we must be absolutely certain about how costs behave. This is the foundation everything else rests on!
1.1 Variable Costs vs. Fixed Costs
These definitions are the single most important prerequisite for this chapter.
- Variable Costs (VC): These costs change in total directly with the level of activity (production or sales volume). The variable cost per unit stays the same.
Example: The cost of raw materials for one t-shirt. If you make 10 t-shirts, the material cost is 10 times higher than for one t-shirt. - Fixed Costs (FC): These costs remain constant in total regardless of the level of activity within a relevant range. The fixed cost per unit changes as volume changes.
Example: The monthly rent for the factory. Whether you make 1 t-shirt or 1,000, the rent remains the same (for that month).
1.2 Product Costs vs. Period Costs
The core difference between Marginal and Absorption costing is how they treat fixed costs, specifically whether they are considered a Product Cost or a Period Cost.
- Product Costs: These are the costs necessary to manufacture the product. They are attached to the inventory and only become an expense (Cost of Sales) when the goods are sold.
- Period Costs: These are costs that are expensed immediately in the period they are incurred. They are treated as running costs of the business and are not included in inventory valuation.
Quick Review Box: The biggest fight in this chapter is over Fixed Manufacturing Overheads (FOH). Are they a product cost or a period cost?
Section 2: Marginal Costing (The Variable Approach)
Marginal Costing (sometimes called Variable Costing) is a method of costing where only the variable manufacturing costs are included in the cost of the product.
2.1 Defining the Product Cost
Under Marginal Costing, the product cost per unit includes:
Key Concept: Fixed Manufacturing Overheads (FOH) are treated as Period Costs. They are charged in full against the revenue of the period they are incurred. They never sit in inventory.
Analogy: Think of Marginal Costing as a minimalist backpacker. They only pack the absolute essentials (variable costs) into their product. The fixed costs (like rent or admin salaries) are treated as unavoidable monthly bills.
2.2 The Importance of Contribution
The key measure of performance under marginal costing is Contribution.
What is Contribution?
Contribution is the amount of revenue remaining after deducting only the variable costs. This remaining amount 'contributes' towards covering the fixed costs and making a profit.
2.3 The Marginal Costing Income Statement
The structure of the Income Statement changes significantly under this method:
Marginal Costing Income Statement Template
- Sales Revenue
- (Less) Total Variable Costs (Cost of Sales + Variable Selling/Admin)
- = Total Contribution
- (Less) Total Fixed Costs (Manufacturing + Selling/Admin)
- = Net Profit (or Loss)
Remember the Trick: Under marginal costing, the fixed costs are deducted all together at the end of the statement, after calculating contribution.
Section 3: Absorption Costing (The Full Cost Approach)
Absorption Costing (sometimes called Full Costing) is a method of costing where the product absorbs all manufacturing costs—both variable and fixed.
3.1 Defining the Product Cost
Under Absorption Costing, the product cost per unit includes:
Key Concept: Fixed Manufacturing Overheads (FOH) are treated as Product Costs. They are included in the inventory valuation and only become an expense when the units are sold.
Analogy: Absorption Costing is like a suitcase packed for a long trip. Every single cost associated with getting that product ready (even the fixed factory rent) must be absorbed (packed) into the price tag of the unit.
3.2 The Overhead Absorption Rate (OAR)
Since fixed costs are constant in total, we need a way to determine how much fixed cost to assign to each individual unit. We do this using a predetermined Overhead Absorption Rate (OAR).
The OAR is calculated at the beginning of the period based on budgeted figures:
The result is the Fixed Overhead Rate per unit or per hour that is applied to every unit produced.
3.3 The Absorption Costing Income Statement
This statement follows the traditional financial accounting format:
Absorption Costing Income Statement Template
- Sales Revenue
- (Less) Cost of Sales (Opening Inventory + Production Costs - Closing Inventory)
- = Gross Profit
- (Less) Selling and Administrative Expenses (Variable and Fixed)
- (Adjust for Over/Under Absorption - See 3.4)
- = Net Profit (or Loss)
Important Detail: Under absorption costing, the Cost of Sales figure is higher than under marginal costing (if the production volume is high), because it includes the allocated Fixed Overhead per unit.
3.4 Understanding Over and Under Absorption
Because the OAR is based on budgeted figures, the actual fixed overheads incurred in the period rarely match the amount of fixed overheads actually absorbed into the production (the absorbed amount).
- Over-Absorption: Occurs when the fixed overhead absorbed into production is greater than the actual fixed overhead incurred. This boosts profit and must be deducted from Gross Profit. (Credit to the overhead account).
- Under-Absorption: Occurs when the fixed overhead absorbed into production is less than the actual fixed overhead incurred. This reduces profit and must be added to the Cost of Sales or deducted from Gross Profit. (Debit to the overhead account).
If the result is positive, it is Under-Absorption (a cost that must be expensed). If negative, it is Over-Absorption (a gain).
Section 4: Comparing Profits and Inventory Valuation
4.1 Why Profits Differ
The net profit calculated under marginal costing and absorption costing will generally be different if the inventory levels change during the period.
The difference arises because of the different treatment of Fixed Manufacturing Overheads (FOH):
- Marginal Costing: FOH is expensed immediately (Period Cost).
- Absorption Costing: FOH is carried forward in Closing Inventory (Product Cost) and is only expensed when those specific units are sold.
The Golden Rule for Profit Differences:
- Production > Sales: Inventory levels increase. Absorption costing profit > Marginal costing profit. (Under absorption, some FOH is trapped in inventory.)
- Production < Sales: Inventory levels decrease. Marginal costing profit > Absorption costing profit. (Absorption costing is releasing FOH from previous periods’ inventory.)
- Production = Sales: Inventory levels are stable. Absorption costing profit = Marginal costing profit.
Did you know? In statutory financial reporting (for the tax authorities and shareholders), most jurisdictions require the use of Absorption Costing because it complies with the matching principle (matching all production costs to the revenue they generate).
4.2 Reconciling the Profits
You must be able to calculate the exact difference between the two profit figures. This difference is always equal to the change in fixed overheads carried in inventory.
Step-by-Step Reconciliation:
- Find the change in inventory (Closing Units - Opening Units).
- Determine the Fixed Overhead Rate Per Unit (FOHPU).
- Multiply the change in inventory by the FOHPU. This gives you the difference in profits.
- Start with one profit figure and add/subtract the difference to arrive at the other.
Reconciliation Formula Layout:
Marginal Costing Profit
Add: FOH carried forward in Closing Inventory (if inventory increased)
Less: FOH released from Opening Inventory (if inventory decreased)
= Absorption Costing Profit
Section 5: Uses, Advantages, and Disadvantages
Why do companies use two different methods? Because they serve different purposes! Marginal costing is usually better for internal decisions, while absorption costing is better for external reporting.
5.1 Advantages and Uses of Marginal Costing
- Pricing and Decision Making: Focuses on the minimum price needed to cover variable costs, helping managers make short-term decisions (e.g., accepting a one-off order).
- Cost Control: Separating fixed and variable costs makes cost behaviour clearer and easier to control.
- Profit Clarity: Profit directly relates to sales volume. If sales go up, profit goes up (assuming variable costs remain constant), as fixed costs are always expensed. This makes CVP analysis easier.
5.2 Disadvantages of Marginal Costing
- It does not comply with GAAP/IFRS for external reporting because it ignores the matching principle for fixed overheads.
- It suggests that products can be sold just above variable cost, which is dangerous in the long run as fixed costs still need to be covered.
- It ignores the necessity of overhead absorption required for full factory utilisation.
5.3 Advantages and Uses of Absorption Costing
- External Reporting: Required by financial accounting standards (IFRS/GAAP) as it provides a 'fuller' picture of inventory costs.
- Long-Term Pricing: Essential for setting long-term selling prices, as all costs (fixed and variable) must be recovered in the final price.
- Inventory Valuation: Provides a more accurate valuation of inventory on the balance sheet, as it includes all production costs.
5.4 Disadvantages of Absorption Costing
- Profit Manipulation: Managers can artificially boost reported profit by overproducing inventory (since fixed costs get trapped in inventory instead of being expensed).
- Decision Making: Including fixed costs in the unit cost can make managers mistakenly drop a product line that appears unprofitable, even if that product is contributing significantly towards covering fixed overheads.
Key Takeaway: Marginal Costing is the management tool for quick decisions; Absorption Costing is the financial tool for reporting to the outside world.
Conclusion and Final Review
You have successfully navigated one of the most conceptually challenging areas of Management Accounting!
The key to success is remembering the definition of Product Cost for each method:
- Marginal Costing Product Cost: Variable Costs ONLY.
- Absorption Costing Product Cost: Variable Costs PLUS allocated Fixed Manufacturing Overheads.
Keep practising those reconciliation statements and profit calculations. You’ve got this!