The Institute of Chartered Accountants of Bangladesh

MARGINAL COSTING AND ABSORPTION COSTING

Absorption Costing or Full Costing System:
Absorption costing is a costing system which treats all costs of production as product costs, regardless weather they are
variable or fixed. The cost of a unit of product under absorption costing method consists of direct materials, direct labor and
both variable and fixed overhead. Absorption costing includes all costs of production as product costs; it is frequently referred
to as full costing method.

Variable, Direct or Marginal Costing:

Variable costing is a costing system under which those costs of production that vary with output are treated as product costs.
This would usually include direct materials, direct labor and variable portion of manufacturing overhead. Fixed manufacturing
cost is not treated as a product costs under variable costing. Rather, fixed manufacturing cost is treated as a period cost and,
like selling and administrative expenses, it is charged off in its entirety against revenue each period.

The concepts explained so for are illustrated below

Cost classifications—Absorption versus variable costing
Absorption Costing Variable Costing
Direct materials
Direct Labor Product cost
Product cost
Variable Manufacturing overhead
Fixed manufacturing overhead
Variable selling and administrative expenses Period cost
Period cost
Fixed selling and administrative expenses
The concept of contribution
• Contribution is total sales less all the variable costs (DM + DL + V. OH)
• Contribution can be calculated on a per unit basis or on total basis.
The format of Profit Statement for Marginal Costing
Company AA
Profit Statement for year ended 31 December 200X using marginal costing
Particulars Amount Amount
Sales XXX
Less: Production costs
Opening stock XXX
Add: Variable production costs XXX
(XXX) (XXX)
Less: Closing stock XXX
Contribution margin
Less: Fixed overhead costs XXX
Fixed production costs XXX
Administration and selling costs XXX
Total Fixed overhead costs XXX
Operating profit/(loss)

1 Prepared by: Md. Arshadul Kabir, FCA

The format of Profit Statement for Absorption Costing
Company AA
Profit Statement for the year ended 31 December 200X (Absorption Costing)
Sales XXX
Less: Production costs
Opening stock XXX
Add: Variable production costs XXX
Add: Fixed production costs XXX
Less: Closing stock (XXX) (XXX)
Gross profit XXX
Over/ (Under) absorption XXX/(XXX)
Less: Fixed overhead costs
Administration and selling costs XXX
Total Fixed overhead costs (XXX)
Operating profit/(loss) XXX
Example:
TLF Ltd manufactures a single product, the Claud. The following figures relate to the Claud for a one-year period.
Sales and production (units) 800
Amount
Sales 16,000
Production costs
Variable 6,400
Fixed 1,600
Sales and distribution costs
Variable 3,200
Fixed 2,400
The normal level of activity for the year is 800 units. Fixed costs are incurred evenly throughout the year, and actual fixed costs
are the same as budgeted. A predetermined overhead absorption rate is used for the year.
There were no inventories of Claud at the beginning of the year.
In the first quarter, 220 units were produced and 160 units sold.
Requirements
For the first quarter:
a) Calculate the fixed production costs absorbed by Clauds if absorption costing is used.

Overhead Absorption rate = Budgeted cost/ Budgeted Production unit = Tk. 1,600/800 = Tk. 2 per unit
Overhead absorbed = Actual units produced x OAR = 220 units x Tk. 2 per unit = Tk. 440

b) Calculate inventory values per unit using both absorption costing and marginal costing.

Absorption costing Variable costing

Variable production cost (6,400/800 units) Tk. 8 per unit Tk. 8 per unit
Fixed Production cost (Tk. 1,600/800 units) Tk. 2 per unit -
Inventory value per unit Tk. 10 per unit Tk. 8 per unit

c) Calculate the under/over absorption of overheads.

Actual production cost for a quarter (Tk. 1,600/4) = Tk. 400

Overhead absorbed = Tk. 440
Over absorption of overhead = Tk. 40

d) Calculate the profit using absorption costing.

e) Calculate the profit using marginal costing.

f) Explain why there is a difference between the answers to (d) and (e).

2 Prepared by: Md. Arshadul Kabir, FCA

The difference between Marginal and Absorption Costing

Marginal Costing Absorption Costing

 Only variable costs are charged to the product.  All variable and fixed costs are charged to the
 Stocks of work in progress and finished goods are product.
valued at the marginal costing.  Stocks of work in progress and finished goods
 If stocks increase during a period, it will show less net contain fixed costs.
profit.  If stocks increase during the period, it will show
gain on a profit.

The advantages and disadvantages of Marginal Costing and Absorption Costing

Marginal Costing
Advantages Disadvantages
 It does not applied fixed cost to the  By not applying to the products, it creates a belief that fixed
products costs have nothing to do with production.
 It shows the relationship between cost,  It is difficult to classify costs into variable and fixed costs.
price and volume.  The application of variable overheads is based on
 Simple to understand. estimation only.

Absorption costing
Advantages Disadvantages
• It recognizes the importance of fixed costs. • It is not useful in planning, control and managerial decision making as
• Prices are set by reference to fixed costs. costs are not differentiated into fixed and variable costs.
• Almost like preparing a financial account. • Ignored the administration, selling and distribution costs.
• Pricing decisions manager has no direct knowledge of cost volume profit
relationship.

Marginal Costing versus Absorption Costing

After knowing the two techniques of marginal costing and absorption costing, we have seen that the net profits are not the
same because of the following reasons:
1. Over and Under Absorbed Overheads
In absorption costing, fixed overheads can never be absorbed exactly because of difficulty in forecasting costs and volume of
output. If these balances of under or over absorbed/recovery are not written off to costing profit and loss account, the actual
amount incurred is not shown in it. In marginal costing, however, the actual fixed overhead incurred is wholly charged against
contribution and hence, there will be some difference in net profits.
2. Difference in Stock Valuation
In marginal costing, work in progress and finished stocks are valued at marginal cost, but in absorption costing, they are valued
at total production cost. Hence, profit will differ as different amounts of fixed overheads are considered in two accounts.
The profit difference due to difference in stock valuation is summarized as follows:
a. When there is no opening and closing stocks, there will be no difference in profit.
b. When opening and closing stocks are same, there will be no difference in profit, provided the fixed cost element in
opening and closing stocks are of the same amount.
c. When closing stock is more than opening stock, the profit under absorption costing will be higher as comparatively a
greater portion of fixed cost is included in closing stock and carried over to next period.
d. When closing stock is less than opening stock, the profit under absorption costing will be less as comparatively a
higher amount of fixed cost contained in opening stock is debited during the current period.

3 Prepared by: Md. Arshadul Kabir, FCA

 Absorption Costing (AC) Marginal Costing (MC)
If the production = Sales, AC Profit = MC Profit

If production > Sales, AC Profit >MC Profit.

Reported Profit As some factory overhead will be deferred as product costs under the absorption costing.

If production < Sales, AC Profit <MC Profit.

As the previously deferred factory overhead will be released and charged as cost of goods sold.

Reconciliation Statement for Marginal Costing and Absorption Costing Profit

Particulars Amount
Marginal Costing Profit XX
Add: (Closing stock - opening Stock) x OAR XX
Absorption costing profit XX
Where OAR (Overhead Absorption Rate) = Budgeted fixed production overhead/Budgeted levels of activities.

Nov-Dec 2016
Q # 1 Tamim & Company gathered the following information for the year ended December 31, 2015:
Units produced………………………………………………………………………………………… 45,000
Units expected to be produced 45,000
Units sold………………………………………………………………………………………………….. 43,200
Direct labor Tk.137,200
Direct materials used…………………………………………………………………………. Tk.126,400
Fixed selling and administrative expenses Tk. 51,000
Variable selling and administrative expenses………………………………………. Tk. 58,000
Fixed manufacturing overhead Tk. 83,250
Variable manufacturing overhead………………………………………………………..Tk. 73,900
Direct materials inventory, December 31, 2015 0
Direct materials inventory, December 31, 2014…………………………………………………… 0
Work-in-process inventory, December 31, 2015 0
Work-in-process inventory, December 31, 2014…………………………………………………… 0
Finished goods inventory, December 31, 2014 0
Required:
a) Under absorption costing, what is the cost of the finished goods inventory on December 31, 2015?
A. Tk. 16,830
B. Tk. 13,500
C. Tk. 14,000
D. Tk. 20,000
b) Under variable costing, what is the cost of the finished goods inventory on December 31, 2015?
A. Tk. 16,830
B. Tk. 13,500
C. Tk. 14,000
D. Tk. 20,000

c) Why is absorption costing more widely used than variable costing?

d) In which costing system profit will be higher and what is the amount
A. Tk. 3,330
B. Tk. 5,000
C. Tk. 6,000
D. Tk. 3,000

4 Prepared by: Md. Arshadul Kabir, FCA

Solution:

a) Cost of Finished goods inventory under Amount b) Cost of Finished goods inventory Amount
Absorption costing: under Variable costing:

Direct Materials 126,400 Direct Materials 126,400

Direct Labor 137,200 Direct Labor 137,200
Fixed manufacturing overhead 83,250 Fixed manufacturing overhead
Variable manufacturing overhead 73,900 Variable manufacturing overhead 73,900
420,750 337,500
Units Produced 45,000 Units Produced 45,000
Cost per unit (Tk. 420,750/45,000) 9.35 Cost per unit (Tk. 337,500/45,000) 7.50
Value of Closing inventory (1,800 x Tk. 9.35) 16,830 Value of Closing inventory (1,800 x Tk. 13,500
7.50)

c) Reasons:
 Variable Costing is not allowed for tax purpose, but absorption costing is allowed.
 Variable costing is not allowed for external reports as it is not supported by International Accounting Standards, but
absorption costing is allowed.

Nov-Dec 2017
1(C) Shikol Steel Products Co. is a manufacturer of gardening equipment. The income statement for last year is given below
developed under the Marginal costing system:

Sales 754,000
Less: Variable manufacturing cost (102,000)
Variable marketing and general expenses (54,000)
Contribution margin 598,000
Less: Fixed manufacturing cost (78,000)
Fixed marketing and general expenses (46,000)
Operating Income 474,000

The variable and fixed costs in inventories for last year were:
Beginning Inventory (TK) Ending Inventory (TK)
Work in process:
Variable cost 7,000 8,000
Fixed cost 6,000 11,000
Total 13,000 19,000
Finished goods:
Variable cost 28,000 20,000
Fixed cost 16,000 9,000
Total 44,000 29,000
There were no cost variances.
Required: What is the amount of profit under absorption costing income statement for last year, including inventory detail
and explain the profit difference between the systems.

A. Tk. 474,000
B. Tk. 500,000
C. Tk. 465,000
D. Tk. 470,000

5 Prepared by: Md. Arshadul Kabir, FCA

 Calculation of Income Statement
Under Absorption Costing System
Sales 754,000
Less: Cost of Goods sold
Opening Inventory - WIP 13,000
Add: Variable Manufacturing cost 102,000
Fixed Manufacturing cost 78,000 180,000
193,000
Less: Closing WIP 19,000
Cost of goods manufactured 174,000
Add: Opening inventory FG 44,000
218,000
Less: Closing Inventory FG 29,000
Cost of Goods sold 189,000

Gross Profit 565,000

Less: Marketing and General expenses 100,000
Net Income 465,000

May-June 2016, Q # 02
a) Last period a company reported absorption costing profits of BDT 36,000. Actual fixed production overheads were
BDT 42,000 and the actual production volume of 6,000 units resulted in over absorbed fixed production overhead of
BDT 6,000. A sales volume of 7,100 units was achieved during the period. Calculate marginal costing profit for the
period. 7

A. Tk. 44,800
B. Tk. 44,000
C. Tk. 45,000
D. Tk. 46,000

Solution: Amount

Actual fixed production overhead 42,000

Over absorbed OH 6,000
Absorbed fixed production overhead 48,000

Therefore, absorption rate per unit = Tk. 48,000/6,000 = Tk. 8.00

Inventory decrease = 7,100 units – 6,000 units = 1,100 units

Absorption costing profit = 36,000

Add: (Opening inventory – Closing inventory) * OAR or (1,100 units x Tk. 8.00) = 8,800
Marginal costing profit = 44,800

b) In 2015, Company X produced 17,500 units at a total cost of BDT 16 each. Three quarters of the costs were variable
and one quarter was fixed. The Company sold 15,000 units at BDT 25 each. There were no opening inventories.

6 Prepared by: Md. Arshadul Kabir, FCA

 By how much will the profits calculated using absorption costing principles differ from the profit if marginal costing
principles had been used
A. Tk. 10,000
B. Tk. 12,000
C. Tk. 15,000
D. Tk. 10,500

Solution:
Fixed cost per unit = Tk. 16/4 = Tk. 4
Units in closing inventory = 17,500 – 15,000
= 2,500 units
Profit difference = Inventory increase in units x Fixed overhead per unit
= 2,500 x Tk. 4 = Tk. 10,000
Inventory increased, therefore fixed overhead would have been carried forward in
inventory using absorption costing and the profit would be higher than with marginal
costing.

Nov-Dec 2015
3. (a) Differentiate Marginal Costing and Absorption Costing 5
(b) A company has just completed its first year of trading. The budgeted production volume of 26,000 units was achieved and
the sales volume was 24,500 units at BDT 40 each.
The following actual cost information is available.
BDT
Variable cost per unit:
Manufacturing 18.5
Selling and administration 9.2
Budgeted Fixed costs
Manufacturing 91,000
Selling and administration 49,000
Calculate the net profit using both absorption and marginal costing.

4(a) In a company production for the last year was 17,500 units at a total cost of BDT 16 each. 75% of the costs were variable
and 25% fixed. 15,000 units were sold at the rate of BDT 25 each. There were no opening inventories.
By how much will the profit calculated using absorption costing principles differ from the profit if marginal costing principles
had been used?

Question # 01, May-June 2015

3. (a) Explain the situation whether you are agree or not for the following two statements.

(i) When closing inventory levels are higher than opening inventory levels and overheads are constant, absorption
costing gives a higher profit than marginal costing. 5rt a low
er profit than absorption costing
A. A product showing a loss under absorption costing will also make a negative contribution under marginal
costing. 5
Answer: The statement is incorrect because a negative contribution will not always show a profit under either
costing system. The level of reported profit will depend on the magnitude of fixed overheads.

(b) A new product has a variable material cost of Tk. 5.50 per unit, a variable labor cost of Tk. 2 per unit and a fixed overhead
absorption rate of Tk. 3.50 per unit.
Production during the first month was 23,000 units and sales were 21,000 units.

7 Prepared by: Md. Arshadul Kabir, FCA

Calculate the value of inventory under both marginal costing and absorption costing. 7
Under Marginal Costing
A. Tk. 22,000
B. Tk. 15,000 (2,000 x Tk. 7.50)
C. Tk. 10,000
D. Tk. 20,000
Under Absorption Costing
A. Tk. 22,000 (2,000 x Tk. 11.00)
B. Tk. 15,000
C. Tk. 10,000
D. Tk. 20,000

Solution (b)
Under Marginal Costing:
In marginal costing, closing inventories are valued at marginal production cost which includes the direct material cost of Tk.
5.50 and the direct labour cost of Tk. 2.00 for 2,000 units.
Marginal cost of product = Direct material cost + direct labour cost = Tk. 5.50 + Tk. 2.00 = Tk. 7.50
Therefore, inventory valuation = Tk. 7.50 x 2,000 = Tk. 15,000.

Under Absorption Costing:

Absorption cost of product = Marginal cost + fixed production overheads = Tk. 7.50 + Tk. 3.50 = Tk. 11.00
Therefore, inventory valuation = Tk. 11x 2,000 = Tk. 22,000

Question # 02, Nov- Dec 2014 2(b)

A company manufactures Luxury and Standard items. The following information relates to period 1:
Luxury Standard
Variable Materials per unit Tk. 16 Tk. 12
Variable labor per unit Tk. 21 Tk. 9
Variable production overhead per unit Tk. 10 Tk. 8
Budgeted Production 3,500 Units 3,300 Units
Actual Production 3,500 Units 3,300 Units
Closing Inventory 290 Units 570 Units
Variable labor is paid Tk. 6 per hour. Total Fixed cost Tk. 120,400 are recovered on the basis of variable labor hours.
Calculate the value of inventory under both marginal costing and absorption costing

Answer:
Marginal costing
In marginal costing, closing inventories are valued at marginal production cost (variable materials, variable labour and variable
production overhead).
Luxury = Tk. 16 + Tk. 21 + Tk. 10 = Tk. 47 per unit.
There are 290 of them, so closing inventory value = 290 *Tk. 47 = Tk. 13,630.

Standard = Tk. 12 + Tk. 9 + Tk. 8 = Tk. 29 per unit.

There are 570 of them, so closing inventory value = 570 * Tk. 29 = Tk. 16,530.
Absorption costing
Absorption costing includes fixed production overheads in inventory values rather than charging them against profit.
The number of hours required to produce each item
For Luxury= 3.5 (Tk. 21 /Tk.6),
For Standard = 1.5 (Tk. 9/Tk. 6).
The fixed overhead absorption rate is Tk. 120,400 / ((3,500 * 3.5) + (3,300 * 1.5)) = Tk. 7 per direct labour hour.

Luxury = Tk. 16 + Tk. 21 + Tk. 10 +Tk. 7 x 3.5 = Tk. 72 per unit.

There are 290 of them, so closing inventory value = 290 *Tk. 72 = Tk. 20,735.
Standard = Tk. 12 + Tk. 9 + Tk. 8 + Tk. 7 x 1.5 = Tk. 39.5 per unit.

8 Prepared by: Md. Arshadul Kabir, FCA

 There are 570 of them, so closing inventory value = 570 * Tk. 39.5 = Tk. 22,515.

Question # 03, Nov-Dec 2013

4. (a) Describe the problems with traditional absorption costing. 3
(b) Senjuti Kites Ltd. (SKL) produces and markets specialized kite. SKL follows a standard costing system and its
standard cost card is as follows:
Standard cost card Taka
Sales Price 80
Direct Material 11
Direct Labour 19
Variable Overheads 8
Budgeted data for September, 2013
Production in unit 20,000
Fixed production overhead Tk. 100,000
Fixed administration expenses Tk. 36,000
Fixed selling expenses Tk. 22,000
Variable selling expenses 5% of sales
The actual data in unit for September, 2013 is as follows:
Production Sales
September, 2013 20,000 15,000
The opening inventory for the month of September, 2013 is 1000 units.
With the help of the above information, calculate the profit of SKL under marginal costing and absorption costing
for September, 2013.

9 Prepared by: Md. Arshadul Kabir, FCA

Answer:
Profit and Loss account
Under Marginal Costing Systems
For the month ended September 2013
Particulars Amount ('000) Amount ('000)
Sales (15,000*Tk. 80) 1,200
Less: Variable Production cost
Opening inventory (3,000 x Tk. 38) 114
Variable cost incurred during the year (20,000 x Tk. 38) (W#1) 760
874
Less: Closing inventory (8,000 x Tk. 38) (W#2) 304 570
630
Less: Variable selling expenses (5% x 1200) 60
Contribution Margin 570
Less: Fixed overheads
Fixed production 100
Administration 36
Selling expenses 22 158
Net Profit or (Loss) 412

W#1 W#2
Calculation of Variable cost Calculation of Closing Inventory
Direct material = Tk. 19 Opening inventory = 3,000
Direct material = Tk. 11 Add: Production = 20,000
Variable OH = Tk. 8 Less: Sales = 15000
Total = Tk. 38 Closing inventory = 8,000

Profit and Loss account

Under Absorption Costing Systems
For the month ended September 2013
Particulars Amount ('000) Amount ('000)
Sales (15,000*Tk. 80) 1,200
Less: Total Production cost
Opening inventory (3,000 x Tk. 43) 129
Add: Variable cost (20000 x Tk. 38) 760
Add: Fixed production OH (20,000 x Tk. 5) (W#3) 100
Less: Closing inventory (8,000 x Tk. 43) (W#4) 344 645
Gross Profit 555
Less: Non-manufacturing OH
Variable selling expenses (5% x 1200) 60
Administration 36
Selling expenses 22 118
Net Profit or (Loss) 437

W # 3 Calculation of Fixed production OH Rate W#4, Calculation of Variable cost

Fixed production OH expense = Tk. 120,000 Direct material = Tk. 19
Production during the year = 20,000 Direct material = Tk. 11
Fixed production OH rate = Tk. 120,000/20,000 or Tk. 5 Variable OH = Tk. 8
Fixed. Man OH = Tk. 5
Total = Tk. 43

10 Prepared by: Md. Arshadul Kabir, FCA