Example: Marginal and absorption costing compared
Big Woof Co manufactures a single product, the Bark, details of which are as
follows.
Per unit
$
180.00
40.00
16.00
10.00
Selling price
Direct materials
Direct labour
Variable overheads
Annual fixed production overheads are budgeted to be $1.6 million and Big Woof
expects to produce 1,280,000 units of the Bark each year. Overheads are absorbed
on a per unit basis. Actual overheads are $1.6 million for the year.
Budgeted fixed selling costs/overheads are $320,000 per quarter.
Actual sales and production units for the first quarter of 2018 are given below.
Sales
Production
January-March
240,000
280,000
There is no opening inventory at the beginning of January.
Prepare statements of profit or loss for the quarter, using:
(a) Absorption costing
(b) Marginal costing
1
Solution:
Step 1
Calculate the overhead absorption rate per unit
𝑂𝑣𝑒𝑟ℎ𝑒𝑎𝑑 𝑎𝑏𝑠𝑜𝑟𝑝𝑡𝑖𝑜𝑛 𝑟𝑎𝑡𝑒 =
𝐵𝑢𝑑𝑔𝑒𝑡𝑒𝑑 𝑓𝑖𝑥𝑒𝑑 𝑜𝑣𝑒𝑟ℎ𝑒𝑎𝑑
𝐵𝑢𝑑𝑔𝑒𝑡𝑒𝑑 𝑢𝑛𝑖𝑡𝑠
You are dealing with a three month period but the figures in the question are for a
whole year. You will have to convert these to quarterly figures.
𝐵𝑢𝑑𝑔𝑒𝑡𝑒𝑑 𝑜𝑣𝑒𝑟ℎ𝑒𝑎𝑑𝑠 (𝑞𝑢𝑎𝑟𝑡𝑒𝑟𝑙𝑦) =
𝐵𝑢𝑑𝑔𝑒𝑡𝑒𝑑 𝑝𝑟𝑜𝑑𝑢𝑐𝑡𝑖𝑜𝑛 (𝑞𝑢𝑎𝑟𝑡𝑒𝑟𝑙𝑦) =
Overhead absorption rate per unit =
Step 2
$1.6 𝑀𝑖𝑙𝑙𝑖𝑜𝑛
= $400,000
4
1,280,000
= 320,000 𝑢𝑛𝑖𝑡𝑠
4
$400,000
= $1.25 𝑝𝑒𝑟 𝑢𝑛𝑖𝑡
320,000 𝑢𝑛𝑖𝑡𝑠
Calculate total cost per unit
𝑇𝑜𝑡𝑎𝑙 𝑐𝑜𝑠𝑡 𝑝𝑒𝑟 𝑢𝑛𝑖𝑡(𝐴𝑏𝑠𝑜𝑟𝑝𝑡𝑖𝑜𝑛 𝑐𝑜𝑠𝑡𝑖𝑛𝑔) = 𝑉𝑎𝑟𝑖𝑎𝑏𝑙𝑒 𝑐𝑜𝑠𝑡 + 𝐹𝑖𝑥𝑒𝑑 𝑝𝑟𝑜𝑑𝑢𝑐𝑡𝑖𝑜𝑛 𝑐𝑜𝑠𝑡
𝑇𝑜𝑡𝑎𝑙 𝑐𝑜𝑠𝑡 𝑝𝑒𝑟 𝑢𝑛𝑖𝑡(𝐴𝑏𝑠𝑜𝑟𝑝𝑡𝑖𝑜𝑛 𝑐𝑜𝑠𝑡𝑖𝑛𝑔) = (40 + 16 + 10) + 1.25 = $67.25
𝑇𝑜𝑡𝑎𝑙 𝑐𝑜𝑠𝑡 𝑝𝑒𝑟 𝑢𝑛𝑖𝑡(𝑀𝑎𝑟𝑔𝑖𝑛𝑎𝑙 𝑐𝑜𝑠𝑡𝑖𝑛𝑔) = 𝑉𝑎𝑟𝑖𝑎𝑏𝑙𝑒 𝑐𝑜𝑠𝑡 = $66
Step 3
Calculate closing inventory in units
𝐶𝑙𝑜𝑠𝑖𝑛𝑔 𝑖𝑛𝑣𝑒𝑛𝑡𝑜𝑟𝑦 = 𝑂𝑝𝑒𝑛𝑖𝑛𝑔 𝑖𝑛𝑣𝑒𝑛𝑡𝑜𝑟𝑦 + 𝑝𝑟𝑜𝑑𝑢𝑐𝑡𝑖𝑜𝑛 – 𝑠𝑎𝑙𝑒𝑠
𝐶𝑙𝑜𝑠𝑖𝑛𝑔 𝑖𝑛𝑣𝑒𝑛𝑡𝑜𝑟𝑦 = 0 + 280,000 – 240,000 = 40,000 𝑢𝑛𝑖𝑡𝑠
Step 4
Calculate under/over absorption of overheads
This is based on the difference between actual production and budgeted production.
Actual production
= 280,000 units
Budgeted production
= 320,000 units (see Step 1 above)
Under-production
= 40,000 units
As Big Woof produced 40,000 fewer units than expected, there will be an under
absorption of overheads of 40,000 x $1.25 (see Step 1 above) = $50,000.
This will be added to production costs in the statement of profit or loss.
2
Step 5
Produce statements of profit or loss
Sales (240,000 x $180)
Less cost of sales:
Opening inventory
Plus: production cost
280,000 x $66
280,000 x $67.25
Less: Closing inventory
40,000 x $66
40,000 x $67.25
Marginal Costing
$000
$000
43,200
0
Absorption Costing
$000
$000
43,200
0
18,480
18,830
(2,640)
(15,840)
Add under-absorbed O/H
(2,690)
16,140
50
(16,190)
Contribution
Gross Profit
Less:
Fixed production O/H
Fixed selling O/H
Net profit
27,360
27,010
400
320
NIL
320
(720)
26,640
(320)
26,690
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No Changes in Inventory
You will notice from the calculations in the example that there are differences
between marginal and absorption costing profits.
Before we go on to reconcile the profits, how would the profits for the two different
techniques differ if there were no changes between opening and closing inventory
(that is, if production = sales)?
For the first quarter we will now assume that sales were 280,000 units.
Sales (280,000 x $180)
Less cost of sales:
Opening inventory
Plus: production cost
280,000 x $66
280,000 x $67.25
Less: Closing inventory
Marginal Costing
$000
$000
50,400
0
Absorption Costing
$000
$000
43,200
0
18,480
NIL
(18,480)
Add under-absorbed O/H
18,830
NIL
18,830
50
18,880
Contribution
Gross Profit
Less:
Fixed production O/H
Fixed selling O/H
Net profit
31,920
31,520
400
320
NIL
320
(720)
31,200
(320)
31,200
Reconciling Profits
The profits reported under absorption costing and marginal costing for January to
March in the Big Woof question above can be reconciled as follows:
$’000
Marginal costing profit
Adjust for fixed overhead included in inventory: Inventory increase of
26,640
50
40,000 units x $1.25
Absorption costing profit
26,690
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