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Learning Objectives
After completing this chapter, students should be able to;
1. Understand and explain the nature of variable costing and
absorption costing
2. Describe the advantages and limitations of absorption and
variable costing
3. Differentiate and understand the elements of cost involved in
absorption costing and variable costing respectively
4. Understand allocation, apportionment and absorption of Fixed
Factory Overhead Cost accordingly
5. Calculate profit using variable costing and absorption costing
6. Know how to analyse the degree of profit based on inventory level
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Overview
Manufacturing firms passes on all the costs incurred in the production
process to the final goods or services produced.
 Variable costing and Absorption costing are both used to calculate
profit. However, the applications are different.
 Absorption costing – includes all of the direct costs associated with
manufacturing a product, while variable costing can exclude some
direct fixed costs.
 Absorption costing – also known as full costing, involves allocating fixed
overhead costs across all units produced for the period, resulting in a
per-unit cost.
 Variable costing – also known as Marginal Costing, includes all of the
variable direct costs in COGS but excludes direct, fixed overhead costs.
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Absorption Costing & Variable Costing
 Differences in computing for profit;
The difference between the absorption and variable costing
methods depends on the treatment of fixed factory overhead
costs.
 Absorption costing “absorbs” all variable unit costs used in
production and also the unit cost of fixed factory overhead as
product costs and is part of inventory.
 Variable costing (Marginal Costing) – Considers the variable
unit costs and does not consider unit cost of fixed factory
overhead as part of a product cost. Thus, fixed factory
overhead is treated as expense and not part of inventory.
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Advantages & Disadvantages of Absorption Costing
Advantages
Disadvantages
• Covering all relevant production
• Confusion in the basis of
cost – (GAAP/IAS)
• It sets competitive and realistic
Selling Price (SP)
• Cost are fairly to distributed to
products
• It accounts for All Production
Costs
allocating fixed overhead
cost and adjusting variance.
• Have to adjust over/under
absorbed of o/h cost at the
end of the each acc. Period.
• Not easily computed as
variable costing approach.
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Advantages & Disadvantages of Marginal Costing
Advantages
Disadvantages
• Apportionment & Allocation are
• Does not comply with
not needed
• No over/under absorbed fixed
o/h cost. Write off fixed cost in
the income statement
• Production cost is easy to
compute.
• Helpful in short-term decision,
esp. identify relevant costs
GAAP/IAS
• Difficult to understand cost
behaviour in variable costs &
fixed costs
• Does not recover full cost in
the production
• Pricing consider only variable
costs
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Cost elements vs. Marginal & Absorption Costing
Absorption costing involves allocating all of the costs (variable and
fixed cost) associated with manufacturing a product to COGS. Fixed
factory overhead is inventoried. This includes:




Cost of raw materials (per unit)
Hourly cost of labor (per unit)
Variable overhead costs (per unit)
Fixed factory overhead (per unit)
Marginal costing involves allocating only the variable costs
associated with manufacturing a product to COGS. Fixed factory is
expensed. This includes:
 Cost of raw materials (per unit)
 Hourly cost of labor (per unit)
 Variable overhead costs (per unit)
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Fixed Factory Overhead
Fixed Factory Overhead Costs can be;
1) Allocated, 2) Apportioned, or 3)Absorbed.
1 - Allocation of Fixed Factory Overhead Costs
 This is the process of assigning overhead costs to cost centers (cost object)
which are incurred within a particular cost center.
2 - Apportionment of Fixed Factory Overhead Costs
 This is the process of fair distribution of factory overhead costs to cost
centers. Costs for other center/division are assigned to another cost center
on some approved basis.
3 - Absorption of Fixed Factory Overhead Costs
 This is the process where overhead cost for a particular cost center are
assigned to individual units or jobs (the output). Absorption is when the final
units absorb the overhead cost for product costing purpose.
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Profit: Absorption & Marginal Costing
 Differences in computing for profit;
Refer to handouts;
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Marginal Costing & Management Decision
 One of the fundamental consideration of variable cost is that the
fixed overhead is treated as a period cost which is expensed
within the reporting period.
 Marginal Costing is the tool for various managerial decision
made internally. Most of the decisions are based on CVP analysis
where the benefits of productions volumes are measured with its
related costs and profit.
 CVP Purpose is to;
 Determine the number of units that must be sold to break even or to earn a
targeted profit.
 Calculate the amount of revenue required to break even or to earn a
targeted profit.
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Income analysis: Marginal Costing
 Marginal Revenue
Marginal revenue measures the change in the revenue when there
is change in volume of sales, SP, or VC.
Usual production data
•
•
•
•
Unit selling price – K10
Variable cost per unit – K4
Fixed cost p.a. – K90,000
Sales unit p.a. – 40,000
Changes in production data
•
•
•
•
Unit selling price – K15
Variable cost per unit – K6
Fixed cost p.a. – K90,000
Sales unit p.a. – 30,000
NB: Fixed cost has not changed.
What is the effect of the change in production data?
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Analysing the degree of profit based on inventory
Closing inventory > Opening inventory = AC profit > MC profit
Fixed overhead cost allocated to units are trapped in ending inventory. Thus,
part of fixed cost is still in the ending inventories.
Closing inventory < Opening inventory = AC profit < MC profit
More of fixed overhead cost allocated to units has been deducted. Thus,
more cost has been deducted in fixed overhead that the actual fixed
overhead cost.
Closing inventory = Opening inventory = AC profit = MC profit
The fixed overhead allocated is equal to what has been deducted.
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Over & Under Absorption of Overhead Costs
Over/under absorption of overhead costs is only considered
under Absorption Costing calculations
 Over Absorption – Occurs when the overheads absorbed are higher
than the actual overheads incurred
 Under Absorption – This occurs when the overhead absorbed is lower
than the actual overheads incurred during the accounting period
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Summary
 The treatment of factory overhead costs, whether as part of product cost or




expense, distinguishes marginal costing from absorption costing.
Marginal Costing is more useful for internal reporting and decision making
Marginal Costing does not comply with GAAP standards, thus, it is not used by
public companies
Absorption costing is compliant with GAAP, and is used for financial reporting
by public companies (listed companies)
Variable cost and period cost are the basis of consideration for calculating
marginal and absorption costing.
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Bibliography
 Balakrishnan, R., Sprinkle, G. B., & Sivaramakrishnan, K. (2010). Managerial
Accounting (1st ed.). New Delhi, India: John Wiley & Sons, Inc.
 Charles, T. H., Monte, W., William, M., Rebecca, T., Srikant, M. D., George, F., . . .
Christopher, I. (2011). Cost Accounting - A Managerial Emphasis (1st ed.). (K.
Hutchings, S. Goodhall, M. Stone, K. Pittard, R. Deighton, C. Pike, . . . J. Rudd, Eds.)
Frenchs Forest, Sydney, Australia: Pearson.
 Garg, A. K. (2012). Production and Operations Management. (K. Bellani, V. Mahajan,
& K. K. Jha, Eds.) New Delhi, India: McGraw Hill Education.
 Khan, M. Y., & Jain, P. K. (2013). Management Accounting; Text, Problems and
Cases (6th ed.). (K. Bellani, V. Mahajan, T. K. Maji, S. Khare, & S. Negi, Eds.) New
Delhi, India: McGraw Hill Education (India) PTY LTD.
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End of Lecture
Complete the
exercise on the
student course
book
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