The basis of all financial accounting statements is absorption costing or total absorption costing , using absorption costing, operating statements don’t distinguish between fixed and variable costs, all costs are absorbed into production.
Marginal costing on the other hand, distinguishes between fixed and variable costs. The marginal cost of a product is its variable cost. Variable cost is direct material, direct labor, direct expenses and variable portion of overheads.
Using marginal costing, fixed costs are not absorbed into the production cost. They are treated as period costs and written off at the end of every period in the costing profit and loss account. What this means is that finished goods or work-in-progress are valued at variable cost only (marginal cost). Sales revenue minus marginal cost of sales is the contribution from which fixed costs are deducted to arrive at the net profit.
Example 1:
In a particular period, 16,000 units of a particular product were produced and all were sold. Production costs of sales were: variable – $25,000, fixed – 10,000 and other overheads(fixed) – 18,000. Sales revenue was $80,000.
Operating statements on the basis of Absorption and Marginal Costing were:
Operating Statements.
| Absorption Costing Basis | Marginal Costing Basis. | |||
| ($) | ($) | |||
| Sales | 80,000 | Sales | 80,000 | |
| Less production cost of sales (25,000 + 10,000) | 35,000 | Less marginal cost. | 25,000 | |
| = Gross Profit (A-B) | 45,000 | = Contribution | 55,000 | |
| Less other overheads (fixed) | 18,000 | Less fixed costs (production + overheads – 10,000 + 18,000)) | 28,000 | |
| = Net Profit | 27,000 | Net Profit | 27,000 |
The contribution of $55,000 in the marginal statement is the key difference.
Both marginal and absorption costing produced the same net profit because there was no stock at the beginning or end of the period. When stocks arise, both approaches produce different profit figures because both approaches value stock differently. Let us use example 1 to illustrate this but this time, let us assume that only 13,000 of the 16,000 units produced were sold. 3,000 units were carried forward as stock to the next period.
Example 2:
Operating Statements.
| Absorption Costing | Marginal Costing | ||||
| $ | $ | $ | $ | ||
| Sales (13,000 x $5 | 65,000 | Sales | 65,000 | ||
| Less production cost of sales(25,000 + 10,000) | 35,000 | Less marginal cost | 25,000 | ||
| Closing stock (3,000 x $2.19) | 6,570 | 28,430 | Closing stock (3,000 x $1.56) | 4,680“ | 20,320 |
| = Gross Profit | 36,570 | = Contribution | 44,680 | ||
| Less other overheads (fixed) | 18,000 | Less fixed costs (production + overheads – 10,000 + 18,000)) | 28,000 | ||
| == Net Profit | 18,570 | = Net Profit | 16,680 |
Notes:
- Sales price per unit = 80,000/16,000 – $5
- Average production cost of sales – 35,000/16,000 = $2.19 – (Absorption costing)
- Marginal cost – 25,000/16,000 = $1.56
- Absorption costing produces higher profits than marginal costing in periods of increasing stocks. In periods of decreasing stocks, marginal costing produces higher profits than absorption costing. The difference is due to the different treatment of fixed costs in stock valuation,
- Absorption costing includes fixed costs in stock valuation and consequently, transfers a portion of one period’s fixed cost to the next where they are charged against revenue derived from the sales of stock carried forward. Using marginal costing, all fixed costs are written off in the period they are incurred.
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