F2 MANAGEMENT ACCOUNTING

EAGLES BUSINESS SCHOOL

F2 MANAGEMENT
ACCOUNTING
TOPIC: MARGINAL COSTING &
CONTRIBUTION THEORY

TUTOR: MR
KANYONGANISE
+263 782 487 521

Corner Angwa and Kwame Nkrumah, 3rd Floor Robinson House, Opp Karigamombe Building
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CHAPTER OBJECTIVES
Absorption and marginal costing

a) Explain the importance of, and apply, the concept of contribution.

b) Demonstrate and discuss the effect of absorption and marginal costing on inventory
valuation and profit determination.
c) Calculate profit or loss under absorption and marginal costing.
d) Reconcile the profits or losses calculated under absorption and marginal costing.
e) Describe the advantages and disadvantages of absorption and marginal costing

ABSORPTION versus MARGINAL COSTING EXPLAINED

There are two main methods of costing:

1. Absorption costing
 where the fixed production overhead costs are absorbed into the product cost by
means of an overhead absorption rate (OAR).
 It is used by financial accountants (for external reporting) and fixed cost is charged to
cost unit.
2. Marginal costing
 where the total fixed costs are written off in full in the period in which they occur. It is
used for planning & decision making. The focus is on cost behaviour. Marginal costing is
used internally by management.
 In order to correctly assess the full cost of production we need to have a portion of these
overheads included in the cost of the item.

Absorption costing

Sales – production costs = gross profit

Gross profit – non-production costs = net profit

Marginal costing

Sales – variable costs = contribution

Contribution – fixed overheads = profit

Contribution per unit = Unit selling price – variable cost/unit

PROFIT CALCULATIONS

Absorption costing

Absorption Costing profit is calculated using the following pro forma:

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Sales revenue X

Production Costs

Opening inventory X

Direct materials X

Direct labour X

Production overheads absorbed X

Under/over absorption X/(X)

Closing inventory (X)

Total Production Costs (X)

Gross Profit X

Non Production Costs (X)

Net Profit X

In an absorption costing system, inventory is valued at the production cost per unit.

 Under absorption increases costs and should be added to production costs.

 Over absorption decreases costs and should be subtracted from production costs.

Marginal costing

Marginal Costing profit is calculated using the following pro forma

Sales revenue X

Variable Costs

Opening inventory X

Direct materials X

Direct labour X

Variable overheads X

Closing inventory (X)

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Total Variable Costs (X)

Contribution X

Fixed Costs (X)

Profit X

In a marginal costing system, inventory is valued at the variable cost per unit.

Exercise 1

A company makes and sells a single product. Details of this product are as follows:

Per unit

Selling price $20

Direct materials $6

Direct labour $3

Variable production overheads $4

Fixed production overheads $20,000 per month

The fixed overhead is absorbed on the basis of expected production of 20,000 units per month.

Required:

If actual production and sales are 20,000 units in a month, calculate:

(a) The contribution per unit, the total contribution for the month and the total profit
for the month, using marginal costing.
(b) The profit for the month using absorption costing.

Exercise 2

A company produces a single product with the following budget:

Selling price $10

Direct materials $3 per unit

Direct wages $2 per unit

Variable production overheads $1 per unit

Fixed production overheads $10,000 per month

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Budgeted production 5,000 units per month

Required:

Show the operating statement for the month when 4,800 units were produced and sold using:

(a) Absorption costing.

(b) Marginal costing.
 Assume that all costs were as budget.

PROFIT RECONCILIATIONS

 In the two exercises just done the profits achieved under both methods are exactly the
same. This is because opening inventory = closing inventory. If there is a movement in
inventory, the profits will differ. We need to be able to reconcile these profits. This is a
simple matter and very easy to do. It is also a common exam question.

Using the above budget in Exercise 2, recalculate the operating statements assuming that
production had been 6,000 units and sales 4,800 units

Reconcile the profits.

 From the figures you have calculated you will see that there is a closing stock balance of
1,200 units. The value of these balances differ because of the amount of fixed overhead
contained within the absorption costing stock. From this we can deduce that the difference
in the profit figures is because of the change in the number of units of stock x fixed
production overhead cost per unit.

IMPORTANT EXAM POINT

Please remember:

 If closing inventory > opening inventory, then absorption costing profit will be greater
than marginal costing profit. This is because some of the fixed overhead for the period
is contained in the closing stock.
 If closing inventory < opening inventory, then absorption costing profit will be less than
marginal costing profit. This is because some of the overhead from a prior period has
been written off in the current period from the stock taken from the opening stock.
 If closing inventory = opening inventory then absorption costing profit will be equal to
marginal costing profit
 Difference in profit = movement in inventory × fixed production overhead cost per unit

NB: FOR Quick understanding, remember our magic word SIAM

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S - If Stock

I - Increased , ie (Closing stock > O/Stock), then

A - Absorption costing profit is

M - More

So to Calculate the difference there are 3 steps

1) Calculate OAR/U
2) Calculate change in Stock (which = C/S – O/S)
3) Calculate the Difference (which = OAR/U X Change in Stock)

Exercise 4

A company has a profit of $75,000 using a marginal costing system. Budgeted fixed costs were
$30,000 and budgeted activity was 10,000 units. The following information is also available:

Opening inventory 500 units

Production 10,500 units

Sales 10,750 units

What would the profit be using absorption costing?

A $72,750

B $74,250

C $75,750

D $77,250

Exercise 5

Z Ltd produces a single product. The management currently uses marginal costing, but is considering
using absorption costing in the future. The budgeted fixed production overheads for the period are
$250,000. The budgeted output for the period is 1,000 units. There were 400 units of opening stock
for the period and 250 units of closing stock.

Required:

If absorption costing principles were applied, by how much would the profit for the period compared
to marginal costing differ?

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