MARGINAL AND ABSORPTION COSTING

Marginal/ direct/ variable costing

 It is a technique of presenting costing information whereby, only variable manufacturing
costs are considered as the only manufacturing costs. The fixed costs are therefore treated
as the periodic cost and they are written in the income statement in the period in which
they were incurred. This does not comply with the accounting rules i.e. the international
accounting standards and the international financial reporting standards.
 Marginal costing is used to prepare the reports that are to be used internally. In the
marginal costing, the opening and closing stock is valued on the basis of the variable
manufacturing costs only.

ABSORPTION/INDIRECT /TOTAL/FULL COSTING

It is a technique of presenting financial information whereby the manufacturing costs is a
combination of both variable and fixed costs. Absorption costing information is used by external
parties e.g. the creditors. In absorption costing opening and closing stock is valued on the basis
of the total production cost i.e. fixed + variable production cost.

 DIFFERENCE BETWEEN MARGINAL & ABSORPTION COSTING

Absorption Costing Marginal Costing
1. The report is used by external parties. 1. The report is used by internal
parties i.e. the management.
2. It’s a method used in applying 2. It’s a technique concerned with
overheads at the pre-determined rates the effect of the overheads on
into production. running the business.
3. Costs are classified as production/ 3. Costs are classified as fixed or
administrative/ distribution. variable costs.
4. It takes into account both fixed and 4. It only includes the variable
variable production cost in valuation production cost in valuation of
of stocks stocks
5. It complies with international 5. It doesn’t comply with IAs or
accounting standards ( IAS) and IFRS when preparing the report
international financial reporting
standards (IFRS) when preparing the
report.
6. It is recommended by the accounting 6. It is not recommended by the
standards. standards in the report.
7. Overheads are recovered using the pre- 7. Over/ under absorption doesn’t
determined rates and therefore it leads arise as the fixed overheads is
into over & under absorption used as a periodic cost.

Similarities between marginal and Absorption Costing

1. They are both used to determine the profitability of the company.
 2. Both reports are used for decision-making.

CPA DEC 2005 Q3

The company has been reporting its profits using absorption-costing system. During the financial
year ended 30 September 2005, the following summary statement was provided.

Sales (4000 units) 5000,0000

Production cost of sales:
Variable 3000,000
Fixed 1000,000 (4000,000)
Gross profit 1000,000
Expenses:
Variable 800,000
Fixed 800,000 (1600000)
Net loss (600,000)

Currently the company is implementing strategies to improve its profitability, which are to be
implemented in two phases; A and B. Each phase will cover a period of six months.

The expected production and sales in units for each of the phases are shown below:

Phase A Phase B
units Units
Production 2,500 3000
Sales 2,400 2,900

The fixed costs are expected to increase by 20% while the variable costs per unit will remain as
they were in the previous period. The selling price per unit will be sh. 1,500.
Required:
(a) Profit and loss statement for phases A and B using:
(i) Marginal costing.
(ii) Absorption costing
(b) Briefly explain the differences resulting from the two methods employed in (a) above of
reporting profits.
(c) Reconcile the resulting difference in the reported profit under the two methods.
(d) Briefly explain which of the two methods is better in estimating profits of manufacturing
enterprises

Solution:
Variable production cost per unit 3000000/4000 =750
Fixed production cost per unit 1000,000/4000 = 250+(20% X 250) = 300
Variable expenses per unit 800,000/4000 =200
Fixed expenses per unit 800000/4000 =200 + (20% x 200) =240

PHASE A
INCOME STATEMENT USING MARGINAL COSTING

Sales: 2400 x 1500 3,600,000

Less: Marginal cost of sales:
Opening stock ( 0 x 750) -
Add: variable production cost: 2500 x 750 1875000
Less: Closing stock : 100 x 750 ( 75000) (1800,000)
Gross marginal profit 1800000
Less: variable expenses : 2400 x 200 (480,0000
Net marginal profit 1,320,000
Less : fixed costs
Fixed production costs: 2500x 300 750,000
Fixed expenses 2400 x 240 57600 (1326000)
Net loss (6000)

INCOME STATEMENT USING ABSORPTION COSTING

Sales: 2400 x 1500 3600000
Less: Cost of Sales
Opening Stock: 0 x 1050 -
Production cost: 2500 x1050 2625000
Less: Closing stock: 100 x 1050 ( 105000) 2520000
Gross profit 1080000
Less expenses:
Fixed expenses : 2400 x 240 576000
Variable cost: 2400 x 200 480000 (1056000)
Net profit 24000

Reconciliation Statement

Net profit as per Marginal statement ( 6000 )

Adjustment in Stock:
 Marginal - Absorption
Opening stock - -
Less closing stock 75000 105000
-75000 - -105000 30000
Net profit as per Absorption costing 24000

(b) The reasons for the difference in the profits in the two methods is in the valuation of opening
and closing stock. Under marginal costing the value of the opening and closing stock takes into
account only variable production cost while under Absorption costing the value of the closing
stock and opening stock take into account variable and fixed production costs.

PHASE B
INCOME STATEMENT USING MARGINAL COSTING

Sales: 3000x 1500 4500000

Less: Marginal cost of sales:
Opening stock ( 0 x 750) -
Add: variable production cost: 3000x 750 2250000
Less: Closing stock : 100 x 750 ( 75000) (2175000)
Gross marginal profit 2325000
Less: variable expenses : 2900 x 200 (580,000)
Net marginal profit 1745000
Less : fixed costs
Fixed production costs: 3000x 300 900,000
Fixed expenses 2900 x 240 696000 (1596000)
Net profit 149000

INCOME STATEMENT USING ABSORPTION COSTING

Sales: 3000 x 1500 4500000
Less: Cost of Sales
Opening Stock: 0 x 1050 -
Production cost: 3000x1050 3150000
Less: Closing stock: 100 x 1050 ( 105000) 3045000
Gross profit 1455000
Less expenses:
Fixed expenses : 2900 x 240 696000
Variable cost: 2900 x 200 580000 (1276000)
Net profit 179000

Reconciliation Statement

Net profit as per Marginal statement 149000

Adjustment in Stock
Marginal - Absorption
Opening stock - -
Less closing stock 75000 105000
-75000 - -105000 30000
Net Profit as per 179000
Absorption costing

CPA MAY 2015 Q 3b

INCOME STATEMENT USING MARGINAL COSTING

“000”
Sales: 1000 x 10,000 10000
Less: Marginal cost of sales:
Opening stock -
Add: production cost: 500x12000 6000
Less: Closing stock : 500x2000 (1000) (5000)
Gross marginal profit 5000
Less: variable expenses : 10%x10,000 (1000)
Net marginal profit 4000
Less : fixed costs
production costs: 1980
Selling expenses 300
Administration 500 (2780)
Net profit 1220

INCOME STATEMENT USING ABSORPTION COSTING

Sales: 10000
Less: Cost of Sales
Opening Stock: -
Production cost: 12000x680 8160
Less: Closing stock: 2000x680 (6800)
(1360)
Gross profit 3200
Over/under Absorption (12000-11000)x180 180
Less: Operating expenses
Fixed selling expenses 1000
 Variable selling expenses 300
Fixed administrative 500 (1800)
Net profit 1580

Reconciliation Statement

Net profit as per Marginal statement 1220

Adjustment in Stock
Marginal - Absorption
Opening stock - -
Less closing stock 1000 1360
-1000 - - 1360 360
Net Profit as per Absorption 1580
costing

APPLICATION OF MARGINAL COSTING

1. COST VOLUME PROFIT ANALYSIS (CVP)
This is also known as break-even analysis. At breakeven point the 𝑇𝑜𝑡𝑎𝑙 𝑐𝑜𝑠𝑡 =
𝑇𝑜𝑡𝑎𝑙 𝑟𝑒𝑣𝑒𝑛𝑢𝑒 therefore there will be no profit/ loss.

It is a technique, which is used by the management to study the behaviour of the profit in
response to the changes in volume, selling price and the total cost. It is used by the
management to determine the optimal volume, cost and the selling price.

ASSUMPTIONS/ LIMITATION OF CVP ANALYSIS

2. All the cost are either fixed or variable i.e. semi- variable costs are not included
3. All the units produced are sold.
4. The volume is known in advance and is assumed to be the only factor affecting profit.
5. The selling price remains constant at all levels of sales.
6. All the functions encountered in CVP i.e. profit function, cost function e.t.c are linear.
7. All the parameters are known in advance and remain constant.
8. It assumes that organisation produce and sells one product
NB//= for the limitation of the CVP analysis entices the assumptions.

The CVP model is normally analysed graphically in two ways;

ACCOUNTANT MODEL
 - Under this method, there will be only one breakeven point in the company i.e. when the
TC=TR
- Its represented graphically as follows;

TR

BEP Variable cost

value

Cost Fixed cost

Margin of Safety

BEP units Units

 Economic model
- Under this model there will be 2 break even points i.e. during the growth stage of the
company and the decline stage of the company

BEP I BEP II Units

Using the above models the CVP analysis would be analysed using
P – Selling price per units
V – Variable cost per units
X – Number of units manufactured and sold
F – Total fixed cost
𝜋 – Profits
𝑅 – Sales Revenue
XT – Target profit in units
RT – Target profits in shillings
Cm – Contribution margin (p –v)
CMR – contribution margin ratio/ contribution to sales ratio
𝑝−𝑣
= 𝑃
𝑣
VCR (variable cost Ratio) = 𝑝
VCR+CMR=1
Using the above variables, the CVP models is represented as follows:
a) Sales in units (x)
i) Profit (𝜋) = (𝑝 − 𝑣)𝑥 − 𝑓
= 𝑐𝑚 × 𝑥 − 𝑓
𝐹 𝐹
ii) BEP in units = 𝐶𝑀 = 𝑝−𝑣
iii) Sales for the target profit in units (x)
𝐹+𝑇
X= 𝐶𝑚
b) Sales in shilling/ value(S)
i) Profit 𝜋 = 𝑐𝑚𝑟 × 𝑅 − 𝑓
𝑝−𝑣
= 𝑝 ×𝑅−𝑓
𝑓
ii) BEP in shillings = 𝑐𝑚𝑟
iii) Sales in shillings for the target profit (s)
𝐹+𝑇
𝑠=
𝐶𝑚𝑟
 iv) 𝐶𝑀𝑅 + 𝑉𝐶𝑅 = 1
v) Margin of safety = 𝑎𝑐𝑡𝑢𝑎𝑙 𝑜𝑟 𝑏𝑢𝑑𝑔𝑒𝑡𝑒𝑑 𝑠𝑎𝑙𝑒𝑠 – 𝐵𝐸𝑃𝑠𝑎𝑙𝑒𝑠

CPA - November 2010 Q4

𝐹
i) BEP in units = 𝐶𝑀
F= 600000
P = 200
V = 100
600000 600000
=
200 − 100 100
= 𝟔𝟎𝟎𝟎Tickets
𝐹
BEP shillings = 𝑐𝑚𝑟
𝑝 − 𝑣 200 − 100
𝑐𝑚𝑟 = =
𝑃 100
= 0.5
600000
= 𝑲𝑺𝑯. 𝟏𝟐𝟎𝟎𝟎𝟎𝟎
0.5
𝑓+𝑇
ii) XT = 𝑖𝑛 𝑢𝑛𝑖𝑡𝑠
𝑐𝑚
6000000+300000
= 𝟗𝟎𝟎𝟎TICKET
200−100
In shillings (RT)
𝐹+𝑇 600000 + 300000
= = 1800000
𝑐𝑚𝑟 0.5
iii) Profit = (𝑝 − 𝑣)𝑥 − 𝑓
(200 − 100)8000 − 600000 = 200000
Or profit = 𝑐𝑚𝑟 × 𝑅 − 𝑓
0.5 × 8000 × 200 = 800000 − 600000
= 200,000
iv) S.P
Profit = (𝑃 − 𝑣)𝑥 − 𝐹
300000 = (𝑝 − 100)8000 − 600000
300000 = 8000𝑝 − 800000 − 600000
900000
𝑝 − 100 =
8000
𝑝 − 100 = 112.5
𝑝 = 212.5
v) Margin of safety = 𝐵𝑢𝑑𝑔𝑒𝑡𝑒𝑑 𝑜𝑟 𝑎𝑐𝑡𝑢𝑎𝑙 𝑠𝑎𝑙𝑒𝑠 − 𝐵𝐸𝑃 𝑠𝑎𝑙𝑒𝑠
In units
8000 − 6000 = 2000
% 𝑚𝑎𝑟𝑔𝑖𝑛 𝑜𝑓 𝑠𝑎𝑓𝑒𝑡𝑦
 2000
= × 100 = 25%
8000
In shillings
= (8000 × 200) − 1200000 = 400000

(i) % margin of safety Margin of safety = 𝐵𝑢𝑑𝑔𝑒𝑡𝑒𝑑 𝑜𝑟 𝑎𝑐𝑡𝑢𝑎𝑙 𝑠𝑎𝑙𝑒𝑠 − 𝐵𝐸𝑃 𝑠𝑎𝑙𝑒𝑠
In units.
8000-6000=2000
2000
× 100 = 25%
8000
CPA MAY 2016 Q 1b
𝐹
(i) BEP in units = 𝐶𝑀
F= 1300000
P = 1500
V = 1375
1300000 1300000
=
1500 − 1375 125
= 10,400Units
𝐹
BEP shillings = 𝑐𝑚𝑟

𝑝 − 𝑣 1500 − 1370
𝑐𝑚𝑟 = =
𝑃 1500
= 0.08333333
1300000
= 𝐾𝑆𝐻. 15,600,000𝑢𝑛𝑖𝑡𝑠
0.0833333
(ii) Margin of safety = 𝐵𝑢𝑑𝑔𝑒𝑡𝑒𝑑 𝑜𝑟 𝑎𝑐𝑡𝑢𝑎𝑙 𝑠𝑎𝑙𝑒𝑠 − 𝐵𝐸𝑃 𝑠𝑎𝑙𝑒𝑠
In units.
16000 − 10400 = 5600𝑢𝑛𝑖𝑡
Should the company sales fall below 5600 units it will begin to generate losses.
𝑓+𝑇
(iii) XT = 𝑖𝑛 𝑢𝑛𝑖𝑡𝑠
𝑐𝑚
1300000 + 250000
= 12400 𝑢𝑛𝑖𝑡𝑠
125

CVP ANALYSIS WITH SEVERAL PRODUCT/ MULTIPLE PRODUCTS

In the multiple product, where we had the contribution margin (cm) in the single
product we replace it with the weighted average contribution margin (wacm)
Where we had contribution margin ration (cmr) in the single product, we replace it
with weighted contribution margin ratio (wacmr)

CPA JUNE 2008 Q2

(i) BEP
 Gloss
Selling price per litre 15000
50000 = 13
Variable cost 90000
50000 = 1.8
F = 30,000
BEP in units F 30000
Cm 3-1.8 = 25000litre

BEP in shillings 𝑐𝑚𝑟

𝑝−𝑣
=
𝑃
3 − 1.8
=
3
= 0.4
=
sh.75,000

(ii) BEP
Shine
Selling price per litre 15000
40000 = 3.75
Variable cost 45000
40000 = 1.125
F = 84000
BEP in units F 84000
Cm 3.75-1.125 = 32000litre

BEP in shillings 𝑝−𝑣

𝑐𝑚𝑟 =
𝑃
3.75 − 1.125
=
3
= 0.7
=
sh.120,000

(iii) Weighted contribution margin (WACM)

=6+4 =10
(6/10X1.2) + (4/10X2.625) = 1.77
 (iv) Combined BEP = Total fixed cost
WACM
= 30,000 + 84000
1.77
= 64407Units
(v) Weighted contribution margin ratio
Total units = 1+1= 2
1 1
WACMR = 2 𝑋0.4 + 2X0.7 = 0.55
(vi)BEP = Total fixed costs
WACMR
= 84000+30000 =207272.7
0.55
2. APPLICATION OF MARGINAL COSTING

NON- ROUTINE DECESION

- These are short-term decisions not made on regular basis. These include:
1. Product mix decisions
2. Make or buy decision
3. Drop or continue decisions
4. Special offer decisions
- Not all costs are important and relevant for decision-making. Only relevant costs are
considered for decision-making.
Relevant Cost: It is the incremental costs or cost savings, which arise directly due to the
decision made.
- For a cost to be relevant, it must meet all or any of the following requirements.
1. Future cost: The cost, which has already been uncured, is historical cost and cannot
be used for decision making. A relevant cost therefore must be a future cost which is
yet to be incurred.
2. Incremental cost: A relevant cost must be the extra cost, which arises as a consequence
of the decision made. Regular payments such as salaries which are normally incurred
and paid for at the end of each month are not incremental therefore not relevant.
3. Cash flows- For a cost to be relevant it must constitute cash flows especially to the
decision maker. Non-cash items such as depreciation, national rent, deferred tax etc.
are not relevant for decision-making.
 4. Opportunity cost- This is the contribution cost as a consequence of making alternative
decision.

PRODUCT MIX WITH A LIMITING FACTOR DECISION.

A limiting factor is a scarce resource that prevents further production as the resource is not enough.
The total demand for the Company’s products cannot be satisfied because of this scarce resource
and therefore the Company must determine how well to maximize profitability from the available
resources.
Steps

1. Identify the limiting factor/unit of output

2. Compute the contribution per unit
3. Compute the contribution per limiting factor.
4. Rank the products based on three above.
5. Allocate available resources based on the ranking above.

CPA Dec 2009 Q 4

Limiting factor.
Labour hours at unit in testing department.
150
X= = 2.5 ℎ𝑟𝑠
60
180
Y= = 3 ℎ𝑟𝑠
60
300
Z= = 5 ℎ𝑟𝑠
60

Shortfall hours
Required hours:
X =12000 x 2.5 = 30000
Y =7000 x 3 = 21000
Z = 9000x 5 = 45000
96000
Available hours
x= 10000 x 2.5 = 25000
Y= 5000x 3 = 15000
Z = 6000x5 = 30000
70000
Shortfall hours = 96000-70000=26000
1. Cm per unit
=𝑝−𝑣
X Y Z
P 1500 1900 2600
V (1140) (1220) (1910)
CM 3600 680 690
2. Cm per limiting factor
360 680 690
= 144 = 226.7 = 138
2.5 3 5
3. Ranking;
1. Y
2. X
3. Z
4. Optimal production mix
Allocation of resources/available hours based on the ranking above.
Product Hours allocated units
Y 21000 7000
X 30000 12000
Z 19000/45000 x 9000 3800

c) Profit = 𝑝 − 𝑣)𝑥 − 𝑓
Y (1900-1220)7000 – (7000 x 200) =3360000
X (1500-1140)12000- (12000 x200) =1920000
Z (2600-1910)3800 – ( 3800 x200) =1862000
7142000

Other factors to consider in product mix decision

I. Contractual obligation – whether the company has contract to supply certain
number of units to the customer.
II. Effects on sales of the other product i.e. if the customer normally buys all the
product together.
III. Quality of the products – outsourced from external suppliers to cover the deficit.
IV. Whether the company is able to increase capacity by paying higher wages,
increasing machine time through hiring more machines.
V. Effects on fixed cost if production reduces

DROPPING A PRODUCTION
 Before a product is discontinued the total profit before discontinuation would be compared
with the total profit after discontinuation. The general rule is that any product making
positive contribution should not be discontinued

CPA MAY 2012 Q 1

AA 24000/15 =1600
BB 1500/15 =1000
CC 16020/15 =1068
DD 27900/15 =1860
Required hours 5528
Available hours (5000)
Shortfall hours 528hours

Contribution

AA BB CC DD
Sales 90,000 44000 56000 64000
Less: Variable costs
Direct Materials 20000 16000 22000 20000
Direct Labour 24000 15000 16020 27900
Variable overheads 6000 4000 6000 5000
Contribution 40000 9000 11980 11100
Contribution per 40000/1600 9000/1000 11980/1068 11100/1860
limiting factor
25 9 11 6
Ranking 1 3 2 4

PRODUCTION MIX
hours units
AA 1600 8000
 CC 1068 3600
BB 1000 2000
DD 1332/1860*3720 2664
Hours Available 5000

Total profit with BB

AA 40,000
BB 9000
CC 11980
DD 11100
Total contribution 72080
Fixed cost (42000)
Profit 30080

Profit without BB
AA 40000
CC 11980
DD 11100
Total contribution 63080
Fixed cost (42000)
Profit 21080

The company should not discontinue the product BB since it will lead to a reduction in the total
profit by sh.9000.

CPA DEC 2013 Q3

Neb ltd
Optimal production when we purchase component MT200

A B C
Selling price 112 136 153
Less: variable costs
Direct materials 12 16 12
Labour skilled 16 24 8
Labour unskilled 18 12 9
Variable overhead 12 12 9
 Component - - 80
Contribution per 54/1 72/1.5 35/0.5
limiting factor
54 4.8 70
Ranking 2 3 1

A 16/16 = 1X2400 2400

B 24/16=1.5X2200 3300
C 8/16 = 0.5X3000 1500
Hours required 7200
Hours available 5400
Shortfall 1800

Optimal production Mix

C 0.5X3000 = 1500 Hours

A 1x 2400 = 2400 Hours
B 1.5x 1000 = 1500 Hours
5400 hours

Total contribution
A 54 X 2400 129600
B 72 X 1000 72000
C 35X3000 105000
Total contribution 306600

When component MT 200 is produced.

Changes in product C on production
Selling price 153
Less: Variable costs:
Direct materials 12
Labour - Skilled 8
-unskilled 9
Variable overheads 9
MT 200 37
Contribution 78
 A B C
Contribution margin 54/1 72/1.5 78/1.5
54 48 52
Ranking 1 3 2

OPTIMAL PRODUCTION MIX.

A 1 x2400 = 2400
B 1.5X2000=3000
C 1.5x 0 = 0
5400

Total contribution
Contribution margin
A 54x2400 129600
C 78x2000 156000
Total contribution 285600
We go for a higher contribution. The company should purchase the component.

SPECIAL OFFERS/ORDERS
These are one –off contracts, which involves the decision of either accepting or rejecting an
offer. To make such decision the variable cost of production and any other variable cost e.g.
selling and distribution should be considered.

CPA JUNE 2010 Q3

Existing labour hour’s capacity.
A 19.6/60X4560 = 1489.6
B 13/60X6960 = 1508
C 9.9/60X3480 = 574.2
D 17/60X2300 = 651.7
4223.5Hours
Extra hours created for product A
From existing capacity 5% * 4223.5 = 211.175
From product B 13/60*2000 = 433.3
644.5hours

Extra units of A = 644.5hours = 1973units

19.6/60

ANALYSIS SCHEDULE
DROP B CONTINUE B
Sales revenue A 1973x162 319626 Sales 2000x116.4 232800
revenue
B 2000x116.4 232800 Less: cost
552426 Material 2000x49 98000
Less costs: Labour 2000x13 26000
Material costs 1973x65.2 128639.6 Packaging 2000x7.4 14800
A
Labour cost A 1973x19.6 38670.8 Contribution 94000
Packaging cost 1973x8.4 16573.2
A
Purchase cost 90%x116.4=104.76
B 2000 x 104.76 209520
Contribution 159022.4
The company should accept the offer since it leads to increase in contribution.

(b) The best product to outsource

A B C D
Selling price 162 116.4 99.2 136.8
Less: variable 93.2 69.4 56.5 78.2
cost
Contribution 68.8 47 42.7 58.6
margin
Contribution 68.8/0.327 47/0.217 42.7/0.165 58.6/0283
margin per =210.4 =216.6 =258.8 =207.1
limiting factor
Ranking 3 2 1 4

The product to outsource is the one that gives the lowest contribution per limiting factor
therefore outsource product D

OTHER FACTORS TO CONSIDER BEFORE DISCONTINUING PRODUCTION

1. If the product is making losses.
2. Effect on the employees/workers i.e. if it requires them to be laid off should the product
be discontinued.
3. The goodwill of the company i.e. if it will affects the loyal customers then the product
should not be dis-continued
4. The trade union action.
5. The usage of the fixed costs.
6. Availability of input resources.