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MARGINAL AND ABSORPTION COSTING (PART 1)
FOG Accountancy Tutorials
Overview
This video introduces marginal and absorption costing, two methods for calculating product costs and profits. It explains that absorption costing includes all manufacturing costs (direct materials, direct labor, variable factory overheads, and fixed factory overheads) in the cost of goods sold and inventory valuation. In contrast, marginal costing treats fixed factory overheads as period costs, excluding them from the cost of goods sold and inventory valuation. The video outlines the distinct profit calculation formats for each method, highlighting that the difference in profit arises primarily from how closing inventory is valued. It sets the stage for subsequent videos that will cover practical application through problem-solving, closing stock valuation, and profit reconciliation.
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Chapters
- Marginal costing (also known as variable costing) excludes fixed production overheads from the valuation of closing stock.
- Absorption costing (also known as full costing) includes both fixed and variable production overheads in the valuation of closing stock.
- The primary difference between the two methods lies in their treatment of fixed manufacturing costs.
- Both methods are used to calculate profits and value inventory, but they yield different results due to the treatment of fixed costs.
Understanding the core difference in how fixed manufacturing costs are treated is crucial for interpreting financial statements and making informed business decisions based on cost data.
- The absorption costing profit statement starts with sales, followed by the cost of sales.
- Cost of sales is calculated as opening inventory + cost of production - closing inventory.
- Cost of production includes direct materials, direct labor, direct expenses, variable factory overheads, and fixed factory overheads.
- Non-factory overheads (administrative, selling, distribution) are deducted from gross profit to arrive at net profit.
This method provides a 'full' cost picture for inventory valuation, which is often required for external financial reporting.
Sales - Cost of Sales (Opening Inventory + Cost of Production [Direct Materials + Direct Labor + Variable Factory Overheads + Fixed Factory Overheads] - Closing Inventory) = Gross Profit - Non-Factory Overheads = Net Profit.
- The marginal costing profit statement begins with sales and then deducts variable costs to arrive at a contribution.
- Variable costs include direct materials, direct labor, variable factory overheads, and variable non-factory overheads (selling, administrative).
- Fixed factory overheads and fixed non-factory overheads are treated as period costs and are deducted from the contribution to arrive at net profit.
- Closing inventory is valued using only variable production costs.
This method focuses on the variable costs, making it useful for short-term decision-making, such as pricing and break-even analysis, by highlighting the contribution each sale makes towards covering fixed costs and generating profit.
Sales - Variable Costs (Variable Cost of Sales [Direct Materials + Direct Labor + Variable Factory Overheads] + Variable Non-Factory Overheads) = Contribution - Fixed Costs (Fixed Factory Overheads + Fixed Non-Factory Overheads) = Net Profit.
- The net profit under marginal and absorption costing will differ because of the treatment of fixed factory overheads in inventory valuation.
- When production exceeds sales, absorption costing profit will be higher because fixed overheads are deferred in closing inventory.
- When sales exceed production, marginal costing profit will be higher because fixed overheads from previous periods are released from inventory.
- Profit reconciliation is necessary to explain the difference between the profits calculated by the two methods.
Understanding why profits differ and how to reconcile them is essential for accurate financial analysis and for explaining discrepancies to stakeholders.
If more units are produced than sold, the fixed manufacturing overheads attached to the unsold units are included in the inventory value under absorption costing, thus reducing the current period's reported profit compared to marginal costing.
Key takeaways
- Marginal costing treats fixed manufacturing overheads as period costs, expensing them immediately.
- Absorption costing treats fixed manufacturing overheads as product costs, including them in inventory and cost of goods sold.
- The valuation of closing inventory is the primary driver of profit differences between the two methods.
- Absorption costing profit is higher than marginal costing profit when inventory levels increase.
- Marginal costing profit is higher than absorption costing profit when inventory levels decrease.
- Contribution margin (Sales - Variable Costs) is a key metric in marginal costing, used to cover fixed costs and generate profit.
- Non-factory overheads (administrative, selling, distribution) are treated as period costs under both methods, deducted after gross profit (absorption) or contribution (marginal).
Key terms
Marginal CostingAbsorption CostingVariable CostingFull CostingFixed Production OverheadsVariable Production OverheadsPrime CostCost of SalesClosing Inventory ValuationContribution MarginPeriod CostsProduct Costs
Test your understanding
- What is the fundamental difference in how marginal and absorption costing treat fixed factory overheads?
- How does the valuation of closing inventory differ between marginal and absorption costing?
- Why would absorption costing report a higher profit than marginal costing when production volume exceeds sales volume?
- What is the purpose of calculating 'contribution' in marginal costing?
- How are non-factory overheads (like administrative and selling expenses) handled in both costing methods?