In marginal costing system, only variable costs attributable to a product are included in the cost of product, excluding fixed overheads.
In absorption costing system, all costs attributable to a product are included in the cost of product, including fixed overheads.
Due to this basic reason, the following differences are observed in marginal costing and absorption costing.
- Gross profits of individual sales under marginal costing will be higher than absorption costing as fixed overheads are not subtracted from sales, as cost of goods sold.
- In marginal costing, fixed overheads are charged in the period in which they are incurred whereas fixed overheads, being included in the cost of inventory is charged to profit and loss account in the period in which goods are sold.
- In marginal costing, “contribution” is calculated (sales – variable costs) whereas in absorption costing, “gross profit” is calculated (sales – all costs attributable to inventory, including fixed overheads).
- Applicable frameworks for financial reporting such as IFRS do not allow marginal costing. Therefore use marginal costing is limited to internal use only whereas absorption costing can be used internally as well as for external financial reporting.
Example: Marginal vs Absorption Costing
Judo Hops Ltd is a company involved in the manufacture and sale of karate kits. The following data relates to the year ended 31 December 2017:
Selling price per unit: $ 80 per unit
Costs include:
- Direct material cost $ 20 per unit
- Direct labor cost $ 10 per unit
- Variable production overheads $ 8 per unit
- Fixed production overheads $ 100,000
- Variable selling expenses $ 6 per unit
- Variable admin expenses $ 3 per unit
- Fixed selling expenses $ 80,000
- Fixed admin expenses $ 40,000
- Normal capacity 20,000 units
- Overhead application rate (OAR) $ 5 per unit
(OAR = $100,000/20,000 units)
Other information is as follows:
- Opening stock 2,100 units
- Production during the year 20,000 units
- Sales during the year 19,000 units
- Closing stock 3,100 units
Required: Prepare the following statements for the year ended 31 December 2017:
- Income statement under marginal costing
- Income statement under absorption costing
- Profit reconciliation statement
Income Statement (Under Marginal Costing)
Judo Hops Ltd
Income Statement (Under Marginal Costing)
For the year ended 31 December 2017
| —-Amount in $—- | ||
| Sales ($80 x 19,000 units) | 1,520,000 | |
| Variable cost of goods sold: (Note – 1) | ||
| Opening stock ($38 x 2,100 units) | 79,800 | |
| Production ($38 x 20,000 units) | 760,000 | |
| 839,800 | ||
| Closing stock ($38 x 3,100 units) | (117,800) | |
| (722,000) | ||
| Gross contribution | 798,000 | |
| a | ||
| Variable selling expenses ($6 x 19,000 units) | 114,000 | |
| Variable admin expenses ($3 x 19,000 units) | 57,000 | |
| (171,000) | ||
| Total contribution or Net contribution | 627,000 | |
| a | ||
| Fixed costs: | ||
| Fixed production overheads | 100,000 | |
| Fixed selling expenses | 80,000 | |
| Fixed admin expenses | 40,000 | |
| (220,000) | ||
| Net profit | 407,000 | |
Note – 1
Production cost per unit is as follows:
| Amount in $ | |
| Direct material cost | 20 |
| Direct labor cost | 10 |
| Variable production overheads | 8 |
| Per unit cost of inventory | 38 |
Income Statement (Under Absorption Costing)
Judo Hops Ltd
Income Statement (Under Absorption Costing)
For the year ended 31 December 2017
| —-Amount in $—- | ||
| Sales ($80 x 19,000 units) | 1,520,000 | |
| Variable cost of goods sold: (Note – 2) | ||
| Opening stock ($43 x 2,100 units) | 90,300 | |
| Production ($43 x 20,000 units) | 860,000 | |
| 950,300 | ||
| Closing stock ($43 x 3,100 units) | (133,300) | |
| (817,000) | ||
| Gross profit | 703,000 | |
| a | ||
| Variable selling expenses ($6 x 19,000 units) | 114,000 | |
| Variable admin expenses ($3 x 19,000 units) | 57,000 | |
| Fixed selling expenses | 80,000 | |
| Fixed admin expenses | 40, 000 | |
| (291,000) | ||
| Net profit | 412,000 | |
Note – 2
Production cost per unit is as follows:
| Amount in $ | |
| Direct material cost | 20 |
| Direct labor cost | 10 |
| Variable production overheads | 8 |
| Fixed production overheads per unit | 5 |
| Per unit cost of inventory | 43 |
Profit Reconciliation Statement
Judo Hops Ltd
Profit Reconciliation Statement
For the year ended 31 December 2017
| Amount in $ | |
| Profit as per marginal costing | 407,000 |
| Less: | |
| Closing stock as per marginal costing | (117,800) |
| Opening stock as per absorption costing | (90,300) |
| Add: | |
| Closing stock as per absorption costing | 133,300 |
| Opening stock as per marginal costing | 79,800 |
| Profit as per absorption costing | 412,000 |