ABSORPTION AND MARGINAL COSTING

Definitions
Absorption costing: It is a costing system which treats all manufacturing costs including both
the fixed and variable costs as product costs.
Marginal costing: It is a costing system which treats only the variable manufacturing costs as
product costs. The fixed manufacturing overheads are regarded as period costs.
Under and over absorption
As planned level of activity and the actual level of activity is not the same there is always an Over or
Under Absorption situation
This is because overhead absorption rate is set at the start of the period based upon an expected level of
production and that during the period, the level of output and or overheads will be different from the
planned overheads and or output.
OVER-absorption occurs when the total overhead recovered or absorbed is GREATER than the actual
level of overheads for the period.
UNDER-absorption occurs when the total overheads recovered or absorbed is LESS than the actual
overheads incurred in the period.
Company A recovers its overheads based upon direct labor hours. The planned overhead expenditure is
$2,500 per month and the planned direct labor hours are 1,000 per month. The results for the first 3
months were as follows:
Actual overhead ($)
Direct labour hours

Month 1
4000
1000

Month 2
5000
2000

Month 3
3500
2000

Required:
(a) Compute the overheads recovered each month;
(b) Compute the total overheads over/under-absorbed
Solution:
(a)The pre-determined overhead absorption rate:
= Budgeted overhead per month/Budgeted direct labors per month
=$2,500/1,000 hours=$2.50 per direct labor hour.

Actual overhead
Direct labour hours (a)
Overhead recovery/direct labour hr (b)
Overhead recovered or absorbed (a) x (b)

1
4000
1000
2.5
2500

2
5000
2000
2.5
5000

3
3500
2000
2.5
5000

(b)The monthly over/under absorption of overheads is the difference between the overhead recovered or
absorbed and the actual level of overhead for the period
1
4000
2500
(1500)

Actual overhead
Overhead recovered
Over/under absorbed (a)-(b)

Difference between absorption and marginal costing

Absorption
Treatment for
Fixed manufacturing overheads are
fixed
treated as product costs. It is believed
manufacturing
that products cannot be produced
overheads
without the resources provided by
fixed manufacturing overheads.
Value of closing
stock

High value of closing stock will be

obtained as some factory overheads
are included as product costs and
carried forward as closing stock.

2
5000
5000
0

3
3500
5000
1500

Marginal
Fixed manufacturing overheads
treated period costs. It is believed that
only the variable costs are relevant to
decision making. Fixed
manufacturing overheads will be
incurred regardless there is
production or not.
Lower value of closing stock that
included the variable cost only.

Trading and profit and loss account layout

Absorption costing
Sales
Less Cost of Sales
Gross profit
Less expenses
Selling expenses
Admin expenses

Net profit

X
(X)
X
X
X

(X)

Marginal costing
Sales
Less variable cost of goods sold
Product contribution
Less variable non-manufacturing
expenses
Variable selling expenses
Variable admin expenses
Total contribution expenses
Less expenses
Fixed selling expenses
Fixed admin expenses
Net profit

X
(X)
X
X
X

X
X

(X )
X

(X )
X

Example
A company started its business in 2005. The following information was available for January to
February 2005 for the company that produced a single product.
$

Selling price
100
Direct material/unit
20
Direct labour/unit
10
Fixed factory overhead/month
30 000
Variable factory overhead/unit
5
Fixed selling overheads
1 000
Variable selling overheads/unit
4
Budgeted activity was expected to be 1 000 units each month. Production and sales for each
month were as follows:
Jan
Feb
Unit sold
800
1100
Unit produced
1300
900
Required
Prepare absorption and marginal costing statements for the months.
Absorption costing
Sales
Less cost of goods sold ($65)
Adjustment for over - /(under)
Absorption of factory overhead
Gross profit
Less expenses
Fixed selling overheads
Variable overheads
Net profit

January
80 000
52 000
28 000
9 000

February
110 000
71 500
38 500
(3 000)

37 000

35 500

1 000
3 200
32 800

1 000
4 400
30 100

January
80 000
28 000
52 000
3 200
48 800

February
110 000
38 500
71 500
4 400
67 100

30 000
1 000
32 800

30 000
1 000
30 100

Marginal costing
Sales
Less variable cost of goods sold ($35)
Product contribution
Less variable selling overheads
Total contribution
Less fixed expenses
Fixed factory overhead
Fixed selling overheads
Net profit
Working 1
Standard fixed overhead rate
= budgeted total fixed factory overheads
Budgeted number of units produced

= $30 000 = $30/unit

1000

Working 2
Production cost per unit under absorption costing
Direct materials
20
Direct labour
10
Fixed factory absorbed
30
Variable overheads
5_
65
Working 3
Under/over absorption of fixed factory overheads
January
Fixed overhead
Fixed overheads incurred

39 000
30 000
9 000
January (1300 x $30)

Working 4 (no fixed factory overhead)

Variable production cost/unit under marginal costing
Direct material
20
Direct labour
10
Variable factory overhead
5
35

February
27 000
30 000
3 000
February (900 x $30)