Make your own free website on Tripod.com
Absorption and marginal costing systems

by Nigel Coulthurst

A popular topic for examination at Foundation Level has been the preparation of profit statements in both absorption and marginal costing formats, and the reconciliation of the profits reported by the two systems. In recent Paper 3 examinations, the topic has appeared in December 2000 (Q2), June 2000 (Q6), June 1999 (Q6) and December 1997 (Q3). Question 6 from the June 2000 paper (slightly adapted) will be used for the purpose of illustration in this article. The adapted question is set out below (Example 1).

Example 1
A company sells a single product at a price of £14 per unit. Variable manufacturing costs of the product are £6.40 per unit. Fixed manufacturing overheads, which are absorbed into the cost of production at a unit rate (based on normal activity of 20,000 units per period), are £92,000 per period. Any over-absorbed or under-absorbed fixed manufacturing overhead balances are transferred to the profit and loss account at the end of each period, in order to establish the manufacturing profit.

Sales and production (in units) for two periods are as follows:

  Period 1 Period 2
Sales 15,000 21,600
Production 18,000 21,000

Required:
(a) Prepare a trading statement to identify the manufacturing profit for Period 2 using the existing absorption costing method.
(b) Determine the manufacturing profit that would be reported in Period 2 if marginal costing was used.
(c) Explain, with supporting calculations, why the manufacturing profit in (a) and (b) differs.

The cost accounting process
An earlier article in the Students’ Newsletter placed these two costing systems (i.e., absorption and marginal costing) in the context of the cost accounting process as a whole. A diagram included in that earlier article on process costing is reproduced on the following page (Figure 1).

Figure 1

The key issue between absorption costing and marginal costing is how the costs of a business’s input resources are best organised and presented so as to identify individual product/service and total business profit.

The choice of costing system may be influenced by the costing method adopted. Specific order costing methods will frequently deploy full absorption costing. One reason for this is that the pricing of each unique piece of work will invariably make reference to the total costs incurred. Continuous operation costing methods are more likely to deploy marginal costing (although this may be in addition to absorption costing) because of the opportunities in such an environment to use cost-volume-profit (CVP) analysis.

It is not the purpose of this article to debate the relative merits of absorption and marginal costing systems. The purpose is simply to consider the respective processes of profit statement preparation, and to reconcile the results in terms of profits reported.

Absorption costing principles
In product/service costing, an absorption costing system allocates or apportions a share of all costs incurred by a business to each of its products/services. In this way, it can be established whether, in the long run, each product/service makes a profit. This can only be a guide. Arbitrary assumptions have to be made about the apportionment of many of the costs which, given that some costs will tend to remain fixed during a period, will also be dependent on the level of activity.

An absorption costing system traditionally classifies costs by function. Sales less production costs (of sales) measures the gross profit (manufacturing profit) earned. Gross profit less costs incurred in other business functions establishes the net profit (operating profit) earned.

Using an absorption costing system, the profit reported for a manufacturing business for a period will be influenced by the level of production as well as by the level of sales. This is because of the absorption of fixed manufacturing overheads into the value of work-in-progress and finished goods stocks. If stocks remain at the end of an accounting period, then the fixed manufacturing overhead costs included within the stock valuation will be transferred to the following period.

Absorption costing profit statement
The first stage in the preparation of absorption costing profit statements is the measurement of the gross profit (manufacturing profit) earned. This requires the calculation of unit production costs, including the establishment of absorption rates for manufacturing overheads.

Referring to the example being used for illustration in this article (see earlier), variable manufacturing costs per units are given in the question (at £6.40 per unit). Fixed manufacturing overheads of £92,000 per period are to be absorbed at a unit rate (based on normal production activity of 20,000 units per period). The fixed manufacturing overhead absorption rate is therefore £4.60 per unit (£92,000 ¸ 20,000 units) giving a total manufacturing cost of £11.00 per unit (£6.40 + £4.60).

The use of normal activity as the basis for overhead absorption is similar to the use of budgeted activity. It is to be expected that actual activity (and indeed actual expenditure also) will be different to normal/budget thus giving rise to overhead over or under absorption. It is important that this is highlighted in profit statements. The use of normal (or budgeted) activity and expenditure to establish the absorption rate not only helps to focus attention on overhead recovery but also has the effect of ‘normalising’ per unit product/service costs.

Referring again to the example, fixed manufacturing overheads will be over-absorbed in Period 2 because the actual production of 21,000 units exceeds the normal activity, the basis used to establish the absorption rate, by 1,000 units. The extent of the over-absorption (the balance remaining in the fixed manufacturing overhead account) is, therefore, £4,600 (1,000 units at £4.60 per unit). This amount will be transferred to the profit and loss account in order to establish the manufacturing profit. It will have a positive effect (i.e., it will be added to profit) because more manufacturing overhead has been absorbed into stock in the period than has been incurred (see the entries in the fixed manufacturing overhead account demonstrated later in examples).

The Examiner’s Report for the June 2000 Paper 3 noted that the over-absorption of fixed manufacturing overhead caused problems for many candidates. It was frequently not identified. Where it was calculated, it was at times described as ‘under-absorbed’ or was at least treated as such in terms of its impact on the manufacturing profit. Other candidates wrongly calculated the over/under- absorption based upon the difference between sales and production quantities, rather than upon the difference between actual production and normal production.

Preparation of the remainder of the trading statement (to identify the manufacturing profit for Period 2 using absorption costing) should be straightforward (see Example 2). The manufacturing cost of sales (the transfer out of the finished goods stock account) is simply the 21,600 units sold in the period (which at a selling price of £14.00 per unit yields total sales for the period of £302,400) multiplied by the unit manufacturing cost of £11.00.

Example 2
Period 2 Trading Statement: £000  
Sales 302.4 (21,600 units at £14.00 per unit)
Manufacturing cost of goods sold 237.6 (21,600 units at £11.00 per unit)
Manufacturing profit (before adjustment) 64.8 (21,600 units at £3.00 per unit)
Fixed manufacturing overhead over-absorbed 4.6 (1,000 units at £4.60 per unit)
Manufacturing profit (after adjustment) 69.4  

The Examiner’s Report noted that there were many examples (in the examination scripts marked) of candidates matching the cost of the goods produced in the period (not the manufacturing cost of the goods sold) with sales.

Many examination candidates also got into difficulty because they attempted to introduce stock into the profit statement. There is generally no requirement to do this (unless opening and closing stocks are valued at a different rate per unit) but such an approach should (but often did not) lead to the same profit result.

In this example, no details of stock are provided in the question, but it could be assumed, for example, that
3,000 units were in stock at the end of Period I (production of 18,000 units less sales of 15,000 units). Finished goods stock at the end of Period 2 would then be 2,400 units due to the excess of sales over production of 600 units in that period (see Example 3).

Example 3
A trading statement including stock would be:    
Period 2 Trading Statement £000  
Sales 302.4  
Manufacturing cost of goods sold:    
Opening stock of finished goods 33.0 (3,000 units at £11.00 per unit)
Cost of goods produced 231.0 (21,000 units at £11.00 per unit)
Closing stock of finished goods (26.4) (2,400 units at £11.00 per unit)
  237.6  
Manufacturing profit (before adjustment) 64.8  
Fixed manufacturing overhead over-absorbed 4.6    
Manufacturing profit (after adjustment) 69.4  

In the adapted question used for illustration in this article (Example 1) there is no information provided about costs incurred in other business functions (selling, administration, distribution) and thus it is not possible to complete the profit statement. If information on other costs was available, the costs incurred in the period would simply be deducted from the adjusted manufacturing profit to arrive at net profit.

Marginal costing principles
In product/service costing, a marginal costing system emphasises the behavioural, rather than the functional, characteristics of costs. The focus is on separating costs into variable elements (where the cost per unit remains the same with total cost varying in proportion to activity) and fixed elements (where the total cost remains the same in each period regardless of the level of activity). Whilst this is not easily achieved with accuracy, and is an oversimplification of reality, marginal costing information can be very useful for short-term planning, control and decision-making, especially in a multi-product business.

In a marginal costing system, sales less variable costs (regardless of function) measures the contribution that individual products/services make towards the total fixed costs incurred by the business. The fixed costs (regardless of function) are treated as period costs and, as such, are simply deducted from contribution in the period incurred to arrive at net profit.

Marginal costing profit statement
Referring back to Example 1, as there is no information regarding non-manufacturing costs, it may be assumed that sales less variable manufacturing costs measures contribution. NB. If any variable costs are incurred in non-manufacturing functions then they would also be deducted from sales in the measurement of contribution.

The trading statement for Period 2, assuming that a marginal costing system was in place instead, would be as in Example 4.

Example 4
Period 2 Trading Statement: £000  
Sales 302.40  
Variable cost of goods sold 138.24 (21,600 units at £6.40 per unit)
Contribution 164.16 (21,600 units at £7.60 per unit)
Fixed manufacturing overhead 92.00  
Manufacturing profit 72.16  

Once costs have been separated into variable and fixed elements, the marginal costing approach is more straightforward. The Examiner’s Report noted that candidates generally had rather more success with the marginal costing statement in part (b) than with the absorption costing statement in part (a), although some confusion between the two was demonstrated.

In practice, the marginal costing profit statement would be completed by the further deduction of fixed costs incurred in other functions.

Profit reconciliation
The net profit reported by absorption and marginal costing systems may not be the same owing to the differing treatment of fixed manufacturing overheads. As has been demonstrated above, whilst marginal costing systems treat fixed manufacturing overheads as period costs (i.e. a charge against profit in the period incurred), in absorption costing systems they are absorbed into the cost of goods produced and are only charged against profit in the period in which those goods are sold.

As a result, if quantities produced and sold in a period are not the same (i.e., if the levels of work-in-progress or finished goods stock change) a different profit will be reported by the two systems. The differing profits can be reconciled, and the difference explained, by an analysis of the product of the stock change and the fixed manufacturing overhead absorption rate. Thus, in answer to part (c) of Example 1:

Period 2 finished goods stock reduction 600 units
x fixed manufacturing overhead absorption rate, £4.60 per unit
= £2,760
difference in profit

i.e., the difference between the absorption costing manufacturing profit of £69,400 and the marginal costing manufacturing profit of £72,160. Absorption costing has a lower profit because more goods are being taken out of stock (including a charge for fixed manufacturing overhead) than are going into stock.
This is demonstrated by the entries in the respective cost accounting systems (fixed manufacturing overhead only) as in Example 5.

Example 5
In the absorption costing system:
Fixed Manufacturing Overhead Account
Incurred £92,000 Absorbed into finished goods £96,600
Over-absorbed – to P&L A/c (1,000 units at £4.60/unit)  £4,600 (21,000 units at £4.60/unit)             
  £96,600   £96,600
  Finished Goods Stock Account  
Fixed mfg o’hd absorbed £96,600 Cost of sales (fixed mfg o’hd only) £99,360
    (21,600 units at £4.60/unit)  
The total fixed manufacturing overhead charged against profit in the period =
Overhead in cost of sales £99,360    
Less over-absorption  £4,600    
  £94,760    
In the marginal costing system:
Fixed Manufacturing Overhead Account
Incurred £92,000 P&L A/c-period cost £92,000

Absorption costing £94,760 less marginal costing £92,000 =£2,760 more fixed manufacturing overheads and less profit in absorption costing.

NB. The difference in profit between absorption and marginal costing systems is nothing to do with overhead over/under absorption, a popular misconception amongst examination candidates. Despite an over-absorption of £4,600, which is a positive adjustment to the absorption costing profit, the profit was nevertheless less than the marginal costing profit.

To emphasise again – the difference in reported profit demonstrated above, which can only be a timing difference, is due to changes in the level of finished goods stock which in an absorption costing system moves overhead, and therefore profit, from one period to another. As a general rule:

If production quantity > sales quantity then absorption costing profit > marginal costing profit. If production quantity < sales quantity then absorption costing profit <marginal costing profit.

Many candidates, when answering examination questions on this topic, do appreciate that the different treatment of fixed manufacturing overhead is the reason for profit differences but they are rarely able to reconcile the profits.

Reference
1. Coulthurst, N. ‘Process Costing’. Students’ Newsletter, January 2000.