Marginal vs Absorption Costing

Introduction

• Speaker: Steve Willis
• Topic: Difference between Marginal and Absorption Costing using examples

Marginal Costing

• Example Business: Small kiosk selling bottles of fancy mineral water
• Selling Price: $1 per bottle
• Variable Cost: 55 cents per unit
• Fixed Costs: $75 per month (kiosk rent)

Key Concepts

• Variable Costs: Costs that vary with production volume
• Fixed Costs: Costs that remain constant regardless of production volume
• Contribution per Unit:
  • Selling Price - Variable Cost
  • In this example: $1 - 55 cents = 45 cents

Profit and Loss (P&L) Statement

• Revenue - Total Variable Costs = Total Contribution
• Total Contribution - Fixed Costs = Profit or Loss
  • Profit if Contribution > Fixed Costs
  • Loss if Fixed Costs > Contribution

Break-Even Point (BEP)

• Formula: Fixed Costs / Contribution per Unit
• Example BEP: $75 / 45 cents ≈ 167 bottles
  • 168th bottle onward contributes to profit

Inventory Valuation

• Closing inventory valued only at variable production costs

Absorption Costing

• Example Business: Bicycle manufacturing and selling
• Selling Price: $25 per bike
• Variable Cost: $13 per unit
• Fixed Costs: $100 per month (factory rent)
• Production Plan: 10 bikes/month

Key Concepts

• Contribution per Unit: $25 - $13 = $12

Wesley’s Strategy

• New Selling Price: $15 per bike
• New Contribution per Unit: $15 - $13 = $2
• Risk: Low demand may not cover fixed costs (e.g., 10 bikes sold = $20 contribution, rent = $100)

Overhead Absorption Rate (OHAR)

• Calculation: Fixed Production Costs / Production Plan
• Example: $100 / 10 bikes = $10 per unit

Full Cost Per Unit

• Calculation: Variable Cost per Unit + Fixed Cost per Unit
• Example: $13 (Variable) + $10 (Fixed) = $23 per unit
• Profit per Unit: Selling Price - Full Cost per Unit
• Example: $25 - $23 = $2

P&L Statement (Absorption Costing)

• Revenue - Full Production Costs = Gross Profit
• Gross Profit - Non-production Costs = Net Profit

Comparison: Marginal vs Absorption Costing

• Marginal Costing:
  • Inventory valued at variable cost
  • Used for internal decision-making and segment reporting
• Absorption Costing:
  • Inventory valued at full cost (fixed + variable)
  • Used for external financial reporting (e.g., under IFRS)

Conclusion

• Marginal Costing: Useful for short-term decisions and internal reporting
• Absorption Costing: Required for external financial statements and long-term perspective