hello friends steve willis here in this short video i'm going to explain the difference between marginal and absorption costing let's start with marginal costing and we'll use an imaginary business to get to the bottom of this topic let's imagine we have a small business and we run our business out of a kiosk and we sell one product bottles of fancy mineral water and we charge one dollar in some countries dollars as our price so let's look at the costs we have a variable cost per unit very simple guys we're keeping it super simple right the variable cost per unit let's imagine is 55 cents okay and i have one fixed cost the rent of my kiosk so fixed costs let's say 75 dollars per month that is the heart of marginal costing understanding our variable versus our fixed costs now here's how i think about my business at the unit level i sell a bottle of water for one dollar my variable cost per unit is 55 cents so one dollar comes into the business 55 cents goes out to make that sale now what's left over very important idea that's the idea of contribution per unit everybody contribution towards fixed costs and profit so my price minus my variable cost per unit is my contribution per unit which would be 45 cents that is an important idea in marginal costing working with this idea of contribution the difference between my price and my variable cost at the unit level or my total sales less my total variable costs at the p l level now at the end of the month at the end of an accounting period when i want to report my financial performance over a period of time okay we use the profit or loss statement so my p and l okay i'm going to break in very simple terms guys my top line will be my sales or my revenue from that i subtract my total variable costs and i am left then with my total contribution now to get down to a profit line from my contribution i have to cover my fixed costs if my contribution is greater than my fixed costs there is a surplus that would be a profit wouldn't it okay if however my fixed costs are greater than my contribution i did not earn enough contribution to pay my rent i am in a loss now using marginal costing is helpful for making short-term business decisions i would like to understand how many bottles of water i need to sell to break even so that i my my revenue covers all my costs so i can now do that quite easily because i understand the formula for a break even point which i can abbreviate bep that will be simply right my fixed costs divided by my contribution per unit so we know that the fixed costs in this silly little little example are 75 dollars we know the contribution per unit we said was 45 cents so we need to sell 167 bottles of water rounding up to make a profit the 168th bottle forward will be adding contribution into my pocket or my profit another important aspect of marginal costing when we're looking at a manufacturing company for example when we have inventory at the end of the period when we have our closing inventory we're going to value that only at the variable production costs the fixed production costs are treated as a period cost and are below contribution so we're saying there that the marginal costing inventory is valued at variable cost per unit friends let's now look at absorption costing for absorption costing let's use a different business let's look at a business that manufactures and sells bicycles okay and the rent okay for my bicycle factory let's pretend is 100 per month now i have a production plan guys my plan every month is to do 10 bikes and let me now tell you a bit more about my business i sell my bicycles for 25 dollars per bike my variable cost per unit let's imagine is 13 okay so the contribution per unit that's unit level everybody is twelve dollars okay just like before now here's my friend wesley the owner of this business let's imagine okay now wesley tells me about a daring plan wesley is going to reduce his selling price to 15 per unit in an attempt to grow sales hoping that his demand is elastic so he lowers his price he sells more bicycles so if he drops his price to 15 let's imagine variable cost will remain 13. but his contribution will go to two dollars and he's thinking to himself well i have positive contribution so as long as i'm earning contribution my profit should be increasing at least i'll be earning contribution to offset my fixed costs friends does anyone see a major problem with this strategy think about it for a second well i see a big risk here if demand is not as elastic as he hopes and he only sells 10 bicycles he'll only earn 20 dollars contribution his rent guys is one hundred dollars a month so he won't earn enough contribution to pay his rent let's look at the situation now from an absorption costing approach and it means looking at our concept of cost per unit from a different perspective instead of thinking about our inventory valuation at variable cost per unit we're thinking about it from the longer term perspective so look what i'm going to do i'm going to spread my fixed costs over my production plan and i will then get a fixed production cost per unit that is called the overhead absorption rates i abbreviate that o-h-a-r many books call it an o-a-r either way is fine and what we're going to do we're going to take the budgeted fixed overheads fixed production overheads that's the rent okay divided by the budgeted production plan budgeted units okay so in our simple example that would be 100 divided by 10 bicycles equals 10 dollars per unit now using the absorption costing approach we understand the variable cost per unit now using the working of the overhead absorption rate we can now have our fixed cost per unit which is 10. so rather than thinking of a contribution for per bicycle i can now think in terms of profits per bicycle and that would be two dollars and we also then think of these two numbers combined the fixed cost per unit and the variable cost per unit that is the full cost per unit okay so if we compare the two approaches now under marginal costing we have a price of 25 per bicycle we value our inventory guys at the variable cost per unit only which we said was thirteen dollars okay and we then can think about contribution per unit as 12 and my objective then in the month is to earn enough contribution to cover my fixed costs and give me a profit okay we could also then use an absorption costing approach and we'll have the same selling price okay now we will have a full cost per unit which will be the fixed and the variable cost and we said that that was the 10 and the 13 so that would be 8 23 and then we can have a profit per unit of two marginal costing versus absorption costing if we now look at p l statements under both approaches we talked about marginal costing okay we subtract our variable costs from our sales and we get a contribution line from our contribution we subtract our fixed costs and we get a profit under absorption course costing of course we also start with our sales from which we subtract our full production costs fixed and variable now in here will also be our over or under absorption okay the complication of absorption costing we subtract our full production costs from our sales and we will have then our gross profit line we subtract from that non-production costs we subtract from that our non-production costs and we then have a net profit line okay now if you work in financial accounting it's the absorption costing approach that's driving the ifrs approach and financial statements for external stakeholders are often prepared under absorption costing whereas under marginal costing we can use this for internal reporting we can try and understand the profit for any segment of our business we could run a p l for let's say we have a training company what's the profit or the loss for the training course or for the department or for the business friends i hope that shed some light on this topic of marginal and absorption costing this is steve signing out for now