Lecture Notes: Marginal and Absorption Costing

Introduction

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

Marginal Costing

• Business Example: Small kiosk selling mineral water
• Pricing: $1 per bottle
• Variable Cost per Unit: $0.55
• Fixed Costs: $75 per month (rent)
• Contribution per Unit:
  • Calculation: Selling price - Variable cost
  • Example: $1 - $0.55 = $0.45

Financial Reporting

• Profit & Loss Statement (P&L):
  • Top line: Sales/Revenue
  • Subtract Total Variable Costs to get Total Contribution
  • Subtract Fixed Costs from Contribution to determine profit or loss
• Break-Even Point (BEP):
  • Calculation: Fixed Costs / Contribution per Unit
  • Example: $75 / $0.45 = 167 bottles to cover costs (profit starts from 168th bottle)

Inventory Valuation

• Valued only at variable production costs
• Fixed production costs are treated as period costs

Absorption Costing

• Business Example: Bicycle manufacturing
• Fixed Costs: $100 per month (factory rent)
• Production Plan: 10 bikes per month
• Pricing: $25 per bike
• Variable Cost per Unit: $13
• Contribution per Unit: $12

Pricing Strategy

• Scenario: Lowering price to $15 with $13 variable cost
• Risk: Insufficient sales may not cover fixed costs

Overhead Absorption Rate (OAR)

• Calculation: Fixed production overheads / budgeted production units
• Example: $100 / 10 bikes = $10 per unit

Profit Calculation

• Full Cost per Unit: Variable cost + Overhead absorption rate
• Example: $13 + $10 = $23 per unit
• Profit per Unit: Selling price - Full cost per unit

Comparison: Marginal vs. Absorption Costing

• Marginal Costing P&L:
  • Sales - Variable Costs = Contribution
  • Contribution - Fixed Costs = Profit
• Absorption Costing P&L:
  • Sales - Full Production Costs = Gross Profit
  • Gross Profit - Non-Production Costs = Net Profit
  • Includes over or under absorption adjustments

Application

• Financial Accounting: Absorption costing aligns with IFRS for external reporting
• Internal Reporting: Marginal costing is useful for analyzing individual segments of the business

Conclusion

• Understanding both methods is crucial for business decision-making
• Marginal costing aids in short-term decisions; absorption costing for compliance and external reports

End of lecture.