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 $1 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.
And I have one fixed cost, the rent of my kiosk. So fixed costs, let's say $75 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 $1.
My variable cost per unit is $0.55. So $1 comes into the business, $0.55 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, we use the... profit or loss statement. So my P and L. I'm going to bring 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? 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 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 my fixed costs divided by my contribution per unit. So we know that the fixed costs in this silly little example are $75. 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. 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 per bike. My variable cost per unit, let's imagine is $13. Okay.
So the contribution per unit, that's unit level everybody, is $12. 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 $2. 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 you? 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 contribution.
His rent, guys, is $100 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 rate. 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, divided by the budgeted production plan, budgeted units. So in our simple example, that would be...
$100 divided by 10 bicycles equals $10 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 contribution per bicycle, I can now think in terms of profit per bicycle. And that would be $2.
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. 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 $13. 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. We could also then use an absorption costing approach. And.
We'll have the same selling price. 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 a 23. And then we can have a profit per unit of 2. Marginal costing versus absorption costing. If we now look at P&L statements under both approaches, we talked about marginal costing. 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 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, 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 and we then have a net profit line. 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 sheds some light on this topic of marginal and absorption costing.
This is Steve signing out for now.