ICAB Accounting Notes: Marginal & Absorption Costing Guide

Marginal & Absorption Costing

Marginal costing and absorption costing are key concepts in cost accounting, crucial for ICAB exam success and real-world decision-making. Marginal costing focuses on variable production costs, treating fixed costs as period expenses, while absorption costing allocates a portion of fixed overhead to each unit, affecting inventory valuation and reported profit.

1. Marginal Costing Essentials

What is Marginal Costing?

Marginal costing considers only variable production costs:

  • Variable materials
  • Variable labour
  • Variable production overhead

Fixed costs, including factory overhead and administrative expenses, are treated as period costs and deducted from revenue when incurred.

Contribution — The Core Concept

Contribution = Sales Revenue − Total Variable Cost

Contribution per unit = Selling Price per Unit − Variable Cost per Unit

This measures the amount available to cover fixed costs and profit.

Worked Example — Splash Product

  • Selling price = CU10/unit
  • Variable cost = CU6/unit
  • Fixed costs = CU45,000
  • Production = 20,000 units

Contribution per unit = 10 − 6 = CU4

Profit Calculation:

  • Sales 10,000 → Contribution = 40,000; Profit = 40,000 − 45,000 = CU5,000 loss
  • Sales 15,000 → Contribution = 60,000; Profit = 15,000
  • Sales 20,000 → Contribution = 80,000; Profit = 35,000

2. Key Marginal Costing Mechanics & Exam Tips

Inventory Valuation

Closing stock is valued at variable cost per unit. Example: Variable cost = CU6, closing inventory 2,000 units → 2,000 × 6 = CU12,000.

Contribution per Unit is Constant

Assumes selling price and variable cost per unit remain constant. Total contribution varies with sales volume.

Quick Exam Shortcut

Profit = Contribution per unit × Units Sold − Total Fixed Costs

3. Absorption Costing (Full Costing)

Absorption costing assigns both variable and fixed overhead costs to each unit:

Full unit cost = Variable production cost + Allocated fixed overhead per unit

Predetermined Overhead Rate (POHR) = Budgeted fixed production overhead ÷ Budgeted activity

Short Example

Budgeted fixed overhead = CU1,600; Budgeted production = 800 units → POHR = CU2/unit

Each unit carries CU2 fixed overhead in inventory.

4. Absorption vs Marginal — When Profit Differs

Profit under absorption differs if inventory changes:

  • Closing inventory ↑ → Absorption profit higher (fixed costs carried forward)
  • Closing inventory ↓ → Absorption profit lower (fixed costs released)

Difference formula: Change in inventory units × Fixed overhead/unit

5. Worked Example — Quarter Comparison

  • Annual fixed overhead = CU1,600; normal output = 800 → Fixed overhead/unit = CU2
  • Variable cost/unit = CU8; Selling price = CU20
  • Quarter production = 220; Sales = 160 → Closing inventory = 60

Absorption inventory/unit = 8+2=CU10; Marginal inventory/unit = CU8

Profit difference = 60 × 2 = CU120 → Absorption profit higher

6. Over- and Under-Absorption of Overheads

Over-absorption: Applied overhead > Actual → Credit adjustment

Under-absorption: Applied overhead < Actual → Debit adjustment

Example: Budget = 80,000; Hours = 40,000 → POHR=2/hr; Actual OH = 84,000; Actual hours = 45,000; Absorbed = 90,000 → Over-absorbed = 6,000

7. Comparative Strengths — Quick Table

Feature Marginal Costing Absorption Costing
Inventory Valuation Variable costs only Full production cost (variable + fixed share)
Fixed Costs Treatment Period cost Included in inventory
Profit with Inventory Changes Sensitive; profit lower if inventory ↑ Profit higher if inventory ↑
Usefulness Decision-making focus External reporting (GAAP/IFRS)
Complexity Simpler More complex (POHR apportionment)

8. Practical Exam Questions & Model Answers

  • Q1: Selling price = 35, Variable = 15, Fixed OH/unit = 5, Produced 1,500, Sold 1,200 → Profit difference = 300×5=1,500 (Absorption higher)
  • Q2: Water Ltd, 15,000 units sold → Contribution=60,000; Profit=60,000−45,000=15,000
  • Q3: Budgeted OH=80,000, 40,000 hrs, Actual OH=84,000, Actual hours=36,000 → Absorbed=72,000 → Under-absorbed=12,000

9. Common Exam Pitfalls & Killer Tips

  • Don’t mix valuation bases between marginal and absorption costing
  • Fixed costs under marginal costing must be fully expensed
  • POHR must be applied correctly per exam instructions
  • Use shortcut: Contribution × Sales − Fixed Costs to check profit quickly
  • Reconciliation formula: Change in units × Fixed OH/unit

10. Conclusion — Mastering the Chapter

Memorize contribution definition, practice problems with inventory changes, compute POHR and over/under absorption, and always structure answers clearly. Writing step-by-step for both methods earns partial marks even under exam pressure.

MCQs Practice

  • 1. Contribution per unit where Selling price = 1,009.99, Variable costs = 320+192+132?
    Answer: 365.99
  • 2. Budgeted OH=80,000/40,000 hrs=2/hr; Actual 45,000 hrs, OH=84,000 → Over/Under?
    Answer: Over-absorbed 6,000
  • 3. Production=1,500, Sales=1,200; Fixed OH/unit=1 → Absorption vs Marginal profit difference?
    Answer: 300 (Absorption higher)

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