Marginal vs Absorption Costing Simplified | for ACCA students | How to pass ACCA Exams

Summary

In this video, Steve Willis explains the key differences between marginal and absorption costing using simple business examples. Marginal costing focuses on variable costs and contribution per unit to help businesses make short-term decisions, like calculating the break-even point. Absorption costing, on the other hand, allocates fixed costs over all units produced, providing a more comprehensive picture of production costs for external financial reporting. The video breaks down both methods with examples from a water bottle business and a bicycle manufacturer, highlighting when each costing method is most useful for financial decision-making.

Takeaways

• 😀 Marginal costing focuses on the difference between variable costs and fixed costs, with the goal of understanding contribution towards covering fixed costs and generating profit.
• 😀 Contribution per unit is calculated as the selling price minus the variable cost per unit, providing insight into the business’s ability to cover fixed costs.
• 😀 The break-even point (BEP) is a critical concept in marginal costing. It is calculated by dividing fixed costs by the contribution per unit.
• 😀 Marginal costing is particularly useful for short-term business decisions, like determining the number of units needed to cover fixed costs and achieve profitability.
• 😀 Fixed costs, such as rent, are treated as period costs in marginal costing and are not allocated to products.
• 😀 In absorption costing, both variable and fixed costs are assigned to products. Fixed production costs are spread across units using an overhead absorption rate (OAR).
• 😀 The overhead absorption rate (OAR) is calculated by dividing total fixed production costs by the planned production units, yielding a fixed cost per unit.
• 😀 Absorption costing allows businesses to assess the total cost per unit (including both fixed and variable costs) and is used for external financial reporting.
• 😀 In absorption costing, the full production cost per unit is important for determining profitability, which includes both fixed and variable costs.
• 😀 Financial statements prepared under absorption costing provide a more comprehensive view of production costs, including fixed costs that are allocated to inventory and the cost of goods sold.
• 😀 While marginal costing is suitable for internal reporting and decision-making, absorption costing is essential for external reporting, aligning with IFRS guidelines.

Q & A

What is the main difference between marginal costing and absorption costing?

The main difference is in how fixed costs are treated. In marginal costing, fixed costs are treated as period costs and are subtracted after calculating the contribution from sales. In absorption costing, fixed costs are included in the cost of production and are spread over each unit produced, affecting the cost per unit.

How is contribution per unit calculated in marginal costing?

Contribution per unit is calculated by subtracting the variable cost per unit from the selling price per unit. For example, if a product is sold for $1 and the variable cost is $0.55, the contribution per unit is $0.45.

What role does the break-even point (BEP) play in marginal costing?

The break-even point (BEP) indicates the number of units that need to be sold to cover all fixed costs. It is calculated by dividing fixed costs by the contribution per unit. For example, with fixed costs of $75 and a contribution of $0.45, the BEP is 167 bottles.

Why is marginal costing useful for short-term business decisions?

Marginal costing helps businesses make short-term decisions by focusing on variable costs and contribution. It is particularly useful for pricing decisions, cost control, and understanding how changes in sales volume impact profitability.

How does absorption costing allocate fixed costs?

In absorption costing, fixed production costs are spread over the total number of units produced. This allocation results in a fixed cost per unit, which is then added to the variable cost per unit to determine the full cost of each unit.

What is the overhead absorption rate (OHAR) in absorption costing?

The overhead absorption rate (OHAR) is calculated by dividing the total fixed production costs by the budgeted number of units to be produced. For example, if fixed costs are $100 and the planned production is 10 units, the OHAR is $10 per unit.

What problem might arise from lowering the selling price in the context of absorption costing?

If the selling price is lowered without a corresponding increase in sales volume, the contribution per unit may not be sufficient to cover fixed costs, leading to a loss. For example, reducing the price of a bicycle from $25 to $15 while keeping the fixed costs the same could result in a loss if sales do not increase as expected.

How are inventory values treated differently under marginal costing versus absorption costing?

Under marginal costing, inventory is valued at the variable cost per unit, excluding fixed costs. In absorption costing, inventory is valued at the full cost per unit, which includes both variable and fixed production costs.

What is the gross profit line in an absorption costing profit and loss (P&L) statement?

The gross profit line in an absorption costing P&L statement is calculated by subtracting the full production costs (both variable and fixed) from sales revenue. This represents the profit before accounting for non-production costs.

When is marginal costing typically used, and when is absorption costing preferred?

Marginal costing is typically used for internal decision-making, such as pricing and cost control, and is useful for understanding segment profits. Absorption costing is required for external financial reporting under standards like IFRS, as it includes all production costs and provides a more complete picture of the business’s profitability.