How To Prepare Income Statement Using Principles of Marginal And Absorption Costing

MARGINAL COSTING

The marginal cost of an item is its variable cost. The marginal production cost of an item is the addition of its direct materials cost, direct labour cost, direct expenses cost and variable production overhead cost. The higher the volume of production, the higher will be the total variable cost of sales.

Contrarily, fixed costs are costs that remain unchanged in the short run, regardless of the quantity of production and sale.


Marginal production cost is the portion of the cost of one unit of production or service which would be abstained from, if that unit were not produced, or which would increase if one extra unit were produced.

Using this, we can develop the following definition of marginal costing as it is used in accounting:

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Marginal costing is the accounting system in which variable costs are charged to cost units and fixed costs of that period are written off fully against the aggregate contribution.

It must be noted that variable costs are costs which change as output changes - these are treated under marginal costing as costs of the product or service.  Fixed costs, in this same system, are treated as costs of that period.

Marginal costing is also the major costing technique used in decision making. The main reason for this is that the approach of marginal costing allows the attention of management to be focused on the changes which arise from the decision under consideration.

Concept of Contribution

The concept of contribution lies at the centre of marginal costing. Contribution can be calculated using the following formula. 

                        Contribution = Sales price - Variable costs

The idea of profit is not a precisely useful one because it depends on the quantities that are sold. Due to this reason, the concept of contribution is often employed by management accountants.

• Contribution gives an idea of the amount of money that is available to contribute towards paying for the overheads of the company.
• At changing amount of output and sales, contribution per unit remains constant.
• At changing amount of output and sales, profit per unit changes.
• Total contribution = Contribution per unit x Sales volume.
• Profit = Total contribution - Fixed overhead

FORMAT OF MARGINAL COSTING

	$	$
Sales Less cost of sales: -opening stock -variable cost of production Less closing stock Less other variable costs Contribution Less fixed cost	xx xx xx (xx)	xx xx xx (xx)  xx   xx  (xx)
Profit		xx

 
 NOTE:
Valuation of inventory - opening and closing stocks are valued at marginal (variable) cost under marginal costing.
The fixed costs actually incurred are deducted from the contribution earned so as to determine the profit for the period.

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ABSORPTION COSTING

Absorption costing is a method of building up a full product cost which adds direct costs and a part of production overhead costs by means of one or more rates of overhead absorption.

The effect of absorption and marginal costing on inventory valuation and profit determination.

Marginal costing values inventory at the total variable cost of production of a unit of product while Absorption costing values inventory at the full cost of production of a unit of product.

Inventory values will therefore be different at the beginning and at the end of a period under marginal and absorption costing. 

If inventory values are different, then this will affect profits reported in the income statement in the period. Profits determined using marginal costing principles will, as a result, be different to those using principles of absorption costing.  

 FORMAT OF ABSORPTION COSTING

	$	$
Sales Less cost of sales: -opening stock -variable cost of production -fixed overhead absorption Less closing stock (Under)/Over absorption Gross profit Less non-production cost	xx xx xx xx (xx)	xx   xx     xx (xx)/xx   xx  (xx)
Profit		xx

NOTE:

Under/over-absorbed overhead - an adjustment for under or over absorption of overheads is very necessary in the preparation of absorption costing income statements.

Valuation of inventories - opening and closing stocks are valued at full production cost under absorption costing.