CIMA P1 Syllabus A. Cost Accounting For Decision And Control - Absorption and Marginal Costings - Notes ^{2 / 10}

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

1. Marginal costing

   values inventory at the total variable production cost of a product. 

   E.g. direct labour, direct material, direct expenses and variable production overheads

   No FIXED overheads!

2. Absorption costing
    
   values inventory at the full production cost (including fixed production overheads) of a product.

3. Inventory values using absorption costing are therefore greater than those calculated using marginal costing.

4. Since inventory values are different, profits reported in the Income statement (I/S) will also be different.

Illustration

The cost of Product A:

Direct materials $10
Direct labour $5
Direct expenses $2
Variable production overhead $6
Fixed production overhead $8

What will the inventory valuations be according to marginal and absorption costing?

Solution

• Marginal costing:

  Direct materials $10
  Direct labour $5
  Direct expenses $2
  Variable production overhead $6

  Value of 1 unit of Product A = 10 + 5 + 2 + 6 = $23

• Absorption costing

  Direct materials $10
  Direct labour $5
  Direct expenses $2
  Variable production overhead $6
  Fixed production overhead $8

  Value of 1 unit of product A = 10 + 5 + 2 + 6 + 8 =  $31

Pricing decisions: Marginal & absorption costing

1. Marginal costing

   - is appropriate for short-term pricing decisions.

   - when used for pricing decisions includes the 'marginal (variable) cost' of the product.

   - is more appropriate than absorption costing for use in one-off pricing decisions.

2. Absorption costing
    
   - is appropriate for long-term pricing decisions.

   - when used for pricing decisions includes the 'total-cost' of the product.