Absorption and marginal costing are alternative inventory costing methodologies. They are two varying approaches to determine the cost of products for accounting purposes. The main difference lies in the allocation of fixed production costs. Under marginal costing -- also known as variable or direct costing -- product costs are limited to those that vary with output, including direct labour, direct materials and variable overhead costs. Under absorption costing, all manufacturing costs are included in the cost of a product, thus it is also referred to as full costing. On the income statement, product costs are reflected in the cost of goods sold (COGS).
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Things you need
- Spreadsheet software
Calculate variable manufacturing cost of goods sold as beginning inventory plus variable cost of goods manufactured minus ending inventory. For example, if inventory started at £65, £3,250 worth of product was produced based on variable costs and ending inventory balance was £325, then COGS = £65 + £3,250 - £325 = £2,990. Variable product costs are labour, materials and overhead costs that can be expressed on a per-unit basis and vary proportionately with the volume of units produced.
Calculate variable marketing costs as the marketing cost per unit times the number of units sold. Assuming it costs £1.30 per unit for marketing and selling 1,000 units, variable marketing costs would be £1,300. On the next row, calculate "total variable costs" as the sum of variable COGS and variable marketing costs. Draw a top border line for the dollar amount to indicate that the number is derived from above figures.
Deduct total variable costs from net sales to find the "contribution margin." Enter the respective dollar amount with a top border line to indicate that the number is derived from above figures.
Enter fixed factory overhead costs and fixed marketing and administrative costs into the next two rows. Then, compute the sum as "total fixed costs" and enter the dollar amount with a top border line to indicate that it is derived from above figures.
Deduct total fixed costs from contribution margin to reach "operating income." Marginal costing has no bearing on further income statement items beyond this point.
Income Statement Under Marginal Costing
Calculate standard cost of goods sold using the same formula: beginning inventory plus cost of goods manufactured minus ending inventory. Under absorption costing, product costs (allocated to inventory and expensed through COGS) include fixed overhead costs in addition to variable manufacturing costs. Fixed overhead costs are applied using a standard rate based on budgeted output levels. To demonstrate, assume a total variable manufacturing cost of £3 per unit. If fixed factory costs are £780 based on a standard output level of 1,200 units, then the standard fixed overhead rate is 60p per unit. The result is a product cost of £4 per unit under absorption costing compared to £3 per unit under marginal costing.
To adjust for output fluctuations, calculate the "production volume variance" as the applied fixed overhead rate multiplied by the difference between budgeted and actual output. Enter this item on the next line below COGS. Assuming actual output of 1,000 and a budgeted output of 1,200, the standard rate of 60p per unit understates fixed overhead costs by £130 (i.e. [1200 - 1000] x 60p). Add this unfavorable variance to the standard COGS to reach the "adjusted" COGS. Draw a top border line on the dollar amount to indicate that it is derived from above figures.
Calculate gross profit margin by deducting adjusted COGS from net sales. Enter this item on the next line with a top border line for the dollar amount to indicate that it is derived from above figures.
Calculate marketing and administrative costs -- variable and fixed -- by multiplying the variable cost per unit by the number of units sold and then adding any fixed costs to the product. Enter this item on the next line.
Deduct marketing and administrative costs from the gross margin to find "operating income." Draw a top border line to indicate that the dollar amount was derived from above figures. This is as far as absorption costing impacts the preparation of an income statement.
Income Statement Under Absorption Costing
Tips and warnings
- Most accounting software can generate income statements in either absorption or marginal costing methodology. Consult your software instructions for more details.
- The same steps apply for a retailer; simply replace the word "manufacturing" with "purchasing."
- When preparing financial statements for a third party, e.g. a banker or an investor, it is best to have them prepared and audited by qualified accountant for maximum credibility.
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