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Lesson 9 — Costing Methods

Absorption Costing · Marginal Costing · Contribution · Overhead Absorption Rates · Profit Differences · Decision Making | Cambridge A Level Accounting 9706

📘 Lesson 9 of 20
45% complete Paper 1 Paper 3 Paper 4
📌 Prerequisites: You need to understand the distinction between fixed and variable costs from Lesson 8. Costing methods are a core management accounting topic — they determine how costs are attached to products and therefore what profit is reported. Both methods are examined extensively in Paper 3 and Paper 4.

1. Cost Classification — The Foundation 9706 / 4.2

Before studying costing methods, we must be clear about how costs behave. The distinction between fixed and variable costs is the foundation of everything in this lesson.

Cost Type Behaviour Examples Per Unit Behaviour
Variable Costs Total cost changes in direct proportion to output level Direct materials, direct labour, variable overheads, sales commission Cost per unit stays CONSTANT regardless of output
Fixed Costs Total cost remains unchanged regardless of output level (within relevant range) Rent, insurance, depreciation, management salaries, loan interest Cost per unit FALLS as output rises (fixed cost spread over more units)
Semi-Variable Costs Contains both fixed and variable elements — rises with output but not proportionately Electricity (fixed standing charge + variable usage), telephone, maintenance Falls per unit as output rises but not as steeply as pure fixed costs
Direct vs Indirect Costs: A direct cost can be specifically traced to a particular product — e.g. materials used in making that product. An indirect cost (overhead) cannot be traced directly to one product — e.g. factory rent benefits all products. This distinction determines how costs are treated under absorption vs marginal costing.

2. Absorption Costing Method 1

Under absorption costing, the full cost of a product includes both variable costs and a share of fixed overheads. Fixed overheads are absorbed into product cost using a predetermined overhead absorption rate (OAR).

Principle: Every unit produced absorbs a share of the total fixed overhead — because fixed costs are incurred to support production and should therefore be part of the cost of each unit produced. This is required by accounting standards (IAS 2) for inventory valuation in published financial statements.

Overhead Absorption Rate (OAR)

Calculating the OAR

OAR = Budgeted Fixed Overhead ÷ Budgeted Activity Level Activity Level can be: budgeted units, budgeted labour hours, budgeted machine hours Most common: OAR per labour hour = Budgeted Fixed Overhead ÷ Budgeted Labour Hours Fixed overhead absorbed = OAR × Actual activity (hours or units)

📋 Example 1 — Calculating OAR and Absorbed Overhead

Lahore Manufacturing Ltd has budgeted fixed overheads of $180,000 and budgeted production of 60,000 labour hours.

OAR = $180,000 ÷ 60,000 = $3.00 per labour hour

Actual labour hours worked = 55,000 hours
Overhead absorbed = 55,000 × $3.00 = $165,000
Actual fixed overhead incurred = $172,000

Item$
Overhead absorbed (55,000 × $3.00)165,000
Actual overhead incurred172,000
Under-absorbed overhead7,000 (adverse)
Under-absorption: Absorbed less overhead than actually incurred — because actual hours were less than budgeted. The $7,000 under-absorbed overhead is charged as an additional expense in the Income Statement.

Over-absorption: If absorbed > incurred, the surplus is credited back to the Income Statement.

Full Cost per Unit — Absorption Costing

Unit Cost Under Absorption Costing

Full Cost per Unit = Direct Materials + Direct Labour + Variable Overhead + Fixed Overhead Absorbed per unit Fixed Overhead per unit = Total Fixed Overhead ÷ Budgeted/Actual Units Produced

3. Marginal Costing Method 2

Under marginal costing, only variable costs are included in the cost of a product. Fixed costs are treated as period costs — charged in full to the Income Statement in the period they are incurred, regardless of how many units are produced or sold.

Principle: Fixed costs do not change with output — they would be incurred even if nothing was produced. Therefore they are not truly part of the cost of making one more unit. The marginal cost of one additional unit is its variable cost only.

Contribution — The Key Concept

Contribution Formula

Contribution = Selling Price per unit − Variable Cost per unit Total Contribution = Contribution per unit × Units sold Profit = Total Contribution − Fixed Costs Contribution first covers fixed costs — any surplus is profit
💡 Why "Contribution"? Each unit sold contributes towards covering the fixed costs of the business. Once total contribution equals total fixed costs (the break-even point), every additional unit sold generates pure profit. Contribution is the single most important concept in management accounting decision making.

Marginal Cost Income Statement Format

Marginal Costing Income Statement — Proforma
Revenue (Selling price × Units sold)X
Less: Variable cost of sales(X)
ContributionX
Less: Fixed costs (in full — period charge)(X)
ProfitX

4. Absorption vs Marginal Costing — Key Differences Exam Focus

Feature Absorption Costing Marginal Costing
Fixed overhead treatment Included in product cost — absorbed into each unit produced Period cost — charged in full to the Income Statement when incurred
Inventory valuation Closing inventory includes fixed overhead — valued at full cost Closing inventory excludes fixed overhead — valued at variable cost only
Profit reported Higher profit when production > sales (fixed costs carried in inventory) Higher profit when sales > production (all fixed costs charged immediately)
IAS 2 compliance ✅ Required for published financial statements — IAS 2 mandates full cost inventory valuation ❌ Not permitted for external reporting — for internal management use only
Decision making Less useful — fixed costs per unit change with volume, distorting decisions More useful — contribution approach clearly shows impact of volume changes
Key metric Profit per unit (full cost) Contribution per unit (variable cost basis)

5. Why Profits Differ Between the Two Methods Core Topic

The two methods produce different profit figures whenever closing inventory differs from opening inventory. This happens because absorption costing carries fixed overhead in inventory whereas marginal costing does not.

Profit Difference Formula

Difference in profit = Change in inventory units × Fixed overhead per unit If closing inventory > opening inventory: Absorption profit > Marginal profit If closing inventory < opening inventory: Marginal profit > Absorption profit If closing inventory = opening inventory: Both methods give the SAME profit

📋 Example 2 — Full Comparison: Both Methods Side by Side

Punjab Products Ltd — Year 1 data:

ItemDetail
Selling price per unit$20
Variable cost per unit$12
Total fixed costs$40,000
Units produced10,000
Units sold8,000
Opening inventoryNil
Closing inventory2,000 units
Fixed cost per unit (for absorption)$40,000 ÷ 10,000 = $4.00
Absorption Costing I/S
Revenue (8,000 × $20)160,000
Cost of Sales$
Variable costs (8,000 × $12)96,000
Fixed overhead absorbed (8,000 × $4)32,000
Total cost of sales(128,000)
Profit32,000
Closing inventory: 2,000 × ($12 + $4) = $32,000
Marginal Costing I/S
Revenue (8,000 × $20)160,000
Variable cost of sales (8,000 × $12)(96,000)
Contribution64,000
Less: Fixed costs (in full)(40,000)
Profit24,000
Closing inventory: 2,000 × $12 = $24,000
Why the difference?
Absorption profit ($32,000) − Marginal profit ($24,000) = $8,000
Closing inventory increase (2,000 units) × Fixed overhead per unit ($4) = $8,000 ✓

Under absorption costing, $8,000 of fixed overhead is carried forward in closing inventory — reducing the cost charged to this period's Income Statement. Under marginal costing, all $40,000 of fixed costs is charged this period regardless of unsold inventory.

6. Decision Making Using Marginal Costing

Marginal costing and the contribution concept are the primary tools for short-term management decisions. The key rule: accept a decision if it increases total contribution (assuming fixed costs are unchanged).

Six Common Decision Types

① Make or Buy

Should we make a component or buy it externally?
Compare: variable cost of making vs external purchase price.
Rule: Make if variable cost < buying price (assuming spare capacity exists).

② Special Order Pricing

Should we accept a one-off order below normal selling price?
Rule: Accept if the special price exceeds variable cost — any positive contribution helps cover fixed costs already being paid.

③ Shutdown Decision

Should we close a loss-making department or product?
Rule: Only close if the lost contribution exceeds the avoidable fixed costs — some fixed costs continue even after closure (unavoidable costs).

④ Limiting Factor Analysis

When a resource is scarce, rank products by contribution per unit of limiting factor (not contribution per unit) to maximise total contribution.

⑤ Breakeven Analysis

At what output level does contribution exactly equal fixed costs?
Breakeven point = Fixed Costs ÷ Contribution per unit
Covered in detail in Lesson 10.

⑥ Target Profit

How many units must be sold to achieve a target profit?
Units needed = (Fixed Costs + Target Profit) ÷ Contribution per unit

📋 Example 3 — Special Order Decision

Karachi Plastics Ltd normally sells Product X at $18 per unit. Variable cost = $11 per unit. Fixed costs = $60,000 per year. Current production is 8,000 units against capacity of 10,000 units. A new customer offers to buy 1,500 units at $13 each.

Normal contribution per unit: $18 − $11 = $7

Special order contribution per unit: $13 − $11 = $2

Total additional contribution: 1,500 × $2 = $3,000

Spare capacity available: 10,000 − 8,000 = 2,000 units ✓ (no need to reduce normal sales)

Decision: Accept the order. The order generates an additional contribution of $3,000. Fixed costs are already covered by normal sales — every dollar of contribution from the special order goes directly to profit. The price of $13 exceeds the variable cost of $11, so accepting is better than leaving capacity idle.
💡 Important condition: This decision only holds because spare capacity exists. If production was already at full capacity, accepting the special order would mean diverting capacity from normal sales — and the lost contribution from normal sales would need to be factored in as an opportunity cost.

📋 Example 4 — Limiting Factor Analysis

Sindh Furniture Ltd makes two products. Machine hours are limited to 3,000 hours per month.

Item Product A ($) Product B ($)
Selling price per unit5040
Variable cost per unit3022
Contribution per unit2018
Machine hours per unit4 hrs2 hrs
Contribution per machine hour$5.00$9.00
Ranking2nd1st
Maximum demand400 units600 units

Optimal production plan:

Product Units Hours Used Contribution ($)
Product B (1st — max demand) 600 1,200 10,800
Product A (2nd — remaining hours: 1,800 ÷ 4) 450 1,800 9,000
Total — 3,000 19,800
💡 Key insight: Although Product A has the higher contribution per unit ($20 vs $18), Product B generates more contribution per machine hour ($9 vs $5). When machine hours are scarce, Product B uses the limiting factor more efficiently — so it is ranked first.

7. Advantages and Disadvantages of Each Method

Absorption Costing — Advantages

  • Required by IAS 2 for external reporting and inventory valuation
  • Ensures all costs (including fixed) are recovered in the long run
  • Avoids reporting a loss when production is high but sales are low
  • More appropriate for pricing decisions — ensures full cost recovery

Absorption Costing — Disadvantages

  • Fixed cost per unit changes with production volume — confusing for decisions
  • Profit can be manipulated by overproducing and storing inventory
  • Under/over-absorption complicates the Income Statement
  • Less useful for short-term marginal decisions

Marginal Costing — Advantages

  • Contribution concept is powerful for short-term decisions
  • Profit cannot be manipulated by changing production levels
  • Simpler — no OAR calculation or under/over-absorption issues
  • Better for breakeven analysis and limiting factor decisions

Marginal Costing — Disadvantages

  • Not permitted for external reporting under IAS 2
  • Ignores fixed costs in pricing — may lead to underpricing in long run
  • Distinction between fixed and variable costs is not always clear
  • Contribution approach may encourage acceptance of unprofitable orders

8. Memory Aids & Common Mistakes

🧠 Memory Aid — Which Method Reports Higher Profit?

Production > Sales (inventory builds up):
→ Absorption profit HIGHER (fixed costs carried in inventory)

Sales > Production (inventory runs down):
→ Marginal profit HIGHER (fewer fixed costs this period)

Production = Sales (no inventory change):
→ SAME profit under both methods

Shortcut: inventory increases = absorption wins. Inventory decreases = marginal wins.

🧠 Memory Aid — Contribution Formula

S − V = C → C − F = P
Selling price − Variable cost = Contribution
Contribution − Fixed costs = Profit

Contribution first fills the "fixed cost bucket" — overflow is profit.

⚠️ Mistake 1 — Including fixed costs in marginal cost per unit: Under marginal costing, the cost per unit includes variable costs only. Fixed costs are never included in the unit cost — they are charged as a lump sum period cost. Including fixed costs in the unit cost is the absorption costing approach, not marginal costing.
⚠️ Mistake 2 — Ranking by contribution per unit instead of per limiting factor: When a limiting factor exists, always rank products by contribution per unit of limiting factor — not contribution per unit. The product with the highest contribution per unit may use the scarce resource very inefficiently and should be ranked lower.
⚠️ Mistake 3 — Accepting a special order that requires full capacity: If a company is already at full capacity, accepting a special order means diverting capacity from existing sales. The lost contribution from existing sales is an opportunity cost that must be deducted from the special order contribution before deciding.
⚠️ Mistake 4 — Saying marginal costing is allowed for external reporting: Marginal costing is for internal management use only. IAS 2 (Inventories) requires inventory to be valued at full cost (including a share of fixed production overheads) — which is the absorption costing approach. Published financial statements must use absorption costing for inventory valuation.
⚠️ Mistake 5 — Calculating OAR using actual overhead instead of budgeted: The Overhead Absorption Rate is calculated using budgeted overhead and budgeted activity — not actual figures. Using actual overhead to calculate OAR defeats the purpose — you would only know it at year end, making it useless for product costing during the year.

📝 Exam Practice Questions

Question 1 Knowledge — 2 marks Paper 1

Explain the term contribution and state the formula used to calculate it.

Contribution is the difference between selling price and variable cost per unit — it represents the amount each unit sold contributes towards covering the fixed costs of the business. (1 mark)

Contribution per unit = Selling price per unit − Variable cost per unit
Once total contribution from all units sold equals total fixed costs, the business has broken even — any further contribution becomes profit. (1 mark)

Question 2 Application — 8 marks Paper 3

Islamabad Components Ltd produces one product with the following data:

Item$
Selling price per unit25
Variable cost per unit15
Total fixed costs50,000
Units produced12,000
Units sold10,000
Opening inventoryNil

Prepare Income Statements using both absorption costing and marginal costing. Reconcile the difference in profit.

Fixed overhead per unit (absorption): $50,000 ÷ 12,000 = $4.167 per unit

ABSORPTION COSTING
Revenue (10,000 × $25)                         250,000
Variable cost of sales (10,000 × $15)         (150,000)
Fixed overhead absorbed (10,000 × $4.167)    (41,667)
Profit                                              58,333
Closing inventory: 2,000 × ($15 + $4.167) = $38,333
MARGINAL COSTING
Revenue (10,000 × $25)                         250,000
Variable cost of sales (10,000 × $15)         (150,000)
Contribution                                      100,000
Fixed costs (in full)                            (50,000)
Profit                                               50,000
Closing inventory: 2,000 × $15 = $30,000

Reconciliation:
Difference = $58,333 − $50,000 = $8,333
Inventory increase (2,000 units) × Fixed overhead per unit ($4.167) = $8,333 ✓

(4 marks each Income Statement + reconciliation)

Question 3 Application — 4 marks Paper 3

A company makes three products with the following data. Machine hours are limited to 4,800 hours per period.

Product Contribution/unit ($) Machine hours/unit Max demand (units)
Alpha243600
Beta182800
Gamma305400

Determine the optimal production plan and calculate total contribution.

Contribution per machine hour:
Alpha: $24 ÷ 3 = $8.00 → Rank 2nd
Beta: $18 ÷ 2 = $9.00 → Rank 1st
Gamma: $30 ÷ 5 = $6.00 → Rank 3rd
(1 mark)

Product Units Hours Cumulative Hours Contribution ($)
Beta (1st — max 800) 800 1,600 1,600 14,400
Alpha (2nd — max 600) 600 1,800 3,400 14,400
Gamma (3rd — remaining 1,400 ÷ 5 = 280) 280 1,400 4,800 8,400
Total — 4,800 4,800 ✓ 37,200
(3 marks — 1 for ranking, 1 for plan, 1 for total contribution)

Question 4 Analysis — 3 marks Paper 1

Explain why a company might report a higher profit under absorption costing than under marginal costing in the same period, even though the same number of units were sold.

If production exceeds sales during the period, closing inventory is higher than opening inventory — the level of inventory increases. (1 mark)

Under absorption costing, closing inventory includes a share of fixed overhead per unit — so some fixed overhead is carried forward in the inventory value rather than being charged to the Income Statement this period. This reduces the cost charged against revenue and increases reported profit. (1 mark)

Under marginal costing, all fixed costs are charged to the Income Statement in full regardless of production levels — no fixed overhead is carried in inventory. Therefore marginal costing charges more fixed cost this period, producing a lower profit than absorption costing whenever inventory increases. (1 mark)

Question 5 Analysis — 3 marks Paper 3

A company is operating at 75% capacity. A customer offers a special order of 2,000 units at $14 per unit. Normal selling price is $20. Variable cost per unit is $11. Fixed costs are $80,000 per year. Advise management whether to accept the order and explain your reasoning.

Contribution from special order: $14 − $11 = $3 per unit × 2,000 = $6,000 additional contribution (1 mark)

Recommendation: Accept the order. The company is operating below full capacity (75%) — spare capacity exists to fulfil the order without diverting production from existing customers. The special order price of $14 exceeds the variable cost of $11, so each unit contributes $3 towards fixed costs and profit. Fixed costs are already being covered by existing sales — the additional $6,000 contribution flows directly to profit. (1 mark)

However, management should consider: whether accepting this price sets a precedent that undermines the normal selling price; whether the customer might expect the same price in future orders; and whether there are other opportunity costs not mentioned. The decision should also confirm the order does not exceed remaining spare capacity. (1 mark)

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