Edexcel A-Level Accounting: Marginal costing and absorption costing (YAC11) – Revision Notes

These notes condense topic 2.8, Marginal costing and absorption costing, from the Pearson Edexcel International Advanced Subsidiary/Advanced Level in Accounting (XAC11/YAC11) specification, Issue 2, September 2018. They cover outcomes 2.8.1 to 2.8.6, which are Unit 2 (A2) only. The study guide explains each idea in full with longer examples; for timed practice, try the practice questions. All businesses and figures are invented; money is in dollars.

Links: course hub, YAC11 checklist, Unit 1 costing guide for absorption rates, break-even guide for contribution, and free 10-minute diagnostics.

2.8.1 The two concepts in one table

Term	Meaning
Marginal cost	Variable production cost of one unit: direct materials + direct labour + direct expenses + variable production overhead
Contribution	Selling price less all variable costs (production and selling)
Marginal costing	Units carry variable production cost only; all fixed costs are period costs
Absorption costing	Units carry variable production cost plus fixed production overhead absorbed at a predetermined rate
Period cost	Written off in full in the period it is incurred
Product cost	Attached to units and carried forward in inventory until they are sold
Under-absorption	Fixed overhead absorbed < fixed overhead incurred: added to cost of sales
Over-absorption	Fixed overhead absorbed > fixed overhead incurred: deducted from cost of sales

Fixed production overhead per unit = budgeted fixed production overhead ÷ normal (budgeted) output.

Selling, distribution and administration costs are never in inventory value, under either method.

2.8.3 Valuing inventory

Method	Value per unit in inventory
Marginal	Variable production cost
Absorption	Variable production cost + fixed production overhead per unit

Published financial statements must follow IAS 2 Inventories, which includes fixed production overheads in the cost of inventory, allocated on normal capacity. So absorption costing is used for external reporting; marginal costing is an internal tool.

2.8.5 Profit statements: layouts

Method in steps: marginal costing statement

1. Revenue.
2. Variable cost of sales = opening inventory + variable cost of production − closing inventory (all at marginal cost).
3. Deduct variable selling and distribution costs.
4. Contribution.
5. Deduct all fixed costs: fixed production overhead incurred, then fixed administration and selling.
6. Profit for the year.

Method in steps: absorption costing statement

1. Revenue.
2. Cost of sales = opening inventory + cost of production − closing inventory (all at full production cost).
3. Add under-absorbed overhead, or deduct over-absorbed overhead.
4. Gross profit.
5. Deduct selling, distribution and administration costs (variable and fixed).
6. Profit for the year.

The reconciliation

Absorption profit − marginal profit
  = (closing inventory units − opening inventory units) × fixed production overhead per unit

Inventory change	Higher profit
Rises (made more than sold)	Absorption
Falls (sold more than made)	Marginal
No change	Neither: equal

Over the whole life of a business, when all inventory has been sold, total profit is the same under both methods. Only the timing differs.

Small reminder: Purslow Ltd

Fixed production overhead is absorbed at 5 per unit. Opening inventory is 800 units and closing inventory is 2,000 units. Marginal costing profit is 31,000.

Inventory rose by 2,000 − 800 = 1,200 units
Absorption profit = 31,000 + (1,200 × 5) = 37,000

Absorption profit is higher because 6,000 more fixed overhead is carried forward than was brought forward.

2.8.2 Advantages and disadvantages

	Marginal costing	Absorption costing
For	Profit tracks sales volume; no profit from stockpiling. Shows contribution, the right figure for short-term decisions and break-even. Avoids arbitrary apportionment of fixed overhead.	Meets IAS 2. Full cost per unit supports long-term pricing so all costs are recovered. Smooths profit when production is steady but sales are seasonal.
Against	Not acceptable for published inventory. Risk of prices that ignore fixed costs. Needs a reliable split of semi-variable costs.	Profit can be raised by overproducing. Absorption rate depends on budgeted output and chosen bases. Full cost can lead to wrong short-term decisions.

2.8.4 Decision tests at a glance

Golden rule: compare the change in contribution with the change in fixed costs. Unavoidable fixed costs, including apportioned head-office costs, are irrelevant.

Decision	Calculate	Financial rule	Non-financial checks
Accept or refuse a new order	Order revenue − marginal cost of the order − any extra fixed cost; if capacity is full, subtract contribution lost on normal sales	Accept if the net effect is positive	Effect on regular customers’ prices; repeat business; customer’s credit risk; using spare staff
Make or buy	Marginal cost of making + fixed costs saved by buying + income from freed capacity, against the purchase price	Choose the lower relevant cost	Supplier quality, reliability and control; jobs; know-how
Continue or discontinue a service or product	Contribution lost against fixed costs actually saved	Continue if contribution > avoidable fixed costs, unless the resources have a better use	Customers who buy other lines too; redundancies; morale; reputation

Small reminder: make or buy

A component has a marginal cost of 8.70 and absorbed fixed overhead of 2.80 (full cost 11.50). A supplier charges 10.20. No fixed costs are saved by buying. Compare 8.70 with 10.20: make, saving 1.50 a unit. Comparing 11.50 with 10.20 would wrongly say “buy”.

2.8.6 Limiting factors

Method in steps

1. Show that the factor limits output: amount needed for full demand > amount available.
2. Contribution per unit ÷ quantity of the factor per unit = contribution per unit of limiting factor.
3. Rank highest first.
4. Produce the top-ranked product up to its demand, then the next, until the factor runs out.
5. Total contribution − fixed costs = maximum profit. Fixed costs do not change the ranking.

Small reminder: Ellerdine Ltd

Labour is limited. Product K earns contribution 20 using 4 hours (5 per hour). Product M earns contribution 15 using 2 hours (7.50 per hour). Make M first, even though K earns more per unit.

If only one product exists, there is no ranking to do: output is simply the factor available ÷ factor per unit, up to demand.

Must-know distinctions

• Marginal cost vs full cost: marginal excludes fixed production overhead; full includes it.
• Contribution vs gross profit: contribution is after all variable costs, including variable selling costs; gross profit is after full production cost of sales only.
• Period cost vs product cost: fixed production overhead is a period cost under marginal costing and a product cost under absorption costing.
• Avoidable vs unavoidable fixed costs: only avoidable fixed costs matter in decisions.
• Contribution per unit vs per limiting factor: use the second whenever a resource is scarce.

Quick self-test

1. State what is included in the marginal cost of a unit.
2. A unit has direct materials 7, direct labour 5, variable production overhead 2, absorbed fixed production overhead 4 and variable selling cost 1. Calculate the unit cost for inventory under each method.
3. Using question 2, value a closing inventory of 600 units under each method.
4. Opening inventory 1,000 units, closing inventory 400 units, fixed production overhead 6 per unit. Absorption costing profit is 52,000. Calculate marginal costing profit.
5. Using question 2, a customer offers to buy 400 units at 16 each. There is spare capacity and no extra fixed cost. Calculate the effect on profit.
6. A product line has a contribution of 12,000 and is charged 15,000 of fixed costs, of which 4,000 would be saved on closure. Calculate the effect on profit of closing it.
7. Using the Ellerdine Ltd figures above, which product should be made first and why?
8. Which method does IAS 2 require for inventory in published financial statements?
9. Budgeted fixed production overhead is 60,000 and normal output 15,000 units. Actual output is 13,500 units and actual fixed overhead 60,000. Calculate the under- or over-absorption.
10. Production and sales are equal and there is no opening inventory. Compare the two profits.

Answers

1. Direct materials, direct labour, direct expenses and variable production overhead.
2. Marginal: 7 + 5 + 2 = 14. Absorption: 14 + 4 = 18. The selling cost is excluded from both.
3. Marginal: 600 × 14 = 8,400. Absorption: 600 × 18 = 10,800.
4. Inventory fell by 600 units, so marginal profit is higher by 600 × 6 = 3,600: 55,600.
5. 400 × (16 − 14) = 800 extra profit. Accept on financial grounds.
6. Contribution lost 12,000, costs saved 4,000: profit falls by 8,000.
7. M: 7.50 per labour hour against 5 for K. Labour is the scarce resource, so rank by contribution per hour.
8. Absorption costing (fixed production overhead included, based on normal capacity).
9. Rate = 60,000 ÷ 15,000 = 4 per unit. Absorbed = 13,500 × 4 = 54,000. Under-absorbed by 6,000.
10. They are equal: closing inventory is nil, so no fixed overhead is carried forward.

Where marks are usually lost

• Including variable selling costs in the inventory value; they are deducted in the period of sale.
• Charging budgeted fixed overhead in a marginal statement when the actual figure is given; marginal costing deducts the amount incurred.
• Leaving out under- or over-absorption, so the absorption statement does not reconcile with the marginal one.
• Reconciling in the wrong direction; write the inventory change first, then decide which profit is higher.
• Labelling the marginal subtotal “gross profit” instead of “contribution”.
• Using full cost per unit to judge an order price or a make-or-buy quote.
• Treating apportioned fixed costs as saved when a service or product is dropped.
• Forgetting lost contribution when an order uses capacity already needed for normal sales.
• Choosing products by unit contribution when a resource is scarce, or not proving the factor is limiting.
• Giving a recommendation with no non-financial factors when the question asks you to evaluate or advise.

Official syllabus

Pearson Edexcel International Advanced Subsidiary/Advanced Level in Accounting (XAC11/YAC11) specification, Issue 2, September 2018 (first teaching September 2015), Pearson Education Limited. Unit 2: Corporate and Management Accounting, topic 2.8 Marginal costing and absorption costing.