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

This guide teaches 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. It covers outcomes 2.8.1 to 2.8.6. The topic belongs to Unit 2 (Corporate and Management Accounting) and is Unit 2 (A2) only. All businesses and numbers are invented; amounts are in dollars.

Hub page: Edexcel A-Level Accounting. Printable checklist: YAC11 topic checklist. The revision notes give fast recall; then try the practice questions. Find your weak spots first with a free 10-minute diagnostic.

What topic 2.8 asks of you

Spec ref	Skill
2.8.1	Explain the concepts of marginal costing and absorption costing
2.8.2	Give the advantages and disadvantages of each method
2.8.3	Value inventory under each method
2.8.4	Use marginal costing to decide whether to accept or refuse a new order, whether to make or buy, and whether to continue or stop a service or product
2.8.5	Prepare profit statements under both methods (the specification calls them profit and loss statements)
2.8.6	Choose the preferred course of action when there are limiting factors

Overhead absorption rates come from the Unit 1 costing guide; contribution is defined in the break-even analysis guide.

The two concepts (2.8.1)

Both methods charge direct materials, direct labour and variable production overhead to each unit. They differ over fixed production overhead.

• Marginal costing charges each unit with its variable production costs only. Fixed production overhead is a period cost: the whole amount is written off against that period’s profit.
• Absorption costing (full costing) charges each unit with its variable production costs plus a share of fixed production overhead, using an overhead absorption rate. Some fixed overhead can therefore be carried forward in closing inventory.

Selling, distribution and administration costs are period costs under both methods.

Worked example 1: unit costs at Ostrell Glassware Ltd

Ostrell Glassware Ltd makes vases. Per vase: direct materials 9.50, direct labour 6.30 and variable production overhead 2.20. Fixed production overheads are budgeted at 96,000 a year, and normal output is 12,000 vases. Selling price is 40.00. Variable selling costs are 1.20 for each vase sold, and fixed administration and selling costs are 58,000 a year.

Marginal (variable) production cost = 9.50 + 6.30 + 2.20 = 18.00 per vase
Fixed production overhead per vase  = 96,000 ÷ 12,000    =  8.00 per vase
Absorption (full) production cost   = 18.00 + 8.00       = 26.00 per vase

Valuing inventory (2.8.3)

Marginal costing:   units in inventory × variable production cost
Absorption costing: units in inventory × (variable production cost + fixed production overhead per unit)

At the end of its first year Ostrell has 1,500 vases unsold:

• marginal costing: 1,500 × 18.00 = 27,000
• absorption costing: 1,500 × 26.00 = 39,000

The 12,000 gap is fixed production overhead held in inventory: 1,500 × 8.00. For published financial statements, IAS 2 Inventories requires the cost of inventory to include a systematic allocation of fixed and variable production overheads, with fixed production overheads allocated on the basis of normal capacity. That is absorption costing. Marginal costing is used internally for decisions.

Profit statements under each method (2.8.5)

Worked example 2: Ostrell’s first year

Year 1: 12,000 made, 10,500 sold, no opening inventory, fixed costs as budgeted.

Marginal costing

	Detail	Total
Revenue (10,500 × 40.00)		420,000
Opening inventory	0
Variable cost of production (12,000 × 18.00)	216,000
Less closing inventory (1,500 × 18.00)	(27,000)
Variable cost of sales		(189,000)
Variable selling costs (10,500 × 1.20)		(12,600)
Contribution		218,400
Fixed production overheads		(96,000)
Fixed administration and selling costs		(58,000)
Profit for the year		64,400

Absorption costing

	Detail	Total
Revenue		420,000
Opening inventory	0
Cost of production (12,000 × 26.00)	312,000
Less closing inventory (1,500 × 26.00)	(39,000)
Cost of sales		(273,000)
Gross profit		147,000
Variable selling costs		(12,600)
Fixed administration and selling costs		(58,000)
Profit for the year		76,400

Absorption profit is 12,000 higher: 12,000 of the fixed production overhead is carried into Year 2 in closing inventory, while marginal costing wrote off all 96,000.

Worked example 3: Ostrell’s second year

Year 2: 11,000 vases made, 12,200 sold. Opening inventory is 1,500 vases, so closing inventory is 1,500 + 11,000 − 12,200 = 300 vases. Fixed production overheads were 96,000 and the rate stays at 8.00.

Only 11,000 × 8.00 = 88,000 is absorbed, so 8,000 is under-absorbed and added to cost of sales (topic 1.4.11).

	Marginal	Absorption
Revenue (12,200 × 40.00)	488,000	488,000
Opening inventory	27,000	39,000
Cost of production	198,000	286,000
Less closing inventory	(5,400)	(7,800)
Under-absorbed fixed production overhead	–	8,000
Cost of sales	(219,600)	(325,200)
Variable selling costs (12,200 × 1.20)	(14,640)	(14,640)
Fixed production overheads	(96,000)	–
Fixed administration and selling costs	(58,000)	(58,000)
Profit for the year	99,760	90,160

Contribution is 253,760 (marginal); gross profit is 162,800 (absorption).

This time marginal profit is higher, by 9,600: inventory fell by 1,200 vases, releasing 1,200 × 8.00 of Year 1 fixed overhead into Year 2’s absorption cost of sales.

The reconciliation rule

Difference in profit = (closing inventory units − opening inventory units) × fixed production overhead per unit

Inventory rises: absorption profit is higher. Inventory falls: marginal profit is higher. No change: profits are equal.

Over both years the totals are 164,160 (marginal) and 166,560 (absorption): the 2,400 gap is 300 vases still in inventory × 8.00.

Advantages and disadvantages (2.8.2)

	Advantages	Disadvantages
Marginal costing	Profit follows sales, so building up inventory cannot raise it. Contribution shows what each product or order adds, which suits short-term decisions and break-even analysis. No arbitrary apportionment of fixed overheads.	Does not meet IAS 2 for published inventory. Fixed costs may be overlooked in long-term pricing, so prices can be set too low. Splitting semi-variable costs relies on estimates.
Absorption costing	Complies with IAS 2. Each product carries a share of all production costs, which helps long-term pricing. Profits are smoother when sales are seasonal but production is steady.	Producing for inventory raises profit, which may encourage overproduction. Rates depend on budgeted output and arbitrary bases. Full cost per unit can mislead short-term decisions, because absorbed fixed overheads are often unavoidable.

Marginal costing in decision making (2.8.4)

Ask which costs and revenues change because of the decision? Fixed costs paid anyway are irrelevant; fixed costs saved or added are relevant. Finish with non-financial factors.

Accepting or refusing a new order

In Year 3 Ostrell plans 12,000 vases; capacity is 15,000. A hotel group offers to buy 1,800 vases at 24.00 each. Special packing costs 0.60 a vase, and the hotel collects the goods, so there are no selling costs.

Marginal cost of the order = 18.00 + 0.60      = 18.60 per vase
Contribution               = 24.00 − 18.60     =  5.40 per vase
Extra profit               = 1,800 × 5.40      =  9,720

The price is below the absorption cost of 26.00, but normal sales already cover fixed overheads. On financial grounds, accept. Then consider: will regular customers ask for the lower price? Could it lead to repeat work? Is the hotel a sound credit risk?

After accepting it, a second buyer wants 2,500 vases at 21.00, with no extra costs. Only 1,200 vases of spare capacity remain, so 1,300 normal sales would be lost. Each normal sale earns 40.00 − 18.00 − 1.20 = 20.80.

Contribution from new order    = 2,500 × (21.00 − 18.00) =   7,500
Contribution lost on 1,300 normal sales × 20.80        = (27,040)
Effect on profit                                       = (19,540)

Refuse. When capacity is full, lost contribution is a cost of the order.

Make or buy

Ostrell makes its own gift boxes, 12,000 a year: materials 1.10, labour 0.85, variable overhead 0.25 and absorbed fixed overhead 0.90, a full cost of 3.10. A supplier offers boxes at 2.60. If Ostrell buys, it can dismiss a box-room supervisor paid 3,000 a year; all other fixed overheads continue.

Make: 12,000 × 2.20 (marginal cost) + 3,000 avoidable salary = 29,400
Buy:  12,000 × 2.60                                         = 31,200

Making is cheaper by 1,800, although the full cost (3.10) exceeds the supplier’s price. If the box room could be let for 4,000 a year, making costs 33,400 and buying saves 2,200. Non-financial points: supplier quality and reliability, control over a branded item, and jobs.

Continuing or discontinuing a service or product

Hatherden Coaches runs three services. Fixed costs of 140,000 are apportioned in proportion to revenue.

	Airport	Schools	Tours	Total
Revenue	240,000	160,000	100,000	500,000
Variable costs	(150,000)	(92,000)	(78,000)	(320,000)
Contribution	90,000	68,000	22,000	180,000
Apportioned fixed costs	(67,200)	(44,800)	(28,000)	(140,000)
Profit/(loss)	22,800	23,200	(6,000)	40,000

Closing Tours saves only its depot hire of 8,500; the rest of its 28,000 share is charged to the other services.

Contribution lost        (22,000)
Fixed costs saved          8,500
Change in profit         (13,500)   → total profit falls from 40,000 to 26,500

Continue Tours: its contribution exceeds its avoidable costs. Consider also whether Tours customers book other services, and drivers’ jobs.

Limiting factors (2.8.6)

A limiting factor is a scarce resource (materials, labour hours, machine hours, space) that stops the business meeting all demand. When one applies:

1. Check it limits output: resource needed for full demand > resource available.
2. Work out contribution per unit of the limiting factor for each product.
3. Rank, highest first, and allocate the resource in that order, meeting full demand before moving on.

Worked example 4: Mardale Paints Ltd

A special resin is restricted to 17,000 kg next quarter. Fixed costs are 50,000.

Paint (per tin)	Price	Variable cost	Contribution	Resin kg	Contribution per kg	Demand
Matt	22	13	9	1.5	6.00	4,000
Satin	30	18	12	3.0	4.00	3,000
Gloss	37	23	14	2.0	7.00	2,500

Resin for full demand = 6,000 + 9,000 + 5,000 = 20,000 kg, more than 17,000, so resin is limiting. Rank: Gloss, Matt, Satin.

Paint	Tins	Resin kg	Contribution
Gloss	2,500	5,000	35,000
Matt	4,000	6,000	36,000
Satin	2,000 (6,000 kg ÷ 3)	6,000	24,000
Total		17,000	95,000

Maximum profit = 95,000 − 50,000 = 45,000. Ranking by contribution per tin would give only 39,000: Satin earns more per tin than Matt but uses twice the resin.

Common errors

• Putting selling or administration costs into inventory value.
• Putting fixed production overheads above contribution in a marginal statement.
• Forgetting under- or over-absorbed overhead when output differs from normal output.
• Using full cost per unit in order or make-or-buy decisions.
• Treating all apportioned fixed costs as saved when a service or product closes.
• Choosing products by unit contribution when a resource is scarce.
• Ignoring lost contribution when capacity is full.

Where to go next

• Condensed layouts and a self-test: revision notes.
• Original questions with worked answers: practice questions.
• Check your gaps: free 10-minute diagnostics.

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.