ACCA Applied Knowledge · Management Accounting

Absorption and marginal costing: formula sheet

Full chapter guide

Key formulas

Overhead absorption rate (OAR): OAR = Budgeted overheads ÷ Budgeted activity level; Use the same cost centre for both figures. Activity is labour hours, machine hours or units.
Overhead absorbed: Overhead absorbed = OAR × Actual activity; Use actual hours or units produced, not budgeted ones.
Rate per unit base: Overhead per unit = OAR × hours per unit; Use when the rate is per hour and you need the cost of one unit.
Full production cost per unit: Prime cost + Variable overhead + Absorbed fixed overhead; Prime cost is direct materials plus direct labour plus direct expenses.
Predetermined absorption rate: Rate = budgeted overheads ÷ budgeted activity; Set before the period. Activity is usually labour hours, machine hours or units.
Overhead absorbed: Absorbed = actual activity × predetermined rate; Use actual hours or units, not budgeted.
Over/under absorption: Absorbed − actual overhead incurred; Positive = over absorbed. Negative = under absorbed.
Income statement adjustment: Under absorbed: deduct from profit. Over absorbed: add to profit.; Under absorption is an extra cost. Over absorption is a credit.
Contribution per unit: Contribution per unit = selling price per unit − variable cost per unit; Variable cost includes variable production and variable selling and administration costs.
Total contribution: Total contribution = sales revenue − total variable costs = contribution per unit × units sold; Use units sold, not units produced.
Marginal costing profit: Profit = total contribution − total fixed costs; All fixed costs for the period, production and non-production, are deducted.
Inventory valuation: Inventory value = units × variable production cost per unit; No fixed overhead is included. Variable selling costs are not part of inventory.
Cost of sales (marginal): Opening inventory + variable production cost of units produced − closing inventory; Add variable selling costs separately, based on units sold.
Profit difference: Absorption profit − Marginal profit = (Closing inventory units − Opening inventory units) × Fixed overhead absorption rate per unit; A positive answer means absorption profit is higher. A negative answer means marginal profit is higher.
Fixed overhead absorption rate per unit: Budgeted fixed production overhead ÷ Budgeted production units; Use the rate absorbed in the period. If the rate is per labour hour, convert it to a rate per unit first.
Inventory rule: Inventory up: absorption profit > marginal profit. Inventory down: absorption profit < marginal profit. No change: profits equal.; Holds when the fixed overhead rate per unit is the same in both periods.
Inventory value: Marginal: variable production cost per unit. Absorption: variable production cost + fixed production overhead per unit; Do not include selling or administration costs in inventory under either method.
Absorption cost per unit: Direct materials + direct labour + variable production overhead + fixed production overhead absorbed; Non-production costs such as selling and administration are not included in inventory value.
Marginal cost per unit: Direct materials + direct labour + variable production overhead (+ variable direct expenses); Variable selling costs are deducted in arriving at contribution but are not part of inventory value.
Contribution: Sales revenue − variable costs; Fixed costs are then deducted as a period cost to give marginal costing profit.
Profit difference: Absorption profit − marginal profit = change in inventory units × fixed overhead absorbed per unit; Inventory increase: absorption profit is higher. Inventory decrease: absorption profit is lower. This assumes the same absorption rate in both periods.

Quick revision

Absorption costing includes fixed production overheads in unit cost. Marginal costing does not.
Overhead absorption rate = budgeted overhead ÷ budgeted activity.
Absorbed overhead = absorption rate × actual activity.
Under absorption: absorbed overhead is less than actual overhead. Profit is reduced by the adjustment.
Over absorption: absorbed overhead is more than actual overhead. Profit is increased by the adjustment.
Contribution = sales − variable costs.
Marginal costing profit = total contribution − total fixed costs for the period.
Inventory is valued at variable production cost under marginal costing.
If production is more than sales, inventory rises and absorption costing profit is higher.
If sales are more than production, inventory falls and marginal costing profit is higher.
If inventory does not change, both methods give the same profit.
Profit difference = change in inventory units × fixed overhead per unit.

Common mistakes

Using actual overheads or actual hours to calculate the rate. Fix: The rate uses budgeted overheads and budgeted activity. Use actual activity only to work out overhead absorbed.
Forgetting to reapportion service centre costs. Fix: Always move service centre costs to production centres before calculating any OAR.
Using budgeted activity instead of actual activity to calculate overhead absorbed. Fix: Budget figures are for the rate only. Absorbed always uses actual activity.
Mixing up over and under absorption. Fix: Always do absorbed − actual. Plus is over absorbed. Minus is under absorbed.
Including fixed production overhead in inventory valuation Fix: In marginal costing, value inventory at variable production cost only. Charge fixed costs to the period.
Using units produced instead of units sold to calculate contribution Fix: Contribution comes from sales. Always multiply contribution per unit by units sold.
Using the wrong direction for the adjustment. Fix: Ask: did overhead get stored or released? Inventory up means stored, so absorption profit is higher.
Multiplying by total inventory instead of the change in inventory. Fix: Use closing units minus opening units. Only the movement affects the profit difference.
Saying marginal costing ignores fixed costs completely. Fix: Fixed costs are still deducted in full as a period cost. They are just not in inventory value.
Choosing marginal costing as the method for published accounts. Fix: IFRS requires inventory to include production overheads, so absorption costing is used for external reporting.

Exam tips

Check which activity figure the question calls budgeted. The OAR always uses it.
Watch the base. If a question gives both machine hours and labour hours, pick the one linked to the department's main activity.
In multiple response questions, a statement saying the OAR is set using actual costs is false. Cross it out quickly.
For number entry, keep full decimals in your calculator and round only the final answer to the places requested.
Write allocation, apportionment and absorption on your scrap paper as a three-step reminder before service centre questions.
Write the rate first. Most wrong answers start from a wrong rate.
Read whether the question gives actual hours or budgeted hours. Use actual hours for absorbed overhead.
In multiple response questions, check both the label (over or under) and the profit effect.