The same business, in the same month, can report two different profits depending on how it treats fixed production overhead. Absorption costing spreads that overhead over units and carries part of it forward in stock. Marginal costing charges all of it against the month it was incurred and values stock at variable cost only.
Both are correct under their own rules, and an accountant must be able to produce either statement from the same data.
This topic defines marginal cost, explains why marginal costing is used, sets out its assumptions and the idea of contribution, and then shows how to prepare a profit statement under each method. The next topic reconciles the two profits and compares the merits of each. Exam questions often ask for both statements from one set of figures, so that is how the worked example here is set out.
In 30 seconds
Marginal cost is variable cost. Marginal production cost = direct materials + direct labour + direct expenses + variable production overhead. Contribution = sales − variable costs. Marginal costing profit = total contribution − fixed costs, with stock valued at marginal production cost, so fixed production overhead is a period cost. Absorption costing values stock at full production cost (including absorbed fixed production overhead), adjusts for under- or over-absorbed overhead, then deducts administration and selling costs.
Fixed selling and administration costs are period costs under both methods.
Marginal cost
The marginal cost of an item is its variable cost: the extra cost of making and selling one more unit.
- Marginal production cost = direct materials + direct labour + direct expenses + variable production overhead.
- Marginal cost of sale (product) = marginal production cost + other variable overheads, such as variable selling and distribution costs.
- Marginal cost of sale (service) = direct materials + direct labour + direct expenses + variable overhead.
Points to watch when identifying marginal cost
- Direct labour is usually assumed to be variable. In practice it can be fixed, for example where staff are paid a salary whatever output is. If so, it is not part of marginal cost.
- Variable overhead can be hard to identify. It can be measured by separating total overhead into fixed and variable parts using the high-low method or regression analysis.
- The activity measure for variable production overhead is often direct labour hours or machine hours. For variable selling and distribution cost it may be sales volume or sales revenue.
- Administration overhead is usually treated as fixed. Variable administration overhead is very unusual.
Uses and assumptions of marginal costing
Marginal costing is an alternative to absorption costing. Fixed production overhead is not absorbed into product costs. Only costs that change with the number of units produced are included in production costs. It is used:
- to measure profit or loss, as an alternative to absorption costing;
- to forecast future profit;
- to calculate the minimum sales volume needed to make a profit (break-even);
- to give management information for decision making; and
- above all, for planning (such as budgeting), forecasting and decisions.
| Assumption | Meaning |
|---|---|
| Constant variable cost per unit | Every extra unit of output or sale has the same variable cost as every other unit |
| Fixed costs are fixed in total | They stay the same in each period however many units are produced and sold |
| Costs are fixed, variable or mixed | Mixed costs can be separated into a variable cost per unit and a fixed cost per period |
| Marginal cost is the extra cost of one more unit | So marginal costing focuses on what changes as the result of a decision, which is why it helps decision making |
Contribution
Contribution is the central idea in marginal costing.
Contribution = sales − variable costs. Profit = total contribution − fixed costs.
It means contribution towards covering fixed costs and making a profit. Fixed costs stay the same each period, so a business must first earn enough contribution to cover them. After that, each extra naira of contribution is profit. If total contribution falls short of fixed costs, there is a loss.
If the variable cost per unit and the selling price are both constant, contribution per unit is constant, so total contribution = units sold × contribution per unit.
Example. Product A sells for ₦20 with a variable cost of ₦12. Product B sells for ₦30 with a variable cost of ₦21. In a period the firm sells 5,000 units of A and 4,000 of B. Fixed costs are ₦60,000.
| Per unit | Units | Contribution (₦) | |
|---|---|---|---|
| Product A | 20 − 12 = 8 | 5,000 | 40,000 |
| Product B | 30 − 21 = 9 | 4,000 | 36,000 |
| Total contribution | 76,000 | ||
| Fixed costs | (60,000) | ||
| Profit | 16,000 |
Profit statement under marginal costing
Profit is revenue less the cost of goods sold, less other expenses. The cost of goods sold equals the production costs of the period adjusted for the change in stock. In marginal costing, opening and closing stock are valued at marginal production cost, with no fixed production overhead in them.
| Layout: marginal costing | Notes |
|---|---|
| Sales | Units sold × selling price |
| Opening stock at variable production cost | Units × marginal production cost per unit |
| Add: variable production costs of the period | Materials, labour, variable overhead for units produced |
| Less: closing stock at variable production cost | Units × marginal production cost per unit |
| Variable production cost of sales | |
| Variable selling and distribution costs | Per unit sold |
| Contribution | Sales − all variable costs |
| Less: fixed costs (production, administration, selling) | All written off in full |
| Profit |
If the variable production cost per unit is the same in every period, the stock figures can be left out and variable cost of sales shown simply as units sold × variable cost per unit.
Profit statement under absorption costing
Absorption costing is the traditional way of measuring profit in manufacturing. Stock is valued at full production cost: direct costs plus absorbed fixed and variable production overhead. Because the fixed overhead rate is predetermined, there will be under- or over-absorption, which is adjusted in the statement. Non-production costs are charged in full as period costs.
| Layout: absorption costing | Notes |
|---|---|
| Sales | |
| Opening stock at full production cost | Includes fixed overhead absorbed last period |
| Add: production costs of the period, including production overhead absorbed | Fixed overhead at the predetermined rate × units produced |
| Less: closing stock at full production cost | Carries forward some fixed overhead |
| Full production cost of sales | |
| Gross profit before adjustment | |
| Add: over-absorbed overhead (or less: under-absorbed) | Overhead absorbed minus overhead incurred |
| Less: administration, selling and distribution costs | Period costs |
| Profit |
The ideas in more depth
What fixed overhead does in each method
Under marginal costing, fixed production overhead is a period cost: the whole amount incurred in the month is deducted from that month’s contribution. Under absorption costing, a share is attached to each unit made. Units sold carry their share into cost of sales. Units still in stock carry theirs forward on the statement of financial position.
If production is higher than sales, some fixed overhead is carried forward and profit is higher than under marginal costing. If sales are higher than production, fixed overhead from earlier months is released and profit is lower.
Why contribution per unit is useful
Contribution per unit does not change with volume, but profit per unit does, because the fixed cost per unit falls as volume rises. A manager deciding whether to accept an extra order, or whether a product is worth keeping, needs the figure that changes with the decision. That is contribution.
Normal activity and the absorption rate
The fixed overhead absorption rate is set from budgeted fixed overhead and normal activity. Suppose fixed production overhead is ₦240,000 a month and normal production is 3,000 units. The rate is ₦80 per unit. If 3,200 units are made, ₦256,000 is absorbed, which is ₦16,000 more than incurred (over-absorbed). If 2,600 are made, ₦208,000 is absorbed and ₦32,000 is under-absorbed.
Same data, same sales, different profit
Neither method changes cash, sales or costs incurred. They change when part of the fixed production overhead is charged to profit.
Worked example: two months, two methods
Scenario. Zaria Tools Ltd makes one product. Selling price ₦300. Direct materials ₦50, direct labour ₦40 and variable production overhead ₦20 per unit. Variable selling cost ₦10 per unit sold. Fixed production overhead ₦240,000 a month; normal production 3,000 units a month. Fixed administration ₦60,000 and fixed selling ₦45,000 a month. Month 1: production 3,200 units, sales 2,800 units, no opening stock. Month 2: production 2,600 units, sales 3,000 units. Prepare profit statements for each month under marginal costing and absorption costing.
Marginal costing
Marginal production cost per unit = ₦50 + ₦40 + ₦20 = ₦110.
| ₦ | Month 1 | Month 2 |
|---|---|---|
| Sales (2,800 and 3,000 × ₦300) | 840,000 | 900,000 |
| Opening stock | nil | 44,000 |
| Variable production cost (3,200 and 2,600 × ₦110) | 352,000 | 286,000 |
| Closing stock (400 × ₦110 in month 1; nil in month 2) | (44,000) | nil |
| Variable production cost of sales | (308,000) | (330,000) |
| Variable selling cost (₦10 per unit sold) | (28,000) | (30,000) |
| Contribution | 504,000 | 540,000 |
| Fixed production overhead | (240,000) | (240,000) |
| Fixed administration | (60,000) | (60,000) |
| Fixed selling | (45,000) | (45,000) |
| Profit | 159,000 | 195,000 |
Absorption costing
Fixed overhead absorption rate = ₦240,000 ÷ 3,000 = ₦80 per unit. Full production cost per unit = ₦110 + ₦80 = ₦190.
| ₦ | Month 1 | Month 2 |
|---|---|---|
| Sales | 840,000 | 900,000 |
| Opening stock | nil | 76,000 |
| Production cost: variable (3,200 and 2,600 × ₦110) | 352,000 | 286,000 |
| Production cost: fixed absorbed (3,200 and 2,600 × ₦80) | 256,000 | 208,000 |
| Closing stock (400 × ₦190 in month 1; nil in month 2) | (76,000) | nil |
| Full production cost of sales | (532,000) | (570,000) |
| Gross profit before adjustment | 308,000 | 330,000 |
| Over-absorbed (256,000 − 240,000) / under-absorbed (208,000 − 240,000) | 16,000 | (32,000) |
| Fixed administration | (60,000) | (60,000) |
| Fixed selling | (45,000) | (45,000) |
| Variable selling | (28,000) | (30,000) |
| Profit | 191,000 | 163,000 |
| Profit (₦) | Month 1 | Month 2 | Both months |
|---|---|---|---|
| Marginal costing | 159,000 | 195,000 | 354,000 |
| Absorption costing | 191,000 | 163,000 | 354,000 |
| Difference | 32,000 | (32,000) | nil |
Over the two months the total profit is the same because all stock has been sold by the end of month 2. The next topic explains the monthly difference: 400 units × ₦80 = ₦32,000.
Using contribution to forecast profit
Because contribution per unit is constant, marginal costing makes quick profit forecasts easy. In the Zaria Tools example, contribution per unit sold = ₦300 − ₦110 − ₦10 = ₦180. Each extra unit sold adds ₦180 to profit, whatever the level of production, since fixed costs do not change. If sales are 3,500 units, contribution = 3,500 × ₦180 = ₦630,000, and profit = ₦630,000 − ₦345,000 of fixed costs = ₦285,000.
The contribution to sales ratio (C/S ratio) expresses contribution as a percentage of sales. Month 1: ₦504,000 ÷ ₦840,000 = 60%. If the ratio stays constant, a sales target of ₦900,000 gives contribution of 60% × ₦900,000 = ₦540,000, which matches month 2. This ratio is useful when units are not meaningful, such as in a multi-product business or a service business.
The simplified marginal statement (with no stock detail) for month 2 is therefore: sales ₦900,000; variable cost of sales 3,000 × (₦110 + ₦10) = ₦360,000; contribution ₦540,000; fixed costs ₦345,000; profit ₦195,000. This works only because the variable production cost per unit is the same in both months. Under absorption costing there is no such shortcut, because profit also depends on how many units were produced.
Why the choice of method matters to a manager
Suppose management is told that month 1 profit was ₦191,000 (absorption) or ₦159,000 (marginal). Under absorption costing, a rise in production alone raised profit by ₦32,000, though no extra unit was sold. Under marginal costing, profit moved only with sales. For a manager judging performance from sales, the marginal costing figure is the more reliable signal. For a bank or the tax authority, the absorption costing figure follows the reporting rules.
This is why many firms keep both: marginal costing for internal decisions and absorption costing for the financial statements.
When opening stock was costed at a different price
So far the unit cost has been the same each month. When costs change, opening stock carries last period’s cost and the period’s production carries the new cost. A first-in, first-out flow is normally assumed: opening stock is sold first.
Example. Selling price ₦200. Opening stock 200 units valued at the previous month’s marginal cost of ₦100 (₦20,000). This month production is 1,000 units at a marginal cost of ₦110. Sales are 1,100 units, so closing stock is 100 units, valued at this month’s cost of ₦110 (₦11,000).
| Marginal costing (₦) | ₦ |
|---|---|
| Sales (1,100 × ₦200) | 220,000 |
| Opening stock | 20,000 |
| Production cost (1,000 × ₦110) | 110,000 |
| Closing stock | (11,000) |
| Variable cost of sales | (119,000) |
| Contribution | 101,000 |
Check: the 1,100 units sold cost 200 × ₦100 + 900 × ₦110 = ₦20,000 + ₦99,000 = ₦119,000. ✓ The same logic applies to absorption costing, where opening stock also carries the previous period’s fixed overhead rate.
A product-by-product marginal costing statement
Marginal costing is often used to show the contribution of each product, with fixed costs that can be traced to products deducted next, and common fixed costs last. This format shows which products are carrying their weight.
| ₦ | Product A | Product B | Total |
|---|---|---|---|
| Sales | 600,000 | 400,000 | 1,000,000 |
| Variable costs | (360,000) | (300,000) | (660,000) |
| Contribution | 240,000 | 100,000 | 340,000 |
| Fixed costs traceable to the product | (80,000) | (60,000) | (140,000) |
| Product margin | 160,000 | 40,000 | 200,000 |
| Common fixed costs (not traceable) | (100,000) | ||
| Profit | 100,000 |
The statement shows that B contributes only ₦40,000 after its own fixed costs. It still makes a positive margin, so dropping it would reduce profit unless its resources can be used better. The common fixed costs of ₦100,000 are not shared out among products because any share would be arbitrary. This presentation links directly to the shutdown decisions in the decision-making chapters.
Marginal costing and financial reporting
International Accounting Standard 2 requires inventory in the financial statements to include production overhead, fixed as well as variable, at normal capacity. Marginal costing values inventory without fixed production overhead, so it cannot be used for published statements without adjustment. Many businesses use marginal costing for internal management reports and adjust to absorption costing for external reporting at the period end, using the reconciliation described in the next topic.
Where inventory is small or does not change much between periods, the two profit figures are very close and the difference is not material.
Marginal costing in a service business
A service business has no stock, so absorption and marginal costing give the same profit. Contribution is still the key measure: the contribution per customer, per room-night or per hour of professional time. A clinic with a fee of ₦15,000 per consultation, variable costs (consumables and the part-time nurse’s pay) of ₦6,000 and fixed costs of ₦900,000 a month has a contribution of ₦9,000 per consultation and breaks even at 100 consultations. The same decision tools apply as for a manufacturer.
Questions examiners ask on these statements
| Typical request | What to do |
|---|---|
| Prepare an income statement using marginal costing | Sales, variable cost of sales (adjusting for stock at variable production cost), variable selling cost, contribution, then all fixed costs |
| Prepare an income statement using absorption costing | Sales, full production cost of sales (stock at full cost), adjustment for over- or under-absorption, then non-production costs |
| Calculate the absorption rate | Budgeted fixed production overhead ÷ normal or stated production capacity |
| Reconcile the two profits | Change in stock in units × fixed overhead per unit, with the direction of the difference |
| Comment on the results | Say which method gives the higher profit and why, and which is more suitable for decisions |
Common mistakes in the exam
- Including fixed production overhead in marginal costing stock values.
- Forgetting variable selling and distribution costs when finding contribution.
- Deducting fixed costs before arriving at contribution.
- Using the wrong activity for the absorption rate, such as actual production instead of normal production.
- Forgetting to adjust for under- or over-absorption in the absorption statement.
- Adding the over-absorption to profit when it was under-absorption, or the reverse.
- Treating administration and selling costs as part of stock value.
- Valuing opening stock at this period’s cost per unit when last period’s cost was different.
Quick revision
- Marginal production cost = DM + DL + direct expenses + variable production overhead.
- Contribution = sales − variable costs. Profit = contribution − fixed costs.
- Marginal costing: stock at marginal production cost; all fixed costs are period costs.
- Absorption costing: stock at full production cost; adjust for over- or under-absorption; non-production costs are period costs.
- Marginal costing assumes constant variable cost per unit and fixed costs fixed in total.
Practice questions
These are original questions written in the style of the Institute of Chartered Accountants of Nigeria (ICAN) exam. Try each one before you open the answer.
Section A style: multiple choice
Question 1. Marginal production cost per unit consists of:
- Direct materials, direct labour, direct expenses and variable production overhead
- All production costs including fixed overhead
- Selling costs only
- Fixed overhead only
Show the answer
A. Only variable production costs.
Question 2. Contribution equals:
- Sales − fixed costs
- Sales − variable costs
- Profit + variable costs
- Sales − total costs
Show the answer
B. Sales less variable costs.
Question 3. Selling price ₦300 and variable cost ₦180 per unit. 4,000 units are sold. Total contribution is:
- ₦240,000
- ₦480,000
- ₦720,000
- ₦1,200,000
Show the answer
B. (₦300 − ₦180) × 4,000 = ₦480,000.
Question 4. Total contribution is ₦520,000 and fixed costs are ₦400,000. Profit is:
- ₦120,000
- ₦920,000
- ₦400,000
- ₦520,000
Show the answer
A. ₦520,000 − ₦400,000 = ₦120,000.
Question 5. Under marginal costing, closing stock is valued at:
- Full production cost
- Variable production cost
- Selling price
- Variable selling cost
Show the answer
B. No fixed overhead is included.
Question 6. Under marginal costing, fixed production overhead is:
- Absorbed into units
- Charged in full to the period in which it is incurred
- Carried in closing stock
- Ignored
Show the answer
B. It is a period cost.
Question 7. Marginal cost per unit is ₦110 and the fixed overhead absorption rate is ₦80 per unit. 500 units in stock are valued under absorption costing at:
- ₦55,000
- ₦40,000
- ₦95,000
- ₦110,000
Show the answer
C. 500 × (₦110 + ₦80) = ₦95,000.
Question 8. Budgeted fixed production overhead ₦240,000 and normal output 3,000 units give an absorption rate of:
- ₦40
- ₦60
- ₦80
- ₦100
Show the answer
C. ₦240,000 ÷ 3,000 = ₦80.
Question 9. 3,200 units are made. The rate is ₦80 and actual fixed overhead is ₦240,000. The overhead is:
- Over-absorbed by ₦16,000
- Under-absorbed by ₦16,000
- Correctly absorbed
- Over-absorbed by ₦32,000
Show the answer
A. 3,200 × ₦80 = ₦256,000, which is ₦16,000 more than incurred.
Question 10. Administration overheads are usually treated as:
- Variable costs
- Fixed costs
- Direct costs
- Part of stock value
Show the answer
B. Variable administration overhead is very unusual.
Section B style: written questions
Question 11 (10 marks). Explain what marginal costing is, state its assumptions and give four uses.
Question 12 (20 marks). Kogi Plastics Ltd makes one product. Selling price ₦250. Direct materials ₦40, direct labour ₦30 and variable production overhead ₦15 per unit. Variable selling cost ₦5 per unit sold. Fixed production overhead ₦180,000 a month and normal production 2,000 units. Fixed administration ₦50,000 and fixed selling ₦30,000. In the month, opening stock was 100 units (marginal cost ₦85; absorption cost ₦175), production 2,200 units and sales 1,900 units.
(a) Distinguish between marginal costing and absorption costing. (4 marks)
(b) Prepare the profit statement under marginal costing. (8 marks)
(c) Prepare the profit statement under absorption costing. (8 marks)
A further written question
Question 13 (10 marks). Product A sells for ₦20 with a variable cost of ₦12, and Product B sells for ₦30 with a variable cost of ₦21. The firm sells 5,000 units of A and 4,000 of B. Fixed costs are ₦60,000. (a) Calculate the contribution per unit and the total contribution of each product. (4 marks) (b) Calculate the profit. (2 marks) (c) Explain why contribution, not profit per unit, is used in decisions. (4 marks)
Model answers
Show the model answer to Question 11
Marginal costing is a costing method in which only variable (marginal) production costs are charged to units. Fixed production overhead is not absorbed but is written off as a period cost. Stock is valued at marginal production cost.
Assumptions. (1) Every extra unit has the same variable cost, so variable cost per unit is constant. (2) Fixed costs are the same in total in each period whatever the volume. (3) Costs are fixed, variable or mixed, and mixed costs can be separated. (4) Marginal cost is the extra cost of one more unit, so the method focuses on what changes with a decision.
Uses. Measuring profit as an alternative to absorption costing; forecasting future profit; finding the minimum sales volume needed to make a profit; supplying information for decision making; and planning, such as budgeting.
Show the model answer to Question 12
(a) Marginal costing charges only variable production costs to units, values stock at marginal production cost and writes off fixed production overhead as a period cost. Absorption costing charges units with variable production cost plus a share of fixed production overhead, values stock at full production cost and adjusts profit for under- or over-absorbed overhead.
(b) Marginal costing.
- Variable production cost per unit.
₦40 + ₦30 + ₦15 = ₦85. - Sales = 1,900 × ₦250 = ₦475,000.
- Opening stock 100 × ₦85 = ₦8,500.
- Production 2,200 × ₦85 = ₦187,000.
- Closing stock.
100 + 2,200 − 1,900 = 400 units × ₦85 = ₦34,000. - Variable production cost of sales.
₦8,500 + ₦187,000 − ₦34,000 = ₦161,500. - Variable selling.
1,900 × ₦5 = ₦9,500. - Contribution = ₦475,000 − ₦161,500 − ₦9,500 = ₦304,000. Fixed costs = ₦180,000 + ₦50,000 + ₦30,000 = ₦260,000.
- Profit = ₦44,000.
(c) Absorption costing.
- Rate = ₦180,000 ÷ 2,000 = ₦90 per unit.
- Full cost per unit.
₦85 + ₦90 = ₦175. - Production cost.
2,200 × ₦85 = ₦187,000 plus fixed absorbed 2,200 × ₦90 = ₦198,000, total ₦385,000. - Add opening stock 100 × ₦175 = ₦17,500 to give ₦402,500.
- Less closing stock 400 × ₦175 = ₦70,000.
- Cost of sales = ₦332,500.
- Gross profit before adjustment.
₦475,000 − ₦332,500 = ₦142,500. - Over-absorbed overhead.
₦198,000 − ₦180,000 = ₦18,000, added: ₦160,500. - Less administration ₦50,000, fixed selling ₦30,000 and variable selling ₦9,500 = ₦89,500.
- Profit = ₦71,000. The difference of ₦27,000 from marginal costing equals the increase in stock of 300 units × ₦90.
Show the model answer to Question 13
(a)
- Contribution per unit.
A = ₦20 − ₦12 = ₦8. - B = ₦30 − ₦21 = ₦9.
- Total.
A = 5,000 × ₦8 = ₦40,000. - B = 4,000 × ₦9 = ₦36,000.
(b)
- Total contribution = ₦76,000.
- Profit = ₦76,000 − ₦60,000 = ₦16,000.
(c) Contribution per unit is constant whatever the volume, because variable cost and selling price per unit are constant. Profit per unit changes with volume because the fixed cost per unit falls as volume rises.
A decision, such as whether to take an extra order or drop a product, changes revenue and variable cost but not fixed cost, so the relevant measure is the contribution that the decision adds or removes.
Pathfinder on Marginal and absorption costing: profit statements
These are the ICAN Pathfinder questions that test this topic. ICAN owns the questions and the suggested solutions, so we point you to them and do not copy them. Open your Pathfinder, attempt each question under exam conditions, then check your answer against the notes above.
Bally Nigeria Limited. Asks for an income statement under marginal costing (7½ marks) and under absorption costing (10½ marks), using sales, unit costs, fixed overheads and opening and closing stock.
Revise first: Profit statement under absorption costing
Opens with the choice between absorption and marginal costing when preparing an operating statement. Part (a) asks for a differentiation under given criteria (5 marks), then operating statements under absorption costing and under marginal costing (6 marks for the marginal costing statement).
Revise first: Profit statement under absorption costing
An absorption costing approach question requiring profit to be calculated and compared under marginal and absorption costing.
Revise first: Profit statement under marginal costing
Multiple-choice items often ask for contribution, marginal cost per unit, or the effect of stock on profit. Check Section A of every diet you practise.
Revise first: Contribution
Source: ICAN Pathfinder, Management Accounting. Diets covered: May Diet, 2026, November Diet, 2025 and November Diet, 2014 (previous syllabus). May Diet, 2025 and November Diet, 2024 are not covered here.
Spotted a mistake? Tell us and we will check it.
