Fenwick Mouldings Ltd: absorption, marginal costing and the stock movement
Fenwick Mouldings Ltd makes a single moulded component. Budgeted fixed production overhead for the year is £180,000 and budgeted production is 24,000 units, each taking 2.5 direct labour hours. Overhead is absorbed on direct labour hours. Last month the company produced 23,000 units using 57,500 direct labour hours and incurred fixed production overhead of £186,000. Sales for the month were 23,500 units; opening inventory was 2,000 units and closing inventory was 1,500 units. The sales director wants to know why the absorption-costing profit differs from the marginal-costing figure, and the finance director, frustrated by a £13,500 'under-recovery' charge, is asking whether the company should abandon absorption costing altogether.
1. Calculate the overhead absorption rate, the overhead absorbed, and the total under- or over-absorption. Split the total between the expenditure and volume elements and explain what each tells management.
Read the worked answer
OAR: £180,000 ÷ 60,000 budgeted hours (24,000 units × 2.5) = £3.00 per direct labour hour.
Absorbed: 57,500 actual hours × £3.00 = £172,500.
Under-absorbed: £186,000 − £172,500 = £13,500 under-absorbed, written off to profit and loss.
Split:
- Expenditure: £180,000 − £186,000 = £6,000 adverse - the overhead actually cost more than budgeted. Controllable by the managers who spend it.
- Volume: (60,000 − 57,500) hours × £3.00 = £7,500 adverse - the factory worked 2,500 hours fewer than budgeted (23,000 units instead of 24,000), so £7,500 of fixed overhead was never carried into product.
What it tells management: £6,000 is a spending problem and is actionable within the month. £7,500 is a capacity-utilisation signal that belongs with the sales/production planning discussion, not with the cost centre manager's performance review. Reporting a single £13,500 figure mixes the two and makes both conversations harder.
2. Calculate the difference between the absorption-costing and marginal-costing profit for the month, state which is higher, and explain the rule that drives it.
Read the worked answer
Fixed overhead per unit: £180,000 ÷ 24,000 units = £7.50 per unit.
Inventory movement: opening 2,000 − closing 1,500 = 500 units decrease.
Difference: 500 units × £7.50 = £3,750.
Because inventory fell, £3,750 of fixed overhead that had been carried forward in opening stock was released to profit and loss without being replaced in closing stock. So absorption profit is £3,750 lower than marginal profit.
The rule: absorption and marginal profit differ only by the fixed overhead carried in the change in inventory (production × OAR per unit less sales × OAR per unit). Production 23,000 < sales 23,500, so stock is run down and absorption profit falls. If the two profits ever differ by anything other than this amount, there is an error in the workings.
3. Advise the finance director on which costing basis to use, both for the annual accounts and for a one-off export order that would use otherwise idle capacity. Justify each answer.
Read the worked answer
Annual accounts and stock valuation: keep absorption. Closing inventory must include a fair share of production overhead to comply with stock valuation rules and to avoid understating profit by dumping all fixed cost into the months it was incurred. Marginal costing for external reporting is not permitted.
Short-term decisions: use marginal. With idle capacity, the only costs that change if the order is accepted are the variable/incremental ones. Any price above variable cost adds contribution and improves profit, whereas a full-cost floor would reject work that genuinely helps. Relevant costs here are the incremental material, labour and any order-specific costs - not the £3.00 per hour absorbed overhead.
Caveats before accepting:
- Does the order use scarce capacity that could earn more elsewhere? Then compare contribution per limiting factor, not per unit.
- Is it genuinely one-off and export-only, or will it reset customer expectations of price? Price discipline is a real cost.
- Will it become recurring? If so, fixed costs must be covered over time and the marginal price is not sustainable.
Recommendation: keep absorption for valuation and reporting, run a marginal reconciliation alongside it for decisions, and never let the £13,500 write-off distort the decision on a specific order.