marginal costing and absorption costing · marginal costing is a method of costing with marginal...

THE INSTITUTE OF CHARTERED ACCOUNTANTS OF PAKISTAN 85

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CHAPTER 5

MARGINAL COSTING AND

ABSORPTION COSTING

AT A GLANCE

In marginal costing only variable costs (marginal costs) are charged to the cost of making and selling a product or service. Fixed costs are treated as period costs and are deducted from profit. They are charged in full against the profit of the period in which they are incurred.

In absorption costing variable costs as well as fixed production costs are charged to the cost of making the product or service. Fixed production cost are absorbed using a predetermined absorption rate.

In marginal costing the closing stocks are valued at marginal (variable) production cost where as in absorption costing stocks are valued at their full production cost which includes absorbed fixed production overhead.

If the opening and closing stock levels differ the profit for the accounting period under the two methods of cost accumulation will be different because the two systems value stock differently.

IN THIS CHAPTER

AT A GLANCE

SPOTLIGHT

1. Marginal Cost and Marginal Costing

2. Reporting Profit with Marginal Costing

3. Reporting Profit with Absorption Costing

4. Marginal and Absorption Costing Compared

5. Advantages and Disadvantages of Absorption and Marginal Costing

6. Comprehensive Examples

STICKY NOTES

CHAPTER 5: MARGINAL COSTING AND ABSORPTION COSTING CAF 8: CMA

86 THE INSTITUTE OF CHARTERED ACCOUNTANTS OF PAKISTAN

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1. MARGINAL COST AND MARGINAL COSTING

1.1 Marginal cost

The marginal cost of an item is its variable cost.

Marginal production cost = Direct materials + Direct labor + Direct expenses + Variable production overhead.

Marginal cost of sale for a product = Direct materials + Direct labor + Direct expenses + Variable production overhead + Other variable overhead (for example, variable selling and distribution overhead).

Marginal cost of sale for a service = Direct materials + Direct labor + Direct expenses + Variable overhead.

It is usually assumed that direct labor costs are variable (marginal) costs, but often direct labor costs might be fixed costs, and so would not be included in marginal cost. E.g. If the workers are not being paid on piece rate basis but rather on fixed salary.

Variable overhead costs might be difficult to identify. In practice, variable overheads might be measured using a technique such as high/low analysis or linear regression analysis, to separate total overhead costs into fixed costs and a variable cost per unit of activity.

For variable production overheads, the unit of activity is often either direct labor hours or machine hours, although other suitable measures of activity might be used.

For variable selling and distribution costs, the unit of activity might be sales volume or sales revenue.

Administration overheads are usually considered to be fixed costs, and it is very unusual to come across variable administration overheads.

In simple words…

In marginal costing the cost of the product is variable Production Cost only.

1.2 Marginal costing and its uses

Marginal costing is a method of costing with marginal costs. It is an alternative to absorption costing as a method of costing. In marginal costing, fixed production overheads are not absorbed into product costs.

There are several reasons for using marginal costing:

To measure profit (or loss), as an alternative to absorption costing

To forecast what future profits will be

To calculate what the minimum sales volume must be in order to make a profit

It can also be used to provide management with information for decision making.

Its main uses, however, are for planning (for example, budgeting), forecasting and decision making as it deals with costs that can be directly changed in the short term.

1.3 Assumptions in marginal costing

For the purpose of marginal costing, the following assumptions are normally made:

Every additional unit of output or sale, or every additional unit of activity, has the same variable cost as every other unit. In other words, the variable cost per unit is a constant value.

Fixed costs are costs that remain the same in total in each period, regardless of how many units are produced and sold.

Costs are either fixed or variable, or a mixture of fixed and variable costs. Mixed costs can be separated into a variable cost per unit and a fixed cost per period.

CAF 8: CMA CHAPTER 5: MARGINAL COSTING AND ABSORPTION COSTING


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The marginal cost of an item is therefore the extra cost that would be incurred by making and selling one extra unit of the item. Therefore, marginal costing is particularly important for decision making as it focuses on what changes as a result of a decision.

1.4 Contribution margin

Contribution is a key concept in marginal costing.

Contribution margin = Sales – Variable costs

Fixed costs are a constant total amount in each period. To make a profit, an entity must first make enough contribution to cover its fixed costs. Contribution therefore means: ‘contribution towards covering fixed costs and making a profit’.

Total contribution margin – Fixed costs = Profit

In simple words…

Contribution margin is sales minus all Variable costs



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2. REPORTING PROFIT WITH MARGINAL COSTING

2.1 Total contribution minus fixed costs

Profit is measured by comparing revenue to the cost of goods sold in the period and then deducting other expenses.

The cost of goods sold is the total cost of all production costs in the period adjusted for the inventory movement.

In a marginal cost system, the opening and closing inventory is measured at its marginal cost. The cost per unit only includes the variable costs of production (direct materials + direct labor + direct expenses + variable production overhead).

When measuring profits using marginal costing, it is usual to identify contribution, and then to subtract fixed costs from the total contribution, in order to get to the profit figure.

Illustration: Rs. Rs.

Sales 360,000

Direct costs 105,000

Variable production costs 15,000

Variable sales and distribution costs 10,000

Total marginal costs (130,000)

Total contribution 230,000

Total fixed costs (150,000)

Profit 80,000

Total contribution and contribution per unit

In marginal costing, it is assumed that the variable cost per unit of product (or per unit of service) is constant. If the selling price per unit is also constant, this means that the contribution earned from selling each unit of product is the same.

Total contribution can therefore be calculated as: Units of sale Contribution per unit.

Example 01:

A company manufactures and sells two products, A and B.

Product A has a variable cost of Rs.6 and sells for Rs.10, and product B has a variable cost of Rs.8 and sells for Rs.15.

During the period, 20,000 units of Product A and 30,000 units of Product B were sold.

Fixed costs were Rs.260,000. What was the profit or loss for the period?

Contribution per unit:

Product A: Rs.10 – Rs.6 = Rs.4

Product B: Rs.15 – Rs.8 = Rs.7

Rs.

Contribution from Product A: (20,000 Rs.4) 80,000

Contribution from Product B: (30,000 Rs.7) 210,000

Total contribution for the period 290,000

Fixed costs for the period (260,000)

Profit for the period 30,000



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2.2 A marginal costing income statement with opening and closing inventory

The explanation of marginal costing has so far ignored opening and closing inventory.

In absorption costing, the production cost of sales is calculated as ‘opening inventory value + production costs incurred in the period – closing inventory value’.

The same principle applies in marginal costing. The variable production cost of sales is calculated as ‘opening inventory value + variable production costs incurred in the period – closing inventory value’.

When marginal costing is used, inventory is valued at its marginal cost of production (variable production cost), without any absorbed fixed production overheads.

If an income statement is prepared using marginal costing, the opening and closing inventory might be shown, as follows:

Illustration: Marginal costing income statement for the period Rs. Rs.

Sales 440,000

Opening inventory at variable production cost 5,000

Variable production costs

Direct materials 60,000

Direct labor 30,000

Variable production overheads 15,000

110,000

Less: Closing inventory at variable production cost (8,000)

Variable production cost of sales 102,000

Variable selling and distribution costs 18,000

Variable cost of sales 120,000

Contribution 320,000

Fixed costs:

Production fixed costs 120,000

Administration costs (usually 100% fixed costs) 70,000

Selling and distribution fixed costs 90,000

Total fixed costs 280,000

Profit 40,000

If the variable production cost per unit is constant (i.e. it was the same last year and this year), there is no need to show the opening and closing inventory valuations separately, and the income statement could be presented more simply as follows:

Illustration: Marginal costing income statement for the period Rs. Rs.

Sales 440,000

Variable production cost of sales 102,000

Variable selling and distribution costs 18,000

Variable cost of sales 120,000




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Rs. Rs.

Fixed costs:

Production fixed costs 120,000

Administration costs (usually 100% fixed costs) 70,000

Selling and distribution fixed costs 90,000

Total fixed costs 280,000

Profit 40,000

2.3 Calculation of marginal cost profit

The following example illustrates the calculation of marginal cost profit.

In the next section the same scenario will be used to show the difference between marginal cost profit and total absorption profit.

Example 02:

Mingora Manufacturing makes and sells a single product:

Rs.

Selling price per unit 150

Variable costs:

Direct material per unit 35

Direct labor per unit 25

Variable production overhead per unit 10

Marginal cost per unit 70

Budgeted fixed production overhead Rs. 110,000 per month

The following actual data relates to July and August:

July August

Fixed production costs Rs. 110,000 Rs. 110,000

Production 2,000 units 2,500 units

Sales 1,500 units 3,000 units

There was no opening inventory in July.

This means that there is no closing inventory at the end of August as production in the two months (2,000 + 2,500 units = 4,500 units) is the same as the sales (1,500 + 3,000 units = 4,500 units)



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The profit statements for each month are shown below. Work through these carefully one month at a time.

July August

Sales:

1,500 units Rs. 150 225,000

3,000 units Rs. 150 450,000

Opening inventory nil 35,000


Direct material: 2,000 units Rs. 35 70,000

Direct labor: 2,000 units Rs. 25 50,000

Variable overhead 2,000 units Rs. 10 20,000




Closing inventory

500 units @ (70) (35,000)

Zero closing inventory nil

Cost of sale (105,000) (210,000)

Contribution 120,000 240,000

Fixed production costs (expensed) (110,000) (110,000)

Profit for the period 10,000 130,000

In simple words…

To calculate profit, we have to deduct all Fixed Cost from Contribution Margin.



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3. REPORTING PROFIT WITH ABSORPTION COSTING

3.1 Reporting profit with absorption costing

Absorption costing is the ‘traditional’ way of measuring profit in a manufacturing company. Inventory is valued at the full cost of production, which consists of direct materials and direct labor cost plus absorbed production overheads (fixed and variable production overheads).

Fixed production overhead may be under- or over- absorbed because the absorption rate is a predetermined rate. This was covered in chapter 3.

Over and under absorption is the difference between absorbed and actual overheads. If absorbed are greater than actual overheads, it is over absorption and vice versa.

The full presentation of an absorption costing income statement might therefore be as follows (illustrative figures included):

Illustration: Total absorption costing income statement for the period Rs. Rs.

Sales 430,000

Opening inventory at full production cost 8,000

Production costs

Direct materials 60,000

Direct labor 30,000

Production overheads absorbed 100,000

198,000

Less: Closing inventory at full production cost (14,000)

Full production cost of sales (184,000)

246,000

(Under)/over absorption

Production overheads absorbed 100,000

Production overheads incurred (95,000)

Over-absorbed overheads 5,000

251,000

Administration, selling and distribution costs (178,000)

Profit 73,000

3.2 Calculation of total absorption costing profit

The following example uses the same base scenario as that used to illustrate marginal costing. This means you can compare the difference between absorption and marginal costing profits.



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Example 03:

Mingora Manufacturing makes and sells a single product

Rs.

Selling price per unit 150

Variable costs:

Direct material per unit 35

Direct labor per unit 25

Variable production overhead per unit 10

70

Fixed overhead per unit (see below) 50

Total absorption cost per unit 120

Normal production 2,200 units per month

Budgeted fixed production overhead Rs. 110,000 per month

Fixed overhead absorption rate Rs. 110,000/2,200 units= Rs. 50 per unit

The following data relates to July and August:

July August

Fixed production costs Rs. 110,000 Rs. 110,000



There was no opening inventory in July.

This means that there is no closing inventory at the end of August as production in the two months (2,000 + 2,500 units = 4,500 units) is the same as the sales (1,500 + 3,000 units = 4,500 units)

Total absorption cost profit statement

July August

Sales:

1,500 units Rs. 150 225,000

3,000 units Rs. 150 450,000



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July August

Opening inventory nil 60,000








Fixed production costs (absorbed)

2,000 units Rs. 50 100,000

2,500 units Rs. 50 125,000

Closing inventory

500 units @ (70 + 50) (60,000)

Zero closing inventory nil

Cost of sale (180,000) (360,000)

Profit for the period before adjustment for over and under absorption

(Under)/over absorption 45,000 90,000

Production overheads absorbed 100,000 125,000

Production overheads incurred 110,000 110,000

Over- (under)absorbed overheads (10,000) 15,000

Profit for the period after adjustment for over and under absorption

35,000

105,000

Example 04:

Silver Limited (SL) produces and markets a single product. Following budgeted information is available from SL’s records for the month of March 20X4:

Volumes

Sales 100,000 units

Production 120,000 units

Standard costs:

Direct materials per unit 0.8 kg at Rs. 60 per kg

Labor per unit 27 minutes at Rs. 80 per hour

Variable production overheads Rs. 40 per labor hour

Variable selling expenses Rs. 15 per unit

Fixed selling expenses Rs. 800,000



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Fixed production overheads, at a normal output level of 105,000 units per month, are estimated at Rs. 2,100,000. The estimated selling price is Rs. 180 per unit.

Assuming there are no opening stocks, preparation SL’s budgeted profit and loss statement for the month of March 20X4 using absorption costing would be as follows:

Absorption costing: Rupees

Sales [100,000 x Rs. 180 ] 18,000,000

Less: Cost of sales:

Opening stock -

Add: Direct materials [ 0.8 x 120,000 x 60] 5,760,000

Direct labor [27/60 x 120,000 x 80] 4,320,000

Variable overheads [ 27/60 x 120,000 x 40] 2,160,000

Fixed overheads

[ 2,100,000 / 105,000 x 120,000] 2,400,000

14,640,000

Less: Closing stock

[14,640,000 / 120,000 x 20,000]

(2,440,000)

Cost of sales (12,200,000)

Less: Over-absorbed overheads

[ 2,100,000 / 105,000 x 15,000] (300,000)

Gross profit 6,100,000

Less: Selling expenses:

Variable [ 100,000 x 15] (1,500,000)

Fixed (800,000)

(2,300,000)

Net profit 3,800,000



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4. MARGINAL COSTING AND ABSORPTION COSTING COMPARED

4.1 The difference in profit between marginal costing and absorption costing

The profit for an accounting period calculated with marginal costing is different from the profit calculated with absorption costing.

The difference in profit is entirely due to the differences in inventory valuation as fixed overheads are treated as period cost in marginal costing and as product cost in absorption costing.

The main difference between absorption costing and marginal costing is that in absorption costing, inventory cost includes a share of fixed production overhead costs.

The opening inventory contains fixed production overhead that was incurred last period. Opening inventory is written off against profit in the current period. Therefore, part of the previous period’s costs is written off in the current period income statement provided that the opening inventory is sold during the current year.

The closing inventory contains fixed production overhead that was incurred in this period. Therefore, this amount is not written off in the current period income statement but carried forward to be written off in the next period income statement.

The implication of this is as follows (assume costs per unit remain constant):

When there is no change in the opening or closing inventory, exactly the same profit will be reported using marginal costing and absorption costing.

If inventory increases in the period (closing inventory is greater than opening inventory), the fixed production overhead brought forward from last period will be less than share of production overhead carried forward to next period, thus the absorption costing profit would be higher than marginal costing profit.

Similarly, if inventory decreases in the period (closing inventory is less than opening inventory), marginal costing profit would be higher than absorption costing.

The difference in the two profit figures is calculated as follows:

Formula:

Profit difference under absorption costing (TAC = total absorption costing) and marginal costing (MC)

Assuming cost per unit is constant across all periods under consideration.

Number of units increase or decrease Fixed production overhead per unit

Example 04 (Contd):

Profit difference July August Over the two months

Absorption costing profit 35,000 105,000 140,000

Marginal costing profit 10,000 130,000 140,000

Profit difference 25,000 (25,000) nil

This profit can be explained the different way the inventory movement is cost under each system:

Units Units Units

Closing inventory nil nil

2,000 units made less 1,500 sold 500

Opening inventory nil 500 nil

500 (500) nil

Absorbed fixed production overhead per unit Rs. 50 Rs. 50 Rs. 50




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Note that the difference is entirely due to the movement in inventory value:

Profit difference – due to inventory movement

TAC inventory movement: July August Over the two months

Closing inventory 60,000 nil nil

Opening inventory nil (60,000) nil

60,000 (60,000) nil

MC inventory movement

Closing inventory 35,000 nil nil

Opening inventory nil (35,000) nil

35,000 (35,000) nil


Reconciliation between absorption costing profit and marginal costing profit

July August

Marginal costing profit 10,000 130,000

July-adjust for FOH in inventory (500 units x Rs. 50) 25,000

August-adjust for FOH in inventory (500 units x Rs. 50) (25,000)

Absorption costing profit 35,000 105,000

4.2 Summary: comparing marginal and absorption costing profit

To calculate the difference between the reported profit using marginal costing and the reported profit using absorption costing, you might need to make the following simple calculations.

the increase or decrease in inventory during the period, in units.

the fixed production overhead cost per unit.

The important points to remember are:

The difference in profit is the increase or decrease in inventory quantity multiplied by the fixed production overhead cost per unit.

If there has been an increase in inventory, the absorption costing profit is higher. If there has been a reduction in inventory, the absorption costing profit is lower.

Ignore fixed selling overhead or fixed administration overhead. These are written off in full as a period cost in both absorption costing and marginal costing, and only fixed production overheads are included in inventory values.

Example 05:

A company uses marginal costing. In the financial period that has just ended, opening inventory was Rs.8,000 and closing inventory was Rs.15,000. The reported profit for the year was Rs.96,000.

If the company had used absorption costing, opening inventory would have been Rs.15,000 and closing inventory would have been Rs.34,000.

What would have been the profit for the year if absorption costing had been used?

In doing so, please see the following:

There was an increase in inventory. It was Rs.7,000 using marginal costing (= Rs.15,000 – Rs.8,000). It would have been Rs.19,000 using absorption costing.



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Rs.

Increase in inventory, marginal costing 7,000

Increase in inventory, absorption costing 19,000

Difference (profit higher with absorption costing) 12,000

Profit with marginal costing 96,000

Profit with absorption costing 108,000

The profit is higher with absorption costing because there has been an increase in inventory (production volume has been more than sales volume.)

Example 06:

A company uses absorption costing. In the financial period that has just ended, opening inventory was Rs.76,000 and closing inventory was Rs.49,000. The reported profit for the year was Rs.183,000.

If the company had used marginal costing, opening inventory would have been Rs.40,000 and closing inventory would have been Rs.28,000.

What would have been the profit for the year if marginal costing had been used?

There was a reduction in inventory. It was Rs.27,000 using absorption costing (= Rs.76,000 – Rs.49,000). It would have been Rs.12,000 using marginal costing.

Rs.

Reduction in inventory, absorption costing 27,000

Reduction in inventory, marginal costing 12,000

Difference (profit higher with marginal costing) 15,000

Profit with absorption costing 183,000

Profit with marginal costing 198,000

Profit is higher with marginal costing because there has been a reduction in inventory during the period.

Example 07:

The following information relates to a manufacturing company for a period.

Production 16,000 units Fixed production costs Rs.80,000

Sales 14,000 units Fixed selling costs Rs.28,000

Using absorption costing, the profit for this period would be Rs.60,000. Assuming there is no opening inventory

What would have been the profit for the year if marginal costing had been used?

Ignore the fixed selling overheads. These are irrelevant since they do not affect the difference in profit between marginal and absorption costing.

There is an increase in inventory by 2,000 units, since production volume (16,000 units) is higher than sales volume (14,000 units).

If absorption costing is used, the fixed production overhead cost per unit is Rs.5 (=Rs.80,000/16,000 units).



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The difference between the absorption costing profit and marginal costing profit is therefore Rs.10,000 (= 2,000 units Rs.5).

Absorption costing profit is higher, because there has been an increase in inventory.

Marginal costing profit would therefore be Rs.60,000 – Rs.10,000 = Rs.50,000.

Example 08:

Red Company is a manufacturing company that makes and sells a single product. The following information relates to the company’s manufacturing operations in the next financial year.

Opening stock: Nil

Production: 18,000 units

Sales: 15,000 units

Fixed production overheads: Rs.117,000

Fixed sales overheads: Rs.72,000

Using absorption costing, the company has calculated that the budgeted profit for the year will be Rs.43,000.

What would be the budgeted profit if marginal costing is used, instead of absorption costing?

In completing the requirement, Production overhead per unit, with absorption costing, please see below:

= Rs.117,000/18,000 units

= Rs.6.50 per unit.

The budgeted increase in inventory = 3,000 units (18,000 – 15,000).

Production overheads in the increase in inventory = 3,000 × Rs.6.50 = Rs.19,500.

With marginal costing, profit will be lower than with absorption costing, because there is an increase in inventory levels.

Marginal costing profit = Rs.43,000 - Rs.19,500 = Rs.23,500.

Example 09

Entity T manufactures a single product, and uses absorption costing. The following data relates to the performance of the entity during October.

Profit Rs.37,000

Over-absorbed overhead Rs.24,000

Sales (48,000 units) Rs.720,000

Non-production overheads (all fixed costs) Rs.275,000

Opening inventory Rs.144,000

Closing inventory Rs.162,000

Units of inventory are valued at Rs.9 each, consisting of a variable cost (all direct costs) of Rs.3 and a fixed overhead cost of Rs.6. All overhead costs are fixed costs.

a) When required to calculate the actual production overhead cost for October and the profit that would have been reported in October if Entity T had used marginal costing, see below working.



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units

Opening inventory (Rs.144,000/Rs.9) 16,000

Closing inventory (Rs.162,000/Rs.9) 18,000

Increase in inventory in October 2,000

Sales 48,000

Production in October 50,000

Rs.

Absorbed production overhead (50,000 × Rs.6) 300,000

Over-absorbed overheads 24,000

Actual production overhead expenditure 276,000

a) Since, inventory increased during October; therefore, the reported profit will be higher with absorption costing than with marginal costing, as below

Rs.

Absorption cost profit 37,000

Increase inventory × fixed production overhead per unit

(2,000 × Rs.6) 12,000

Marginal costing profit 25,000

Proof:

Rs. Rs.

Sales 720,000

Variable cost of sales (48,000 × Rs.3) 144,000


Fixed production overheads (see above) 276,000

Other fixed overheads 275,000

Total fixed overheads 551,000

Marginal costing profit 25,000



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5. ADVANTAGES AND DISADVANTAGES OF ABSORPTION AND MARGINAL COSTING

The previous sections of this chapter have explained the differences between marginal costing and absorption costing as methods of measuring profit in a period. Some conclusions can be made from these differences.

The amount of profit reported in the cost accounts for a financial period will depend on the method of costing used.

Since the reported profit differs according to the method of costing used, there are presumably reasons why one method of costing might be used in preference to the other. In other words, there must be some advantages (and disadvantages) of using either method.

5.1 Advantages and disadvantages of absorption costing

Absorption costing has a number of advantages and disadvantages.

Advantages of absorption costing

Inventory values include an element of fixed production overheads. This is consistent with the requirement in financial accounting that (for the purpose of financial reporting) inventory should include production overhead costs.

Calculating under/over absorption of overheads may be useful in controlling fixed overhead expenditure.

By calculating the full cost of sale for a product and comparing it will the selling price, it should be possible to identify which products are profitable and which are being sold at a loss.

Disadvantages of absorption costing

Absorption costing is a more complex costing system than marginal costing.

Absorption costing does not provide information that is useful for decision making (like marginal costing does).

Assigning of Production overheads always include an element of discretion; and

It might led to sub-optimal decision-making as a product might be discontinued due to loss which might be caused by fixed production over head.

5.2 Advantages and disadvantages of marginal costing

Marginal costing has a number of advantages and disadvantages.

Advantages of marginal costing

It is easy to account for fixed overheads using marginal costing. Instead of being apportioned they are treated as period costs and written off in full as an expense the income statement for the period when they occur.

There is no under/over-absorption of overheads with marginal costing, and therefore no adjustment necessary in the income statement at the end of an accounting period.

Marginal costing provides useful information for decision making.

Disadvantages of marginal costing

Marginal costing does not value inventory in accordance with the requirements of financial reporting. (However, for the purpose of cost accounting and providing management information, there is no reason why inventory values should include fixed production overhead, other than consistency with the financial accounts.)

Marginal costing can be used to measure the contribution per unit of product, or the total contribution earned by a product, but this is not sufficient to decide whether the product is profitable enough. Total contribution has to be big enough to cover fixed costs and make a profit.



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6. COMPREHENSIVE EXAMPLES

Example 01:

Entity RH makes and sells one product. Currently, it uses absorption costing to measure profits and inventory values. The budgeted production cost per unit is as follows:

Rs.

Direct labor 3 hours at Rs.6 per hour 18

Direct materials 4 kilograms at Rs.7 per kilo 28

Production overhead (Fixed cost) 20

66

Normal output volume is 16,000 units per year and this volume is used to establish the fixed overhead absorption rate for each year.

Costs relating to sales, distribution and administration are:

Variable 20% of sales value

Fixed Rs.180,000 per year.

There were no units of finished goods inventory at 1 October Year 5.

The fixed overhead expenditure is spread evenly throughout the year.

The selling price per unit is Rs.140.

For the two six-monthly periods detailed below, the number of units to be produced and sold are budgeted as follows:

Six months ending

31 March Year 6

Six months ending

30 September Year 6



The entity is considering whether to abandon absorption costing and use marginal costing instead for profit reporting and inventory valuation.

a) Calculation of the budgeted fixed production overhead costs each year, is as follows.

Budgeted production overhead expenditure =

Normal production volume × Absorption rate per unit

= 16,000 units × Rs.20 = Rs.320,000.

Since expenditure occurs evenly throughout the year, the budgeted production overhead expenditure is Rs.160,000 in each six-month period.

b) Statements for management showing sales, costs and profits for each of the six-monthly periods using marginal and absorption costing would be prepared as follows

i. marginal costing

ii. absorption costing



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Workings Rs. per unit

Direct material 18

Direct labor 28

Marginal cost of sale 46

i. Marginal costing

Six months to

31 March Six months to 30

September

Units sold 7,000 8,000

Rs. Rs. Rs. Rs.

Sales at Rs.140 980,000 1,120,000

Marginal cost of sales (at Rs.46) 322,000 368,000

658,000 752,000

Variable admin & distribution (20% of sales value)

196,000 224,000

Contribution 462,000 528,000

Fixed costs

Production (Rs.320,000/2) 160,000 160,000

Other (Rs.180,000/2) 90,000 250,000 90,000 250,000

Profit 212,000 278,000

ii. Absorption costing

The fixed overhead absorption rate is based on the normal volume of production. Since budgeted output in each six-month period is different from the normal volume, there will be some under- or over-absorption of production overhead in each six-month period.

Six months to


September

Units sold 7,000 8,000

Rs. Rs. Rs. Rs.

Sales at Rs.140 980,000

Production cost of sales (at Rs.66) 462,000 528,000

518,000 592,000

Production overhead absorbed 170,000 140,000

(8,500 × Rs.20: 7,000 × Rs.20)

Actual production overhead 160,000 160,000

Over-/(under-) absorbed overheads

10,000 (20,000)

528,000 572,000



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Six months to


September

Sales, distribution, admin costs

Variable 196,000 224,000

(7,000 × Rs.28: 8,000 × Rs.28)

Other 90,000 90,000

286,000 314,000

Profit 242,000 258,000

c) An explanatory statement reconciling for each six-monthly period the profit using marginal costing with the profit using absorption costing, is prepared below.

Reconciliation of profit figures

Six months to 31 March Year 6

Increase in inventory (8,500 – 7,000 units) 1,500 units

Production overhead absorbed in these units (absorption costing)

Rs.20 per unit

Therefore absorption costing profit higher by

Rs.30,000

Six months to 30 SeptemberYear 6

Reduction in inventory (7,000 – 8,000 units) 1,000 units

Production overhead absorbed in these units (absorption costing)

Rs.20 per unit

Therefore absorption costing profit lower by

Rs.20,000

The difference in reported profits is due entirely to differences in the valuation of inventory (and so differences in the increase or reduction in inventory during each period).

Example 02:

Zulfiqar Limited makes and sells a single product and has the total production capacity of 30,000 units per month. The company budgeted the following information for the month of January 20X4:

Normal capacity (units) 27,000

Variable costs per unit:

Production (Rs.) 110

Selling and administration (Rs.) 25

Fixed overheads:

Production (Rs.) 756,000

Selling and administration (Rs.) 504,000

The actual operating data for January 20X4 is as follows:

Production 24,000 units

Sales @ Rs. 250 per unit 22,000 units

Opening stock of finished goods 2,000 units



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During the month of January 20X4, the variable factory overheads exceeded the budget by Rs. 120,000.

a) Preparation of profit statement for the month of January using marginal and absorption costing would be as follows

Profitability Statement under Marginal Costing Rupees

Sales (22,000 units @ Rs. 250) 5,500,000

Variable Costs:

Production Costs:

Cost of productions (24,000 x Rs.110) 2,640,000

Additional Variable Costs. 120,000

2,760,000

Less: Closing stocks (2,760,000 / 24,000 x 4,000) (460,000)

Add: Opening stocks (2,000 x Rs. 110) 220,000

2,520,000

Selling and administrative expenses (22,000 x 25) 550,000

3,070,000

Contribution Margin 2,430,000

Less: Fixed costs

Production 756,000

Selling and administrative expense 504,000

1,260,000

Net Profit 1,170,000

Profitability Statement under Absorption Costing Rupees

Sales (22,000 units @ Rs. 250) 5,500,000

Cost of Goods Sold

Cost of production (24,000 x Rs. 138 (W-1) 3,312,000

Additional variable costs. 120,000

3,432,000

Less: Closing stocks (3,432,000 / 24,000 x 4,000) (572,000)

Add: Opening stocks (2,000 x Rs. 138) 276,000

3,136,000

Under applied factory overhead

(3,000 (W-2) x Rs.28 (W-1)) 84,000

3,220,000

Gross Profit 2,280,000

Selling expenses

(Rs. 504,000 + 22,000 x Rs.25) 1,054,000

1,226,000



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W-1: Rupees

Variable overhead per unit 110

Fixed overhead per unit (Rs. 756,000 / 27,000) 28

138

W-2: Units

Budgeted production - Normal capacity 27,000

Actual production 24,000

Under-utilized capacity 3,000

b) Then, if required to reconcile the difference in profits under the two methods, please see below

Rupees

Profit under absorption costing 1,226,000

Less: Closing stock (under-valued in marginal costing)

(Rs. 572,000 - Rs. 460,000) (112,000)

Add: Opening stock (under-valued in marginal costing)

(Rs. 276,000 - Rs. 220,000) 56,000

Profit under marginal costing 1,170,000

Example 03:

Following information has been extracted from the financial records of ATF Limited: Production during the year units 35,000

Finished goods at the beginning of the year units 3,000

Finished goods at the end of the year units 1,500

Sale price per unit Rs. 200

Fixed overhead cost for the year Rs. 1,000,000

Administration and selling expenses Rs. 200,000

Annual budgeted capacity of the plant units 40,000

The actual cost per unit, incurred during the year, was as follows:

Rupees

Material 70

Labor 40

Variable overheads 30

Company uses FIFO method for valuation of inventory. The cost of opening finished goods inventory determined under the absorption costing method system was Rs. 450,000. Fixed overhead constituted 16% of the total cost last year.



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a) Preparation of profit statements for the year, under absorption and marginal costing systems, would be as follows

Absorption Costing

(Rs.)

Marginal Costing

(Rs.)

Sales (3,000 + 35,000-1,500) × Rs. 200 7,300,000 7,300,000

Cost of goods manufactured

Opening Inventory 450,000 378,000*

Add: Cost of goods manufactured (35,000 × 165) & (35,000 / 140)

5,775,000 4,900,000

6,225,000 5,278,000

Less: Ending inventory (1,500 x 165) & (1,500 × 140)

(247,500) (210,000)

(5,997,500) 5,068,000

Gross profit / contribution margin 1,322,500 2,232,000

Less: unabsorbed overheads [1,000,000 – (Rs. 25 × 35,000)]

(125,000) -

Less: Administration and selling expenses (200,000) (200,000)

Fixed overheads - (1,000,000)

Net Profit 997,500 1,032,000

*Cost of opening finished goods under marginal costing Rs. 450,000 × (100%-16%) = Rs. 378,000

Computation of Cost of goods manufactured (COGM) & Ending Inventory:

Rupees

Material Cost 70

Labor Cost 40

Variable overhead 30

Cost per unit under marginal costing system 140

Fixed overhead (Rs. 1,000,000/40,000) 25

Cost per unit under absorption costing system 165

b) Then, if required to reconcile net profits determined under each system, following computations would be required.

Rupees

Net Profit under Absorption Costing 997,500

Add: Difference in opening finished goods (Rs. 450,000 – 378,000) 72,000

Less: Difference in ending finished goods (Rs. 247,500 – 210,000) (37,500)

Net Profit under Marginal Costing 1,032,000



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STICKY NOTES

In marginal costing, cost of product is variable production cost only but in absorption costing the cost of the product is variable plus fixed production cost

In marginal costing there is a concept of contribution margin i.e. Contribution Margin = Sales – all variable cost (both production and non-

production)

To arrive at profit all Fixed cost (both production and non-production) should be deduced from contribution margin.

In Absorption costing the cost of the product includes variable production cost plus fixed production overheads estimated by using predetermined absorption

rate

In absorption costing over / under absorbed overheads are calculated by comparing absorbed overheads with actual overheads.

In marginal costing the stock is valued at variable production cost only but in absorption costing it is valued at variable plus fixed production cost. This is the

reason that the profit figure is different in marginal and absorption costing.

marginal costing and absorption costing · marginal costing is a method of costing with marginal...

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