Transcript Marginal and absorption costing

Marginal and absorption costing
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Introduction to marginal costing
• Marginal costing is an alternative to absorption
costing
• In Marginal costing, only variable costs are
charged as a cost of sale and a contribution is
calculated
• Closing inventories of work in progress or
finished goods are valued at marginal (variable)
production cost
• Fixed costs are treated as a period cost, and are
charged in full to the profit and loss account of the
accounting period in which they are incurred
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Contribution
• An important measure in marginal costing
• Is the difference between the sales value and the
marginal or variable cost of sales
• Contribution may be defined as the profit before
the recovery of fixed costs
• contribution goes toward the recovery of fixed
cost and profit, and is equal to fixed cost plus
profit (C = F + P).
• In case a firm neither makes profit nor suffers loss,
contribution will be just equal to fixed cost (C =
F). this is known as break even point.
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The principles of marginal costing
The principles of marginal costing are as follows:(a) For any given period of time, fixed costs will be the
same, for any volume of sales and production
(provided that the level of activity is within the
‘relevant range’). Therefore, by selling an extra item
of product or service the following will happen.
– Revenue will increase by the sales value of the item
sold.
– Costs will increase by the variable cost per unit.
– Profit will increase by the amount of contribution
earned from the extra item.
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The principles of marginal costing
(Cont…)
(b)
(c)
Similarly, if the volume of sales falls by one
item, the profit will fall by the amount of
contribution earned from the item.
Profit measurement should therefore be
based on an analysis of total contribution.
Since fixed costs relate to a period of time,
and do not change with increases or
decreases in sales volume, it is misleading to
charge units of sale with a share of fixed
costs.
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The principles of marginal costing
(Cont…)
(d)
When a unit of product is made, the
extra costs incurred in its manufacture
are the variable production costs. Fixed
costs are unaffected, and no extra fixed
costs are incurred when output is
increased.
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Features of Marginal Costing
• The main features of marginal costing are as
follows:
1. Cost Classification
The marginal costing technique makes a sharp
distinction between variable costs and fixed
costs. It is the variable cost on the basis of
which production and sales policies are
designed by a firm following the marginal
costing technique.
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Features of Marginal Costing (Cont…)
2. Stock/Inventory Valuation
Under marginal costing, inventory/stock for profit
measurement is valued at marginal cost. It is in
sharp contrast to the total unit cost under
absorption costing method.
3. Marginal Contribution
Marginal costing technique makes use of
marginal contribution for marking various
decisions. Marginal contribution is the difference
between sales and marginal cost. It forms the
basis for judging the profitability of different
products or departments.
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Marginal costing proforma
Sales revenue
xxx
Less Marginal cost of production:Opening stock (valued at marginal cost)
xxx
Add production cost
xxx
Less closing stock (valued at marginal cost)
(xxx)
Marginal cost of production
xxx
Add selling, distribution cost
xxx
Marginal cost of sales
(xxx)
Contribution
xxx
Less Fixed cost
(xxx)
Profit
xxx
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Example- Marginal costing
principles
• Alpha makes a product, the marble, which has a variable
production cost of Rs 6 per unit and a sales price of Rs 10
per unit. At the beginning of Sept. 2000 there were no
opening inventories production during the month was
20,000 units. Fixed costs for the month were Rs 45,000.
There were no variable marketing costs.
• Calculate the contribution and profit for Sept 2000, using
marginal costing principles if sales were as follows:– 10,000 marbles
– 15,000 marbles
– 20,000 marbles
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Example- Marginal costing
principles (Cont…)
• Based on your answer in the first part,
calculate the expected profit from the sale
of 17,000 marbles
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Activity- Marginal costing
principles
• Mike Jagger
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Marginal costing and Absorption costing
• In marginal costing, fixed production costs are treated as
period cost and are written off as they are incurred.
• In absorption costing, all costs are absorbed into
production and thus operating statements do not
distinguish between fixed and variable costs.
• The valuation of stock and work in progress contains both
fixed and variable elements.
• Inventory values are therefore greater than those calculated
using marginal costing
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Example
In a period 20,000 units of Z were produced and only
18,000 units were sold and 2,000 units were carried
forward as stock to the next period. Costs and revenues
were:
$
Sales
100,000
Production Costs:
Variable
35,000
Fixed
15,000
Administrative and selling overheads
25,000
Prepare profit statements based on marginal costing and
on absorption costing.
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Activity
• Marginal and absorption costing compared
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Reconciling profits
• The difference in profits reported under the two
costing systems is due to the different inventory
valuation method used.
• If inventory levels increase between the beginning
and the end of the period, absorption costing will
report a higher profit.
• This is because some of the fixed production
overhead incurred during the period will be
carried forward in closing inventory (which
reduces cost of sales) to be set against sales
revenue in the following period instead of being
written off in full against profit in the period
concerned.
• If inventory levels decrease, absorption costing
will report the lower profit.
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Example
• Reconciliation of profit of ING Inc
• Marginal costing profit
26,640
• To calculate absorption costing profit given
a change in inventory level of 40,000
(280,000 – 240,000) and an overhead
absorption rate of Rs 1.25
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Activity
• The overhead absorption rate for product X is Rs
10 per machine hour. Each unit of product X
requires five machine hours. Inventory of product
X on 1 Jan was 150 units and on 31 Dec it was
100 units. What is the difference in profit between
results reported using absorption costing and
results reported using marginal costing.
– Hint- Difference in profit = change in inventory * fixed
overhead absorption per unit
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Activity
• When opening inventories were 8,500 litres
and closing inventories were 6,750 litres, a
company had a profit of Rs 62,100 using
marginal costing.
• Assume that the fixed overhead absorption
rate was Rs 3 per litres, what would be the
profit using absorption costing?
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Student activity
• What are the advantages and disadvantages
of marginal costing
• What are the advantages and disadvantages
of absorption costing
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