Marginal and Absorption Costing 7: This Chapter Covers..
Marginal and Absorption Costing 7: This Chapter Covers..
Marginal and Absorption Costing 7: This Chapter Covers..
Marginal and
absorption costing
n the different treatment of product costs and period costs in marginal costing and
absorption costing
n how marginal costing works, including the calculation of contribution, and its role in
short-term decision-making
n how absorption costing works, including the valuation of closing inventory
n a comparison of profits when marginal costing and absorption costing are used
n the layout of
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These two costing systems are often used in cost accounting, but for different
purposes:
n marginal costing helps with short-term decision-making
The use of each system is dependent on the information needs of the business
or organisation:
These costing systems use the same costs, but they are treated differently
according to their behaviour. We will now look at each of these costing
systems in turn and then make a comparison between them.
marginal costing
Marginal cost is often but not always the total of the variable costs of
producing a unit of output. For most purposes, marginal costing is not
concerned with fixed period costs (such as the rent of a factory); instead it is
concerned with variable product costs direct materials, direct labour, direct
expenses, and variable production overheads which increase as output
increases. For most decision-making, the marginal cost of a unit of output is,
therefore, the variable cost of producing one more unit.
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It follows that the difference between the sales revenue and the variable costs
of the units sold in a period is the total contribution that the sales of all the
units in the period make towards the fixed period costs of the business. Once
these are covered, the remainder of the contribution is profit.
Thus a business can work out its profit, using a marginal costing statement,
for any given period from the total contribution and fixed costs figures:
total contribution less total fixed costs = profit
Sales revenue
less
equals
less
equals
Variable costs
Contribution
Fixed costs
PROFIT
Note from the marginal costing statement how the contribution goes firstly
towards the fixed costs and, when they have been covered, secondly
contributes to profit.
Case
Study
W Y V E R N B I K E C O M PA N Y: M A R G I N A L C O S T I N G
situation
The Wyvern Bike Company makes 100 bikes each week and its costs are as follows:
Direct materials
Direct labour
Production overheads
4,000
5,000
5,000
Investigations into the behaviour of costs has revealed the following information:
of the production overheads, 2,000 is a fixed cost, and the remainder is a variable
cost
The selling price of each bike is 200.
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As an accounts assistant at the Wyvern Bike Company, you are asked to:
prepare a marginal costing statement to show clearly the total contribution and the
total profit each week
solution
40
50
30
120
equals
Variable costs:
Direct materials
Direct labour
Production overheads
equals
less
equals
120
less
200
Total contribution
80
20,000
4,000
5,000
3,000
12,000
8,000
2,000
6,000
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n with the marginal cost of output identified, the managers can focus on the
break-even analysis
margin of safety
target profit
absorption costing
Absorption costing absorbs the costs of the business amongst the cost
units.
Absorption costing answers the question, What does it cost to make one unit
of output?
add
add
add
equals
Direct materials
Direct labour
Direct expenses
ABSORPTION COST
Note that the production overheads comprise the factory costs of indirect
materials, indirect labour, and indirect expenses.
Case
Study
205
W Y V E R N B I K E C O M PA N Y: A B S O R P T I O N C O S T I N G
situation
The Wyvern Bike Company makes 100 bikes each week and its costs are as follows:
Direct materials
Direct labour
Production overheads
4,000
5,000
5,000
As an accounts assistant at the Wyvern Bike Company, you are asked to:
solution
Direct materials
4,000
Production overheads
5,000
Direct labour
5,000
Total cost
equals
14,000
100 bikes
14,000
= 140 per bike
Total cost
20,000
14,000
6,000
Conclusion
Profit for the week of 6,000 is the same as with the marginal costing method, so we
could say Does it matter whether we use marginal or absorption costing? The answer
to this is that it does:
marginal costing, with its focus on variable costs and contribution, is useful for shortterm decision-making
absorption costing is a simple method of calculating the cost of output and is used
in financial statements for inventory valuation
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n will direct labour still be 50 per bike? (with lower production, the
workforce may not be able to specialise in certain jobs, and may be less
efficient)
m a r g i n a l a n d a b s o r p t i o n c o s t i n g c o m pa r e d
Marginal costing recognises that fixed period costs vary with time rather
than activity, and identifies the variable production cost of one extra unit.
For example, the rent of a factory relates to a certain time period, eg one
month, and remains unchanged whether 100 units of output are made or
whether 500 units are made (always assuming that the capacity of the
factory is at least 500 units); by contrast, the production of one extra unit
will incur an increase in variable costs, ie direct materials, direct labour,
direct expenses (if any), and variable overheads this increase is the
marginal cost.
n absorption costing
This technique absorbs all production costs into each unit of output
through the use of an overhead absorption rate (see Chapter 5). Therefore
the more units that are produced, the cheaper will be the cost per unit
because the overheads are spread over a greater number of units.
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The diagram below demonstrates how the terms in marginal costing relate to
the same production costs as those categorised under absorption costing
terms. As noted above, when using marginal costing it is the behaviour of the
cost fixed or variable that is important, not the origin of the cost.
absorption costing
direct costs
direct materials
direct labour
direct expenses
indirect costs
variable overheads
fixed overheads
marginal costing
variable costs
variable overheads
fixed costs
fixed overheads
The table on the next page gives a comparison between marginal costing and
absorption costing, including a note on the usefulness and the limitations of
each.
Note that the marginal cost approach is used to help with short-term
decision-making (see Chapter 9). However, for financial statements,
absorption costing must be used for inventory valuation purposes in order to
comply with IAS 2 (see page 44). Under IAS 2, Inventories, the closing
inventory valuation is based on the costs of direct materials, direct labour,
direct expenses (if any), and production overheads. Note that non-production
overheads are not included, as they are charged in full to the statement of
profit or loss in the year to which they relate.
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absorption costing
how does
it work?
main focus
marginal cost
contribution
usefulness
concept of contribution is
easy to understand
useful for short-term
decision-making, but no
consideration of overheads
limitations
main use
to calculate profit
to calculate inventory
valuation for financial
statements
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ChAIRS LIMITED:
MARGINAL AND ABSORPTION COSTING
Case
Study
situation
5,000
4,500
selling price
direct labour
40 per chair
direct materials
30 per chair
100,000
The directors ask for your help in producing profit statements using the marginal
costing and absorption costing methods. They say that they will use the one that
shows the higher profit to the companys bank manager.
solution
cHairs limited
marginal costing
Variable costs
proFit
150,000
495,000
200,000
absorption costing
150,000
495,000
200,000
350,000
35,000
315,000
100,000
100,000
450,000
415,000
80,000
45,000
405,000
90,000
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absorption costing, variable and fixed costs, ie 450,000 5,000 chairs = 90 per
chair
The difference in the profit figures is caused only by the closing inventory figures:
35,000 under marginal costing and 45,000 under absorption costing the same
costs have been used, but fixed production overheads have been treated differently.
Only fixed production overheads are dealt with differently using the techniques of
marginal and absorption costing both methods charge non-production overheads
in full to the statement of profit or loss in the year to which they relate.
With marginal costing, the full amount of the fixed production overheads has been
charged in this years statement of profit or loss; by contrast, with absorption costing,
part of the fixed production overheads (here, 10,000) has been carried forward in the
inventory valuation.
With regard to the directors statement that they will use the one that shows the higher
profit, the following points should be borne in mind:
A higher profit does not mean more money in the bank.
The two methods simply treat fixed production overheads differently and, in a year
when there is no closing inventory, total profits to date are exactly the same but
they occur differently over the years. Over time, profits are identical under both
methods.
For financial statements, Chairs Limited must use the absorption cost inventory
valuation of 45,000 in order to comply with IAS 2, Inventories.
t H e u s e o F a m a n u Fa c t u r i n g a c c o u n t
211
manufacturer, though, the costs are more complex as they comprise the direct
and indirect costs of materials, labour and expenses; also, a manufacturer
will invariably have opening and closing inventory in three different forms
direct materials, work-in-progress and finished goods.
In its year-end financial statements a manufacturer prepares:
The financial statements, which are part of the double-entry system, use the
following outline:
MANUFACTURING
ACCOUNT
add
add
equals
add
equals
STATEMENT OF
PROFITORLOSS
less
equals
less
Direct materials
Direct labour
Direct expenses
PRIME COST
Production overheads
GROSS PROFIT
Non-production overheads, eg
administration expenses
equals
finance expenses
notes
n Adjustments have to be made to allow for changes in the value of
inventory at the start of the accounting period (opening inventory) and at
the end of the accounting period (closing inventory) for:
direct materials, in the manufacturing account
work-in-progress (or partly manufactured goods), in the
manufacturing account
finished goods, in the statement of profit or loss
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gross profit, the difference between selling price and production cost
(after allowing for changes in the value of opening and closing
inventory)
profit for the year, the profit after all costs have been deducted and
which belongs to the owner(s) of the business
n Absorption costing absorbs the costs of the business amongst the cost units
by means of overhead absorption rates. It is used to cost units of output to
calculate inventory valuations for financial statements and to calculate profit.
Key
Terms
marginal cost
contribution
absorption cost
manufacturing account
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6,000
49,000
Direct labour
26,000
Direct expenses
Add
Indirect materials
Indirect labour
Indirect expenses:
Rent of factory
2,500
2,000
5,000
10,000
4,000
4,000
3,000
Gross profit
Less
Non-production overheads:
37,000
114,500
118,500
77,500
16,000
Sales revenue
5,000
50,000
55,000
PRIME COST
115,500
6,500
115,500
122,000
7,500
38,500
32,000
3,500
195,500
114,500
81,000
74,000
7,000
Note: a layout for a manufacturing account and statement of profit or loss is given in the
Appendix.
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Activities
7.1
Coffeeworks Limited manufactures coffee machines for domestic use. The management of the
company is considering next years production and has asked you to help with certain financial
decisions.
80
25
20
(a)
(b)
(c)
7.2
prepare a statement of profit or loss to show the profit or loss if 15,000 coffee machines are
sold
Cook-It Limited makes garden barbecues. The management of the company is considering the
production for next year and has asked for help with certain financial decisions.
90
30
25
215
Maxxa Limited manufactures one product, the Maxx. For the month of January 20-7 the following
information is available:
4,000
3,000
Selling price
8 per unit
5,000
9,000
6,000
There was no finished goods inventory at the start of the month. Both direct materials and direct
labour are variable costs.
required:
You are to produce statements of profit or loss using marginal costing and absorption costing
methods.
7.4
Activtoys Limited commenced business on 1 January 20-1. It manufactures the Activ, an outdoor
climbing frame. Information on the first years trading is as follows:
Selling price
Direct materials
Direct labour
1,500
1,300
30 per frame
82,500
required
(a)
The directors ask for your help in producing statements of profit or loss using the marginal
costing and absorption costing methods. They say that they will use the one that gives the
higher profit to show to the companys bank manager.
(b)
Write a note to the directors explaining the reason for the different profit figures and
commenting on their statement.
216
7.5
Durning Limited manufactures one product, the Durn. For the month of April 20-4 the following
information is available:
Selling price
10,000
8,000
4 per unit
8,000
16,000
10,000
There was no finished goods inventory at the start of the month. Both direct materials and direct
labour are variable costs.
required
(a)
(b)
7.6
marginal costing
absorption costing
explain briefly the reason for the difference between recorded profits under the alternative
costing methods
(a)
(b)
(c)
(d)
indirect labour
For a manufacturing business, which type of inventory is recorded in the statement of profit or loss?
(a)
raw materials
(b)
work-in-progress
(d)
finished goods
(c)
Allocate the following costs to either the manufacturing account or the statement of profit or loss by
ticking the appropriate column in the table below:
(a)
(b)
(c)
(d)
factory rent
manufacturing
account
statement of
profit or loss
(e)
sales commission
(g)
advertising
(f)
7.9
217
The following figures relate to the accounts of Crown heath Manufacturing Company for the year
ended 31 December 20-6:
Finished goods
Finished goods
10,500
4,300
10,200
3,200
27,200
12,600
1,200
Factory power
Non-production overheads
3,900
2,000
900
300
900
6,500
60,400
manufacturing account
Note: a layout for a manufacturing account and statement of profit or loss is given in the Appendix.
218
7.10
The following figures relate to the accounts of Barbara Francis, who runs a furniture manufacturing
business, for the year ended 31 December 20-7:
Inventory of direct materials at 1 January 20-7
31,860
44,790
42,640
96,510
237,660
796,950
Manufacturing wages
234,630
Manufacturing power
Salaries
Advertising
Office expenses
32,920
7,650
2,370
8,190
138,700
22,170
7,860
7,450
Rent and rates are to be apportioned 75 per cent to manufacturing and 25 per cent to
administration.
you are to prepare the year end:
manufacturing account
Note: a layout for a manufacturing account and statement of profit or loss is given in the Appendix.
219
The following figures relate to the accounts of Ryedale Limited, a manufacturing business, for the
year ended 31 October 20-4:
Inventory of direct materials at 1 November 20-3
41,210
46,380
7,200
8,450
29,470
38,290
311,050
874,360
180,860
35,640
45,170
Factory power
12,040
10,390
Administration salaries
Advertising
Office expenses
5,030
154,610
30,780
10,390
12,500
2,500
Additional information:
rent and rates are to be allocated 75% to manufacturing and 25% to administration
manufacturing account
Note: a layout for a manufacturing account and statement of profit or loss is given in the Appendix.