Marginal and absorption costing

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

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.

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.

The principles of marginal costing (Cont…) (b) Similarly, if the volume of sales falls by one item, the profit will fall by the amount of contribution earned from the item. (c) 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.

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.

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.

Features of Marginal Costing (Cont…) 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. 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.

Marginal costing proforma Sales revenue xxx Less Marginal cost of production:- Opening stock (valued at marginal cost) Add production cost Less closing stock (valued at marginal cost) (xxx) Marginal cost of production Add selling, distribution cost Marginal cost of sales Contribution Less Fixed cost Profit

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

Example- Marginal costing principles (Cont…) Based on your answer in the first part, calculate the expected profit from the sale of 17,000 marbles

Activity- Marginal costing principles Mike Jagger

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

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.

Activity Marginal and absorption costing compared

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.

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

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

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?

Student activity What are the advantages and disadvantages of marginal costing What are the advantages and disadvantages of absorption costing