Cost and Management Accounting

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Absorption Costing
Marginal Costing
100 units
100 units
Direct Material
8,000
8,000
Rs. 80 per unit
5,000
5,000
Direct Labor
Rs. 50 per unit
3,000
3,000
2,000
Variable FOH
Fixed FOH
18,000
16,000
Product Cost
2,000
Fixed Cost
(Period Expenses)
Cost per Unit
Under Absorption costing
18,000
Rs. 180 per unit
100
Under Marginal costing
16,000
Rs. 160 per unit
100
Contribution Margin
Contribution margin is the difference between sales and the variable cost of sales.
This can be written as:
Contribution margin = Sales less variable costs of sales
Contribution margin is short for "contribution to fixed costs and profits".
The idea is that after deducting the variable costs from sales, the figure remaining is the amount
that contributes to fixed costs, and once fixed costs are covered the remaining amount is that of
profits.
Contribution and profit
Marginal costing values goods at variable cost of production (or marginal cost) and contribution
can be shown as follows;
Marginal costing: Profit calculation
Rs X
Sales
(X)
Less: variable costs
X
Contribution margin
(X)
Less: fixed costs
X
Profit
Profit is contribution less fixed costs. In absorption costing this is effectively calculated in one
stage as the cost of sales already includes fixed costs
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Absorption costing: profit calculation
Rs
Sales
X
Less: absorption cost
(X)
Profit
X
Profit statements under absorption and marginal costing
To produce financial statements in accordance with IFRS 2, absorption costing must be used, but
either marginal or absorption costing can be useful for internal management reporting the choice
· The way in which profit information is presented
· The level of reported profit if sales do not exactly equal production (i.e. stock is increasing or
decreasing).
PRACTICE QUESTION
This example continues with the Company from the above practice question.
Show profit statements for the month if sales are 4,800 units and production is 5,000 units under
(a) Total absorption costing
(b) Marginal costing.
Solution
(a) Profit statement under absorption casting
Rs.
Rs
Sales (4,800 @ Rs10)
48,000
Less:
Cost of sates
Opening stock
Production
(5,000 @ Rs. 8)
40,000
Less: Closing stock (200 @ Rs. 8)
(1,600)
(38.400)
Operating profit
9,600
(b) Profit statement under marginal costing
Sales (4.800 @ Rs10)
48,000
Less:
Cost of sates
Opening stock
Production (5,000 @ Rs6)
30,000
Less: Closing stock (200 @ Rs6)
(1,200)
(28,800)
Contribution
19,200
10,000
Operating profit
9,200
170 Cost & Management Accounting (MGT-402)
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PRACTICE QUESTION
Absorption Costing
Marginal
100 units
Costing
100 units
Direct Material
8,000
8,000
Rs. 80 per unit
Direct Labor
5,000
5,000
Rs. 50 per unit
Variable FOH
3,000
3,000
Fixed FOH
2,000
Product Cost
18,000
16,000
Fixed Cost
(Period Expenses)
2,000
Cost per Unit
Under Absorption costing
18,000
Rs. 180 per unit
100
Under Marginal costing
16,000
Rs. 160 per unit
100
Prepare income statements under absorption and marginal costing systems assuming the following
facts:
a)
All produced units Sold
b)
No. of units sold
80
No. of units in closing stock
20
No. of units produced
100
c)
No. of units sold
110
No. of units in opening stock
10
No. of units produced
100
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Selling price Rs. 240 per unit
Solution
a)
All Units Sold
Absorption
Marginal
costing
costing
Sales  (110 x 240)
24,000
24,000
Less Product cost
100 x 180
18,000
100 x 160
16,000
Gross profit
6,000
Contribution margin
8,000
Less Fixed cost
0
(2000)
Profit
6,000
6,000
b)
80 units sold & 20 units in closing stock
Absorption costing
Marginal costing
Sales 80 x 240
19,200
19,200
Production cost
100 x 180 =
18,000
100 x 160 =
16,000
Less closing stock
20 x 180 =
(3600)
20 x 160 =
(3,200)
14,600
12,800
Less Fixed cost
2,000
Contribution Margin
4,600
Profit
4,600
4,400
c)
110 units sold
Absorption costing
Marginal costing
Sales 110 x 240
26,400
26,400
Opening stock
10 x 180 =
1,800
10 x 160 =
1,600
Production cost
100 x 180 =
18,000
100 x 160 =
16,000
19,800
17,600
Less Fixed cost
2,000
Contribution Margin
6,600
Profit
6,600
6,800
Reconciliation of the difference in profit
The difference in profit is due to there being a movement in stock levels - an increase from 0 to
200 units over the month.
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Under absorption costing closing stock has been valued at Rs 1,600 (i.e. Rs 8 per unit which
includes Rs 2 of absorbed fixed overheads). Under marginal costing the increase in stock is valued
at Rs 1,200 (i.e. at Rs 6 per unit) and all fixed overheads are charged to the profit and loss account.
Only if stock is rising or falling will absorption costing give a different profit figure from marginal
costing. If sales equal production, the fixed overheads absorbed into cost of sales under absorption
costing will be the same as the period costs charged under marginal costing and thus the profit
figure will be the same.
The two profit figures can therefore be reconciled as follows:
Rs
Absorption costing profit
9,600
Less: fixed costs included in the increase in stock (200 x Rs2)
(400)
Marginal costing profit
9,200
If stock levels are rising from opening to closing balance
Absorption Costing profit > Margin Costing profit
If stock levels are falling from opening to closing balance
Absorption Costing profit < Margin Costing profit
(Fixed costs carried forward are charged in this period, under absorption costing)
If stock levels are the same
Absorption Costing profit = Margin Costing profit
Absorption Costing  Marginal Costing
Produced units = Units
Same Profit
Same Profit
sold
Produced units > Units
More Profit
Less Profit
sold
Produced units < Units
Less Profit
More Profit
sold
Reconciliation of the above practice question
b)
80 units sold & 20 units in closing stock
Rs
Absorption Profit
4,800
Less Closing Stock @ Fixed FOH Rate
20
x
20
(400)
Marginal Costing Profit
4,400
c)
110 units sold with an opening stock of 10 units
Absorption Profit
6,600
Add Opening Stock @ Fixed FOH Rate
10
x
20
200
Marginal Costing Profit
6,800
173 Cost & Management Accounting (MGT-402)
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Reconciliation formula to learn
Rs
Profit as per absorption costing system
xxx
Add Opening stock @ fixed FOH rate at opening date
xxx
Less Closing stock @ fixed FOH rate at closing date
xxx
Profit as per marginal costing system
xxx
(Relative to the absorption costing)
Preparation of routine operating statements using absorption costing is considered less informative
for the following reasons:
1. Profit per unit is a misleading figure: in the example above the operating margin of Rs2 per
unit arises because fixed overhead per unit is based on output of 5,000 units. If another basis
were used margin per unit would differ even though fixed overhead was the same amount in
total
2. Build-up or run-down of stocks of finished goods can distort comparison of period operating
statements and obscure the effect of increasing or decreasing sales.
3. Comparison between products can be misleading because of the effect of arbitrary
apportionment of fixed costs. Where two or more products are manufactured in a factory and
share all production facilities, the fixed overhead can only be apportioned on an arbitrary basis.
4. Marginal costing emphasizes variable costs per unit and fixed costs in total whereas absorption
costing accounts for all production costs to calculate unit cost. Marginal costing therefore
reflects the behavior of costs in relation to activity. Since most decision-making problems
involve changes to activity, marginal costing is more appropriate for short-run decision-making
than absorption costing.
PRACTICE QUESTION
This practice question illustrates the misleading effect on profit which absorption costing can have.
A company sells a product for Rs10. and incurs Rs4 of variable costs in its manufacture. The fixed
costs are Rs900 per year and are absorbed on the basis of the normal production volume of 250
units per year. The results for the last four years, when no expenditure variances arose- were as
follows:
2nd year
3rd year
4th year  Total
Item
1st year
units
units
units
units
Opening stock
200
300
300
Production
300
250
200
200
950
300
450
500
500
950
Closing stock
200
300
300
200
200
Sales
100
150
200
300
750
Rs
Rs
Rs
Rs
Rs
Sales value
1,000
1,500
2,000
3,000
7,500
Prepare a profit statement under absorption and marginal costing.
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Solution
The profit statement under absorption costing would be as follows:
1st year
2nd year
3rd year
4th year
Items
Total
Rs.
Rs.
Rs.
Rs.
Rs.
Opening stock @ Rs7.60
1,520
2,280
2,280
Variable
costs
of
1,200
1,000
800
800
3,800
production @ Rs4
Fixed costs ® 900/250
1,080
900
720
720
3,420
=Rs3.60
2,280
3,420
3,800
3,800
7,220
Closing stock @Rs7.60
1,520
2,280
2,280
1,520
1,520
Cost of sales
(760)
(1,140)
(1,520)
(2,280)
(5,700)
(Under)/over absorption
180
Nil
(180)
(180)
(180)
(w)
Net Profit
420
360
300
540
1,620
Working:
Calculation of over / under absorption
Fixed cost control account
Incurred Year 1
900
Absorbed
1,080
300 x Rs. 3.60
Over absorption
180
1,080
1,080
Year 2
900
250 x Rs. 3.60
Year 3
900
200 x Rs. 3.60
720
Under absorption
180
900
900
Year 4
900
200 x 3.60
720
Under absorption
180
900
900
175 Cost & Management Accounting (MGT-402)
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If marginal costing had been used instead of absorption, the results would have
been shown as
follows:
Item
1st year
2nd year
3rd year
4th year
Total
Rs
Rs
Rs
Rs
Rs
Sales
1,000
1,500
2,000
3,000
7,500
Variable cost of sales
(@ Rs4)
400
600
800
1,200
3,000
Contribution margin  600
900
1,200
1,800
4,500
Fixed costs
900
900
900
900
3,600
Net profit/ (loss)  (300)
-
300
900
900
The marginal presentation indicates clearly that the business must sell at least 150 units per year to
break even, i.e. Rs900 + (10 - 4), whereas it appeared, using absorption costing, that even at 100
units it was making a healthy profit.
The total profit for the four years is less under the marginal principle because the closing stocks at
the end of the fourth year are valued at Rs800 (Rs4 x 200) instead of Rs 1,520, i.e. Rs720 of the
fixed costs are being carried forward under the absorption principle.
The profit figures shown may be reconciled as follows:
Year 1
Year 2
Yea 3
Yea r4
Total
Rs
Rs
Rs
Rs
Rs
Profit / (loss)
Under marginal costing
(300)
Nil
300
900
900
Absorbed in stock increase
200 x Rs3.60 =
720
100 x Rs3.60=
360
200 x Rs3.60=
720
Absorbed in stock decrease
100 x 3.60=
(360)
Profit per absorption
420
360
300
540
1,620
Problem Questions
Q.1. A factory manufactures three components X, Y and Z and the budgeted production for the
year is 1,000 units1,500 units and 2,000 units respectively. Fixed overhead amounts to Rs6.750 and
has been apportioned on the basis of budgeted units: Rs 1,500 to X, Rs 2,250 to Y and Rs 3,000 to
Z. Sales and variable costs are as follows:
X
Y
Z
Selling price  Rs.
4
6
5
Variable cost Rs.
1
4
4
Q. 2. A company that manufactures one product has calculated its cost on a quarterly production
budget of 10.000 units. The selling price was Rs 5 per unit. Sales in the four successive quarters of
the last year were as follows:
Quarter 1
10,000 units
Quarter 2
9,000 units
Quarter 3
7,000 units
176 Cost & Management Accounting (MGT-402)
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Quarter 4
5,500 units
The level of stock at the beginning of the year was 1,000 units and the company maintained its
stock of finished products at the same level at the end of each of the four quarters.
Based on its quarterly production budget, the cost per unit was as follows:
Cost per unit
Rs.
Prime cost
3.50
0.75
0.30
Total
4.55
Fixed production overhead, which has been taken into account in calculating the above figures,
was Rs 5,000 per quarter. Selling and administration overhead was treated as fixed, and was
charged against sales in the period in which it was incurred.
You are required to present a tabular statement to bring out the effect on net profit of the
declining volume of sales over the four quarters given, assuming in respect of fixed production
(a) Absorbs it at the budgeted rate per unit
(b) Does not absorb it into the product cost, but charges it against sales in each quarter (i.e. the
company uses marginal costing).
(Relative to marginal costing)
Absorption costing is widely used and you must understand both principles.
The only difference between using absorption costing and marginal costing as the basis of stock
valuation is the treatment of fixed production costs.
The arguments used in favor of absorption costing are as follows:
1. Fixed costs are incurred within the production function, and without those facilities
production would not be possible. Consequently such costs can be related to production
and should be included in stock valuation.
2. Absorption costing follows the matching concept by carrying forward a proportion of the
production cost in the stock valuation to be matched against the sales value
3. When the items are sold.
4. It is necessary to include fixed overhead in stock values for financial statements routine
cost accounting using absorption costing produces stock values which include a share of
5. Overhead allotment is the only practicable way of obtaining job costs for estimating prices
and profit analysis.
6. Analysis of under-/over-absorbed overhead is useful to identify inefficient utilization of
production resources.
Arguments against absorption costing
The fixed costs do not change as a result of a change in the level of activity. Therefore such costs
cannot be related to production and should not be included in the stock valuation.
The inclusion of fixed costs in the stock valuation conflicts with the prudence concept, therefore
the fixed costs should be written off in the period in which they are incurred.
177 Cost & Management Accounting (MGT-402)
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PRACTICE QUESTION
Following information relates to a manufacturing company
Selling price
Rs. 20 per unit
Units produced
30,000
Units sold
20,000
Variable cost
Direct material
Rs. 5 per unit
Direct labor
Rs. 3 per unit
F.O.H
Rs. 1 per unit
Rs. 2 per unit
Fixed cost
F.O.H
Rs 120,000
Rs. 15,000
Solution
Working for cost per unit under
Absorption Costing
Fixed FOH Rate
120,000/30,000 =
4
Variable FOH Rate
Direct Material
5
Direct Labor
3
FOH
1
9
13
Marginal Costing
Variable FOH Rate
Direct Material
5
Direct Labor
3
FOH
1
9
Income Statement under Absorption Costing System
Rupees
Sales (20,000 x 20)
400,000
Less Cost of goods sold
Opening stock
0
(13 x 30,000)
390,000
Less Closing stock
(13 x 10,000)
130,000
260,000
Gross Profit
140,000
Less Operating expenses
Variable expenses
(20,000 x 2) =
40,000
Fixed expenses
15,000 55,000
Net profit
85,000
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Income Statement under Marginal Costing System
Rupees
Sales
400,000
Less Variable cost of goods sold
Opening stock
0
(9 x 30,000)
270,000
Less Closing stock
(9 x 10,000)
90,000
180,000
Gross contribution margin
220,000
Less Variable Selling & Admin Expenses
(2 x 20,000)
40,000
Contribution margin
180,000
Less Fixed expenses
Production
120,000
135,000
Net Profit
45,000
Reconciliation
Profit as absorption costing
85,000
Less Closing stock (10,000 x 4)
40,000
Profit as per Marginal costing
45,000
Multiple Choice Questions
Q.1. When comparing the profits reported using marginal costing with those reported using
absorption costing in a period when closing stock was 1,400 units, opening stock was 2,000 units,
and the actual production was 11,200 units at a total cost of Rs 4.50 per unit compared to a target
cost of Rs 5.00 per unit, which of the following statements is correct?
A Absorption costing reports profits Rs 2,700 higher
B Absorption costing reports profits Rs 2,700 lower
C Absorption costing reports profits Rs 3,000 higher
D There is insufficient data to calculate the difference between the reported profits
Q. 2. When comparing the profits reported under marginal and absorption costing during a period
when the level of stocks increased:
A. An absorption costing profits will be higher and closing stock valuations lower than those under
marginal costing
B. An absorption costing profits will be higher and closing stock valuations higher than those
under marginal costing
C. The marginal costing profits will be higher and closing stock valuations lower than those under
absorption costing
D. The marginal costing profits will be lower and closing stock valuations higher than those under
absorption costing
Q. 3. Contribution margin is:
A. Sales less total costs
B. Sales less variable costs
C. Variable costs of production less labor costs
D. None of the above
179 Cost & Management Accounting (MGT-402)
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Problem Question
Rays Company manufactures and sells electric blankets.
The selling price is Rs 12.
Each blanket has the unit cost set out below.
Administration costs are incurred at the rate of Rs20 per annum.
The company achieved the production and sales of blankets set out below.
The following information is also relevant:
1. The overhead costs of Rs2 and Rs3 per unit have been calculated on the basis of a budgeted
production volume of 90 units.
2. There was no inflation.
3. There, was no opening stock.
Unit cost
Rs.
Direct material
2
Direct labor
1
2
3
8
Year
1
2
3
Production
100
110
90
Sales
90
110
95
You are required:
(a) To prepare an operating statement for each year using
(i) Marginal costing and (ii) absorption costing
(b) To explain why the profit figures reported under the two techniques disagree.
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