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Cost and Management Accounting

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Cost & Management Accounting (MGT-402)
VU
LESSON# 27 & 28
MARGINAL AND ABSORPTION COSTING
(Product costing systems)
Following diagram helps to recall the behavior of different cost elements.
Cost Elements
Direct Material
Direct Labor
Factory Overhead Cost
Variable & Fixed Cost
Variable Cost
Marginal cost is the cost the variable cost that changes with the production of each next unit.
Marginal and Absorption Costing
So far we have been looking at the various different types of cost and have gradually built up the
total cost of a cost unit by aggregating the cost of direct materials, direct labor, direct expenses,
variable overheads and fixed overheads (absorbed into cost units). We can display this total cost as
part of a profit and loss account (namely cost of sales). In doing so we must remember to adjust
the profit and loss account for any overhead under- or over-absorbed.
This adjustment is only necessary because we are including fixed overheads in the cost of the cost
unit. In other words, we are presenting cost information according to absorption costing
principles. However, there is another method of presenting cost information, i.e. marginal costing.
Marginal Costing
Under this system, we do not attempt to absorb fixed overheads into cost units, and so we avoid
the difficulties of setting absorption rate, adjusting for under or over-absorbed overhead, etc.
Cost units are valued at their marginal cost only (not their fully absorbed cost). In other words the
cost of a cost unit is presented as the total of direct materials, direct labor, direct expenses and
variable overheads (but not fixed overheads).
Of course, this does not mean that we can simply ignore fixed overheads It is simply that we
choose to treat all fixed overheads as period costs, rather than trying to attribute them to individual
cost units You will find that this presentation of cost information has distinct advantages over-
absorption costing when it comes to decision making.
A key concept in marginal costing is that of contribution margin.
Contribution Margin is defined as the sales value of a cost unit minus its variable cost.
Absorption and marginal costing
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Cost & Management Accounting (MGT-402)
VU
In absorption costing, fixed manufacturing overheads are absorbed into cost units. Thus stock is
valued at absorption cost and fixed manufacturing overheads are charged in the profit and loss
account of the period in which the units are sold.
In marginal costing, fixed manufacturing overheads are not absorbed into cost units, Stock is
valued at marginal (or variable) cost and fixed manufacturing overheads are treated as period costs
and are charged in the profit and loss account of the period in which the overheads are incurred.
Practice Question
A Company produces a single product and has the following budget:
Company Budget Cost Per Unit
Rs.
Selling price
10
Direct materials
3
Direct wages
2
Variable overhead
1
Fixed production overhead is Rs. 10,000 per month; production volume is 5,000 units per month.
Calculate the cost per unit to be used for stock valuation under:
(a) Absorption costing
(b) Marginal costing.
Solution
(a) Absorption cost per unit
Rs
Direct materials
3
Direct wages
2
Variable overhead
1
Absorbed fixed overhead
Rs 10,000
2
5000 units
Cost per Unit
8
(b) Marginal cost per unit
Direct materials
3
Direct wages
2
Variable overhead
1
Cost per Unit
6
The stock valuation will be different for marginal and absorption costing. Under absorption
costing stock will include variable and fixed overheads whereas under marginal costing stock will
only include variable overheads.
Further practice question explaining the concept of product cost, period cost and cost per unit
under two product costing systems:
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Table of Contents:
  1. COST CLASSIFICATION AND COST BEHAVIOR INTRODUCTION:COST CLASSIFICATION,
  2. IMPORTANT TERMINOLOGIES:Cost Center, Profit Centre, Differential Cost or Incremental cost
  3. FINANCIAL STATEMENTS:Inventory, Direct Material Consumed, Total Factory Cost
  4. FINANCIAL STATEMENTS:Adjustment in the Entire Production, Adjustment in the Income Statement
  5. PROBLEMS IN PREPARATION OF FINANCIAL STATEMENTS:Gross Profit Margin Rate, Net Profit Ratio
  6. MORE ABOUT PREPARATION OF FINANCIAL STATEMENTS:Conversion Cost
  7. MATERIAL:Inventory, Perpetual Inventory System, Weighted Average Method (W.Avg)
  8. CONTROL OVER MATERIAL:Order Level, Maximum Stock Level, Danger Level
  9. ECONOMIC ORDERING QUANTITY:EOQ Graph, PROBLEMS
  10. ACCOUNTING FOR LOSSES:Spoiled output, Accounting treatment, Inventory Turnover Ratio
  11. LABOR:Direct Labor Cost, Mechanical Methods, MAKING PAYMENTS TO EMPLOYEES
  12. PAYROLL AND INCENTIVES:Systems of Wages, Premium Plans
  13. PIECE RATE BASE PREMIUM PLANS:Suitability of Piece Rate System, GROUP BONUS SYSTEMS
  14. LABOR TURNOVER AND LABOR EFFICIENCY RATIOS & FACTORY OVERHEAD COST
  15. ALLOCATION AND APPORTIONMENT OF FOH COST
  16. FACTORY OVERHEAD COST:Marketing, Research and development
  17. FACTORY OVERHEAD COST:Spending Variance, Capacity/Volume Variance
  18. JOB ORDER COSTING SYSTEM:Direct Materials, Direct Labor, Factory Overhead
  19. PROCESS COSTING SYSTEM:Data Collection, Cost of Completed Output
  20. PROCESS COSTING SYSTEM:Cost of Production Report, Quantity Schedule
  21. PROCESS COSTING SYSTEM:Normal Loss at the End of Process
  22. PROCESS COSTING SYSTEM:PRACTICE QUESTION
  23. PROCESS COSTING SYSTEM:Partially-processed units, Equivalent units
  24. PROCESS COSTING SYSTEM:Weighted average method, Cost of Production Report
  25. COSTING/VALUATION OF JOINT AND BY PRODUCTS:Accounting for joint products
  26. COSTING/VALUATION OF JOINT AND BY PRODUCTS:Problems of common costs
  27. MARGINAL AND ABSORPTION COSTING:Contribution Margin, Marginal cost per unit
  28. MARGINAL AND ABSORPTION COSTING:Contribution and profit
  29. COST VOLUME PROFIT ANALYSIS:Contribution Margin Approach & CVP Analysis
  30. COST VOLUME PROFIT ANALYSIS:Target Contribution Margin
  31. BREAK EVEN ANALYSIS MARGIN OF SAFETY:Margin of Safety (MOS), Using Budget profit
  32. BREAKEVEN ANALYSIS CHARTS AND GRAPHS:Usefulness of charts
  33. WHAT IS A BUDGET?:Budgetary control, Making a Forecast, Preparing budgets
  34. Production & Sales Budget:Rolling budget, Sales budget
  35. Production & Sales Budget:Illustration 1, Production budget
  36. FLEXIBLE BUDGET:Capacity and volume, Theoretical Capacity
  37. FLEXIBLE BUDGET:ANALYSIS OF COST BEHAVIOR, Fixed Expenses
  38. TYPES OF BUDGET:Format of Cash Budget,
  39. Complex Cash Budget & Flexible Budget:Comparing actual with original budget
  40. FLEXIBLE & ZERO BASE BUDGETING:Efficiency Ratio, Performance budgeting
  41. DECISION MAKING IN MANAGEMENT ACCOUNTING:Spare capacity costs, Sunk cost
  42. DECISION MAKING:Size of fund, Income statement
  43. DECISION MAKING:Avoidable Costs, Non-Relevant Variable Costs, Absorbed Overhead
  44. DECISION MAKING CHOICE OF PRODUCT (PRODUCT MIX) DECISIONS
  45. DECISION MAKING CHOICE OF PRODUCT (PRODUCT MIX) DECISIONS:MAKE OR BUY DECISIONS