Absorption and Marginal Costing | My Assignment Tutor

10/24/20181Absorption and Marginal CostingDr AkangaLearning Outcomes❑ Define and explain absorption (full costing) andmarginal (variable costing)❑ Use simple examples to illustrate both absorptionand marginal costing❑ Prepare and compare profit statements using bothabsorption and marginal costing methods❑ Explain the arguments for and against absorptionand marginal costing10/24/20182Absorption Costing It is a costing system which treats allmanufacturing costs including both the fixed andvariable costs as product costs Allocates all manufacturing costs to productsregardless of whether they are fixed or variable. It determines the full production cost of a unit ofproduction – i.e. direct costs (prime costs) +Indirect Overhead (production costs)Absorption Costing Determine how much a product cost us to produce, ifnot, we would be unlikely to charge the right price for it If we fail to charge the right price for our product, thismay result in us putting a price that is too low to enableus to make a profit; Conversely, it may result in us putting a price that istoo high, and therefore uncompetitive in the market. This too likely to result in us making a financial loss.10/24/20183Marginal Costing This is a costing system which treats only thevariable manufacturing costs as product costs. The key difference with the Absorption Costing isthat the Marginal Costing focuses on only‘Direct’/’Variable Production’ costs (Prime Costs)and on ‘Contribution’. Only Variable Production costs are charged to costunits. Fixed/Indirect costs or Overheads are written offagainst Total Contribution.Absorption & Marginal Costing Absorption Costing focuses on calculating the total productioncost of a unit. Marginal Costing focuses on calculating the extra cost of makinga unit and units are costed using their variable production cost. Contribution is a key concept in marginal costing. It is calculatedas:Unit selling price – unit variable cost = unit contribution.o Contribution is the part of sales revenue that can be used tocontribute to fixed costs (and ultimately profit) once variablecosts have been accounted for.10/24/20184Budgeted overhead rates Actual overhead rates are not used because of: 1. Delay in product costs if actual annual rates are used. 2. Fluctuating overhead rates that will occur if actualmonthly rates are used.Budgeted overhead ratesIn Budgeted overhead rates: an overhead rate iscalculated and is then used to charge outproduction overheads to products:Budgeted overhead allocation rates=Budgeted Production OverheadBudgeted ActivityNote budgeted cost and activity are always usedto calculate absorption rates.10/24/20185Under-and over allocated overheadso If actual activity and/or cost differ from budget a company will allow too muchor too little overhead in its cost accounts. This is known as over or underrecovery of overheads.o Under-and over recovery of overheads is calculated as follows:£ Allocated overhead (actual activity x budgeted rate)Less Actual overheadUnder/Over allocated overheadsxxxxxxxxxxxx Under or over allocated overheads are then charged to the costing profitand loss account.Overheads: ExampleA company has budgeted overheads of £200,000 and budgetedlabour hours of 100,000. The actual overheads were£220,000 and actual labour hours were 90,000. By howmuch were overheads under or over-allocated?Allocation Rate = Budgeted Cost ÷ Budgeted Hours= 200,000 ÷100,000 = £2/hour10/24/20186Overheads: Solution Allocated overhead (actual activity x budgeted rate)(90,000hrs x £2.00)Less Actual overhead180,000220,000 Under allocated 40,000This figure of £40,000 is then debited to the costing profit and loss account.Marginal and Absorption CostingProfit CalculationProfits calculated using marginal and absorption costingcan often vary.Why?Simply put the reason lies with the way that stocks offinished goods are valued under each costing method.Under absorption costing, units of finished goods stockare valued at their total production cost.Under marginal costing, units of finished stock are valuedat their marginal cost of production.10/24/20187Profit StatementsMarginal•Sales•(-) COS – All variable Costs•= Contribution•(-) All Fixed Costs (Pro & non-pro)•= ProfitAbsorption•Sales•(-) COS – All Production Costs•= Gross Profit•(-) Non-Production Costs•= ProfitProfit Statements Absorption costingMarginal costing£ £SalesXSalesLess: Variable cost ofGoods soldProduct contribution marginLess: variable non- manufacturingexpensesVariable selling expensesVariable admin. expensesOther variable expensesTotal contribution expensesLess: ExpensesFixed selling expensesFixed admin. expensesOther fixed expensesNet ProfitXLess: Cost of goods soldXXXGross profitLess: ExpensesXSelling expenses XAdmin. expenses XXOther expensesXXXXXXXXXNet ProfitX 10/24/20188Example 1Using the information below, produce a profit statement usingmarginal and absorption costing Production units2,000Sales units1,500Closing Stock Units 500 (2000-1500)Variable cost of productionTotal fixed production costBudgeted production unitsVariable selling costTotal fixed non-production costUnit Sales Price£10£10,0002,500£1.00£4,000£30 Solution: Absorption Costing£ £ Sales (1500 units x £30)LessVariable Production (2,000x£10)45,00020,000Allocated overhead (2,000x£4) 8,000Closing stock (500X £14)Under allocated overhead (£10K-8K)Total Production cost of sales= Gross ProfitLessVariable non-production costFixed Non-Production cost= Profit(7,000)2,000(23,000)22,000(1,500)(4,000)16,500 10/24/20189Solution: Marginal Costing£ Sales (1500 units @ £30)Less45,000Variable Production (2000@£10) 20,000Closing stock (500@10)Variable selling cost (1500@1)Total Variable cost of sales= ContributionLess(5,000)1,500(16,500)28,500Fixed Production CostFixed Non-Production Cost= Profit(10,000)(4,000)14,500 Solution: Absorption Costing Working: Allocation rate = Budgeted cost ÷ budgeted activitylevel= 10,000 ÷ 2500 = £4/unitAllocated fixed overhead costs = 4 x 2000 = £8,000Under allocated = 10,000 – 8,000 = £2,00010/24/201810ReconciliationMARGINAL COSTING PROFITIncrease in inventory xAllocation rateASORPTION COSTING PROFIT14,500500 x 4 = 2,00016,500Example 2A company started its business in 2015. The following informationWas available for January to March 2015 for the company that producedA single product:£Selling price pre unit 100Direct materials per unit 20Direct Labour per unit 10Fixed factory overhead per month 30000Variable factory overhead per unit 5Fixed selling overheads 1000Variable selling overheads per unit 4Budgeted activity was expected to be 1000 units each monthProduction and sales for each month were as follows: JanFebMarchUnit soldUnit produced1000 8001000 13001100900  Prepare absorption and marginal costing statements for the three months10/24/201811Example 2 Solution, Absorption costing January£100000February£80000 March£Sales 110000Less: cost of good sold (£65) 65000 52000 7150035000 28000 38500Adjustment for Over-/(under) Absorption of factory overheadGross profitLess: ExpensesFixed selling overheads350001000 9000 (3000)37000 355001000 1000Variable selling overheads 4000 3200 4400Net profit 30000 32800 30100Example 2 Solution, Marginal costingJanuary February March£ £ £ SalesLess: Variable cost of good100000sold (£35) 35000Product contribution margin65000Less: Variable selling overhead 4000Total contribution marginLess: Fixed ExpensesFixed factory overhead6100030000Fixed selling overheads1000Net profit30000 80000 11000028000 3850052000 715003200 440048800 6710030000 300001000 100017800 3610010/24/201812Example 2 workingsWk1:Standard fixed overhead rate= Budgeted total fixed factory overheadsBudgeted number of units produced= £300001000 units= £30 per unitWk 2:Production cost per unit under absorption costing:£Direct materials 20Direct labour 10Fixed factory overhead absorbed 30Variable factory overheads 565Example 2 workingsWk 3:(Under-)/Over-absorption of fixed factory overheads: January£30000February£39000March£27000Fixed overheadFixed overheads incurred30000300003000009000(3000) 1000*£30 1300*£30 900*£30Wk 4: No fixed factory overheadVariable production cost per unit under marginal costing:£ Direct materials20Direct labour10Variable factory overhead535 10/24/201813Marginal and Absorption CostingSo which profit is higher?Which profit is higher depends on the change in the stocklevel of finished goods during the accounting period.– If stocks of finished goods increase during a period,absorption costing will give the higher profit.– If stocks of finished goods decrease during a period,marginal costing will give the higher profit.– If stocks of finished goods remain the same, profits arethe same for both methods.Marginal and Absorption Costing ABSORPTION COSTINGMARGINAL COSTINGValuing unitsTotal production costMarginal (variable) productioncostValuing inventoryOpening and closing stock valued at totalproduction costOS and CS valued at marginalcostFixed productionoverheadsCarried forward from one period to thenext as part of the closing / opening stockvaluation. Only hit profit when units aresold.FC charged in full against profitin the period in which they areincurredAdjusting for over- orunder-absorptionYes – in the income statementNone neededImpact of increase ininventory levelsGives higher profitGives lower profitImpact of decrease ininventory levelsGives lower profitGives higher profitInventory level constantSame profit under both systems 10/24/201814Argument for absorption costing• Compliance with the generally accepted accountingprinciples• Importance of fixed overheads for production• Avoidance of fictitious profit or loss✓ During the period of high sales, the production is smallthan the sales, a smaller number of fixed manufacturingoverheads are charged and a higher net profit will beobtained under marginal costing✓ Absorption costing is better in avoiding the fluctuation ofprofit being reported in marginal costingArguments for marginal costing• More relevance to decision-making• Avoidance of profit manipulation✓ Marginal costing can avoid profit manipulation byadjusting the stock level• Consideration given to fixed cost✓ In fact, marginal costing does not ignore fixed costs insetting the selling price. On the contrary, it providesuseful information for break-even analysis that indicateswhether fixed costs can be converted with the change insales volume10/24/201815Reading List Drury, C. (2015), Management & Cost Accounting,9th Edition. Chapter 7


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