MARGINAL AND ABSORPTION COSTING

* LEARNING OBJECTIVES:

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Calculation of unit product cost based on Marginal costing and Absorption costing.

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Statement of Profit or Loss using alternative using Marginal costing and Absorption costing

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Statement of Profit Reconciliation

Reasons for the difference of profit reported

* Is a costing technique that differentiate

between fixed costs and variable costs and determined the effect of these costs on profit given changes in output. * It provides information to management on the effect of costs and revenues to the changes on the volume of output in the short run. * It shows the amount of contribution margin – a fundamental principal of understanding breakeven analysis and marginal costing technique * Contribution is the excess of total revenues after deducting the variable costs.

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* Under marginal costing approach, fixed cost are treated as

period costs and charged directly to the income statement * Product cost under marginal costing consists of only the variable cost of production ( direct material, direct labour and variable production overhead) * Fixed production overhead is not part of the product cost and is written off immediately to the income statement during the period * Fixed administrative, selling and distribution cost is written off as period costs during the period. * Total Contribution = Total Revenues – Variable Cost of Sales * Net profit = Total contribution – Fixed costs

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* It is a costing method that do not differentiate fixed cost and variable cost. It absorbs all production costs to the production units during the period.

* Thus product cost under absorption costing consists of all production costs i.e direct materials, direct labour, variable production overhead and fixed production overhead.

* Fixed and variable selling, administrative and distribution costs will be treated as period costs for the period

* Gross profit = Sales – Cost of goods sold * Net profit = Cost of goods sold – period costs

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*Income Statement under Marginal Costing

*Income Statement under Absorption Costing

(See Appendix 1)

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* Is a statement to reconcile the net profit under Marginal

Costing and Absorption Costing * It will show the differences of profits under both method – due to the different valuation given to the closing stocks in the period due to different costs of production. * Under Absorption Costing method, amount of fixed production overhead is carried forward in stock as part of the inventoriable costs and to be charged against sales in later period. * However under marginal costing method, only variable cost of production is carried forward as part of the inventoriable cost and fixed production overhead is written off immediately as expense in the period it is incurred.

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RM Net Profit as per Marginal costing

XXX

Add : increase in stock (stock units x Fixed prod overhead per unit) XX or Less: decrease in stock (stock units x fixed prod overhead per unit)

{Compare opening and closing stock units) Net Profit as per Absorption costing

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XXX

Units/volume

Marginal Costing

1. Production = sales

Net profit is the same for both methods

2. Production > sales (closing stock exists)

Net profit is lesser than AC

Net profit is higher than MC

3. Production < sales (no closing stock)

Net profit is higher than AC

Net profit is lesser than MC

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Absorption Costing

Marginal Costing

Absorption Costing

Emphasize the behaviour of cost and thus cost are classified into variable and fixed cost

Emphasize on functional classification of cost and thus cost is grouped under production, administration, selling and distribution

Contribution is the important feature

Gross profit is the important feature

Product cost is based on variable production cost

Product cost is based on full production cost (variable and fixed)

All fixed cost are treated as period cost

Fixed production cost is treated as product cost. Non production cost is treated as period cost.

Fixed production cost will be an expense if the product is sold

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 It is useful in managerial decision making as it provides better information

 It shows contribution which enables management to decide where to concentrate on sales

 Under of over absorbed of overhead do not arise  Sales are acceptable as long as it covers the marginal cost and contributes towards the fixed costs so that losses are keep to the minimum

 Emphasize on cost behaviour patterns so that

managers are aware how costs react with changes in units

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 May be misleading as only variable costs are taken

into account for calculation of unit cost or for pricing decision  The contribution margin may be insufficient to cover all the fixed cost  Stock valuation may be distorted by the treatment of overheads  In reality, it is difficult to separate costs into fixed and variable elements  It fails to recognize the long term planning where most of the fixed costs become variable since time span is long enough to meet the intended volume of output

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 It differentiates between product and period cost  It helps to calculate gross and net profit for any given period

 Manufacturing overhead are fully utilized and absorbed to the unit cost

 Prices are set by reference to the fixed cost, thus does not lead to underpricing

 The absorption costing method is often used to prepare financial accounts

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ď&#x201A;§ Decision making is difficult because all types of costs are considered

ď&#x201A;§ Not useful in planning and cost controlling

decision as costs are not differentiated into fixed and variable cost

ď&#x201A;§ Full costing method leads to misleading

conclusions in decision making especially in the area of add or drop the product lines due to operating losses

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