Accounting for Overheads - Marginal Costing Marginal cost is the variable cost of one unit of product or service. Marginal costing is an alternative method of costing to absorption costing. In marginal costing, only variable costs are charged as a cost of sale and a contribution is calculated (sales variable costs). Closing inventories of work in progress or finished goods are valued at marginal 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 (as opposed to each unit or job in absorption costing). The marginal production cost per unit of item therefore usually consists of the following: Direct Materials Direct Labour Variable production overheads Even when staff are on a fixed wage salary, direct labour costs should be treated as variable unless given clear instructions to the contrary. Contribution is an important measure in marginal costing and is calculated as the difference between sales and marginal (variable) cost of sales. The term contribution is really short for contribution towards covering fixed overheads and making a profit. Sales Marginal Costs = Contribution Fixed Costs = Profit The principles of marginal costing are: Fixed costs are the same for any volume of sales or production. 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 Similarly, if the volume of sales falls by one item, the profit will fall by the amount of contribution earned from the extra item. Profit measurement should therefore be based on an analysis of total contribution. Marginal costing suggests that 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. Absorption costing is therefore misleading, and it is more appropriate to deduct fixed costs from total contribution for the period to derive a profit figure. When a unit of product is made, the extra costs incurred in its manufacture are the variable costs. Fixed costs are unaffected, and no extra fixed costs are incurred when output is increased. It is therefore argued that the valuation of closing inventories should be at variable production cost (direct materials, direct labour, any direct expenses and variable production overhead) because these are the only costs properly attributable to the product.
Example: RUS Co. makes a product, the Splash, which has a variable cost of 6 per unit and a sales price of 10 per unit. At the beginning of July 2013 there were no opening inventories and production during the month was 20,000 units. Fixed costs for the month were 45,000. Required: Calculate the contribution and profit for July 2013, using marginal costing principles, if sales were: 1. 10,000 units 2. 15,000 units 3. 20,000 units Solution: 10,000 units 15,000 units 20,000 units Sales 10 per unit 100,000 150,000 200,000 Opening Inventory 0 0 0 Variable prod costs 6 p.u. 120,000 120,000 120,000 Less closing inventory 6 p.u. (60,000) (30,000) 0 Variable cost of sales 60,000 90,000 120,000 Contribution 40,000 60,000 80,000 Less fixed costs (45,000) (45,000) (45,000) Profit (5,000) 15,000 35,000 Profit/loss per unit ( 0.50) 1 1.75 Contribution per unit 4 4 4 Since the contribution per unit does not change, the most effective way of calculating the expected profit at any level of output and sales would be to first find the total contribution and then deduct total fixed costs in order to find the profit. In our example the expected profit from the sale of 17,000 units would be: Total contribution 17,000 x 4 = 68,000 Less Fixed Costs 45,000 Profit 23,000 Marginal costing and absorption costing and the calculation of profit In marginal costing, fixed production costs are treated as period costs and are written off as they are incurred. In absorption costing, fixed production costs are absorbed into the cost of units and carried forward in inventory to be charged against sales for the next period. Inventory values using absorption costing are therefore greater than those calculated using marginal costing. In marginal costing it is necessary to identify variable costs, contribution and fixed costs. In absorption costing it is not necessary to distinguish variable from fixed costs.
The following example will be used to lead you through the various steps in calculating marginal and absorption costing profits, and will highlight the difference between the two techniques. Example: Marginal and absorption costing compared Big Woof Co manufactures a single product, the Bark, details of which are as follows: Per Unit: Selling Price 180 Direct Materials 40 Direct Labour 16 Variable Overheads 10 Annual fixed production overheads are budgeted to be 1.6 million and Big Woof expects to produce 1,280,000 units of the Bark each year. Overheads are absorbed on a per unit basis. Actual overheads are 1.6 million for the year. Budgeted fixed selling costs are 320,000 per quarter. Actual Sales and Production units for the first quarter of 2013 are given below: Jan Mar Sales 240,000 Production 280,000 There is no opening inventory at the beginning of January. Prepare income statements for the quarter, using: 1. Marginal Costing 2. Absorption costing Solution: Step 1: Calculate the overhead absorption rate per unit Remember the overhead absorption rate = budgeted fixed overheads budgeted units Budgeted overheads (quarterly) = 1.6 million / 4 = 400,000 Budgeted units produced (quarterly) = 1,280,000 /4 = 320,000units Overhead absorption rate = 400,000 = 1.25 per unit 320,000 Step 2: Calculate total cost per unit Total cost per unit absorption costing = Variable Cost + fixed production cost (40+16+10) + 1.25 = 67.25 Total cost per unit marginal costing = Variable cost per unit 40+16+10 = 66 Step 3: Calculate closing inventory in units Closing inventory = Opening inventory + production sales 0 + 280,000 240,000 = 40,000 units
Step 4: Calculate under/over absorption of overheads This is based on the difference between actual production and budgeted production. Actual Production = Budgeted Production = Under production = 280,000 units 320,000 units 40,000 units As Big Woof produced 40,000 fewer units than expected there will be an under-absorption of overheads of 40,000 x 1.25 = 50,000. This will be added to the production costs in the income statement. Step 5: Produce Income Statements Marginal Costing Sales (240,000 x 180) 43,200,000 Less cost of sales: Opening Inventory 0 Plus production cost 280,000 x 66 18,480,000 Less Closing Inventory 40,000 x 66 (2,640,000) Total Cost of Sales 15,840,000 Contribution 27,360,000 Less Fixed Production O/H 400,000 Less Fixed Selling O/H 320,000 (720,000) Net Profit 26,640,000 Absorption Costing Sales (240,000 x 180) 43,200,000 Less cost of sales: Opening Inventory 0 Plus production cost 280,000 x 67.25 18,830,000 Less Closing Inventory 40,000 x 67.25 (2,690,000) Add under absorbed O/H 50,000 Total Cost of Sales 16,190,000 Gross Profit 27,010,000 Less Fixed Selling O/H 320,000 (320,000) Net Profit 26,690,000 Reconciling Profits: Reported profit figures using marginal costing or absorption costing will differ if there is any change in the level of inventories in the period. If production is equal to sales there will be no difference in calculated profits using the costing methods. The difference in profits reported under the two costing systems is due to the different inventory valuation methods used.
If inventory levels increase between the beginning and end of a period, absorption costing will report the 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 because as well as the fixed overhead incurred, fixed production overhead which had been carried forward in opening inventory is released and is also included in cost of sales. Example: Reconciling Profits The profits reported under absorption costing and marginal costing for January March in the Big Wolf question above can be reconciled as follows: Marginal Costing Profit = 26,640,000 Adjust for fixed o/h included in inventory: Inventory increase of 40,000 units x 1.25 = 50,000 Absorption Costing Profit 26,690,000 Reconciling Profits A shortcut: A quick way to establish the difference in profits is to use the following formula: Difference in Profits = change in inventory level x overhead absorption rate per unit If inventory levels have gone up (closing inventory greater than opening inventory) then absorption costing profits will be greater than marginal costing profits. If inventory levels have gone down (closing inventory less than opening inventory) then absorption costing profits will be less than marginal costing profits. In the Big Wolf example above: Change in inventory = increase of 40,000 units (0 opening and 40,000 closing) Overhead absorption rate = 1.25 As inventory has gone up we would therefore expect absorption costing profit to be greater than marginal costing profit by 40,000 x 1.25 = 50,000. If you check the solution above you will see this was the case!!! Question: When opening inventories were 8,500 litres and closing inventories 6,750 litres, a firm had a profit of 62,100 using marginal costing. Assuming the fixed overhead absorption rate was 3 per litre, what would the profit be using absorption costing? A 41,850 B 56,850 C 67,350 D 82,350 Solution: Difference in Profits = change in inventory level x overhead absorption rate per unit Difference in profit = 8,500 6,750 = 1,750 litres decrease in inventory x 3 = 5,250 Absorption costing profit = 62,100-5,250 = 56,850 The answer is B. Since inventory levels reduced, the absorption costing profit will be lower than the marginal costing profit. You can therefore eliminate options C and D.
Marginal costing versus Absorption costing Absorption costing is most often used for routine profit reporting and must be used for financial accounting purposes. Marginal costing provides better management information for planning and decision making. There are a number of arguments in favour of both costing systems. These are listed below: Arguments in favour of absorption costing: It is fair to share fixed production costs between units of production as such costs are incurred to make output Closing inventories valued in accordance with IAS2 principles It is easier to determine the profitability of several products by charging a share of fixed overheads to them rather than working out if the total contribution from several products will cover fixed costs Where building up inventory is necessary (e.g. fireworks) fixed costs should be included in inventory valuations in order to prevent a series of losses from occurring (e.g. long before the period in which Halloween falls). Arguments in favour of marginal costing: Simple to operate No apportionment of fixed costs Closing inventory realistically valued at variable production cost per unit Size of contribution provides management with useful information about expected profits Absorption costing encourages management to produce goods in order to absorb allocated overheads instead of meeting market demands Under/over absorption of overheads is avoided It is a great aid to decision making
Aug 2012: Q1
Solution:
CPA SPM Prior Learning