MARGINAL AND ABSORPTION COSTING (Contd.)

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
Less: Fixed overheads 10,000
Operating profit 9,200

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
Factory Overhead
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

c) 110 units sold Absorption costing Marginal costing
Selling price Rs. 240 per unit
Solution
a) All Units SoldSales (110 x 240) Less Product cost Absorption costing 24,000 Marginal costing 24,000
100 x 180 100 x 160 Gross profit 18,000 6,000 16,000
Contribution margin Less Fixed cost Profit 0 6,000 8,000 (2000) 6,000
b) 80 units sold & 20Sales 80 x 240 Production cost 100 x 180 = 100 x 160 = Less closing stock 20 x 180 = 20 x 160 = Less Fixed cost Contribution Margin Profit units in closing Absorption costing 19,20018,000 (3600) 14,600 4,600 4,600 stock 16,000 (3,200) Marginal costing 19,200 12,800 2,000 4,400

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.

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 sold Same Profit Same Profit
Produced units > Units sold More Profit Less Profit
Produced units < Units sold Less Profit More Profit
Reconciliation of the above practice question b) 80 units sold & 20 units in closing stock
Rs
Absorption Profit Less Closing Stock @ Fixed FOH Rate 20 x 20 Marginal Costing Profit 4,800 (400) 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

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

Advantages of marginal costing

(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:

2nd3rd

Item 1st year year year 4th year Total

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.

Solution The profit statement under absorption costing would be as follows:
Items 1st year Rs. 2nd year Rs. 3rd year Rs. 4th year Rs. Total Rs.
Opening stock @ Rs7.60 1,520 2,280 2,280
Variable costs of production @ Rs4 1,200 1,000 800 800 3,800
Fixed costs ® 900/250 =Rs3.60 1,080 900 720 720 3,420
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 (w) 180 Nil (180) (180) (180)
Net Profit 420 360 300 540 1,620

Working: Calculation of over / under absorption

Fixed cost control account

Incurred Year 1 900
Over absorption Year 2 180 1,080 900
Year 3 900
Year 4 900 900
900
Absorbed 1,080
300 x Rs. 3.60
1,080
250 x Rs. 3.60
200 x Rs. 3.60 720
Under absorption 180
900
200 x 3.60 720
Under absorption 180
900

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 Add: Fixed overheads Absorbed in stock increase 200 x Rs3.60 = 720 100 x Rs3.60= 360 200 x Rs3.60= 720 Less: Fixed overheads 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 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 Production overhead 0.75 Selling and administration overhead 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 overhead that the company:

(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).

Advantages of Absorption 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 fixed overhead.

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.

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 Selling & administrative expenses Rs. 2 per unit Fixed cost

F.O.H

Rs 120,000 Selling & administrative expenses 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
Add Production cost
(13 x 30,000) 390,000
Less Closing stock
(13 x 10,000) 130,000
260,000
Gross Profit 140,000
Less Operating expenses

Selling & Administrative expenses

Variable expenses

(20,000 x 2) = 40,000

Fixed expenses 15,000 55,000 Net profit 85,000

Income Statement under Marginal Costing System Rupees

Sales 400,000

Less Variable cost of goods sold

Opening stock 0

Add Variable production cost

(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

Selling & Admin Expenses 15,000 135,000 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

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

Variable production overhead 2

Fixed production overhead 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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