4. Marginal Costing & Absorption Costing

Question 1

What are the two methods of costing we will look at?

Answer 1

• Absorption costing
• Marginal costing

Question 2

What is absorption costing?

Answer 2

With absorption costing, both variable and fixed production costs (material, labour and overheads) are included in the valuation of cost units.

Question 3

Under absorption costing, how is inventory of finished goods valued?

Answer 3

Under absorption costing inventory of finished goods is valued based on the full production cost of those units (including absorbed fixed production overheads).

Question 4

Outline the long form of the pro-forma to calculate profit using the absorption costing method

Answer 4

Question 5

Outline the short form of the pro-forma to calculate profit using the absorption costing method

Answer 5

Question 6

What is marginal costing?

Answer 6

Marginal costing is an alternative costing system to absorption costing.

With marginal costing, only variable production costs (material, labour and overheads) are included in the valuation of cost units.

All fixed costs are treated as period costs and are charged in full in the income statement for the period.

Question 7

What is contribtuion with regards to marginal costing?

Answer 7

Contribution is the difference between sales value and marginal (or variable) cost

Question 8

Outline the equation for calculating contribution per unit

Answer 8

Question 9

Outline the pro-forma for calculating contribution per unit

Answer 9

Question 10

Outline the equation for calculating total contribution

Answer 10

Question 11

Outline the equation for calculating marginal production cost per unit

Answer 11

Question 12

Under marginal costing, how is inventory of finished goods valued?

Answer 12

Under marginal costing inventory of finished goods is valued based on the variable production cost of those units (excluding any fixed production overheads).

Question 13

Outline the long form of the pro-forma to calculate profit using the marginal costing method

Answer 13

Question 14

Outline the short form of the pro-forma to calculate profit using the marginal costing method

Answer 14

Question 15

Summarise the main differences between the two costing methods? (3)

Answer 15

Question 16

Outline the formula that gives the difference in profit between the marginal costing method and the absorption costing method

Answer 16

Change in inventory is closing inventory less opening inventory

Question 17

Under what conditions will absorption profits be greater than marginal profits and vice versa?

Answer 17

• In periods where inventory levels rise, Absorption profits > Marginal profits
• In periods where inventory levels fall, Marginal profits > Absorption profits

Question 18

Outline the handy shortcut method for calculating absorption profit given the marginal profit

Answer 18

1) With the marginal profit to hand, determine the change in inventory and the OAR per unit
2) Rearrange the formula as shown and using this eqaution plug in the numbers to get the absorption profit

Question 19

Outline the handy shortcut method for calculating marginal profit given the absorption profit

Answer 19

1) With the absorption profit to hand, determine the change in inventory and the OAR per unit
2) Rearrange the formula as shown and using this eqaution plug in the numbers to get the absorption profit

Question 20

Outline the advantages for both absorption costing (3) and marginal costing (6)

Answer 20

Advantages of absorption costing
1. Fixed production costs are incurred in order to make output; it is therefore ‘fair’ to charge all output with a share of these costs.
2. 2. Closing inventory values, by including a share of fixed production overhead, will be valued on the principle required by accounting standards for the financial accounting valuation of inventories for external reporting purposes.
3. A problem with calculating the contribution of various products made by a company is that it may not be clear whether the contribution earned by each product is enough to cover fixed costs, whereas by charging fixed overhead to a product it is possible to ascertain whether or not it is profitable.

Advantages of marginal costing
1. It is simple to operate.
2. There are no apportionments of fixed costs, which are frequently done on an arbitrary basis. Many costs, such as the managing director’s salary, are indivisible by nature.
3. Fixed costs will be the same regardless of the volume of output, because they relate to a period of time and are period costs. It makes sense, therefore, to charge them in full as a cost to the period.
4. The cost to produce an extra unit is the variable production cost. It is realistic to value closing inventory items at this directly attributable cost.
5. Under or over absorption of overheads is avoided.
6. Marginal costing information can be more useful for decision-making since it focuses on the variable costs that are most likely to be altered as the result of a decision.