Chapter 4 Marginal costing and absorption costing

Question 1

1.1 Marginal costing (MC) v total absorption costing (TAX)

Answer 1

There are two methods for determining the value of inventory: absorption costing and marginal costing. Each element of cost is classified as a period or product cost.
Period costs are costs charged in full to the profit or loss account in the period in which they are incurred. Product costs are costs included in inventory valuation; therefore, product costs are matched against the sales revenue they generate.
MC and TAC classify fixed production costs differently.

Type of cost MC TAC
Variable production costs Product cost Product cost
Fixed production costs Period cost Product cost
Variable non-production costs Period cost Period cost
Fixed non-production costs Period cost Period cost

Adopting either MC or TAC affects:
- Inventory valuation and therefore cost of sales and profit in any particular period, and
- The format of the profit or loss account

Question 2

2.1 Contribution

Answer 2

Marginal costing helps with short-term decision making. In the short-term many costs are assumed to be committed and unavoidable. These costs should therefore not be considered when making short term decisions. A business may have a one-off order or spare capacity. The business needs to decide:
- Should they accept the order
- What is the minimum price to charge?
- How should the business use the spare capacity?

Contribution per unit
Sales price less variable production costs (inventory valuation) less variable non-production costs (for example sales commission) equals contribution per unit.
Total contribution = CPU x units sold

Contribution and profits
Short-term fixed costs are assumed to be unavoidable. Therefore, only changes in production and sales volume can alter profits. For example, make and sell more units, more sales revenue, more variable sales and production costs, more contribution, fixed costs stay the same and more profit.
Profit equals total contribution less fixed costs

Conclusions
We can note:
- Contribution per unit is constant
- Total contribution rises as volume rises
- Fixed costs remain constant
- Profit per unit rises as activity rises. This is because total contribution rises in line with activity, but fixed costs are constant. Therefore, fixed costs are spread over more units
- Once fixed costs are covered, contribution per unit demonstrates the additional profit made per unit sold

Question 3

3.1 Profit or loss account: MC v TAC

Answer 3

Format:
MC and TAC profit or loss accounts may be presented in different formats. MC emphasises the importance of sales fewer variable costs) equals contribution less fixed costs which equals net profit. TAC uses sales less cost of sales equals gross profit less non-production costs equals net profit.

The value of opening and closing inventories will differ depending on whether MC or TAC is adopted. MC values inventories at variable production cost, TAC values inventories at full production cost. Therefore, MC will only expense fixed production costs in the period in which the inventory is sold.

Over/under absorption of fixed production overheads (which occur because OARs are based on budgeted figures) will only appear in TAC profit or loss accounts. TAC, like MC must ensure that the correct overall production FC value is charge to the profit or loss account.

All values apart from inventory valuations will be the same between MC and TAC.

Question 4

3.2 Reconciling the different in reporting profits

Answer 4

The only difference between the reported profit figures must be due to differences in opening and closing inventory valuations because MC treats fixed production overheads as a period cost and TAC treats fixed production overheads as a product cost therefore the deduction of closing inventory from cost of sales carries forward some of the fixed cost to the next period:

• If closing inventory > opening inventory, then TAC > MC
• If closing inventory < opening inventory, then TAC < MC
• If closing inventory = opening inventory, then TAC = MC

Profit reconciliation statement
Marginal costing profit X
(Closing inv – closing inv) x fixed OAR X/(X)
Equals absorption costing profit X