CHAPTER 6 ABSORPTION AND MARGINAL COSTING Flashcards
what are both marginal costing and absorption costing used for?
Marginal and absorption costing are two different ways of valuing the cost of units sold and finished units in inventory. The basic unit cost consists of the direct costs; the difference arises due to the treatment of the production overheads
what is the marginal cost of a unit
The marginal production cost is the cost of one unit of product or service which would be avoided if that unit were not produced, or which would increase if one extra unit were produced.
The marginal cost of a unit of inventory is the total of the variable costs required to produce the unit (the marginal cost). This includes direct materials, direct labour, direct expenses and variable production overheads.
No fixed overheads are included in the inventory valuation; they are treated as a period cost and deducted in full against the profits for the period.
what is the purpose of the marginal costing principle
Marginal costing is the principal costing technique used in decision making. The key reason for this is that the marginal costing approach allows management’s attention to be focused on the changes which result from the decision under consideration.
what is the contribution concept and its formula
The contribution concept lies at the heart of marginal costing. Contribution can be calculated as follows:
Contribution = Sales price – All variable costs
why is the contribution concept often employed by management accountants?
Using profit per unit is not particularly useful when making short term decisions as profit per unit depends on how many units are sold. For this reason, the contribution concept is frequently employed by management accountants.
Contribution gives an idea of how much ‘money’ there is available to ‘contribute’ towards paying for the fixed costs of the organisation.
At varying levels of output and sales, contribution per unit is constant.
Contribution per unit = Sales price per unit – total variable cost per unit
Total contribution = Contribution per unit × Sales volume.
Profit = Total contribution – Fixed overheads.
what is absorption costing
Absorption costing is a method of building up a full product cost which adds direct costs and a proportion of production overhead costs by means of one or a number of overhead absorption rates.
Absorption costing values each unit of inventory at the cost incurred to produce the unit. This includes an amount added to the cost of each unit to represent the production overheads incurred by that product. The amount added to each unit is based on estimates made at the start of the period.
To calculate a production cost per unit the budgeted production costs are divided by the budgeted activity. The calculation of the cost per unit (overhead absorption rate) was looked at in more detail in Chapter 5 – Accounting for overheads.
how does absorption costing and marginal costing contrast?
Marginal costing values inventory at the variable production cost of a unit of product.
Absorption costing values inventory at the full production cost of a unit of product.
Inventory values will therefore be different at the beginning and end of a period under marginal and absorption costing.
If inventory values are different, this will have an effect on profits reported in the statement of profit or loss in a period.
Profits determined using marginal costing principles will therefore be different to those using absorption costing principles.
what information is needed to prepare a statement of profit or loss under absorption costing
In order to be able to prepare a statement of profit or loss under absorption costing, you need to be able to complete the following proforma:
Valuation of inventory – opening and closing inventory are valued at full production cost under absorption costing.
Under/over-absorbed overhead – an adjustment for under or over absorption of overheads is necessary in absorption costing statements.
Absorption costing statements are split into production costs in the cost of sales and non-production costs after gross profit.
what information is needed to prepare a statement of profit or loss under marginal costing
In order to be able to prepare a statement of profit or loss under marginal costing, you need to be able to complete the following proforma:
Valuation of inventory – opening and closing inventory are valued at marginal (variable) cost under marginal costing.
The fixed costs incurred are deducted from contribution earned in order to determine the profit for the period.
Marginal costing statements are split into all the variable costs before contribution and all the fixed costs after contribution.
Note: only the production variable costs are included in the cost of sales and valuation of inventory. If there are variable non-production costs (i.e. selling costs) these would be deducted before contribution but not included in the cost of sales.
how are profits reconciled which are reported under the different methods?
When inventory levels increase or decrease during a period then profits differ under absorption and marginal costing.
If inventory levels increase, absorption costing gives the higher profit.
If inventory levels decrease, marginal costing gives the higher profit.
If inventory levels are constant, both methods give the same profit.
what is a short cut to reconciling profits reported under the different methods
In an exam question you may be told the profit under either marginal or absorption costing and be asked to calculate the alternative profit for the information provided.
There is a short cut to reconciling the profits:
absorption costing profit =
(opening inv - closing inv) x OAR =
marginal costing profit =
advantages and disadvantages of marginal costing
advantages
- contribution per unit is constant unlike profit per unit which varies with changes in sales volumes
- there I son under or over absorption of overheads (and hence no adjustment is required in the statement of profit or loss)
- fixed costs are a period cost and are charged in full to the period under consideration
- marginal costing is useful in the decision making process and simple to operate
disadvantages
The main disadvantages of marginal costing are that closing inventory is not valued in accordance with IAS 2 principles and that fixed production overheads are not ‘shared’ out between units of production, but written off in full instead.
advantages and disadvantages of absorption costing
advantages
- absorption costing includes an element of fixed production overheads in inventory value (in accordance with IAS 2)
- analysing under/over absorption of overheads is a useful exercise in controlling costs of an organisation
- in small organisations, absorbing overheads into the cost of products is the best way of estimating job costs and profits
disadvantages
- The main disadvantages of absorption costing are that it is more complex to operate than marginal costing and it does not provide as much useful information for short term decision making.
