Week 3

Question 1

What is vairable (marginal) costing?

Answer 1

• Variable (marginal) costing is an
alternative to full costing in internal
management reporting.
• Variable costing often preferred by
management accountants for decision
making and performance evaluation.

-Under variable/marginal costing, all fixed
manufacturing costs are excluded from
inventoriable costs (only manufacturing
variable costs are included).

-Only variable manufacturing costs are included
in the costing of inventory. Fixed
manufacturing costs are charged directly to
the Income Statement as period costs

-Under Marginal costing, variable costs are
charged to cost units and fixed costs of the
period are written off in full against the
total contribution.

-Opening and closing inventory are valued at
marginal (variable) cost.

Question 2

What is full (absorption) costing?

Answer 2

Under full costing, all manufacturing either variable or fixed
manufacturing costs are included as inventoriable costs.

Question 3

What can you say in support of marginal costing?

Answer 3

Modern thinking is that most costs are variable
in the very long run and understand what they
vary with.
Management attention is concentrated on the
more controllable measure of contribution. It is
often argued by proponents of marginal costing
that apportionment of fixed production
overhead to individual units is carried out on a
purely arbitrary basis. This is not very useful
for decision-making and can mislead.

Question 4

What is marginal cost?

Answer 4

• Marginal cost is the aggregate of variable
costs, i.e. prime cost plus variable
overhead (manufacturing and nonmanufacturing).
• Marginal costing system is based on the
system of classification of costs into
fixed and variable.

Question 5

describe a marginal costing income statement

Answer 5

formula sheet

Question 6

What should be considered when chosing costing method?

Answer 6

Consider effects of using different inventory
valuation approaches (over-costing vs. undercosting).

Question 7

What is the difference between actual OAR and Budgeted OAR?

Answer 7

• Actual overhead absorption rates
Not available before the end of the period
• Budgeted overhead absorption rates
– Estimated before the start of the period
– Used in planning and budgeting
– Basis for comparison with actual cost

Question 8

What is the formula for budgeted OAR?

Answer 8

Budgeted OAR= Budgeted total cost in cost centre / budgeted total quantity of cost allocation base

Budgeted OAR= Budgeted expenditure for a production dep./Budgeted activity

Question 9

What is the problem with under-allocated indirect costs?

Answer 9

Problem of under-allocated (under-absorbed) indirect costs -
budgeted overhead absorption rate absorbs too little cost to cost
objects in the period.

Question 10

How to know if over absorbed or under absorbed?

Answer 10

1) divide cost with hours
2) multiply the solution with the actual hours
3) compare the solution and the actual cost

Question 11

Production Volume Variance

Answer 11

PPV= (actual volume- budgeted volume) * fixed OH rate

It explains whether actual production is above or below the budgeted volume.

• If the budgeted period volume is greater than the
actual volume, too little fixed production cost would
be absorbed. To adjust that difference the underabsorbed amount of the fixed production cost will be
subtracted from the profit as an
adverse/unfavourable variance (Denoted as U).

If budgeted volume > actual volume = U

• On the other hand, if the budgeted period volume is
less than the actual volume in the period, too much
fixed cost would have been absorbed. The overabsorbed amount of the fixed production cost will
then be added to the profit as favourable variance
(Denoted as F).

If budgeted volume < actual volume = F

PVV does not inform us about efficicency.

• PVV occurs if the budgeted level of production is different
from the actual production level.

Question 12

Fixed OH rate

Answer 12

Fixed O rate= variable cost + (fixed manufacturing cost/ budgeted production volume)

Fixed oar= profit difference / Change in inventory units

Question 13

Explain the differences under full costing and variable costing.

Answer 13

•The profit differences are caused by the different valuations given to
the closing stocks in each period. With absorption costing, an amount
of fixed production overhead is included.

Fixed manufacturing costs are treated as a period cost and charged
to Income Statement under Marginal costing.

-Under variabl costing closing stock is not inventoried

Question 14

What is an increase in inventory level?

Answer 14

difference between closing and opening inventory

Question 15

How do we calculate the profit differene (marginal vs full costing)?

Answer 15

Profit difference: Change in inventory * fixed oar

Question 16

What are the undesriable effects of full costing?

Answer 16

Encourages operational inefficiencies

– Full costing enables a manager to increase
operating profit in a specific period by increasing
the production schedule. (Real Activities earnings
management)
– Even if there is ZERO customer demand for the
additional production as fixed manufacturing costs
would otherwise have been written off as period
costs. So classifying potentially period cost to
closing inventory if there is ZERO demand.
Undesirable stock building (high closing inventory
i.e. high absorption of fixed costs in the closing
inventory) –
Hence Capitalised rather than expensed

Question 17

How can the negative effects of full costing be alleviated?

Answer 17

 Change internal accounting system into more
integrated systems
– Enterprise Resource Planning (ERP) –
(Automating mostly on real time basis from
several back office operations e.g. accounting ,
procurement, production to front office operations
such as marketing , sales etc.)
 Revise performance evaluation of managers i.e. not
necessarily entirely focused on the bottom line
profit.
 Redesign operating systems
– Reduce waste
– Acquire resources only when needed (do not let stocks
pile up)
Move towards “Just-in-Time” management (Although there
are a number of risks, notably those associated with the
supply chain )
JIT was initially known as the “Toyota Production System”
Owing to the Toyota concept of “kanban,” by sending a
signal (historically through cards to the preceding stage in the
process) - referred to as Pull system
• Companies can predict market demand more
accurately by adopting blockchain technology.
• The transaction records are stored and accessible
to everyone within the network.
• This helps in reducing frauds committed by
employees and provide for a time-saving traceable
procedure if some instance of fraud arises

Question 18

Describe further differences between Full costing and marginal costing

Answer 18

-• When sales are equal to production, profits will be
the same under absorption costing and marginal
costing.

• If production is higher than sales, the absorption
costing will post higher profits than marginal
costing (or the closing inventory is higher than the
opening inventory).

• If sales are higher than production (plus opening
inventories), the absorption costing will show lower
profits than marginal costing (or the opening
inventory is higher than the closing inventory).

-–In the long run the total reported profit
will be the same whichever method is
used. This is because all of the costs
incurred will eventually be charged
against sales; timing of the sales that
causes the profit differences from period
to period

– Absorption costing can smooth out profit
by deferring the fixed production
overheads through high levels of
production than needed.
(Real Earnings Management tool – AND even
income smoothing tool).

– Marginal costing has a strong case in its
favour as in the long run almost all costs
are variable and therefore relevant for user
of financial statements.

• In marginal costing, inventories are valued at variable
(marginal) production cost whereas in absorption costing
they are valued at their full production cost.

Question 19

What are the limitations of marginal costing?

Answer 19

• It is difficult to classify exactly the expenses
into fixed and variable category. Most of the
expenses are neither totally variable nor
wholly fixed..

• Sales staff may mistake marginal cost for
total cost and sell at a low price; which will
result in loss or low profits.

• Some assumptions
regarding the behaviour of
various costs may not be necessarily true in a
realistic situation. For example, the
assumption that fixed cost will remain static
throughout is not correct.

Question 20

What is a differential/incremental cost?

Answer 20

Differential cost (incremental cost) is the
change in the cost due to change in
activity from one level to another.

For example, if the cost of one alternative is
£3,000 per year and the cost of another
alternative is £5,000 per year. The difference
of £2,000 would be differential cost.

Question 21

Why is absorption profit higher?

Answer 21

•Absorption profit is higher because the

inventories have increased