ACOF 014

Introduction to Costing
Semester 2 2008/ 2009

TOPIC 7: ABSORPTION AND MARGINAL COSTING

Outline:
1. Learning Objectives
2. Differences between absorption and variable costing
3. Impact on profit under each costing technique

1. Learning objectives
a. Explaining the differences between absorption costing and marginal costing
b. Explaining the impact on stock valuation & profit under each costing
system
c. Explaining the impact on under each costing system
d. Preparing multi-period absorption and marginal costing profit statements

2. Explaining the differences between absorption costing and Marginal

costing 298)

Flow of Costs under Full Absorption & Marginal Costing

FULL ABSORPTION COSTING
PERIOD COST PRODUCT COSTS

Selling and Fixed Variable Direct

administrative manufacturin manufacturing materials and
expenses g overhead overhead direct labour

Work in
process
inventory

Cost of
Expenses for Closing
goods
the period inventories
sold

MARGINAL COSTING
PERIOD COST PRODUCT COSTS

Selling and Fixed Variable Direct

administrative manufacturin manufacturing materials and

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 expenses g overhead overhead direct labour

Work in
process
inventory

Cost of
Expenses for Closing
goods
the period inventories
sold

Absorption Costing = full costing

- DM + DL + Marginal + fixed manufacturing OH  product cost
- Non-manufacturing cost  period cost

Marginal Costing (Variable/ Direct Costing)

DM + DL + Marginal manufacturing OH  product cost
Fixed manufacturing OH + non-manufacturing cost  period cost

Which method should be used?

External reporting  use absorption Costing

Match costs against revenues.

** absorption costing  may have under/over recovery of fixed overheads

 charged to I/S as period costs (refer Topic #4 on OH)

Internal reporting  debatable  both useful in different ways

The Concept of Contribution Margin

MARGINAL VARIABLE
DIRECT LABOUR
COST = COST =
+ DIRECT MATERIAL
+ DIRECT EXPENSE
+ VARIABLE
OVERHEADS

CONTRIBUTION MARGIN = SALES – MARGINAL COST

 the contribution margin (CM) is the excess of sales revenues over varibale costs

 in other words, CM is the amount available to cover the fixed costs, once they are
covered, any remaining amounts adds directly to the income form the operations.

CM could also be expressed in total or per unit of product.

Illustration 1: Contribution Margin Income Statement

Sales RM 1,000,000
Variable costs 600,000

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 CM RM 400,000 Available to cover the FC of RM300,000.
Fixed costs 300,00
Income from operations RM 100,000

(note: think of the fixed costs as a bucket and the CM is water filling the bucket. Once
the bucket is filled, the overflow represents income from operations. Up until the
point of overflow, however, the CM contributes to fixed costs (filling the bucket)).

3. Preparing multi-period absorption and marginal costing profit

statements

Illustration 2:
The unit cost of production for a firm which produces a single product is:

Direct materials 2.60

Direct labour 3.00
Variable overhead 0.40
Fixed overhead 1.00
7.00

The fixed overhead calculation is based on a budgeted level of activity of 150,000

units and budgeted manufacturing fixed overheads f RM150,000 for each quarter. The
budgeted selling and administration overheads are RM100,000 per quarter (all fixed).
The selling price for the product is RM10 per unit. The production and sales for each
quarter were:

Quarter 1 Quarter 2 Quarter 3 Quarter 4

Production (units) 150,000 170,000 140,000 150,000
Sales (units) 150,000 140,000 160,000 160,000

There was no opening stock in Quarter 1 and you should assume that actual costs
were identical to estimated costs.

You are required to:

a) produce in columnar format, absorption and variable costing profit
statements
b) comment on the results for each quarter and the year as a whole

Illustration 3:
Assume, for example, that on June 1, Hamilton Manufacturing Company opened a new
plant in Nashville. Data for the plant's first month of operations are as follows:

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 Units manufactured and units sold:
Number of units manufactured (all completed by June
11,000
30)
Number of units sold 101,000
Units in inventory of finished goods at June 30 1,000
Sales revenue and selling and administrative expenses:
Net sales (10,000 units sold @ $20) RM 200,000
Selling and administrative expenses:
Variable (RM2 per unit sold) RM 20,000
Fixed RM 30,000

Required:
(a) Prepare manufacturing costs (per unit manufactured) statement under both
costing systems
(b) Prepare partial income statement under both costing systems

4. Explaining the impact on stock valuation & profit under each costing
system

Impact on Profit:
Production = sales  Absorption costing π = Marginal costing π
(i.e. stocks value do not ↑ or ↓, ( same amount of FOH included as expense and as
closing stock)

Production > sales  Absorption costing π > Marginal costing π

(i.e. when there are units produced that become closing stock)
AC: closing stock ↑ as FOH included  higher closing stock  ↑π
VC: closing stock ↓ as FOH NOT included

Production < sales  Absorption costing π < Marginal costing π

(i.e. when part of the units sold covered by opening stock)
AC: closing stock ↓ because less FOH charged to production  ↓ closing stock ↓π

Problems: under Absorption Costing

 profit decrease even though sales up and SP and cost structure
unchanged

Why? Due to under/ over recovery of FOH in AC

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 INCOME STATEMENT FORMATS

 Marginal Costing/Marginal Costing/Direct Costing

 the CVP format:
<company name>
Income Statement
for the <period> ended xx/xx/xxxx
_____________________________________________________________________________________________
Sales ………………………………………………………………….............. xxxxx

Marginal expenses:
Beginning inventory ……………………………………………............xxx
Marginal manufacturing costs …………………………………….......xxx
Cost of goods available for sale …………………………………....... xxx
Closing inventory …………………………………………………..........(xxx)
Marginal cost of goods sold ……………………………………….......xxx
Marginal selling and administrative expenses ……………………. xxx
Total Marginal expenses ………………………………………...... (xxxx)
Contribution margin …………………………………………………............ xxxxx
Fixed expenses:
Manufacturing overhead ………………………………………….........xxx
Selling and administrative ……………………………………….........xxx
Total fixed expenses …………………………………………. ....... (xxxx)
Net Profit (Loss) from operations ……………………………………........ xxxx

 Absorption Costing/Full Costing

<company name>
Income Statement
for the <period> ended xx/xx/xxxx
Sales ………………………………………………………………….............. xxxxx

Less: Cost of Goods Sold:

Beginning inventory ……………………………………………............ xxx
Total production cost ……………………………………………...........xxx
Cost of goods available for sale ………………………………….......xxx
Closing inventory …………………………………………………..........(xxx)
Cost of goods sold ……………………………………………………........... (xxxx)
Adjustments for (Under)/Over recovery of overheads …………….. (xxxx)
Gross Profit …………………………………………………………................ xxxxx
Non-manufacturing overheads/expenses ……………………………..... (xxxx)
Net Profit (Loss) from operations ……………………………………........ xxxx

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 Example Questions:

1. Zeera Limited manufactures a single product, the budgeted selling price and
Marginal cost details of which are as follows:
RM
Selling price 15.00
Marginal costs per unit:
Direct materials 3.50
Direct labour 4.00
Marginal overhead 2.00

Budgeted fixed overhead costs are RM60,000 per annum, charged at a

constant rate each month. Budgeted production is 30,000 units per annum.
In a month when actual production is 2,400 units and exceeded sales by 180
units the profit reported under absorption costing was:

a. RM6,660
b. RM7,570
c. RM7,770
d. RM8,200
e. RM8,400

2. A company made 10,000 units at a total cost of RM20 each. Three-quarters of the
costs were Marginal and one-quarter fixed. 8,000 units were sold at RM30 each.
There were no opening stocks. Calculate the profits under both the absorption and
marginal costing system.

Tutorial Questions:

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1. NyumNyum Ltd. starts business on 1 July, making product Roro. The standard
cost for Roro is as follows:
RM
Direct labour 5
Direct material 8
Variable production overhead 2
Fixed production overhead 5
Total standard production 20
cost

The fixed production overhead figure has been calculated on the basis of a
budgeted normal output of 36,000 units per annum.
You are to assume that all budgeted fixed expenses are incurred evenly over the
year.
Selling, distribution and administration expenses are:

Fixed RM120,000 per annum

Variable 15% of the sales value

The selling price per unit is RM35 and the number of units produced and sold was:

July August
(units) (units)
Production 2,000 3,200
Sales 1,500 3,000

Required:
Prepare profit statements for each of the months of July and August using:
a) marginal costing
b) absorption costing

2. The data below relate to Buat Taktau Company which

makes and sells one product. There was no stock at the
beginning of August.
August September
Units Units
Sales 4,000 6,000
Production 8,000 2,000
RM RM
Selling price per unit 80 80
Variable production costs per unit 40 40
Fixed production overhead incurred 96,000 96,000
Fixed production overhead cost per unit, being the
predetermined overhead absorption rate 12 12
Fixed selling, distribution and administration costs 40,000 40,000

Required:
a) Prepare comparative profit statements for each month using:
(i) Absorption costing;
(ii) Marginal costing.

1. Give two examples where marginal costing is used.

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3. A company, “Macam-Macam Ada” Enterprise which located in Taman Setiawangsa,
manufactures and sells supplement product, “E-Nergy”. The company provides the
standard production costs of which is as follows for one unit of product:-

RM
Direct Materials (4 kg x RM5/kg) 20
Direct Labour (2 hours x r5/hr) 10
Variable production overhead 8
Selling Price 60

Fixed production overhead for the company is RM32,000, which is constant

throughout the year. The company has normal capacity of production units at 16,000
units per annum.

Other expenditures which relating to selling and distribution are as follows:-

Variable : 10% of Sales Values

Fixed : RM18,000 per annum

Since this is the first year of company’s operations of its business, therefore there is
no opening stock for the year 2006.

2006 2007
Sales (units) 7,000 8,500
Production (units) 9,000 11,000

Rquired:

a) Prepare profit statement using Marginal Costing for BOTH years.

b) Prepare profit statement using Absorption Costing for BOTH years.

4. Textbook Drury: Question 8.16 (page 234-235).