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MANAGEMENT & COST ACCOUNTING LO 2: LESSON 4 : MARGINAL VS. ABSORPTION COSTING PROFIT CALCULATIONS
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Management & cost accounting - SE 4.pdf · PROFIT CALCULATION : MARGINAL COSTING Marginal costing is an alternative method of costing to absorption costing. In marginal costing ONLY

Mar 21, 2020

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  • MANAGEMENT & COST ACCOUNTINGLO 2: LESSON 4 : MARGINAL VS. ABSORPTION COSTING PROFIT CALCULATIONS

  • INTRODUCTION TO AN INCOME STATEMENT

    Income statement is prepared to assess the profit or loss derived by an organisation.

    It includes three main elements;

    Revenues/ Turnover : refers to a company’s actual or promised cash inflows resulting from

    completed sale of the company’s products or the satisfactory delivery of its services.

    Expenses : refers to the benefits consumed or used up in the process of earning revenues.

    When preparing income statement, all the expenses are required to be deducted from

    revenues to determine profit or loss of the accounting period.

    Gains and losses : A gain is the net revenue of a company earned as a result of a business

    transaction and vice versa.

  • GENERAL FORMAT OF AN INCOME STATEMENT

    Revenue/ Turnover xx

    - Cost of sales (xx)

    Gross profit xx

    - Operating expenses

    General administration xx

    Selling & distribution xx (xx)

    Profit before interest & tax xx

    LESS: Interest expenses (xx)

    Profit before tax xx

    LESS:Tax (xx)

    Net profit/ (loss) xxx / (xxx)

  • PROFIT CALCULATION : MARGINAL COSTING

    Marginal costing is an alternative method of costing to

    absorption costing.

    In marginal costing ONLY variable costs are charged as cost of

    sale and contribution is calculated i.e. Sales revenue –Variable

    cost of sales.

  • MARGINAL COSTING : CONCEPT

  • THE PRINCIPLES OF MARGINAL COSTING

    Overheads are divided into two parts, variable and fixed

    Fixed overheads are not related to the end product, but rather only to the time

    period. Hence, all FIXED COSTS are taken as end period costs.

    Units (production and stocks) are valued at VARIABLE PRODUCTION COST

    (DM+DL+VPOH).

    With marginal costing the concern is about segregating cost into variable and fixed,

    even the non production cost is now divided into two parts where the VARIABLE

    NON PRODUCTION COST is separately taken to calculate the contribution.

  • MARGINAL COSTING : CONCEPT

    The MARGINAL PRODUCTION COST per unit of an item usually consists the

    following.

    Direct materials

    Direct labour

    Variable PRODUCTION overheads

  • MARGINAL COSTING PROFIT CALCULATION : FORMAT

    SALES REVENUE xxx

    LESS: COST OF SALES

    Opening stock (DM+DL+VPOH) xx

    Production (DM+DL+VPOH) xx

    Closing stock (DM+DL+VPOH) (xx) (xx)

    VARIABLE NON PRODUCTION COST xx

    CONTRIBUTION XX

    LESS : FIXED PRODUCTION COST (xx)

    LESS : FIXED NON PRODUTION COST (xx)

    NET PROFIT XX

  • ABSORPTION COSTING PROFIT CALCULATION

    End products (production and stock) are valued at full production cost

    (DM+DL+VPOH+FPOH)

    Fixed overheads are related using OAR which is a predetermined rate, thus

    giving rise to under/over absorption

    Absorption costing does not handle non production costs, so the only option

    available is to take it as an end period cost.

  • ABSORPTION COSTING: CONCEPT

  • ABSORPTION COSTING PROFIT CALCULATION : FORMAT

    SALES REVENUE xxx

    LESS: COST OF SALES

    Opening stock (DM+DL+VPOH+FPOH) xx

    Production (DM+DL+VPOH+FPOH) xx

    Closing stock (DM+DL+VPOH+FPOH) (xx) (xx)

    GROSS PROFIT xx

    ADJUSTMENT (UNDER)/ OVER ABSORPTION (xx)/xx

    LESS : NON PRODUCTION

    -VARIABLE COST (xx)

    - FIXED COST (xx)

    NET PROFIT XX

  • ADJUSTMENT OF UNDER/OVER ABSORPTION

    Over absorption Cost Profit Add back

    Under absorption Cost Profit Deduct

  • RECONCILIATION OF ABSORPTION AND MARGINAL COSTING

    PROFITS

    In spite of the fact the same information was used in arriving at the profit

    figure, under MC and AC two different profit figures are achieved.

    This is because of the two different techniques being applied

  • RECONCILIATION FORMAT

    Marginal costing based profit = xx

    Increase/ decrease in stocks x FPOAR = xx/ (xx)

    Absorption costing based profit = xx

    The above format indicates that only two reasons

    (change in stocks and FPOAR) impact the reconciliation

  • RECONCILIATION OF ABSORPTION AND MARGINAL COSTING

    PROFITS

    All the other values considered in both the techniques would be same;

    1) Absorption/marginal, sales value is the same. So there is NO impact from sales to

    this profit difference.

    2) Variable non-production or fixed non-production costs, to calculate

    absorption/marginal costing profit, the same values are taken. So there is no impact

    from those items to profit difference.

    3) In absorption/marginal costing, if the total actual production cost is taken we arrive

    at the same values.

  • THE REASON FOR PROFIT DIFFERENCE

    The difference between absorption and marginal costing profits occurred due to

    a timing difference.

    In absorption costing FPOH are travelling with stocks to the next period.

    But in marginal costing FPOH is taken out in TOTAL within the period itself.

  • THREE POSSIBLE SITUATIONS OF PROFIT RECONCILIATION

    1. Increase in stocks

    ABSORPTION MARGINAL

    Opening stock 0 x 34 0 x 25

    Closing stock 100 x 34 100 x 25

    (3,400) (2,500)

    In absorption costing when the closing stocks is more it means stocks will carry the

    FPOAR into the next period and this period cost will be less. Thus, the profits will be

    increased. However, in marginal costing the profit will be considered at the end of the

    time period : Hence, the AC profit is higher than the MC profit

  • THREE POSSIBLE SITUATIONS OF PROFIT RECONCILIATION

    II. Decrease in stocks

    ABSORPTION MARGINAL

    Opening stock 200 x 34 200 x 25

    Closing stock 100 x 34 100 x 25

    3,400 2,500

    Cost

    Profit

    Cost

    Profit

  • THREE POSSIBLE SITUATIONS OF PROFIT RECONCILIATION

    III. Change in stocks

    ABSORPTION MARGINAL

    Opening stock 200 x 34 200 x 25

    Closing stock 200 x 34 200 x 25

    0 0

    Cost = Cost

    Profit = Profit

  • THANK YOU!