Marginal Absorption Costing

Professional Development Programme on Enriching Knowledge of the Business, Accounting and Financial Studies (BAFS) Curriculum

Technology Education Section, Curriculum Development InstituteEducation Bureau, HKSARG

August 2008

Unit 7 : Marginal and Absorption CostingCourse 1 : Contemporary Perspectives on Accounting

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Learning objectivesLearning objectivesOn completion of this unit, you should be able to:On completion of this unit, you should be able to:1.1. Distinguish between direct and indirect costs, fixed Distinguish between direct and indirect costs, fixed and variable costs, factory and administrative and variable costs, factory and administrative overheads, product costs and period costs.overheads, product costs and period costs.2.2. Understand the process of cost allocation and Understand the process of cost allocation and apportionment in marginal and absorption costing.apportionment in marginal and absorption costing.3.3. Calculate stock valuations using marginal and Calculate stock valuations using marginal and absorption costing.absorption costing.4.4. Preparing operating statements using marginal and Preparing operating statements using marginal and absorption costing.absorption costing.5.5. Reconcile the profits and losses from marginal and Reconcile the profits and losses from marginal and absorption costing.absorption costing.6.6. Compare the advantages and disadvantages using Compare the advantages and disadvantages using marginal and absorption costing.marginal and absorption costing.

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ContentContent

1.1. Costs, cost unit and classification of costsCosts, cost unit and classification of costs2.2. Absorption costingAbsorption costing3.3. Marginal costingMarginal costing4.4. Illustrations of absorption costing and marginal costingIllustrations of absorption costing and marginal costing5.5. Illustration of multipleIllustration of multiple--period absorption costing and period absorption costing and

marginal costing income statementsmarginal costing income statements6.6. Advantages and disadvantages of absorption costing Advantages and disadvantages of absorption costing

and marginal costingand marginal costing

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OrganisationOrganisation of Unit 7of Unit 7Management Accounting

AbsorptionCosting MarginalCosting

Illustration Illustration

Advantages and disadvantages

Advantages and disadvantages

Costs, cost unit and classification of costs

Multiple Period Illustration Multiple Period Illustration

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Management accounting (1)

Units 1 to 4Units 1 to 4 deal with deal with financial accountingfinancial accounting..

The major purpose of The major purpose of financial accounting financial accounting is to provide is to provide investors and other external users with useful information investors and other external users with useful information about the financial position, performance and changes in about the financial position, performance and changes in financial position of a company.financial position of a company.

Units 5 and 6Units 5 and 6 deal with two related topics, namely deal with two related topics, namely ICT ICT Applications in AccountingApplications in Accounting and and Ethical Issues in Ethical Issues in AccountingAccounting..

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Management accounting (2)

To achieve a companyTo achieve a companys objectives, s objectives, management management accountingaccounting provides managers with reliable and timely provides managers with reliable and timely information for planning, evaluating and rewarding information for planning, evaluating and rewarding performance. performance.

This Unit, together with Units 8 and 9This Unit, together with Units 8 and 9 introduce the introduce the foundations of management accounting.foundations of management accounting.

This UnitThis Unit will deal with accounting for manufacturing will deal with accounting for manufacturing operations under both absorption costing and marginal operations under both absorption costing and marginal costing systems.costing systems.

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Management accounting (3)

Unit 8Unit 8 explains how costexplains how cost--volumevolume--profit (CVP) analysis is profit (CVP) analysis is applied by managers to answer various operating applied by managers to answer various operating decisions, such as what level of sales is required to break decisions, such as what level of sales is required to break even, how many units of a product is to be sold in order to even, how many units of a product is to be sold in order to earn a target level of operating profit, etc. earn a target level of operating profit, etc.

Unit 9Unit 9 focuses on shortfocuses on short--run decision making. The Unit run decision making. The Unit describes how relevant costs, such as opportunity costs describes how relevant costs, such as opportunity costs and incremental costs, are applied to specific decisions, and incremental costs, are applied to specific decisions, including hire, make or buy, special order decisions.including hire, make or buy, special order decisions.

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Management accounting (4)

Unit 10Unit 10 will deal with the areas of knowledge in will deal with the areas of knowledge in financial financial managementmanagement a closely related business knowledge to a closely related business knowledge to management accounting. The Unit describes how the management accounting. The Unit describes how the basic capital investment methods are applied to evaluate basic capital investment methods are applied to evaluate capital projects: accounting rate of return, payback period, capital projects: accounting rate of return, payback period, net present value and internal rate of return.net present value and internal rate of return.

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1. Costs, cost unit and classification of costs (1)

CostsCosts are the amount of expenditure incurred as a result are the amount of expenditure incurred as a result of producing the goods for sale.of producing the goods for sale.

Total costsTotal costs = Quantity x Unit cost of product= Quantity x Unit cost of product

A A cost unitcost unit is a unit of product in relation to which, costs is a unit of product in relation to which, costs are ascertained. For example, it can be a car, a table, etc.are ascertained. For example, it can be a car, a table, etc.

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1. Costs, cost unit and 1. Costs, cost unit and classification of costs classification of costs (2)(2)

Costing ProcessCosting Process-- Raw input cost data are processed to become useful Raw input cost data are processed to become useful cost information through the different costing systems, cost information through the different costing systems, e.g.:e.g.:

i)i) absorption (or full) costingabsorption (or full) costingii)ii) marginal (or variable) costingmarginal (or variable) costing

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1. Costs, cost unit and 1. Costs, cost unit and classification of costs classification of costs (3)(3)

A.A. Costs can be classified by its relation to cost unit:Costs can be classified by its relation to cost unit:i)i) direct costsdirect costs; and; andii)ii) indirect costsindirect costs..

B.B. Costs can be classified by its behavior to output:Costs can be classified by its behavior to output:i)i) variable costsvariable costs; and; andii)ii) fixed costsfixed costs..

C.C. Costs can be classified by its presentation in financial Costs can be classified by its presentation in financial statements:statements:i)i) product costsproduct costs; and; andii)ii) period costsperiod costs..

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1. A. i) Direct costs 1. A. i) Direct costs (1)(1)Direct costs Direct costs are costs that are costs that can be identified specifically can be identified specifically and directly traceable to a cost unit.and directly traceable to a cost unit.They include:They include:i)i) Direct materialsDirect materials the materials that actually become the materials that actually become part of the cost unit, e.g. components in computers.part of the cost unit, e.g. components in computers.ii)ii) Direct labourDirect labour the remuneration paid to workers the remuneration paid to workers whose work is directly related to production, e.g. whose work is directly related to production, e.g. sewing labour cost in garment factory.sewing labour cost in garment factory.iii)iii) Direct expensesDirect expenses other costs that are directly incurred other costs that are directly incurred on a specific cost unit, e.g. hire of a special plant.on a specific cost unit, e.g. hire of a special plant.

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1. A. i) Direct costs 1. A. i) Direct costs (2)(2)

Prime costsPrime costs

Prime costs are the direct costs that are consumed in Prime costs are the direct costs that are consumed in production.production.

Prime costs = Direct materials + Direct labour Prime costs = Direct materials + Direct labour + Direct expenses+ Direct expenses

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1. A. ii) Indirect costs 1. A. ii) Indirect costs (1)(1)Indirect costsIndirect costs are costs that cannot be identified specifically are costs that cannot be identified specifically or directly traceable to a cost unit. or directly traceable to a cost unit. They include:They include:i)i) Indirect materialsIndirect materials materials that form part of the materials that form part of the products and that can be identified but are too products and that can be identified but are too insignificant in value, e.g. spare parts for machinery.insignificant in value, e.g. spare parts for machinery.ii)ii) Indirect labourIndirect labour salaries of factory supervision staff that salaries of factory supervision staff that are not directly involved in the production of products, are not directly involved in the production of products, e.g. wages of maintenance staff.e.g. wages of maintenance staff.iii)iii) Indirect expensesIndirect expenses other costs that are either other costs that are either impossible or inconvenient to charge directly to a cost impossible or inconvenient to charge directly to a cost unit, e.g. equipment repairs.unit, e.g. equipment repairs.

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1. A. ii) Indirect costs 1. A. ii) Indirect costs (2)(2)

OverheadsOverheads include all indirect costs that cannot be include all indirect costs that cannot be identified specifically or directly traceable to a cost unit.identified specifically or directly traceable to a cost unit.

Overheads = Indirect materials + Indirect labour Overheads = Indirect materials + Indirect labour + Indirect expenses + Indirect expenses

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11. B. i) Variable cost. B. i) Variable costVariable costVariable cost is a cost that varies in approximate is a cost that varies in approximate proportion to changes in the level of activity, e.g. the proportion to changes in the level of activity, e.g. the airline fuel expense is directly proportionate to the airline fuel expense is directly proportionate to the passage miles.passage miles.The relationship between cost and output can often be The relationship between cost and output can often be described as linear:described as linear:

Total variable costs = Total variable costs = bb xxwhere where bb = a constant dollar amount, = a constant dollar amount,

representing the variable cost per unrepresenting the variable cost per unit it x = production volume in unitsx = production volume in units

(Note: The graphical presentation of cost (Note: The graphical presentation of cost behaviorbehavior will be will be introduced in Unit 8.)introduced in Unit 8.)

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1. B. ii) Fixed cost1. B. ii) Fixed cost

Fixed costFixed cost is a cost that remains unchanged or does not is a cost that remains unchanged or does not change significantly in response to the level of activity, e.g.change significantly in response to the level of activity, e.g.depreciation of airplane does not vary with passage miles.depreciation of airplane does not vary with passage miles.

Total fixed costs = Total fixed costs = aawhere where aa = a constant dollar amount = a constant dollar amount

(Note: The graphical presentation of cost (Note: The graphical presentation of cost behaviorbehavior will be will be introduced in Unit 8.)introduced in Unit 8.)

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1. B. iii) Semi1. B. iii) Semi--variable costvariable cost

SemiSemi--variable costvariable cost contains both fixed and variable contains both fixed and variable components.components.

It increases or decreases with activity levels but not in It increases or decreases with activity levels but not in direct proportion, e.g. the cost of telephone expense direct proportion, e.g. the cost of telephone expense comprises a fixed rental charge plus a variable charge for comprises a fixed rental charge plus a variable charge for long distance calls.long distance calls.

Total semiTotal semi--variable costs = variable costs = a a + + b b xxwhere where aa = total fixed costs = total fixed costs

bb = variable cost per unit= variable cost per unitx = production volume in unitsx = production volume in units

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1. C. Product costs and Period cost 1. C. Product costs and Period cost (1)(1)

Product costs are those costs incurred to manufacture the products and included in the stock valuation.

Period costs are those costs associated with time periods, rather than with the manufacturing of the stock.

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1. C. Product costs and Period costs (2)

Product costs

Product Product costscosts

Balance Sheet: record as Inventory

Balance Sheet: Balance Sheet: record as record as InventoryInventory

Period costs

Period Period costscosts

Income Statement:

record as cost of goods sold and

operating expenses

Income Income Statement:Statement:

record as cost of record as cost of goods sold and goods sold and

operating operating expensesexpenses

Unsold

Sold in same period

Sold in Sold in future future

periodsperiods

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1. C. Product costs and Period costs 1. C. Product costs and Period costs (3)(3)

ExampleFortune Ltd has the following cost information for January:Product costs = $100,000Period costs = $80,00050% of the output for January is sold and there are noopening stock.Required:Calculate the total costs of output for January.Calculate the total costs of output for January.

Answer in next pageAnswer in next page

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Answer

130,000Total costs of output for January 80,000Period costs 50,000Cost of goods sold50,000Less: Closing stock (50%)

100,000Product costs$

The total costs of output for January is:

1. C. Product costs and Period costs 1. C. Product costs and Period costs (4)(4)

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1. D. Total costs in a manufacturing firm 1. D. Total costs in a manufacturing firm (1)(1)

Total costsTotal costs = Total direct costs + Total indirect costs= Total direct costs + Total indirect costs= Prime costs + Factory overheads = Prime costs + Factory overheads

+ Administrative expenses+ Administrative expenses+ Selling expenses+ Selling expenses+ Finance expenses+ Finance expenses

Production costs are total of prime costs and indirect production costs incurred during production.A summary of the costs and their relationships is shown in Figure 1 in next page.

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1. D. Total costs in a manufacturing firm 1. D. Total costs in a manufacturing firm (2)(2)

Direct materialsDirect labourDirect expenses

Direct materialsDirect materialsDirect Direct labourlabourDirect expensesDirect expenses Factory

overheadsFactory Factory

overheadsoverheads

Production costs

Production Production costscosts

Period costs:Administrative,

Selling and Finance expenses

Period costs:Period costs:Administrative,Administrative,

Selling and Finance Selling and Finance expensesexpenses

Total costsTotal costsTotal costs

Prime costsPrime costsPrime costs++

Product costs:Cost of goods

sold

Product costs:Product costs:Cost of goods Cost of goods

soldsold++

Indirect materialsIndirect labourIndirect expenses

Indirect materialsIndirect materialsIndirect Indirect labourlabourIndirect expensesIndirect expenses

Expenses shown in Income Statement

Expenses shown Expenses shown in Income in Income StatementStatement

The flow of costs for a manufacturing firm is shown in Figure 1 The flow of costs for a manufacturing firm is shown in Figure 1 below:below:

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2. Absorption costing 2. Absorption costing (1)(1)

The principle of The principle of absorption costingabsorption costing is to attribute all costs, is to attribute all costs, including the application (or absorption) of overhead costs including the application (or absorption) of overhead costs to cost units according to the activity level.to cost units according to the activity level.

Thus, under absorption costing, operating statements do Thus, under absorption costing, operating statements do not distinguish between fixed and variable costs. Valuation not distinguish between fixed and variable costs. Valuation of stock and workof stock and work--inin--progress contains both fixed and progress contains both fixed and variable costs.variable costs.

Absorption costing is the basis of preparing financial Absorption costing is the basis of preparing financial statements for the external users.statements for the external users.

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2. Absorption costing 2. Absorption costing (2)(2)The procedures of absorption costing are:The procedures of absorption costing are:A. Ascertain and charge theA. Ascertain and charge the prime costsprime costs::

i)i) Direct materialsDirect materialsDirect materials = Opening direct materials stockDirect materials = Opening direct materials stock

+ Purchases+ Purchases-- Closing direct materials stock Closing direct materials stock = Cost of direct materials used= Cost of direct materials used

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2. Absorption costing 2. Absorption costing (3)(3)

ii)ii) Direct Direct labourlabour

Direct Direct labourlabour = = LabourLabour rate applied x No. of rate applied x No. of labourlabour hourshours

iii) Direct expensesiii) Direct expenses

Direct expenses = Expense rate per unit x Unit of Direct expenses = Expense rate per unit x Unit of productionproduction

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2. Absorption costing 2. Absorption costing (4)(4)

B. Absorption of B. Absorption of factory overheadsfactory overheads::

The objective of the overhead absorption process is to The objective of the overhead absorption process is to take up in the total costs of a product a fair and take up in the total costs of a product a fair and appropriate share of the companyappropriate share of the companys total factory s total factory overheads. overheads.

Factory overheads are allocated to the cost centre of Factory overheads are allocated to the cost centre of the product. The quantity of outputs is used to absorb the product. The quantity of outputs is used to absorb the overheads.the overheads.

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2. Absorption costing 2. Absorption costing (5)(5)

If there are more than one cost centre and product, If there are more than one cost centre and product, factory overheads are firstly apportioned by a fair and factory overheads are firstly apportioned by a fair and appropriate basis, e.g. floor areas, into the cost centre appropriate basis, e.g. floor areas, into the cost centre of the product concerned. Then the quantity of outputs of the product concerned. Then the quantity of outputs in that centre is used to absorb the overheads.in that centre is used to absorb the overheads.

C.C. Production costsProduction costs= Prime costs + Absorbed factory overheads= Prime costs + Absorbed factory overheads

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3. Marginal costing 3. Marginal costing (1)(1)

Under Under marginal costingmarginal costing, only variable production costs , only variable production costs are charged to cost units. Fixed costs are recognised are charged to cost units. Fixed costs are recognised as expenses when incurred.as expenses when incurred.

Marginal costing is more easy to apply than Marginal costing is more easy to apply than absorption costing since no absorption of fixed absorption costing since no absorption of fixed overheads into cost of good sold is required.overheads into cost of good sold is required.

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3. Marginal costing 3. Marginal costing (2)(2)

The procedures of marginal costing are:The procedures of marginal costing are:

A.A. Ascertain all variableAscertain all variable costscosts and allocate them into and allocate them into prime costs, variable factory overheads to arrive at prime costs, variable factory overheads to arrive at the variable cost of goods sold and together with the the variable cost of goods sold and together with the other variable components grouped under the other variable components grouped under the variablevariable costscosts item.item.

i)i) Prime costs Prime costs = Direct materials + Direct = Direct materials + Direct labourlabour + +

Direct expensesDirect expenses

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3. Marginal costing 3. Marginal costing (3)(3)

ii)ii) Factory overheads are divided into variable and fixed Factory overheads are divided into variable and fixed components respectively.components respectively.

Prime costs and variable factory overheads are added Prime costs and variable factory overheads are added up to give the up to give the variable cost of good soldvariable cost of good sold; fixed factory ; fixed factory overheads are grouped under the overheads are grouped under the fixed costsfixed costs item.item.

iii)iii) Selling, administrative and finance expenses are Selling, administrative and finance expenses are divided into variable and fixed divided into variable and fixed components and components and grouped under their categories respectively.grouped under their categories respectively.

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3. Marginal costing 3. Marginal costing (4)(4)

B. B. Allocate all fixed overhead componentsAllocate all fixed overhead components under the under the fixed costsfixed costs item:item:

All fixed factory overheads, selling, administrative and All fixed factory overheads, selling, administrative and finance expenses are grouped under the finance expenses are grouped under the fixed costsfixed costsitem.item.

C.C. Total costsTotal costs= Variable costs of goods sold = Variable costs of goods sold

+ Variable selling, administrative and finance + Variable selling, administrative and finance expenses expenses

+ Fixed costs+ Fixed costs

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4. Illustrations of absorption costing 4. Illustrations of absorption costing and marginal costing and marginal costing (1)(1)

Absorption costing and marginal costing do not usually Absorption costing and marginal costing do not usually provide the same assessment of profit.provide the same assessment of profit.

The different profit figures are due to the difference in the The different profit figures are due to the difference in the net change in stock valuation between the beginning and net change in stock valuation between the beginning and the end of that accounting period.the end of that accounting period.

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In a period, 40,000 units of goods were produced and sold.In a period, 40,000 units of goods were produced and sold.The revenues and costs were as follows:The revenues and costs were as follows:

Required:Required:Prepare operating statements based on both absorption Prepare operating statements based on both absorption costing and marginal costing.costing and marginal costing.

50,000FixedAdministrative and selling overheads:

30,000Fixed70,000Variable

Production costs:$200,000Sales (40,000 x $5)

4. Illustrations of absorption costing 4. Illustrations of absorption costing and marginal costing and marginal costing (2)(2)

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Solution:Solution:Operating statement Operating statement absorption costingabsorption costing

50,000Net profit50,000Less: Administrative and selling overheads

100,000Gross profit100,000Less: Cost of goods sold200,000Sales

$

4. Illustrations of absorption costing 4. Illustrations of absorption costing and marginal costing and marginal costing (3)(3)

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Operating statement Operating statement marginal costingmarginal costing

50,000Net profit80,00050,000Administrative and selling

30,000ProductionLess: Fixed costs

130,000Contribution

70,000Less: Variable cost of goods sold

200,000Sales$$

4. Illustrations of absorption costing 4. Illustrations of absorption costing and marginal costing and marginal costing (4)(4)

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In the above example when sales equal production and In the above example when sales equal production and so no stock exists at the end of the period, both so no stock exists at the end of the period, both absorption costing and marginal costing systems absorption costing and marginal costing systems produce the same profit figure.produce the same profit figure.

4. Illustrations of absorption costing 4. Illustrations of absorption costing and marginal costing and marginal costing (5)(5)

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Further illustrationFurther illustration

Assume the same data as in previous illustration except Assume the same data as in previous illustration except that only 36,000 of the 40,000 units produced were sold, that only 36,000 of the 40,000 units produced were sold, and so 4,000 units being carried forward as stock to the and so 4,000 units being carried forward as stock to the next period.next period.

Required:Required:

Prepare operating statements based on absorption Prepare operating statements based on absorption costing and marginal costing systems.costing and marginal costing systems.

4. Illustrations of absorption costing 4. Illustrations of absorption costing and marginal costing and marginal costing (6)(6)

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Solution:Solution:Operating statement Operating statement absorption costingabsorption costing

** Unit absorption cost = Average production costsUnit absorption cost = Average production costs= $100,000 / 40,000 units= $100,000 / 40,000 units= = $2.5 per unit$2.5 per unit

40,000 40,000 Net profitNet profit50,000 50,000 Less: Administrative and selling overheadsLess: Administrative and selling overheads90,000 90,000 Gross profitGross profit90,000 90,000

10,00010,000Less: Closing stock (4,000 x 2.5*)Less: Closing stock (4,000 x 2.5*)100,000 100,000 Production costsProduction costs

Less: Cost of goods soldLess: Cost of goods sold180,000 180,000 Sales (36,000 x $5) Sales (36,000 x $5)

$$$

4. Illustrations of absorption costing 4. Illustrations of absorption costing and marginal costing and marginal costing (7)(7)

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Operating statement Operating statement marginal costingmarginal costing

** Unit variable costs = $70,000 / 40,000 unitsUnit variable costs = $70,000 / 40,000 units= = $1.75 per unit$1.75 per unit

$$$

37,000 37,000 Net profitNet profit80,000 80,000

50,00050,000Administrative and sellingAdministrative and selling30,000 30,000 ProductionProduction

Less: Fixed costsLess: Fixed costs117,000 117,000 ContributionContribution63,0007,000Less: Closing stock (4,000 x 1.75*)Less: Closing stock (4,000 x 1.75*)

70,000 70,000 Less:Less: Variable cost of goods soldVariable cost of goods sold180,000 180,000 Sales (36,000 x $5)Sales (36,000 x $5)

4. Illustrations of absorption costing 4. Illustrations of absorption costing and marginal costing and marginal costing (8)(8)

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4. Illustrations of absorption costing 4. Illustrations of absorption costing and marginal costing and marginal costing (9)(9)

You may notice that the value of closing stock differs in You may notice that the value of closing stock differs in absorption costing and marginal costing.absorption costing and marginal costing.

This is because absorption costing transfers some of the This is because absorption costing transfers some of the periodperiods fixed costs which are included in the closing s fixed costs which are included in the closing stock to the next period, but marginal costing stock to the next period, but marginal costing recognisesrecognisesall fixed costs as expenses in the period they are all fixed costs as expenses in the period they are incurred.incurred.

Therefore in a period with increasing stock, absorption Therefore in a period with increasing stock, absorption costing will show higher profit than marginal costing.costing will show higher profit than marginal costing.

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5. Illustration of multiple5. Illustration of multiple--period absorption costing period absorption costing and marginal costing income statements and marginal costing income statements (1)(1)

In preparing accounts based on absorption costing and In preparing accounts based on absorption costing and marginal costing, you can see that the main difference marginal costing, you can see that the main difference is how to handle the fixed factory overheads.is how to handle the fixed factory overheads.

This can be shown in Figure 2 in next page.This can be shown in Figure 2 in next page.

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5.5. Illustration of multipleIllustration of multiple--period absorption costing period absorption costing and marginal costing income statements and marginal costing income statements (2)(2)

Absorption costingAbsorption costing

Direct materials Direct materials + Direct + Direct labourlabour

+ Variable factory overheads+ Variable factory overheads+ + Fixed factoryFixed factory

overheadsoverheads

StockStock

Cost of good soldCost of good sold

Selling, administrative & Selling, administrative & finance expensesfinance expenses

Marginal costingMarginal costingDirect materials Direct materials + Direct + Direct labourlabour

+ Variable factory+ Variable factoryoverheadsoverheads

StockStockVariable cost of good soldVariable cost of good sold

Fixed factoryFixed factoryoverheadsoverheads

+ Fixed selling, administrative & + Fixed selling, administrative & finance expensesfinance expenses

++++

Variable selling, administrative Variable selling, administrative & finance expenses& finance expenses++

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5.5. Illustration of multipleIllustration of multiple--period absorption costing period absorption costing and marginal costing income statements and marginal costing income statements (3)(3)

Since the stock values for absorption costing and marginal Since the stock values for absorption costing and marginal costing are different, and stock is written off as cost of costing are different, and stock is written off as cost of good sold only when they are sold, the profits for good sold only when they are sold, the profits for absorption costing and marginal costing will also be absorption costing and marginal costing will also be different for each period.different for each period.

The difference in reported profits between absorption The difference in reported profits between absorption costing and marginal costing in a period is costing and marginal costing in a period is a timing a timing differencedifference only. The overall profits remain the same across only. The overall profits remain the same across the total multiple periods. This can be shown by the the total multiple periods. This can be shown by the illustration of multipleillustration of multiple--period income statements in next period income statements in next slide. slide.

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5. Illustration of multiple5. Illustration of multiple--period absorption costing period absorption costing and marginal costing income statements and marginal costing income statements (4)(4)

GamboGambo Ltd manufactures only baby shampoo. The sales, Ltd manufactures only baby shampoo. The sales, production and stock figures are as follows:production and stock figures are as follows:

00

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10,00010,000

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20,00020,000

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00

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Closing stock (bottle)Closing stock (bottle)

Selling price per bottleSelling price per bottle

10,00010,00020,00020,0000000Opening stock (bottle)Opening stock (bottle)30,00030,00020,00020,00040,00040,00025,00025,000Production (bottle)Production (bottle)40,00040,00030,00030,00020,00020,00025,00025,000Sales (bottle)Sales (bottle)Year 4Year 4Year 3Year 3Year 2Year 2Year 1Year 1(bottle) (bottle) \\ ($)($)

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5. Illustration of multiple5. Illustration of multiple--period absorption costing period absorption costing and marginal costing income statements and marginal costing income statements (5)(5)

The following absorption rates are used:The following absorption rates are used:

GamboGambo Ltd uses 25,000 bottles as the base for allocation of fixed cosLtd uses 25,000 bottles as the base for allocation of fixed costs.ts.TwoTwo--third of the production overheads are fixed costs. third of the production overheads are fixed costs. All administrative and selling overheads of $80,000 are fixed coAll administrative and selling overheads of $80,000 are fixed costs.sts.

Required:Required:Prepare multiplePrepare multiple--period income statements for year 1 to 4 using absorption period income statements for year 1 to 4 using absorption costing and marginal costing.costing and marginal costing.Note: Reconcile the difference in profits arising from overhead Note: Reconcile the difference in profits arising from overhead absorption.absorption.

6.006.00Production costProduction cost3.003.00Production overheads (150% of direct Production overheads (150% of direct labourlabour rate)rate)2.002.00Direct Direct labourlabour1.001.00Direct materialsDirect materials

Cost per bottle ($)Cost per bottle ($)

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5. Illustration of multiple5. Illustration of multiple--period absorption costing period absorption costing and marginal costing income statementsand marginal costing income statements (6)(6)

MultipleMultiple--period income statements period income statements -- absorption costingabsorption costing

($($000)000)($($000)000)($($000)000)($($000)000)

280280190190100100145145Net profitNet profit

8080808080808080Less: Administrative andLess: Administrative andselling overheadsselling overheads

360360270270180180225225Gross profitGross profit240240180180120120150150

00606012012000Less: Closing stockLess: Closing stock180180120120240240150150Add: Production costsAdd: Production costs

60601201200000Opening stockOpening stockLess: Cost of goods soldLess: Cost of goods sold

600600450450300300375375SalesSales

Year 4Year 4Year 3Year 3Year 2Year 2Year 1Year 1

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5. Illustration of multiple5. Illustration of multiple--period absorption costing period absorption costing and marginal costing income statementsand marginal costing income statements (7)(7)

Since the actual production differs from the planned production Since the actual production differs from the planned production for year 2 for year 2 to year 4, the fixed overheads that are absorbed into productionto year 4, the fixed overheads that are absorbed into production costs are costs are different.different.

Unit absorbed fixed overheadsUnit absorbed fixed overheads= 2/3 of production overheads= 2/3 of production overheads= 2/3 x $3 per bottle = = 2/3 x $3 per bottle = $2 per bottle$2 per bottle

+10,000+10,000--10,00010,000+30,000+30,00000Overhead over+ / under Overhead over+ / under --absorption ($) at $2.00 per bottle absorption ($) at $2.00 per bottle

+5,000+5,000--5,0005,000+15,000+15,00000Difference (bottle)Difference (bottle)30,00030,00020,00020,00040,00040,00025,00025,000Actual production (bottle)Actual production (bottle)25,00025,00025,00025,00025,00025,00025,00025,000Planned production (bottle)Planned production (bottle)

Year 4 Year 4 Year 3 Year 3 Year 2 Year 2 Year 1Year 1

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5. Illustration of multiple5. Illustration of multiple--period absorption costing period absorption costing and marginal costing income statementsand marginal costing income statements (8)(8)

MultipleMultiple--period income statements period income statements -- marginal costingmarginal costingFixed production overheads:Fixed production overheads:Direct Direct labourlabour for 25,000 bottles = 25,000 x $2 per bottle = for 25,000 bottles = 25,000 x $2 per bottle = $50,000$50,000Fixed production overheads = $50,000 x 150% x 2/3 = Fixed production overheads = $50,000 x 150% x 2/3 = $50,000$50,000Variable production overheads = $(3 Variable production overheads = $(3 -- 2) per bottle = 2) per bottle = $1 per bottle$1 per bottle

4.004.00Variable production cost Variable production cost 1.001.00Variable production overheadsVariable production overheads2.002.00Direct Direct labourlabour1.001.00Direct materialsDirect materials

Cost per bottle ($)Cost per bottle ($)

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5. Illustration of multiple5. Illustration of multiple--period absorption costing period absorption costing and marginal costing income statementsand marginal costing income statements (9)(9)

MultipleMultiple--period income statements period income statements -- marginal costingmarginal costing

3103102002009090145145Net profitNet profit

5050505050505050ProductionProduction8080808080808080Administrative and sellingAdministrative and selling

overheadsoverheads130130130130130130130130

Fixed costsFixed costs440440330330220220275275ContributionContribution1601601201208080100100__0__0_40_40_80_80__0__0Less: Closing stockLess: Closing stock1201208080160160100100Add: Production costsAdd: Production costs

404080800000Opening stockOpening stockLess: Variable cost of goods soldLess: Variable cost of goods sold

600600450450300300375375SalesSales

Year 4 Year 4 ($($000)000)

Year 3 Year 3 ($($000)000)

Year 2 Year 2 ($($000)000)

Year 1 Year 1 ($($000 )000 )

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5. Illustration of multiple5. Illustration of multiple--period absorption costing period absorption costing and marginal costing income statementsand marginal costing income statements (10)(10)

Reconciliation of net profitReconciliation of net profit

Profits for year 1 are the same for marginal costing and absorptProfits for year 1 are the same for marginal costing and absorption costing ion costing because there is no opening stock or closing stock. All productibecause there is no opening stock or closing stock. All production overheads on overheads absorbed to the cost units are the same. For year 2 to 4, the prabsorbed to the cost units are the same. For year 2 to 4, the production outputs oduction outputs are different and therefore the unit cost of stock and costs of are different and therefore the unit cost of stock and costs of goods sold are goods sold are different, and the net profits are also different.different, and the net profits are also different.After the overAfter the over--absorbed overheads are accounted for, you can see that the totalabsorbed overheads are accounted for, you can see that the totalnet profits across the 4 years are the same for both the absorptnet profits across the 4 years are the same for both the absorption costing and ion costing and marginal costing.marginal costing.

745745745745

003030OverOver--absorbed production absorbed production overheadsoverheads

3103102802804420020019019033909010010022

14514514514511Marginal costingMarginal costingAbsorption costingAbsorption costingYear Year \\ Net profit ($Net profit ($000)000)

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6. Advantages and disadvantages of absorption 6. Advantages and disadvantages of absorption costing and marginal costingcosting and marginal costing (1)(1)

Marginal costingMarginal costing

Advantages:Advantages:i)i) Simple to use. Only direct costs are used for Simple to use. Only direct costs are used for

calculation. There is no need to apportion fixed costs calculation. There is no need to apportion fixed costs to products.to products.

ii)ii) When sales are constant, marginal costing shows a When sales are constant, marginal costing shows a constant net profit even production fluctuates. constant net profit even production fluctuates. However, absorption costing will show varying However, absorption costing will show varying amounts of net profit depending on the production amounts of net profit depending on the production levels.levels.

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6. Advantages and disadvantages of absorption 6. Advantages and disadvantages of absorption costing and marginal costingcosting and marginal costing (2)(2)

Marginal costingMarginal costing

Advantages:Advantages:

iii)iii) Fixed costs are accounted for in the period when Fixed costs are accounted for in the period when incurred and there is no need to relate them to the incurred and there is no need to relate them to the level of activity.level of activity.

iv)iv) The problem of under or overThe problem of under or over--absorption of absorption of overheads is avoided because fixed costs are overheads is avoided because fixed costs are treated as period costs.treated as period costs.

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6. Advantages and disadvantages of absorption 6. Advantages and disadvantages of absorption costing and marginal costingcosting and marginal costing (3)(3)

Marginal costingMarginal costingDisadvantagesDisadvantagesi)i) Too much focus on marginal costing may mislead the Too much focus on marginal costing may mislead the company to set a price below the total costs and company to set a price below the total costs and result in loss in the long run.result in loss in the long run.ii)ii) If the production department runs in full capacity, the If the production department runs in full capacity, the marginal cost will become inaccurate to be reflected marginal cost will become inaccurate to be reflected as the cost to produce an additional unit.as the cost to produce an additional unit.

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6. Advantages and disadvantages of absorption 6. Advantages and disadvantages of absorption costing and marginal costingcosting and marginal costing (4)(4)

Absorption costingAbsorption costing

AdvantagesAdvantagesi)i) Fixed costs are substantial portion of costs incurred Fixed costs are substantial portion of costs incurred

in most production plants, and should be absorbed in in most production plants, and should be absorbed in cost of goods manufactured.cost of goods manufactured.

ii)ii) If production is constant and sales fluctuate, the net If production is constant and sales fluctuate, the net profit figures for absorption costing fluctuate less profit figures for absorption costing fluctuate less than marginal costing since part of the fixed costs than marginal costing since part of the fixed costs are absorbed into the stock. are absorbed into the stock.

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6. Advantages and disadvantages of absorption 6. Advantages and disadvantages of absorption costing and marginal costingcosting and marginal costing (5)(5)

Absorption costingAbsorption costingAdvantagesAdvantagesiii)iii) For industries requiring a significant amount of fixed For industries requiring a significant amount of fixed costs incurred in the early production stage like timber costs incurred in the early production stage like timber building, firework manufacture, etc, absorption costing building, firework manufacture, etc, absorption costing will be a more appropriate system; otherwise a will be a more appropriate system; otherwise a fictitious loss will be shown at the beginning. fictitious loss will be shown at the beginning. iv)iv) HKAS 2 HKAS 2 InventoriesInventories requires the use of absorption requires the use of absorption costing for financial statements prepared for external costing for financial statements prepared for external use.use.

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6. Advantages and disadvantages of absorption 6. Advantages and disadvantages of absorption costing and marginal costingcosting and marginal costing (6)(6)

Absorption costingAbsorption costingDisadvantagesDisadvantagesi)i) Even when sales are constant, absorption costing Even when sales are constant, absorption costing shows various amount of net profits whenever shows various amount of net profits whenever production fluctuates.production fluctuates.ii)ii) The cost absorbed may be inaccurate. Significant The cost absorbed may be inaccurate. Significant overover--absorption or underabsorption or under--absorption costs may arise.absorption costs may arise.iii)iii) If more than one products are produced, the If more than one products are produced, the apportionment of fixed costs into the cost units may not apportionment of fixed costs into the cost units may not be fair enough to reflect their share of overheads. be fair enough to reflect their share of overheads.

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6.6. Advantages and disadvantages of absorption Advantages and disadvantages of absorption costing and marginal costing costing and marginal costing (7)(7)

There is no general answer which costing system is There is no general answer which costing system is better. better.

Accountants should judge whether absorption Accountants should judge whether absorption costing or marginal costing is more appropriate for costing or marginal costing is more appropriate for their particular uses. their particular uses.

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7. Recapitulation7. Recapitulation

After reading the above materials, you should be able to: Understand the concept of costs, cost unit and Understand the concept of costs, cost unit and classification of costs classification of costs Explain the process of absorption costing and marginal Explain the process of absorption costing and marginal costing.costing. Perform calculation on cost and stock valuation by Perform calculation on cost and stock valuation by absorption costing and marginal costing.absorption costing and marginal costing. Apply absorption costing and marginal costing to Apply absorption costing and marginal costing to preparing income statements.preparing income statements. Understand the effect of absorption costing and Understand the effect of absorption costing and marginal costing in multiplemarginal costing in multiple--period income statements. period income statements. Compare the advantages and disadvantages of Compare the advantages and disadvantages of absorption costing and marginal costing.absorption costing and marginal costing.

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8. Further readings8. Further readings Lucey, T. (2002), Costing, London: Thomson, 6th Edition, Chapter 19, Marginal and Absorption Costing. (ISBN 0-8264-5510-7) Li, T. M. and Ng, P. H. (2007), HKAL - Principles of

Accounts (Volume 2), Pilot Publishing Company Ltd, 2nd Edition, Chapter 23, Absorption and Marginal Costing. (ISBN 962-397-772-7)

Jiambalvo, J. (2003), Managerial Accounting, New York: John Wiley & Sons, 3rd Edition, Chapter 5, Variable Costing. (ISBN 0-471-23823-6) :

225-246(ISBN 957-14-3525-2)

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End of the UnitEnd of the Unit

This is the end of Unit 7. This is the end of Unit 7. Please go to the Unit Please go to the Unit Assessment before Assessment before attempting the next unit.attempting the next unit.

EndEnd--ofof--unit Assessmentunit Assessment