ACCA F2 Management Accounting - 2010 - Study text - Emile Woolf Publishing
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Chapter 8: Marginal costing and absorption costing
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3.2 The difference in profit between marginal costing and absorption costing
The profit for an accounting period calculated with marginal costing is different
from the profit calculated with absorption costing. The difference in profit is due
entirely to the differences in inventory valuation.
When there is no opening or closing inventory, exactly the same profit will be
reported using marginal costing and absorption costing.
The main difference between absorption costing and marginal costing is that:
in absorption costing, inventory cost includes a share of fixed production
overhead costs
in marginal costing, inventory cost contains no fixed production overhead costs.
The following rules may be applied to calculate the difference in the profit for a
period calculated with marginal costing and with absorption costing.
3.3 Calculating the difference in profit: increase in inventory during a
period
Look at the difference between the quantity of opening inventory and closing
inventory. Establish whether:
closing inventory is larger than opening inventory, or
closing inventory is less than opening inventory.
Closing inventory is higher than opening inventory when the quantity produced in
the period is more than the quantity sold. If the cost per unit is a constant amount,
using marginal costing or absorption costing, when the production quantity exceeds
the sales quantity:
There is an increase in inventory during a period
Closing inventory is therefore higher in value than opening inventory
The increase in inventory will be greater with absorption costing, by the amount
of the increase in fixed production costs in the inventory value
The production cost of sales is therefore lower with absorption costing than with
marginal costing, and the difference is this increase in fixed costs in the
inventory value
Therefore the profit is higher with absorption costing than with marginal
costing, by the amount of the increase in fixed costs in the inventory value.
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Basic rule: comparing marginal costing
and absorption costing profit
Production volume bigger than sales
volume
Increase in inventory
(closing – opening inventory)
Absorption costing profit higher than
marginal costing profit
Difference in profit = amount of fixed
production overhead in the increase in
inventory
Example
A company uses marginal costing. In the financial period that has just ended,
opening inventory was $8,000 and closing inventory was $15,000. The reported
profit for the year was $96,000.
If the company had used absorption costing, opening inventory would have been
$16,000 and closing inventory would have been $34,000.
Required
What would have been the profit for the year if absorption costing had been used?
Answer
There was an increase in inventory. It was $7,000 using marginal costing (= $15,000 –
$8,000). It would have been $19,000 using absorption costing.
$
Increase in inventory, marginal costing 7,000
Increase in inventory, absorption costing 19,000
Difference (profit higher with absorption costing) 12,000
Profit with marginal costing 96,000
Profit with absorption costing 108,000
Chapter 8: Marginal costing and absorption costing
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The profit is higher with absorption costing because there has been an increase in
inventory (production volume has been more than sales volume.)
3.4 Calculating the difference in profit: reduction in inventory during a
period
When there is a reduction in inventory during a period, and closing inventory is
lower in value than opening inventory, the reverse situation applies.
Closing inventory is lower than opening inventory when the quantity sold exceeds
the quantity produced in the period. If the cost per unit is a constant amount, using
marginal costing or absorption costing, when the sales quantity exceeds the
production quantity:
There is a reduction in inventory during a period.
Closing inventory is therefore lower in value than opening inventory
The reduction in inventory will be greater with absorption costing, by the fixed
production costs in the amount by which inventory has been reduced.
The production cost of sales is therefore higher with absorption costing than
with marginal costing, and the difference is the amount of fixed production costs
in the reduction in inventory value.
Therefore the profit is lower with absorption costing than with marginal costing,
by the amount of the fixed costs in the fall in inventory value.
Basic rule: comparing marginal costing
and absorption costing profit
Sales volume bigger than production
volume
Reduction in inventory
(closing – opening inventory)
Absorption costing profit lower than
marginal costing profit
Difference in profit = amount of fixed
production overhead in the reduction in
inventory
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Example
A company uses absorption costing. In the financial period that has just ended,
opening inventory was $76,000 and closing inventory was $49,000. The reported
profit for the year was $183,000.
If the company had used marginal costing, opening inventory would have been
$40,000 and closing inventory would have been $28,000.
Required
What would have been the profit for the year if marginal costing had been used?
Answer
There was a reduction in inventory. It was $27,000 using absorption costing (=
$76,000 – $49,000). It would have been $12,000 using marginal costing.
$
Reduction in inventory, absorption costing 27,000
Reduction in inventory, marginal costing 12,000
Difference (profit higher with marginal costing) 15,000
Profit with absorption costing 183,000
Profit with marginal costing 198,000
Profit is higher with marginal costing because there has been a reduction in
inventory during the period.
3.5 Summary: comparing marginal and absorption costing profit
An examination might test your ability to calculate the difference between the
reported profit using marginal costing and the reported profit using absorption
costing. To calculate the difference, you might need to make the following simple
calculations.
Calculate the increase or decrease in inventory during the period, in units.
Calculate the fixed production overhead cost per unit.
The difference in profit is the increase or decrease in inventory quantity
multiplied by the fixed production overhead cost per unit.
If there has been an increase in inventory, the absorption costing profit is higher.
If there has been a reduction in inventory, the absorption costing profit is lower.
You should ignore fixed selling overhead or fixed administration overhead.
These are written off in full as a period cost in both absorption costing and
marginal costing, and only fixed production overheads are included in
inventory values.
Chapter 8: Marginal costing and absorption costing
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Example
The following information relates to a manufacturing company for the next costing
period.
Production 16,000 units Fixed production costs $80,000
Sales 14,000 units Fixed selling costs $28,000
Using absorption costing, the profit for this period would be $60,000
Required
What would have been the profit for the year if marginal costing had been used?
Answer
Ignore the fixed selling overheads. These are irrelevant since they do not affect the
difference in profit between marginal and absorption costing.
There is an increase in inventory by 2,000 units, since production volume (16,000
units) is higher than sales volume (14,000 units).
If absorption costing is used, the fixed production overhead cost per unit is $5 (=
$80,000/16,000 units).
The difference between the absorption costing profit and marginal costing profit
is therefore $10,000 (= 2,000 units × $5).
Absorption costing profit is higher, because there has been an increase in
inventory.
Marginal costing profit would therefore be $60,000 – $10,000 = $50,000.
Exercise 2
A company budgets to make 37,000 units of a product and fixed production costs are
expected to be $111,000.
The budgeted direct costs of production are $5 per unit, and there are no variable
overhead costs. Budgeted sales are 40,000 units and the sales price is $11 per unit.
Budgeted administration overheads and selling and distribution overheads are
$80,000 (all fixed costs).
Required
(a) Calculate the expected profit for the period using marginal costing.
(b) Having calculated the marginal costing profit, calculate what the absorption
costing profit would be for the period. (Assume that the cost per unit of
opening inventory is the same as the cost per unit of closing inventory.)
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Advantages and disadvantages of absorption and marginal costing
Advantages and disadvantages of absorption costing
Advantages and disadvantages of marginal costing
4 Advantages and disadvantages of absorption and
marginal costing
The previous sections of this chapter have explained the differences between
marginal costing and absorption costing as methods of measuring profit in a period.
Some conclusions can be made from these differences.
The amount of profit reported in the cost accounts for a financial period will
depend on the method of costing used.
Since the reported profit differs according to the method of costing used, there
are presumably reasons why one method of costing might be used in preference
to the other. In other words, there must be some advantages (and disadvantages)
of using either method.
4.1 Advantages and disadvantages of absorption costing
Absorption costing has a number of advantages and disadvantages.
Advantages of absorption costing
Inventory values include an element of fixed production overheads. This is
consistent with the requirement in financial accounting that (for the purpose of
financial reporting) inventory should include production overhead costs.
Calculating under/over absorption of overheads may be useful in controlling
fixed overhead expenditure.
By calculating the full cost of sale for a product and comparing it will the selling
price, it should be possible to identify which products are profitable and which
are being sold at a loss.
Disadvantages of absorption costing
Absorption costing is a more complex costing system than marginal costing.
Absorption costing does not provide information that is useful for decision
making (like marginal costing does).
4.2 Advantages and disadvantages of marginal costing
Marginal costing has a number of advantages and disadvantages.
Chapter 8: Marginal costing and absorption costing
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Advantages of marginal costing
It is easy to account for fixed overheads using marginal costing. Instead of being
apportioned they are treated as period costs and written off in full as an expense
the income statement for the period when they occur.
There is no under/over-absorption of overheads with marginal costing, and
therefore no adjustment necessary in the income statement at the end of an
accounting period.
Marginal costing provides useful information for decision making.
Contribution per unit is constant, unlike profit per unit which varies as the
volume of activity varies.
Disadvantages of marginal costing
Marginal costing does not value inventory in accordance with the requirements
of financial reporting. (However, for the purpose of cost accounting and
providing management information, there is no reason why inventory values
should include fixed production overhead, other than consistency with the
financial accounts.)
Marginal costing can be used to measure the contribution per unit of product, or
the total contribution earned by a product, but this is not sufficient to decide
whether the product is profitable enough. Total contribution has to be big
enough to cover fixed costs and make a profit.
Practice multiple choice questions
1 The costs and sales revenue in a period are as follows.
$000
Direct materials 24
Direct labour 36
Direct expenses 5
Variable production overheads 6
Fixed production overheads 70
Administration overheads 30
Variable selling overheads 8
Fixed selling overheads 35
Sales 250
What is the total contribution for the period?
A $171,000
B $176,000
C $179,000
D $184,000
(2 marks)
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2 The following information relates to a manufacturing company for the next costing
period.
Production 24,000 units Fixed production costs $96,000
Sales 25,000 units Fixed selling costs $75,000
Using marginal costing, the profit for this period would be $65,000
Required
What would have been the profit for the year if absorption costing had been used?
A $58,000
B $61,000
C $69,000
D $72,000
(2 marks)
3 The following information relates to a manufacturing company for the next costing
period.
Production 32,000 units Fixed production costs $160,000
Sales 30,000 units Fixed selling costs $30,000
Using absorption costing, the profit for this period would be $101,000
Required
What would have been the profit for the year if marginal costing had been used?
A $89,000
B $91,000
C $111,000
D $113,000
(2 marks)
4 The following information relates to a manufacturing company for the next costing
period.
Fixed production costs $125,000
Fixed selling costs $25,000
Production 25,000 units
The profit for the period using absorption costing would be $15,000 less than if
marginal costing were used.
Required
What is the expected sales volume in the period?
A 22,000 units
B 23,000 units
C 27,000 units
D 28,000 units
(2 marks)
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Paper F2
Management Accounting
CHAPTER
9
Job costing, batch costing
and service costing
Contents
1 Jobcosting
2 Batchcosting
3 Servicecosting
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Job costing
The nature of job costing
The cost of a job
Cost records and accounts for job costing
1 Job costing
Costing systems are used to record total costs. They are also used to record the costs
of individual cost units. The method used to measure the cost of cost units depends
on the production system and how the products are made.
1.1 The nature of job costing
Job costing is used when a business entity carries out tasks or jobs to meet specific
customer orders. Although each job might involve similar work, they are all
different and are carried out to the customer’s specific instructions or requirements.
Examples of ‘jobs’ include work done for customers by builders or electricians,
audit work done for clients by a firm of auditors, and repair work on motor vehicles
by a repair firm.
Job costing is similar to contract costing, in the sense that each job is usually
different and carried out to the customer’s specification or particular requirements.
However, jobs are short-term and the work is usually carried out in a fairly short
period of time. Contracts are usually long-term and might take several months or
even years to complete.
1.2 The cost of a job
A cost is calculated for each individual job, and this cost can be used to establish the
profit or loss from doing the job.
Job costing differs from most other types of costing system because each cost unit is
a job, and no two jobs are exactly the same. Each job is costed separately.
The expected cost of a job has to be estimated so that a price for the job can be
quoted to a customer.
A costing system should also calculate the actual cost of each job that has been
carried out.
A job costing system is usually based on absorption costing principles, and in
addition a cost is included for non-production overheads, as follows.