CIMA - C1 Fundamentals of Management Accounting
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100
4: Marginal costing and pricing decisions ⏐ Part A Cost determination and behaviour
Answer
C
Indirect costs are 20% of direct costs. Let D = direct costs and I = indirect costs.
So D + I = Full cost
Therefore D + 20% D = Full cost
Therefore 1.15 (D+ 0.2D) = Selling price
Therefore 1.15 × 1.2D = Selling price
Therefore 1.38D = Selling price
So the mark-up on direct costs is 38%
Or, assume that direct costs are $100
$
$
Direct costs
100
100
Indirect costs
20
120
Mark-up (15%)
18
Mark-up (balancing figure)
38
Selling price
138
Selling price
138
If you struggle with percentage calculations you need to spend some time getting them clear in your head. Percentage
calculations are vital for margin and mark-up questions.
Chapter Roundup
• Whereas fully absorbed product costs include fixed overhead, the marginal cost of a product usually consists of variable
costs only.
• Contribution is an important measure in marginal costing, and it is calculated as the difference between sales value and
marginal or variable cost.
•
Marginal costing is an alternative method of costing to absorption costing. In marginal costing, only variable costs are
charged as a cost of sale and a contribution is calculated. Closing inventories of work in progress or finished goods are
valued at marginal (variable) production cost. Fixed costs are treated as a period cost, and are charged in full against
profit in the accounting period in which they are incurred.
•
A price determined using full cost plus pricing is based on full cost plus a percentage mark-up for profit.
•
Marginal cost plus prices are based on the marginal cost of production or the marginal cost of sales, plus a profit
margin.
Assessment
focus point
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Part A Cost determination and behaviour ⏐ 4: Marginal costing and pricing decisions
101
Quick Quiz
1 Sales value – marginal cost of sales = …………………………………………………………..
2 Identify which of the following relate to either
A = Absorption costing
M = Marginal costing
A or M
(a) Closing inventories valued at marginal production cost
(b) Closing inventories valued at full production cost
(c) Cost of sales include some fixed overhead incurred in previous period in
opening inventory values
(d) Fixed costs are charged in full against profit for the period
3 Which of the following are arguments in favour of marginal costing?
(a) It is simple to operate.
(b) There is no under or over absorption of overheads.
(c) Fixed costs are the same regardless of activity levels.
(d) The information from this costing method may be used for decision making.
4 ABC Co plans to sell 1,200 units of product B. A 12% return is required on the $1,000,000 annual investment in product
B. A selling price of $500 per unit has been set.
The full cost of product B is $
.
5 XYZ Co produces a component W. The standard cost card for component W is as follows:
$
Production costs
Fixed
255.70
Variable
483.50
Selling costs
Fixed
124.80
Variable
75.60
Profit
60.40
Selling price
1,000.00
(a) Under an absorption costing system, what would be the value of inventory?
• $255.70 • $739.20 • $483.20 • $227.80
(b) Under a variable costing system, what would be the value of inventory?
• $483.50 • $75.60 • $136.00 • $124.80
6 When comparing the profits reported under absorption costing and marginal costing during a period when the level of
inventory increased:
A Absorption costing profits will be higher and closing inventory valuations lower than those under marginal
costing
B Absorption costing profits will be higher and closing inventory valuations higher than those under marginal
costing
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4: Marginal costing and pricing decisions ⏐ Part A Cost determination and behaviour
C Marginal costing profits will be higher and closing inventory valuations lower than those under absorption costing
D Marginal costing profits will be higher and closing inventory valuations higher than those under absorption
costing
Answers to quick quiz
1 Contribution
2
(a) Closing inventory valued at marginal production cost M
(b) Closing inventory valued at full production cost A
(c) Cost of sales include some fixed overhead incurred in previous period in
opening inventory values A
(d) Fixed costs are charged in full against profit for the period M
3 All are arguments in favour of marginal costing.
4 Required return = 12% × $1,000,000 = $120,000
Expected revenue = 1,200 × $500 = $600,000
Expected cost = expected revenue – required return
∴ Expected cost = $(600,000 – 120,000) = $480,000
∴ Full cost per unit = $480,000/1,200 = $400
5 (a) $255.70 + $483.50 = $739.20
Selling costs are never included in inventory valuations. The valuation under absorption costing is the full
production cost so it is the sum of the fixed production cost and the variable production cost.
(b) $483.50
Selling costs are never included in inventory valuations. The valuation under a variable costing system is the
variable production cost.
6 B Closing inventory valuation under absorption costing will always be higher than under marginal costing because
of the absorption of fixed overheads into closing inventory values.
The profit under absorption costing will be greater because the fixed overhead being carried forward in closing
inventory is greater than the fixed overhead being written off in opening inventory.
Now try the questions below from the Question Bank
Question numbers Page
16–20 354
A or M
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103
Topic list Learning outcomes Syllabus references Ability required
1 Inventory valuation A(vi) A(3) Application
2 FIFO (first in, first out) A(vi), (vii) A(3) Application, Comprehension
3 LIFO (last in, first out) A(vi), (vii) A(3) Application, Comprehension
4 AVCO (cumulative weighted average pricing) A(vi) A(3) Application
5 Inventory valuation and profitability A(vi) A(3) Application
6 Documentation A(vi) A(3) Comprehension
Inventory valuation
Introduction
The investment in inventory is a very important one for most businesses, both in terms of
monetary value and relationships with customers (no inventory, no sale, loss of customer
goodwill). It is therefore vital that management are aware of the major costing problem
relating to materials, that of pricing materials issues and valuing inventory at the end of each
period.
In this chapter we will therefore consider the methods for pricing materials issues/valuing
inventory. We will look at the various methods, their advantages and disadvantages and their
impact on profitability.
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5: Inventory valuation ⏐ Part A Cost determination and behaviour
1 Inventory valuation
The correct pricing of issues and valuation of inventory are of the utmost importance because they have a direct effect
on the calculation of profit. Several different methods can be used in practice.
1.1 Valuing inventory in financial accounts
You may be aware from your studies for the Fundamentals of Financial Accounting paper that, for financial accounting
purposes, inventories are valued at the lower of cost and net realisable value. In practice, inventories will probably be
valued at cost in the stores records throughout the course of an accounting period. Only when the period ends will the
value of the inventory in hand be reconsidered so that items with a net realisable value below their original cost will be
revalued downwards, and the inventory records altered accordingly.
1.2 Charging units of inventory to cost of production or cost of sales
It is important to be able to distinguish between the way in which the physical items in inventory are actually issued. In
practice a storekeeper may issue goods in the following way.
• The oldest goods first
• The latest goods received first
• Randomly
• Those which are easiest to reach
By comparison the cost of the goods issued must be determined on a consistently applied basis, and must ignore the
likelihood that the materials issued will be costed at a price different to the amount paid for them.
This may seem a little confusing at first, and it may be helpful to explain the point further by looking at an example.
1.3 Example: inventory valuation
Suppose that there are three units of a particular material in inventory.
Units Date received Purchase cost
A June 20X1 $100
B July 20X1 $106
C August 20X1 $109
In September, one unit is issued to production. As it happened, the physical unit actually issued was B. The accounting
department must put a value or cost on the material issued, but the value would not be the cost of B, $106. The
principles used to value the materials issued are not concerned with the actual unit issued, A, B, or C. Nevertheless, the
accountant may choose to make one of the following assumptions.
(a) The unit issued is valued as though it were the earliest unit in inventory, ie at the purchase cost of A, $100.
This valuation principle is called FIFO, or first in, first out.
(b) The unit issued is valued as though it were the most recent unit received into inventory, ie at the purchase
cost of C, $109. This method of valuation is LIFO, or last in, first out.
(c) The unit issued is valued at an average price of A, B and C, ie $105.
(It may be that each item of inventory is marked with the purchase cost, as it is received. This method is known as the
specific price method. In the majority of cases this method is not practical.)
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Part A Cost determination and behaviour ⏐ 5: Inventory valuation
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1.4 A chapter example
In the following sections we will consider each of the pricing methods detailed above (and a few more), using the
following transactions to illustrate the principles in each case.
TRANSACTIONS DURING MAY 20X6
Market value
per unit on date
Quantity
Unit cost
Total cost
of transaction
Units
$
$
$
Opening balance, 1 May
100
2.00
200
Receipts, 3 May
400
2.10
840
2.11
Issues, 4 May
200
2.11
Receipts, 9 May
300
2.12
636
2.15
Issues, 11 May
400
2.20
Receipts, 18 May
100
2.40
240
2.35
Issues, 20 May
100
2.35
Closing balance, 31 May
200
2.38
1,916
2 FIFO (first in, first out)
FIFO assumes that materials are issued out of inventory in the order in which they were delivered into inventory: issues
are priced at the cost of the earliest delivery remaining in inventory.
FIFO (first in, first out) is 'used to price issues of goods or materials based on the cost of the oldest units held,
irrespective of the sequence in which the actual issue of units held takes place. Closing stock is, therefore, valued at the
cost of the oldest purchases.' CIMA Official Terminology
2.1 Example: FIFO
Using FIFO, the cost of issues and the closing inventory value in the transactions in section 1.4 would be as follows.
Date of issue
Quantity issued
Value
Units
$
$
4 May
200
100 o/s at $2
200
100 at $2.10
210
410
11 May
400
300 at $2.10
630
100 at $2.12
212
842
20 May
100
100 at $2.12
212
Cost of issues
1,464
Closing inventory value
200
100 at $2.12
212
100 at $2.40
240
452
1,916
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5: Inventory valuation ⏐ Part A Cost determination and behaviour
Notes
(a) The cost of materials issued plus the value of closing inventory equals the cost of purchases plus the value of
opening inventory ($1,916).
(b) The market price of purchased materials is rising dramatically. In a period of inflation, there is a tendency with
FIFO for materials to be issued at a cost lower than the current market value, although closing inventories tend to
be valued at a cost approximating to current market value. FIFO is therefore essentially a historical cost method,
materials included in cost of production being valued at historical cost.
2.2 Advantages and disadvantages of the FIFO method
Advantages
Disadvantages
It is a logical pricing method which probably represents
what is physically happening: in practice the oldest
inventory is likely to be used first.
FIFO can be cumbersome to operate because of the
need to identify each batch of material separately.
It is easy to understand and explain to managers.
Managers may find it difficult to compare costs and
make decisions when they are charged with varying
prices for the same materials.
The inventory valuation can be near to a valuation based
on replacement cost.
In a period of high inflation, inventory issue prices will
lag behind current market value.
Question
FIFO
Complete the table below in as much detail as possible using the information in Sections 1.4 and 2.1.
Receipts Issues Inventory
Date
Quantity
Unit price
$
Amount
$
Quantity
Unit price
$
Amount
$
Quantity
Unit price
$
Amount $
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Part A Cost determination and behaviour ⏐ 5: Inventory valuation
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Answer
Receipts Issues Inventory
Date
Quantity
Unit price
$
Amount
$
Quantity
Unit price
$
Amount
$
Quantity
Unit price
$
Amount $
1.5.X3
100
2.00
200.00
3.5.X3
400
2.10
840.00
100
2.00
200.00
400
2.10
840.00
500
1,040.00
4.5.X3
100
2.00
200.00
100
2.10
210.00
300
2.10
630.00
9.5.X3
300
2.12
636.00
300
2.10
630.00
300
2.12
636.00
600
1,266.00
11.5.X3
300
2.10
630.00
100
2.12
212.00
200
2.12
424.00
18.5.
X3
100
2.40
240.00
200
2.12
424.00
100
2.40
240.00
300
664.00
20.5.X3
100
2.12
212.00
100
2.12
212.00
100
2.40
240.00
31.5.X3
200
452.00
Note that this type of record is called a perpetual inventory system as it shows each receipt and issue of inventory as it
occurs.
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5: Inventory valuation ⏐ Part A Cost determination and behaviour
3 LIFO (last in, first out)
LIFO assumes that materials are issued out of inventory in the reverse order to which they were delivered: the most
recent deliveries are issued before earlier ones, and issues are priced accordingly.
LIFO (last in, first out) is 'used to price issues of goods or materials based on the cost of the most recently received
units. Cost of sales in the income statement is, therefore, valued at the cost of the most recent purchases.'
CIMA Official Terminology
3.1 Example: LIFO
Using LIFO, the cost of issues and the closing inventory value in the example above would be as follows.
Date of issue
Quantity issued
Valuation
Units
$
$
4 May
200
200 at $2.10
420
11 May
400
300 at $2.12
636
100 at $2.10
210
846
20 May
100
100 at $2.40
240
Cost of issues
1,506
Closing inventory value
200
100 at $2.10
210
100 at $2.00
200
410
1,916
Notes
(a) The cost of materials issued plus the value of closing inventory equals the cost of purchases plus the value of
opening inventory ($1,916).
(b) In a period of inflation there is a tendency with LIFO for the following to occur.
(i) Materials are issued at a price which approximates to current market value (or economic cost).
(ii) Closing inventories become undervalued when compared to market value.
3.2 Advantages and disadvantages of the LIFO method
Advantages Disadvantages
Inventories are issued at a price which is close to current
market value.
The method can be cumbersome to operate because it
sometimes results in several batches being only part-used
in the inventory records before another batch is received.
Managers are continually aware of recent costs when
making decisions, because the costs being charged to
their department or products will be current costs.
LIFO is often the opposite to what is physically happening
and can therefore be difficult to explain to managers.
As with FIFO, decision making can be difficult because of
the variations in prices.
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Part A Cost determination and behaviour ⏐ 5: Inventory valuation
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3.3 Changing from LIFO to FIFO or from FIFO to LIFO
You may get an assessment question which asks you what would happen to closing inventory values or gross profits if a
business changed its method from LIFO to FIFO or vice versa. You may find it easier to think about this using diagrams.
Let's consider a very simple example where four barrels of inventory are purchased during a month of rising prices, and
two are used. There is no opening inventory.
Cost
Jan 1
st
$100 per barrel
Jan 19
th
$150 per barrel
LIFO – these
barrels would be
left as closing
inventory $250
FIFO – these
barrels would be
issued to
production first
(and charged to
cost of sales)
$250)
Jan 20
th
$200 per barrel
Jan 31
st
$250 per barrel
LIFO – these
barrels would be
issued to
production first
(and charged to
cost of sales)
$450
FIFO – these
barrels would be
left as closing
inventory $450
Notice the rising prices
As you can see, during a period of rising prices, the closing inventory value using LIFO would be $250 and using FIFO
would be higher at $450. The charge to cost of sales will be lower using FIFO and therefore the gross profit will be
higher.
4 AVCO (cumulative weighted average pricing)
The cumulative weighted average pricing method (or AVCO) calculates a weighted average price for all units in
inventory. Issues are priced at this average cost, and the balance of inventory remaining would have the same unit
valuation. The average price is determined by dividing the total cost by the total number of units.
A new weighted average price is calculated whenever a new delivery of materials is received into store. This is the key
feature of cumulative weighted average pricing.
Average cost is 'used to price issues of goods or materials at the weighted average cost of all units held'.
CIMA Official Terminology
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