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In accounting parlance, amalgamation means merger of two or more companies into one new or existing company. Absorption, on t he other
hand, refers to acquisition of business of one company by another company. But it may be noted that the Companies Act, 195 6 does not
make any distinction between amalgamation and absorption. Infact, the Companies Act, 1956 does not properly define the terms
amalgamation and absorption. But Sections 394 and 396 of the Act prescribe the procedure for amalgamation. The Income -tax Act, 1961,
however, defines the term amalgamation to mean ³the merger of one or more companies with another company or the merger of two or
more companies to form one company´. Therefore, it seems that  !"## !$ 
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According to the Accounting Standard 14, ³Accounting for Amalgamations´, amalgamations fall into two broad categories.
i.? In the first category are those amalgamations where there is a genuine pooling not merely of the assets a nd liabilities of the
two companies but also of the shareholders¶ interests and of the businesses of these companies. Such amalgamations are
known as ³amalgamation in the nature of merger´.
ii.? The second type of amalgamations are those which are in effect a mode by which one company acquires another company
and as a consequence the shareholders of the company which is acquired normally do not continue to have a proportionate
share in the equity of the combined company or the business of the company which is a cquired is not intended to be
continued. Such amalgamations are known as ³amalgamation in the nature of purchase.´ Therefore, it can be said that
amalgamations include absorption.

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èooling of interests method o f accounting for amalgamation records amalgamation transactions as if the separate businesses of the
amalgamating companies were intended to be continued by the transferee company. Accordingly, only the minimal changes are mad e in
aggregating the individua l financial statements of the amalgamating companies.
Under the pooling of interests¶ methods the assets, liabilities and reserves of the transferor company will be taken over by the
transferee company at existing carrying amounts unless any adjustment is required due to difference in accounting policies. As a result, the
difference between the amount recorded as share capital issued (plus any additional consideration in the form of cash or othe r assets) by the
transferee company and the amount of share cap ital of transferor company should be adjusted in reserves. At the time of amalgamation, if
the transferor and the transferee companies have conflicting accounting policies, a uniform set of accounting policies is ado pted following
the amalgamation.

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According to AS 14 on Accounting for Amalgamations; the following conditions must be satisfied for an

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(i) All the assets and liabilties of the transferor company become, after amalgamation, the assets and liabilities of the transferee
company.
(ii) Shareholders holding not less than 90% of the face value of the equity shares of the transferor company (other than the equit y
shares already held therein, immediately before the amalgamation, by the transferee company or its subsidiaries or their nominees)
become equity shareholders of the transferee by virtue of the amalgamation.
(iii) The consideration for the amalgamation receivable by tho se equity shareholders of the transferor company who agree to become
equity shareholders of the transferee company is discharged by the transferee company wholly by the issue of equity shares in the
transferee company, except that cash may be paid in respe ct of any fractional shares.
(iv) The business of the transferor company is intended to be carried on, after the amalgamation, by the transferee company.
(v) No adjustment is intended to be made to the book values of the assets and liabilities of the tra nsferor company when they are
incorporated in the financial statements of the transferee company except to ensure uniformity of accounting policies.
(vi) All reserves & surplus of the transferor company shall be preserved by the transferee company.
If any one of the condition is    in a process of amalgamation, it cannot be treated as amalgamation in the nature of
merger but as an amalgamation

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The following are the points of distinction between (i) the pooling of interests method and (ii) the purchase method of recor ding transactions
relating to amalgamation:
(i) The pooling of interests method is applied in c ase of an amalgamation in the nature of merger whereas purchase method is applied
in the case of an amalgamation in the nature of purchase.
(ii) In the pooling of interests method all the reserves of the transferor company are also recorded by the transfe ree company in its
books of account while in the purchase method the transferee company records in its books of account only the assets and
liabilities taken over, the reserves, except the statutory reserves, of the transferor company are not aggregated wi th those of the
transferee company.
(iii) Under the pooling of interests method, the difference between the consideration paid and the share capital of the transferor
company is adjusted in the general reserve or other reserves of the transferee company. Under the purchase method, the difference
between the consideration and net assets taken over is treated by the transferee company as goodwill or capital reserve.
(iv) Under the pooling of interests method, the statutory reserves are recorded by the trans feree company like all other reserves without
opening amalgamation adjustment account. In the purchase method, while incorporating statutory reserves the transferee compan y
has to open amalgamation adjustment account debiting it with the amount of the stat utory reserves being incorporated.

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1. The following were the Balance Sheets of è Ltd. and V Ltd. as at 31st March, 2001 :
Liabilities è Ltd. V Ltd.
(Rs. in lakhs) (Rs. in lakhs)
Equity Share Capital (Fully paid shares of Rs. 10 each) 15,000 6,000
Securities èremium 3,000 ±
Foreign èroject Reserve ± 310
General Reserve 9,500 3,200
 èrofit and Loss Account 2,870 825
12% Debentures ± 1,000
Bills èayable 120
Sundry Creditors 1,080 463
Sundry èrovisions 1,830 702
33,400 12,500
Assets è Ltd. V Ltd.
(Rs. in lakhs) (Rs. in lakhs)
Land and Buildings 6,000 ±
èlant and Machinery 14,000 5,000
Furniture, Fixtures and Fittings 2,304 1,700
Stock 7,862 4,041
Debtors 2,120 1,020
Cash at Bank 1,114 609
Bills Receivable ² 80
Cost of Issue of Debentures ² 50
33,400 12,500
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On 1st April 2001, è Ltd. took over V Ltd in an amalgamation in the nature of merger. It was agreed that in discharge of consideration for
the business è Ltd. would allot three fully paid equity shares of Rs. 10 each at par for every two shares held in V Ltd. It w as also agreed that
12% debentures in V Ltd. would be converted into 13% debentures in è Ltd. of the same amo unt and denomination.
Expenses of amalgamation amounting to Rs. 1 lakh were borne by è Ltd.
You are required to :
(i) èass journal entries in the books of è Ltd. and
(ii) èrepare è Ltd.¶s Balance Sheet immediately after the merger.

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2. Star and Moon had been carrying on business independently. They agreed to amalgamate and form a new company Neptune Ltd. with an
authorised share capital of Rs. 2,00,000 divided into 40,000 equity shares of Rs. 5 each.
On 31st December, 1995, the respective Balance Sheets of Star and Moon were as follows :
Star Moon
Rs. Rs.
Fixed Assets 3,17,500 1,82,500
Current Assets 1,63,500 83,875
4,81,000 2,66,375
Less: Current Liabilities 2,98,500 90,125
Representing Capital 1,82,500 1,76,250
Additional Information :
(a) Revalued figures of Fixed and Current Assets were as follows :
Star Moon
Rs. Rs.
Fixed Assets 3,55,000 1,95,000
Current Assets 1,49,750 78,875
(b) The debtors and creditors²include Rs. 21,675 owed by Star to Moon.
The purchase consideration is satisfied by issue of the following shares and debentures :
(i) 30,000 equity shares of Neptune Ltd., to Star and Moon in the porportion to the profitability of their respective business
based on the average net profit during the last three years which were as follows :
Star Moon
1993 èrofit 2,24,788 1,36,950
1994 (Loss)/èrofit (1,250) 1,71,050
1995 èrofit 1,88,962 1,79,500
(ii) 15% debentures in Neptune Ltd., at par to provide an income equivalent to 8% return on capital employed in their respective
business as on 31st December, 1995 after revaluation of assets.
You are requested to :
(1) Compute the amount of debentures and shares to be issued to Star and Moon.
(2) A Balance Sheet of Neptune Ltd., showing the position immediately after amalgamation.

3. Super Express Ltd. and Fast Express Ltd. were in competing business. They decided to form a new company named Super Fast Express
Ltd. The balance sheets of both the companies were as under:
Super Express Ltd. - Balance Sheet as at 31st December, 1999
Rs. Rs.
20,000 Equity shares of Buildings 10,00,000
Rs. 100 each 20,00,000 Machinery 4,00,000
èrovident fund 1,00,000 Stock 3,00,000
Sundry creditors 60,000 Sundry debtors 2,40,000
Insurance reserve 1,00,000 Cash at bank 2,20,000
Cash in hand 1,00,000
22,60,000 22,60,000

Fast Express Ltd. - Balance Sheet as at 31st December, 1999

Rs. Rs.
10,000 Equity shares of Goodwill 1,00,000
Rs. 100 each 10,00,000 Buildings 6,00,000
Employees profit sharing Machinery 5,00,000
account 60,000 Stock 40,000
Sundry creditors 40,000 Sundry debtors 40,000
Reserve account 1,00,000 Cash at bank 10,000
Surplus 1,00,000 Cash in hand 10,000
13,00,000 13,00,000
The assets and liabilities of both the companies were taken over by the new company at their book values. The companies were allotted
equity shares of Rs. 100 each in lieu of purchase consideration. èrepare opening balance sheet of Super Fast Express Ltd.
4. The following are the summarized Balance Sheets of X Ltd. and Y Ltd :
X Ltd. Y Ltd.
Rs. Rs.
Liabilities :
Share Capital 1,00,000 50,000
èrofit & Loss A/c 10,000 ±
Creditors 25,000 5,000
Loan X Ltd. ² 15,000
1,35,000 70,000
Assets :
Sundry Assets 1,20,000 60,000
Loan Y Ltd. 15,000 ±
èrofit & Loss A/c ² 10,000
1,35,000 70,000

A new company XY Ltd. is formed to acquire the sundry assets and creditors of X Ltd. and Y Ltd. and for this purpose, the sundry assets of
X Ltd. are revalued at Rs. 1,00,000. The debt due to X Ltd. is also to be discharged in shares of XY Ltd. Show the Ledger Acc ounts to close
the books of X Ltd.
5. The financial position of two companies Hari Ltd. and Vay u Ltd. s on 31st March, 2002 was as under:

Assets Hari Ltd. (Rs.) Vayu Ltd. ( Rs.)

Goodwill 50,000 25,000

Building 3,00,000 1,00,000

Machinery 5,00,000 1,50,000

Stock 2,50,000 1,75,000

Debtors 2,00,000 1,00,000

Cash at Bank 50,000 20,000

èreliminary Expenses 30,000 10,000

13,80,000 5,80,000

Liabilities Hari Ltd. (Rs.) Vayu Ltd. (Rs.)

Share Capital:

Equity Shares of Rs. 10 each 10,00,000 3,00,000

9% èreference Shares of Rs. 100 each 1,00,000 ±

10% èreference Shares of Rs. 100 each ± 1,00,000

General Reserve 1,00,000 80,000

 Retirement Gratuity fund 50,000 20,000

Sundry Creditors 1,30,000 80,000

13,80,000 5,80,000

Hari Ltd. absorbs Vayu Ltd. on the following terms:

(a) 10% èreference Shareholders are to be paid at 10% premium by issue of 9% èreference Shares of Hari Ltd.

(b) Goodwill of Vayu Ltd. is valued at Rs. 50,000, Buildings are valued at Rs. 1,50,000 and the Machinery at Rs. 1,60,000.

(c) Stock to be taken over at 10% less value and Reserve for Bad and Doubtful Debts to be created @ 7.5%.

(d) Equity Shareholders of Vayu Ltd. will be issued Equity Shares @ 5% premium.
èrepare necessary Ledger Accounts to close the books of Vayu Ltd. and show the acquisition entries in the books of Hari Ltd. Also draft the
Balance Sheet after absorption as at 31st March, 2002.

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6. The following is the Balance Sheet of A Ltd. as at 31 March, 2006:

Liabilities Rs. Assets Rs.

8,000 equity shares of Rs.100 each 8,00,000 Building 3,40,000

10% debentures 4,00,000 Machinery 6,40,000

Loan from A 1,60,000 Stock 2,20,000

Creditors 3,20,000 Debtors 2,60,000

General Reserve 80,000 Bank 1,36,000

Goodwill 1,30,000

Misc. Expenses 34,000

17,60,000 17,60,000

B Ltd. agreed to absorb A Ltd. on the following terms and conditions:

(1) B Ltd. would take over all Assets, except bank balance at their book values less 10%. Goodwill is to be valued at 4 year¶s
purchase of super profits, assuming that the normal rate of return be 8% on the combined amount of share capital and general
reserve.

(2) B Ltd. is to take over creditors at book value.

(3) The purchase consideration is to be paid in cash to the extent of Rs.6,00,000 and the balance in fully paid equity shares of
Rs.100 each at Rs.125 per share.
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The average profit is Rs.1,24,400. The liquidation expenses amounted to Rs.16,000. B Ltd. sold prior to 31 March, 2006
goods costing Rs.1,20,000 to A Ltd. for Rs.1,60,000. Rs.1,00,000 worth of goods are still in stock of A Ltd. on 3 1st March,
2006. Creditors of A Ltd. include Rs.40,000 still due to B Ltd.
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Show the necessary Ledger Accounts to close the books of A Ltd. and prepare the Balance Sheet of B Ltd. as at 1 April,
2006 after the takeover.

7. Following is the Balance Sheet of X Co. Ltd. as at 31 st March, 2008:

Liabilities Rs. Assets Rs.
Equity share capital 15,00,000 Land and building 10,00,000
(Rs. 100 each)
11% èref. share capital 5,00,000 èlant and machinery 7,00,000
General reserve 3,00,000 Furniture and fittings 2,00,000
Sundry creditors 2,00,000 Stock in trade 3,00,000
Sundry debtors 2,00,000
Cash in hand and at bank 1,00,000
 25,00,000 25,00,000
Y Co. Ltd. agreed to take over X Co. Ltd. on the following terms:
(i) Each equity share in X Co. Ltd. for the purpose of absorption is to be valued at Rs. 80.

(ii) Equity shares will be issued by Y Co. Ltd. by valuing its each equity share of Rs. 100 each at Rs. 120 per share.

(iii) 11% èreference shareholders of X Co. Ltd. will be given 11% redeemabl e debentures of Y Co. Ltd. at equivalent value.

(iv) All the Assets and Liabilities of X Co. Ltd. will be recorded at the same value in the books of Y Co. Ltd.

(a) Calculate èurchase consideration.

(b) èass Journal entries in the books of Y Co. Ltd. for a bsorbing X Co. Ltd.

8. Following are the Balance Sheet of companies as at 31.12.2003:

Liabilities D Ltd. V Ltd. Assets D Ltd. V Ltd.

Rs. Rs. Rs. Rs.
Equity share capital (Rs. 100) Goodwill 6,00,000 ʊ
8,00,000 6,00,000 Fixed Assets 5,00,000 8,00,000
General Reserve 4,00,000 3,00,000 Investments 2,00,000 4,00,000
Investment Allowance Current Assets 4,00,000 3,00,000
Reserve ʊ 4,00,000 
Sundry Creditors 5,00,000 2,00,000 ________ ________
17,00,000 15,00,000 17,00,000 15,00,000

D Ltd. took over V Ltd. on the basis of the respective shares value, adjusting wherever necessary, the book values of assets an d
liabilities on the basis of the following information:

(i) Investment Allowance Reserve was in respect of addition made to fixed assets by V Ltd. in the year 1997 -2002 on which
income tax relief has been obtained. In terms of the Income Tax Act, 1961, the company has to carry forward till 2006
reserve of Rs. 2,00,000 for utilization.

(ii) Investments of V Ltd. included 1,000 shares in D Ltd. acquired at cost of Rs. 150 per share. The other investments of V Ltd.
have a market value of Rs. 1,92,500.

(iii) The market value of investments of D Ltd. are to be taken at Rs. 1,00,000.

(iv) Goodwill of D Ltd. and V Ltd. are to be taken at R s. 5,00,000 and Rs. 1,00,000 respectively.
(v) Fixed assets of D Ltd. and V Ltd. are valued at Rs. 6,00,000 and Rs. 8,50,000 respectively.

(vi) Current assets of D Ltd. included Rs. 80,000 of stock in trade received from V Ltd. at cost plus 25%.
The above scheme has been duly adopted. èass necessary Journal Entries in the books of D Ltd. and prepare Balance Sheet of D Ltd. aft er
taking over the business of V Ltd. Fractional share to be settled in cash, rest in shares of D Ltd. Calculation shall be m ade to the nearest
multiple of a rupee.

9. Exe Limited was wound up on 31.3.2004 and its Balance Sheet as on that date was given below:

Liabilities Rs. Assets Rs.

Share capital: Fixed assets 9,64,000
1,20,000 Equity shares of Rs. Current assets:
10 each 12,00,000 Stock 7,75,000
Reserves and surplus: Sundry debtors 1,60,000
èrofit prior to incorporation Less: èrovision for bad and doubtful debts
42,000 8,000 1,52,000

Contingency reserve 2,70,000 Bills receivable 30,000

èrofit and loss A/c 2,52,000 Cash at bank 3,29,000 12,86,000
Current liabilities:
Bills payable 40,000
Sundry creditors 2,26,000
èrovisions:
èrovision for income tax 2,20,000 ________
22,50,000 22,50,000

Wye Limited took over the following assets at values shown as under:

Fixed assets Rs. 12,80,000, Stock Rs. 7,70,000 and Bills Receivable Rs. 30,000.
èurchase consideration was settled by Wye Limited as under:

Rs. 5,10,000 of the consideration was satisfied by the allotment of f ully paid 10% èreference shares of Rs. 100 each. The balance
was settled by issuing equity shares of Rs. 10 each at Rs. 8 per share paid up.

Sundry debtors realised Rs. 1,50,000. Bills payable was settled for Rs. 38,000. Income tax authorities fixed the taxation liability at
Rs. 2,22,000.

Creditors were finally settled with the cash remaining after meeting liquidation expenses amounting to Rs. 8,000. You are req uired
to:

(i) Calculate the number of equity shares and preference shares to be allotted by Wy e Limited in discharge of purchase
consideration.

(ii) èrepare the Realisation account, Cash/Bank account, Equity shareholders account and Wye Limited account in the books of
Exe Limited.
(iii)? èass journal entries in the books of Wye Limited.

10. The following are the Balance Sheets of Yes Ltd. and No Ltd. as on 31st October, 1999 :
Yes Ltd. No Ltd.
Rs. Rs.
(in crores) (in crores)
Sources of funds:
Share capital:
Authorised 25 5
Issued and Subscribed :
Equity Shares of Rs. 10 each fully paid 12 5
Reserves and surplus 88 10
Shareholders funds 100 15
Unsecured loan from Yes Ltd. ² 10
100 25
Funds employed in:
Fixed assets: Cost 70 30
Less: Depreciation 50 24
20 6
Written down value
Investments at cost :
30 lakhs equity shares of Rs. 10 each of No Ltd. 3
Long-term loan to No. Ltd. 10
Current assets 100 34
Less : Current liabilities 33 67 15 19
100 25
On that day Yes Ltd. absorbed No Ltd. The members of No Ltd. are to get one equity share of Yes Ltd. issued at a premium of R s. 2
per share for every five equity shares held by them in No Ltd. The necessary approvals are obtained. You are asked to pass jou rnal
entires in the books of the two companies to give effect to the above.
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11. The Balance Sheet of A Limited and B Limited as at 31 March, 2008 are as follows:

Liabilities A Ltd. B Ltd. Assets A Ltd. B Ltd.

Equity share of Rs.10 20,00,000 12,00,000 Sundry assets 30,00,000 14,00,000
each
General reserve 4,00,000 2,20,000 40,000 Equity shares
in A Ltd. - 4,00,000
Creditors 6,00,000 3,80,000
30,00,000 18,00,000 30,00,000 18,00,000
A Ltd. absorbed B Ltd. on the basis of intrinsic value of the shares. The purchase consideration is to be discharged in fully paid -up
equity shares. A sum of Rs.1,00,000 is owed by A Ltd. to B Ltd., also included in the stock of A Ltd. is Rs.1,20,000 goods s upplied
by B Ltd. at cost plus 20%.
Give Journal entries in the books of both the companies, if entries are made at intrinsic value. Also prepare Balance Sheet of A Ltd . after
absorption.

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The costs that vary with a decision should only be inclu ded in decision analysis. For many decisions that involve relatively small variations
from existing practice and/or are for relatively limited periods of time, fixed costs are not relevant to the decision. This is because either
fixed costs tend to be impo ssible to alter in the short term or managers are reluctant to alter them in the short term.

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Marginal costing distinguishes between fixed costs and variable costs as convention ally classified.

The marginal cost of a produc t ±³is its variable cost´. This is normally taken to be; direct labour, direct material, direct expenses and the
variable part of overheads.

Marginal costing is formally defined as:

µthe accounting system in which variable costs are charged to cost units and the fixed costs of the period are written -off in full against the
aggregate contribution. Its special value is in decision making¶. (Terminology.)

The term µcontribution¶ mention ed in the formal definition is the term given to the difference between Sales and Marginal cost. Thus

MARGINAL COST = VARIABLE COST DIRECT LABOUR

+
DIRECT MATERIAL
+
DIRECT EXèENSE
+
VARIABLE OVERHEADS

CONTRIBUTION SALES - MARGINAL COST

The term marginal cost sometimes refers to the marginal cost per unit and sometimes to the total marginal costs of a departme nt or batch or
operation. The meaning is usually clear from the context.

Alternative names for marginal costing are the cont ribution approach and direct costing In this lesson, we will study marginal costing as a
technique quite distinct from absorption costing.

  

The theory of marginal costing as set out in ³A report on Marginal Costing´ published by CIMA, London is as follows:

In relation to a given volume of output, additional output can normally be obtained at less than proportionate cost because w ithin limits, the
aggregate of certain items of cost will tend to remain fixed and only the aggregate of the remainder will tend to rise proportionately with an
increase in output. Conversely, a decrease in the volume of output will normally be accompanied by less than proportionate fa ll in the
aggregate cost.

The theory of marginal costing may, therefor e, by understood in the following two steps:

1.? If the volume of output increases, the cost per unit in normal circumstances reduces. Conversely, if an output reduces, the c ost
per unit increases. If a factory produces 1000 units at a total cost of $3,000 an d if by increasing the output by one unit the cost
goes up to $3,002, the marginal cost of additional output will be $.2.
2.? If an increase in output is more than one, the total increase in cost divided by the total increase in output will give the a verage
marginal cost per unit. If, for example, the output is increased to 1020 units from 1000 units and the total cost to produce t hese
units is $1,045, the average marginal cost per unit is $2.25. It can be described as follows:

Additional cost = $ 45 = $2.25

Additional units 20
The ascertainment of marginal cost is based on the classification and segregation of cost into fixed and variable cost. In or der to understand
the marginal costing technique, it is essential to understand the meaning of marginal cost.

Marginal cost means the cost of the marginal or last unit produced. It is also defined as the cost of one more or one less unit produced
besides existing level of production. In this connection, a unit may mean a single commodity, a dozen, a gross or any other m easure of
goods.

For example, if a manufacturing firm produces X unit at a cost of $ 300 and X+1 units at a cost of $ 320, the cost of an addi tional unit will
be $ 20 which is marginal cost. Similarly if the production of X -1 units comes down to $ 280, the cost of marg inal unit will be $ 20 (300 ±
280).

The marginal cost varies directly with the volume of production and marginal cost per unit remains the same. It consists of p rime cost, i.e.
cost of direct materials, direct labor and all variable overheads. It does not c ontain any element of fixed cost which is kept separate under
marginal cost technique.

Marginal costing may be defined as the technique of presenting cost data wherein variable costs and fixed costs are shown separately for
managerial decision -making. It should be clearly understood that marginal costing is not a method of costing like process costing or job
costing. Rather it is simply a method or technique of the analysis of cost information for the guidance of management which t ries to find out
an effect on profit due to changes in the volume of output.

There are different phrases being used for this technique of costing. In UK, marginal costing is a popular phrase whereas in US, it is known
as direct costing and is used in place of marginal costing. Va riable costing is another name of marginal costing.

Marginal costing technique has given birth to a very useful concept of contribution where contribution is given by: Sales rev enue less
variable cost (marginal cost)

Contribution may be defined as the pr ofit before the recovery of fixed costs. Thus, contribution goes toward the recovery of fixed cost and
profit, and is equal to fixed cost plus profit (C = F + è).

In case a firm neither makes profit nor suffers loss, contribution will be just equal to fix ed cost (C = F). this is known as break even point.

The concept of contribution is very useful in marginal costing. It has a fixed relation with sales. The proportion of contrib ution to sales is
known as è/V ratio which remains the same under given condit ions of production and sales.

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The principles of marginal costing are as follows.

a.? For any given period of time, fixed costs will be the same, for any volume of sales and production (provided that the level o f
activity i s within the µrelevant range¶). Therefore, by selling an extra item of product or service the following will happen.
R? Revenue will increase by the sales value of the item sold.
R? Costs will increase by the variable cost per unit.
R? èrofit will increase by th e amount of contribution earned from the extra item.
b.? Similarly, if the volume of sales falls by one item, the profit will fall by the amount of contribution earned from the item.
c.? èrofit measurement should therefore be based on an analysis of total contribution. Since fixed costs relate to a period of ti me, and
do not change with increases or decreases in sales volume, it is misleading to charge units of sale with a share of fixed c osts.
d.? When a unit of product is made, the extra costs incurred in its manufacture are the variable production costs. Fixed costs ar e
unaffected, and no extra fixed costs are incurred when output is increased.

*  

The main features of marginal costing are as follows:

1.? ost lassification

The marginal costing technique makes a sharp distinction between variable costs and fixed costs. It is the variable cost on t he
basis of which production and sales policies are designed by a firm following the marginal costing technique.
2.? „tock/Inventory Valuation
Under marginal costing, inventory/stock for profit measurement is valued at marginal cost. It is in sharp contrast to the tot al unit
cost under absorption costing method.
3.? Marginal ontri bution
Marginal costing technique makes use of marginal contribution for marking various decisions. Marginal contribution is the
difference between sales and marginal cost. It forms the basis for judging the profitability of different products or departm ents.

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 1.? Marginal costing is simple to understand.
2.? By not charging fixed overhead to cost of production, the effect of varying charges per unit is avoided.
3.? It prevents the illogical carr y forward in stock valuation of some proportion of current year¶s fixed overhead.
4.? The effects of alternative sales or production policies can be more readily available and assessed, and decisions taken would
yield the maximum return to business.
5.? It elimi nates large balances left in overhead control accounts which indicate the difficulty of ascertaining an accurate overhead
recovery rate.
6.? èractical cost control is greatly facilitated. By avoiding arbitrary allocation of fixed overhead, efforts can be conc entrated on
maintaining a uniform and consistent marginal cost. It is useful to various levels of management.
7.? It helps in short -term profit planning by breakeven and profitability analysis, both in terms of quantity and graphs. Comparative
profitability a nd performance between two or more products and divisions can easily be assessed and brought to the notice of
management for decision making.

&,

1.? The separation of costs into fixed and variable is difficult and sometimes gives misleading result s.
2.? Normal costing systems also apply overhead under normal operating volume and this shows that no advantage is gained by
marginal costing.
3.? Under marginal costing, stocks and work in progress are understated. The exclusion of fixed costs from inventories affect profit,
and true and fair view of financial affairs of an organization may not be clearly transparent.
4.? Volume variance in standard costing also discloses the effect of fluctuating output on fixed overhead. Marginal cost data
becomes unrealistic in case of highly fluctuating levels of production, e.g., in case of seasonal factories.
5.? Application of fixed ove rhead depends on estimates and not on the actuals and as such there may be under or over absorption of
the same.
6.? Control affected by means of budgetary control is also accepted by many. In order to know the net profit, we should not be
satisfied with cont ribution and hence, fixed overhead is also a valuable item. A system which ignores fixed costs is less effective
since a major portion of fixed cost is not taken care of under marginal costing.
7.? In practice, sales price, fixed cost and variable cost per un it may vary. Thus, the assumptions underlying the theory of marginal
costing sometimes becomes unrealistic. For long term profit planning, absorption costing is the only answer.

è & c!$

Marginal costing is not a method of costing but a technique of presentation of sales and cost data with a view to guide managemen t in
decision-making.

The traditional technique popularly known as total cost or absorption costing technique does not make any di fference between variable and
fixed cost in the calculation of profits. But marginal cost statement very clearly indicates this difference in arriving at t he net operational
results of a firm.

Following presentation of two èerforma shows the difference be tween the presentation of information according to absorption and marginal
costing techniques:

cc

è+* c
£ £
Sales Revenue xxxxx
Less Marginal Cost of Sales
Opening Stock (Valued @ marginal cost) xxxx
Add èroduction Cost (Valued @ marginal cost) xxxx
Total èroduction Cost xxxx
Less Closing Stock (Valued @ marginal cost) (xxx)
Marginal Cost of èroduction xxxx
Add Selling, Admin & Distribution Cost xxxx
Marginal Cost of Sales (xxxx)
Contribution xxxxx
Less Fixed Cost (xxxx)
Marginal Costing èrofit xxxxx
c
è
è+* c
£ £
Sales Revenue xxxxx
Less Absorption Cost of Sales
Opening Stock (Valued @ absorption cost) xxxx
Add èroduction Cost (Valued @ absorption cost) xxxx
Total èroduction Cost xxxx
Less Closing Stock (Valued @ absorption cost) (xxx)
Absorption Cost of èroduction xxxx
 Add Selling, Admin & Distribution Cost xxxx
Absorption Cost of Sales (xxxx)
Un-Adjusted èrofit xxxxx
Fixed èroduction O/H absorbed xxxx
Fixed èroduction O/H incurred (xxxx)
(Under)/Over Absorption xxxxx
Adjusted èrofit xxxxx


#  c!$è 

$
Marginal Costing èrofit xx
ADD xx
(Closing stock ± opening Stock) x OAR
= Absorption Costing èrofit xx
Budgeted fixed production overhead
Where OAR( overhead absorption rate) =
Budgeted levels of activities

,c!$

After knowing the two techniques of marginal costing and absorption costing, we have seen that the net profits are not the sa me because of
the following reasons:

.%,c!!,

In absorption costing, fixed overheads can never be abs orbed exactly because of difficulty in forecasting costs and volume of output. If these
balances of under or over absorbed/recovery are not written off to costing profit and loss account, the actual amount incurre d is not shown in
it. In marginal costing, however, the actual fixed overhead incurred is wholly charged against contribution and hence, there will be some
difference in net profits.

/%& 
01

In marginal costing, work in progress and finished stocks are valued at marginal cost, but in absorption costing, they are valued at total
production cost. Hence, profit will differ as different amounts of fixed overheads are considered in two accounts.

The profit difference due to difference in stock valuation is summarized as follow s:

a.? When there is no opening and closing stocks, there will be no difference in profit.
b.? When opening and closing stocks are same, there will be no difference in profit, provided the fixed cost element in opening a nd
closing stocks are of the same amount.
c.? When closing stock is more than opening stock, the profit under absorption costing will be higher as comparatively a greater
portion of fixed cost is included in closing stock and carried over to next period.
d.? When closing stock is less than opening stock , the profit under absorption costing will be less as comparatively a higher amount
of fixed cost contained in opening stock is debited during the current period.

 "# #!$ "%

a.? In absorption costing, items of stock are costed to include a µfair share¶ of fixed production overhead, whereas in marginal
costing, stocks are valued at variable production cost only. The value of closing stock will be higher in absorption costing than in
marginal costing.
b.? As a consequence of carrying forward an element of fixed production overheads in closing stock values, the cost of sales used to
determine profit in absorption costing will:
i.? include some fixed production overhead costs incurred in a previous period but carried forward into opening stock
values of the current period;
ii.? exclude some fixed production overhead costs incurred in the current period by including them in closing stock
values.

In contrast marginal costing charges the actual fixed costs of a period in full into the profit and loss account of the perio d.
(Marginal costing is therefore sometimes known as period costing.)

c.? In absorption costing, µactual¶ fully absorbed unit costs are reduced by producing in greater quantities, whereas in marginal
costing, unit variable costs are unaffected by the volume of production (that is, provided that variable costs per unit remai n
unaltered at the changed level of production activity) . èrofit per unit in any period can be affected by the actual volume of
production in absorption costing; this is not the case in marginal costing.
 d.? In marginal costing, the identification of variable costs and of contribution enables management to use cos t information more
easily for decision -making purposes (such as in budget decision making). It is easy to decide by how much contribution (and
therefore profit) will be affected by changes in sales volume. (èrofit would be unaffected by changes in producti on volume).

In absorption costing, however, the effect on profit in a period of changes in both:

i.? production volume; and

ii.? sales volume;
is not easily seen, because behaviour is not analysed and incremental costs are not used in the calculation of actual
profit.

# c!$

The following are the criticisms against absorption costing:

1.? You might have observed that in absorption costing, a portion of fixed cost is carried over to the subsequent accounting peri od as
part of closing stoc k. This is an unsound practice because costs pertaining to a period should not be allowed to be vitiated by the
inclusion of costs pertaining to the previous period and vice versa.
2.? Further, absorption costing is dependent on the levels of output which may vary from period to period, and consequently cost per
unit changes due to the existence of fixed overhead. Unless fixed overhead rate is based on normal capacity, such changed cos ts
are not helpful for the purposes of comparison and control.

The cost to produce an extra unit is variable production cost. It is realistic to the value of closing stock items as this is a directly attributable
cost. The size of total contribution varies directly with sales volume at a constant rate per unit. For the decision -making purpose of
management, better information about expected profit is obtained from the use of variable costs and contribution approach in the accounting
system.

##

Marginal cost is the cost management technique for the analysis of cost and reven ue information and for the guidance of management. The
presentation of information through marginal costing statement is easily understood by all mangers, even those who do not hav e preliminary
knowledge and implications of the subjects of cost and managem ent accounting. Absorption costing and marginal costing are two different
techniques of cost accounting. Absorption costing is widely used for cost control purpose whereas marginal costing is used fo r managerial
decision-making and control.

+,#+$ '1è(

CVè analysis involves the analysis of how total costs, total revenues and total profits are related to sales volume, and is t herefore concerned
with predicting the effects of changes in costs and sales volume on profit. It is also know n as 'breakeven analysis'.

The technique used carefully may be helpful in the following situations:

a) Budget planning. The volume of sales required to make a profit (breakeven point) and the 'safety margin' for profits in th e budget can be
measured.

b) èricing and sales volume decisions.

c) Sales mix decisions, to determine in what proportions each product should be sold.

d) Decisions that will affect the cost structure and production capacity of the company.

!$$ 1è

CVè analysis is based on the assumption of a linear total cost function (constant unit variable cost and constant fixed costs ) and so is an
application of marginal costing principles.

The principles of marginal costing can be summarised as follows:

a) èeriod fixed costs are a constant amount, therefore if one extra unit of product is made and sold, total costs will only rise b y the variable
cost (the
 ?) of production and sales for that unit.

b) Also, total costs will fall by the variable cost per unit for each reduction by one unit in the level of activity.
c) The additional profit earned by making and selling one extra unit is the extra revenue from its sales minus its variable c osts, i.e. the
contribution per unit.

d) As the volume of acti vity increases, there will be an increase in total profits (or a reduction in losses) equal to the total revenue minus the
total extra variable costs. This is the extra contribution from the extra output and sales.

e) The total profit in a period is the t otal revenue minus the total variable cost of goods sold, minus the fixed costs of the period.

Revenue X
Variable cost of sales (X)
CONTRIBUTION X
Fixed Costs (X)
èROFIT X

2#$3!0,è 1

„  
? makes and sells a single product. The variable cost is $3/unit and the variable cost of selling is $1/unit. Fixed costs total
$6,000 and the unit sales price is $6.

Sabre èroducts Ltd. budgets to make and sell 3,600 units in the next year.

Draw a breakeven chart, and a è/V graph, each showing the expected amount of output and sales required to breakeven, and the safety
margin in the budget.

3

A breakeven chart records the amount of fixed costs, variable costs, total costs and total revenue at a ll volumes of sales, and at a given sales
price as follows:

*4%. 0,

The 'breakeven point' is where revenues and total costs are exactly the same, so there is no profit or loss. It may be expres sed in terms of
units of sale or in terms of sales revenue. Reading from the graph, the breakeven point is 3,000 units of sale and $18,000 in sales revenue.

The 'margin of safety' is the amount which actual output/sales may fall short of the budget without a loss being made, often expressed as a
percentage of the budgeted sales volume. It is a rough measure of the risk that Sabre èro ducts might make a loss if it fails to achieve its
budget. In our example, the margin of safety is calculated as follows:


Budgeted sales 3,600
Breakeven point 3,000
Margin of safety (MOS) 600
As a percentage of budgeted sales; the

= 16.67%.

A high margin of safety shows a good expectation of profits, even if the budget is not achieved.

è  1#'è 1($

The è/V graph is similar to the breakeven chart, and records the profit or loss at each level of sales, at a given sales pric e. It is a straight line
graph, drawn by recording the following:

i) the loss at zero sales, which is the full amount of fixed costs
ii) the profit/(loss) at the budgeted sales level.

The two points are then joined up. In our example above, the èA/graph wo uld look like this:

*4%/$  ,#'è 1($

The breakeven point may be read from the graph as $18,000 in sales revenue, and the margin of safety is $3,600 in sales reven ue or 16.67%
budgeted sales revenue.

The arithmetic of CVè analysis

a) To calculate the breakeven point the following formula applies:

= ? at the breakeven point,

where:

S = sales revenue
V = variable costs
F = fixed costs (so that V + F = total costs).

Therefore:

(„??) = *

At the breakeven point, total contribution (S - V) equals the amount of fixed costs (F).

b) To calculate the amount of sales needed to achieve a target profit the following formula applies:

= ????

Therefore,

'
+1(5 (??)

To earn a target profit, the total contribution (S - V) must be sufficient to cover fixed costs plus the amount of profit required (F + è).

The C/S ratio shows how much contribution is earned per $1 of sales revenue earned. Since costs and sales revenues are linear functions, the
C/S ratio is constant at all levels of output and sales. It is used sometimes as a measure of performance or profitability, a nd in CVè analysis
to calculate the sales required to breakeven or earn a target profit or the expected t otal contribution at a given volume of sales and with a
given C/S ratio.

As an alternative method of calculation, the breakeven point in sales revenue is calculated as follows:

Similarly, the sales volume needed to achieve a target profit is calculated as follows:

|
 

   

The need for a decision arises in business because a manager is faced with a problem and alternative courses of action are av ailable. In
deciding which option to choose he will need all the information which is relevant to his decision; and he must have some criterion on the
basis of which he can choose the best alternative. Some of the factors affecting the decision may not be expressed in monetar y value. Hence,
the manager will have to make 'qualitative' jud gements, e.g. in deciding which of two personnel should be promoted to a managerial
position. A 'quantitative' decision, on the other hand, is possible when the various factors, and relationships between them, are measurable.
This chapter will concentrate on quantitative decisions based on data expressed in monetary value and relating to costs and revenues as
measured by the management accountant.

Often "information" is interpreted by marketers as being "external" market based information. However, "interna l" sources are just as
important, none more so than financial information. The chapter looks at the relevant elements of cost for decision making, t hen looks at the
various techniques including breakeven analysis. Other important business decisions are whe ther to source components internally or have
them brought in from outside, and whether to continue with operations if they appear uneconomic. The chapter examines the tec hniques
useful in helping to make decisions in these areas.

÷

 



A quantitative decision problem involves six parts:

a)c!6,!-  sometimes referred to as 'choice criterion' or 'objective function', e.g. maximisation of profit or
minimisation of total costs.

b) Many decision problems have one or more constraints, e.g. limited raw materials, labour, etc. It is therefore common to find
an objective that will maximise profits subject to defined constraints.

c)c ,  under consideration. For example, in order to minimise costs of a manufacturing operation, the
available alternatives may be:

i) to continue manufacturing as at present

ii) to change the manufacturing method
iii) to sub-contract the work to a third party.

d)* of the incremental costs and benefits of each alternative course of action.

e)c$$ of the decision criteria or objective function, e.g. the calculation of expected profit or contribution, and the ranking of
alternatives.

f) of preferred alternatives.

›



 

The costs which should be used for decision making are often referred to as "relevant costs". CIMA defines relevant costs as 'costs
appropriate to aiding the making of specific management decisions'.

To affect a decision a cost must be:

a) *: èast costs are irrelevant, as we cannot affect them by current decisions and they are common to all alternatives that we ma y
choose.

b) # &  : ' Meaning, expenditure which will be incurred or avoided as a result of making a decision. Any costs which
would be incurred whether or not the decision is made are not said to be incremental to the decision.

c)  ": Expenses such as depreciation are not cash flows and are therefore not relevant. Similarly, the book value of existing
equipment is irrelevant, but the disposal value is relevant.

Other terms:

d) ##: Costs which will be identical for all alternatives are irrelevant, e.g. rent or rates on a factory would be incurred whatev er
products are produced.

e)
0: Another name for past costs, which are always irrelevant, e.g. dedicated fixed assets, development costs already incurred.

f) ##: A future cash outflow that will be incurred anyway, whatever decision is taken now, e.g. contracts already entered into
which cannot be altered.

Y 

Relevant costs may also be expressed as opportunity costs. An opportunity cost is the benefit foregone by choosing one opport unity instead
of the next best alternative .

2#$

A company is considering publishing a limited edition book bound in special leather. It has in stock the leather bought some years ago for
$1,000. To buy an equivalent quantity now would cost $2,000. The company has no plans to use the leather for other purposes, although it
has considered the possibilities:

a) of using it to cover desk furnishings, in replacement for other material which could cost $900
b) of selling it if a buyer could be found (the proceeds are unlikely to exceed $800).

In calculating the likely profit from the proposed book before deciding to go ahead with the project, the leather would  be costed at
$1,000. The cost was incurred in the past for some reason which is no longer relevant. The leather exists and could be used on the book
without incurring any specific cost in doing so. In using the leather on the book, however, the company will lose the opportu nities of either
disposing of it for $800 or of using it to save an outlay of $900 on desk furnishings.

The better of these alternatives, from the point of view of benefiting from the leather, is the latter. "Lost opportunity" cost of $900 wil l
therefore be included in the cost of the book for decision making purposes.

The relevant costs for decision purposes will be th e sum of:

i) 'avoidable outlay costs', i.e. those costs which will be incurred only if the book project is approved, and will be avoide d if it is not

ii) the opportunity cost of the leather (not represented by any outlay cost in connection to the project ).

This total is a true representation of 'economic cost'.

,$$


 ?
 ? has been approached by a customer who would like a special job to be done for him, and is willing to pay $60,000
for it. The job would require the following materials.
    0, 0 !, $#
- 0 7  7  7 
A 1000 0 - - 16.00
B 1000 600 12.00 12.50 15.00
C 1000 700 13.00 12.50 14.00
D 200 200 14.00 16.00 19.00
a) Material B is used regularly by Zimglass Industries Ltd, and if units of B are required for this job, they would need to be replaced to meet
other production demands.

b) Materials C and D are in stock due to previous over -buying, and they have restricted use. No other use could be found for material C, but
the units of material D could be used in another job as a substitute for 300 units of material E, which currently costs $15 p er unit (of which
the company has no units in stock at the moment).

Calculate the relevant costs of material for de ciding whether or not to accept the contract. You must carefully and clearly explain the reasons
for your treatment of each material.

#$,

Some of the assumptions made in relevant costing are as follows:

a) Cost behaviour patterns are known, e.g. if a department closes down, the attributable fixed cost savings would be known.

b) The amount of fixed costs, unit variable costs, sales price and sales demand are known with certainty.

c) The objective of decision making in th e short run is to maximise 'satisfaction', which is often known as 'short -term profit'.

d) The information on which a decision is based is complete and reliable.

c #0 

.% 0!

A company is often faced with the decision as to whether it should manufacture a component or buy it outside.

Suppose for example, that ‘  

? make four components, W, X, Y and Z, with expected costs for the coming year as follows:

š  8 9
èroduction (units) 1,000 2,000 4,000 3,000
Unit marginal costs $ $ $ $
Direct materials 4 5 2 4
Direct labour 8 9 4 6
Variable production overheads 2 3 1 2
14 17 7 12

Direct fixed costs/annum and committed fixed costs are as follows:

Incurred as a direct consequence of making W 1,000

Incurred as a direct consequence of making X 5,000
Incurred as a direct consequence of making Y 6,000
Incurred as a direct consequence of making Z 8,000
Other committed fixed costs 30,000
50,000
A subcontractor has offered to supply units W, X, Y and Z for $12, $21, $10 and $14 respectively.

Decide whether ‘  
Ltd. should make or buy the components.



a) The relevant costs are the differential costs between making and buying. They consist of differences in unit variable costs plus differences
in directly attributable fixed costs. Subcontracting will result in some savings on fixed cost.

š  8 9
7 7 7 7
Unit variable cost of making 14 17 7 12
Unit variable cost of buying 12 21 10 14
(2) -4 2 2
Annual requirements in units 1,000 2,000 4,000 3,000
Extra variable cost of buying per annum (2,000) 8,000 12,000 6,000
Fixed cost saved by buying 1,000 5,000 6,000 8,000
Extra total cost of buying (3,000) 3,000 6,000 (2,000)

b) The company would save $3,000/annum by sub -contracting component W, and $2,000/annum by sub -contracting component Z.

c) In this example, relevant costs are the variable costs of in -house manufacture, the variable costs of sub -contracted units, and the saving in
fixed costs.

d) Other important considerations are as follows:

i) If components W and Z are sub -contracted, the company will have spare capacity. How should that spare capacity be profitably used? Are
there hidden benefits to be obtained from sub -contracting? Will there be resentment from the workforce?

ii) Would the sub -contractor be reliable with delivery time s, and is the quality the same as those manufactured internally?

iii) Does the company wish to be flexible and maintain better control over operations by making everything itself?

iv) Are the estimates of fixed costs savings reliable? In the case of prod uct W, buying is clearly cheaper than making in -house. However, for
product Z, the decision to buy rather than make would only be financially attractive if the fixed cost savings of $8,000 coul d be delivered by
management. In practice, this may not materia lise.

2#$ 0!

The èip, a component used by Ê ?‘ 

 
? is incorporated into a number of its completed products. The èip is purchased from
a supplier at $2.50 per component and some 20,000 are used annually in production.

The price of $2.50 is considered to be competitive, and the supplier has maintained good quality service over the last five years. The
production engineering department at Goya Manufacturing Ltd. has submitted a proposal to manufacture the èip in -house. The variable cost
per unit produced is estimated at $1.20 and additional annual fixed costs that would be incurred if the èip were manufactured are estimated
at $20,800.

a) Determine whether Goya Manufacturing Ltd. should continue to purchase the èip or manufacture it in -house.

b) Indicate the level of production required that would make Goya Manufacturing Ltd. decide in favour of manufacturing the èi p itself.

 
 


Shutdown problems involve the following types of decisions:

a) Whether or not to close down a factory, department, product line or other activity, either because it is making losses or because it is too
expensive to run.

b) If the decision is t o shut down, whether the closure should be permanent or temporary. Shutdown decisions often involve long term
considerations, and capital expenditures and revenues.
c) A shutdown should result in savings in annual operating costs for a number of years in the future.

d) Closure results in release of some fixed assets for sale. Some assets might have a small scrap value, but others, e.g. pro perty, might have a
substantial sale value.

e) Employees affected by the closure must be made redundant or relocated, perhaps even offered early retirement. There will be lump sums
payments involved which must be taken into consideration. For example, suppose closure of a regional office results in annual savings of
$100,000, fixed assets sold off for $2 million, but red undancy payments would be $3 million. The shutdown decision would involve an
assessment of the net capital cost of closure ($1 million) against the annual benefits ($100,000 per annum).

It is possible for shutdown problems to be simplified into short run d ecisions, by making one of the following assumptions

a) Fixed asset sales and redundancy costs would be negligible.

b) Income from fixed asset sales would match redundancy costs and so these items would be self -cancelling.

In these circumstances the finan cial aspects of shutdown decisions would be based on short run relevant costs.

K%c$ !

m ? manufactures three products, Swans, Ducks and Chicks. The present net annual income from each item is as follows:

" &0 0 
7 7 7 7
Sales 50,000 40,000 60,000 150,000
Variable costs 30,000 25,000 35,000 90,000
Contribution 20,000 15,000 25,000 60,000
Fixed costs 17,000 18,000 20,000 55,000
èrofit/(loss) 3,000 (3,000) 5,000 5,000

Brass Ltd. is concerned about its poor profit performance, and is considering whether or not to cease selling Ducks. It is fe lt that selling
prices cannot be increased or lowered without adversely affecting net income. $5,000 of the fixed costs of Ducks are direct fixed costs
which would be saved if production ceased. All other fixed costs will remain the same.

a) Advise Brass Ltd. whether or not to cease production of Ducks.

b) Suppose, however, it were possible to use the resources real ised by stopping production of Ducks, and switch to produce a new item,
Eagles, which would sell for $50,000 and incur variable costs of $30,000 and extra fixed costs of $6,000. What will the new d ecision be?

K%
$+c$ 6

Firms can occasionally increase total profits by accepting special orders. Generally, a special order should be accepted if:

i.? incremental revenue exceeds incremental cost of the order

ii.? facilities used are idle or have no alternative/profitable use (if alternative/prof itable use exist then opportunity
cost will have to b considered)
iii.? fixed costs are NOT considered because they are fully absorbed by normal production 2$"
$ 
iv.? +   ± the order does not disrup t the market for the firm¶s regular output

Uè&


& ,,"3

In some production processes, particularly in agriculture and natural resources, two or more products undergo the same proces s up to a $+
 $, after which one or m ore of the products may undergo additional processing. An oil company drills for oil and obtains both crude
oil and natural gas. A second -growth forest is harvested, and lumber of various grades are milled. A farmer maintains a herd of dairy cows,
and after the cows are milked, the milk naturally separates into skim and cream or can be separated into various products characteriz ed by
the amount of milkfat. Some of these products then constitute raw materials in the manufacture of other products such as butt er and cheese.

Following are some important terms:

##3 These costs cannot be identified with a particular joint product. By definition, joint products incur common costs until they
reach the split -off point.

$+  $3 At this stage, the joint products acquire separate identities. Costs incurred prior to this point are common costs, and any
costs incurred after this point are separable costs.

$!3 These costs can be identified with a particular joint product. These costs are incurred for a specific product, after the split -
off point.

The characteristic feature of joint products is that all costs incurred prior to the split -off point are common costs, and cannot be identified
with individual products that are derived at split -off. Furthermore, the costs incurred by the dairy farmer to feed and care for the cows do not
significantly affect the relative amounts of cream and skim obtained, and the costs incurred by the lumber company to maintai n and harvest
the second-growth timber do not significantly affect the relative quantities of lumber of various grades that are obtained.

 c##3

Given the lack of a cause -and-effect relationship between the incurrence of common costs and the relative quantitie s of joint products
obtained, any allocation of these common costs to the joint products is arbitrary. Consequently, there is no management accou nting purpose
served by the allocation of these common costs. Literally, there is no managerial decision that b ecomes better informed by such an
allocation. Consider the possibilities:

1. Can the allocation of common costs prompt the manager to favor some joint products over other joint products and to therefore
change the production process, and hence th e quantities of joint products obtained?

po. By definition, the relative quantities obtained from the joint process are inherent in the production process itself, and can not
be managed. In fact, the manager probably does have strong preferences for some joint products over others (high -grade lumber
over low-grade lumber; cream over skim milk), but the manager¶s preferences are irrelevant.

2. Can the allocation of common costs prompt the manager to change the sales prices for the joint products, or to change decisions
about whether to incur separable costs to process one or more of the joint products further?

po. The decision to sell a joint product at split -off or to process it further depends only on the incremental costs and revenues of
the additional processing, not on the common costs. In fact, the common costs can be considered sunk at the time the addition al
processing decision is made. As for pricing, most joint products are commodities, and producers are gener ally price -takers. To
the extent that the producer faces a downward sloping demand curve, determining the optimal combination of price and
production level depends on the variable cost of production, but this calculation would have to be done simultaneousl y for all
joint products, in which case no allocation of common costs would be necessary.

3. Can the allocation of common costs inform the manager that the entire production process is unprofitable and should be termin ated?
For example, does this allocation tell the dairy farmer whether the farmer should sell the herd and get out of the dairy business?

po. Such an allocation is unnecessary for the decision of whether to terminate the joint production process. For this decision, t he
producer can look at the operation in its entirety (total revenues from all joint products less total common costs and total
separable costs).

Yet despite the fact that allocating common costs to joint products serves no decision -making purpose, it is required for exter nal financial
reporting. It is necessary for product costing if we wish to honor the matching principle for common costs, because these com mon costs are
manufacturing costs. For example, if the dairy sells lowfat milk shortly after split -off, but processes high milkfat product into cheese that
requires an aging process, the allocation of common costs is necessary for the valuation of ending inventory (work -in-process for cheese)
and the determination of cost -of-goods sold (lowfat milk).

c,  c##3

Here are four methods of allocating common costs:

1. è#3 Using this method, some common physical measure is identified to describe the quantity of each product obtained at
split-off. For example: the weight o f the joint products, or the volume. Common costs are then allocated in proportion to this physical
measure. This method presumes that the quantities of all joint products can be expressed using a common measure, which is not always the
case. For example, crude oil is a liquid, while natural gas is, naturally, a gas, and volumes of liquids and gasses are not normally measured in
the same units.

2.
,$ + 3 If a market price can be established for the products that are obtained at split -off, common costs can be allocated
in proportion to the sales value of the products at split -off. The sales value of each joint product is derived by multiplying the price per unit
by the number of units obtained. For example, if the dairy farmer obtains 20 g allons of cream, and if cream can be sold for $3 per gallon,
then the sales value for cream is $60. If the farmer also obtains 40 gallons of skim milk that sells for $2 per gallon, then the sales value of
skim milk is $80. The total value of both products is $140, and 43% ($60 ÷ $140) of common costs would be allocated to all 20 gallons of
cream. This method can be used whether or not one or more of the joint products are actually processed further, as long as a market price
exists for the product obtained at split-off. In other words, even if the farmer does not sell any cream, but processes all of the cream into
butter, the fact that there is a market price for cream is sufficient for the farmer to be able to apply this method of commo n cost allocation.
 3.  :! 13 The net realizable value of a joint product at split -off is the sales price of the final product after additional
processing, minus the separable costs incurred during the additional processing. If the joint product is going to be s old at split -off without
further processing, the net realizable value is simply the sales value at split -off, as in the previous method. Under the net realizable value
method of common cost allocation, common costs are allocated in proportion to their net realizable values. As with the previous method, the
allocation is based on the total value of all quantities of each joint product obtained (the net realizable value per unit, m ultiplied by the
number of units of each joint product).

4. è3 This method allocates common costs such that the overall gross margin percentage is identical for
each joint product. The gross margin percentage is calculated as follows:

Êross Margin Percentage = („ales ± ost of Êoods „old) ÷ „ales

Cost of Goods Sold for each product includes common costs and possibly some separable costs. The application of the Constant Gr oss
Margin èercentage requires solving for the allocation of common costs that equates the Gross Margin èercentage across all joi nt products.

3

The choice of method for allocating common costs should depend on the ease of application, the perceived quality of informati on reported
to external parties, and the perceived fairness of the allocation when mult iple product managers are responsible for joint products. However,
as discussed above, the allocation of common costs is arbitrary, and no method is conceptually preferable to any other method . All methods
of allocating common costs across joint products a re generally useless for operational, marketing, and product pricing decisions.