Management Accounting

Cost measurement:
 Absorption and marginal costing
 Traditional overhead absorption and activity-
based costing
 Stock valuation methods

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Marginal Cost and Marginal Costing
 Marginal costing: is an alternative method of costing to absorption
costing.
• Only variable costs are charged as a cost of sales and a Contribution is
calculated which is sales revenue minus the variable cost of sales.
• Closing stocks of work in progress or finished goods are valued at
marginal (variable) production cost.
• Fixed cost are treated as a period cost and are charged in full to the profit
and loss account of the accounting period in which they are incurred.

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Marginal Cost and Marginal Costing
 Marginal cost: is the cost of a unit of product or service
which would be avoided if that unit were not produced or
provided

 Contribution: is the difference between sales value and

marginal cost of sales.
• Contribution is of fundamental importance in marginal
costing.
• Contribution may be defined as the profit 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 + P).
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 The principles of marginal costing
 For any given period of time, fixed costs will be the same, for any volume of
sales and production .Therefore, by selling an extra item of product or service
the following will happen.
 Revenue will increase by the sales value of the item sold.
 Costs will increase by the variable cost per unit.
 Profit will increase by the amount of contribution earned from the extra
item.
 if the volume of sales falls by one item, the profit will fall by the amount of
contribution earned from the item.
 Profit measurement should therefore be based on an analysis of total
contribution. Since fixed costs relate to a period of time, and do not change
with increases or decreases in sales volume, it is misleading to charge units of
sale with a share of fixed costs.
 When a unit of product is made, the extra costs incurred in its manufacture are
the variable production costs. Fixed costs are unaffected, and no extra fixed
costs are incurred when output is increased.
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Example:
 Water Ltd makes a product, Splash, which has a variable
production cost of 6£ per unit and a sale price of £10 per unit. At
the beginning of September 20X4, there were no opening stocks
and production during the month was 20,000 units. Fixed costs
for the month were £45,000(production, administration, sales and
distribution). There were no variable marketing cost.

 Required:
Calculate the contribution and profit for September 20X4, using marginal
costing principles, if sales were as follows:
a) 10,000 Splashes
b) 15,000 Splashes
c) 20,000 Splashes

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Example

6 x 10,000

5,000 /10,000
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Absorption and marginal costing

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Introduction
 Before we allocate all manufacturing costs
to products regardless of whether they are
fixed or variable. This approach is known
as absorption costing/full costing
 However, only variable costs are relevant
to decision-making. This is known as
marginal costing/variable costing

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Definition
 Absorption costing
 Marginal costing

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Absorption costing
 It is costing system which treats all
manufacturing costs including both the
fixed and variable costs as product costs

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Marginal costing
 It is a costing system which treats only the
variable manufacturing costs as product
costs. The fixed manufacturing overheads
are regarded as period cost

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 Absorption Costing
Cost
Manufacturing cost Non-manufacturing cost

Direct Direct Overheads

Materials Labour Period cost

Finished goods Cost of goods sold Profit and loss account

Marginal Costing
Cost
Manufacturing cost Non-manufacturing cost

Direct Direct Variable Fixed

Materials Labour Overheads overhead Period cost

Finished goods Cost of goods sold Profit and loss account

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Presentation of costs on income
statement

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 Trading and profit ans loss account
Absorption costing Marginal costing
$ $
Sales X Sales X
Less: Cost of goods sold X Less: Variable cost of
Goods sold X
Gross profit X Product contribution margin X

Less: Expenses Less: variable non- manufacturing

Selling expenses X expenses
Admin. expenses X Variable selling expenses X
Other expenses X X Variable admin. expenses X
Other variable expenses X
Total contribution expenses X
Variable and fixed manufacturing
Less: Expenses
Fixed selling expenses X
Fixed admin. expenses X
Other fixed expenses X
Net Profit X Net Profit X
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Example

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A company started its business in 2005. The following information
Was available for January to March 2005 for the company that produced
A single product:
$
Selling price per unit 100
Direct materials per unit 20
Direct Labor per unit 10
Fixed factory overhead per month 30000
Variable factory overhead per unit 5
Fixed selling overheads 1000
Variable selling overheads per unit 4

Budgeted activity was expected to be 1000 units each month

Production and sales for each month were as follows:
Jan Feb March
Unit sold 1000 800 1100
Unit produced 1000 1300 900
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 Required:
 Prepare absorption and marginal costing
statements for the three months

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Absorption costing

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 January February March
$ $ $
Sales 100000 80000 110000
Less: cost of good sold ($65) 65000 52000 71500
28000 38500
Adjustment for Over-/(under)
Absorption of factory overhead 9000 (3000)
Gross profit 35000 37000 35500
Less: Expenses
Fixed selling overheads 1000 1000 1000
Variable selling overheads 4000 3200 4400
Net profit 30000 32800 30100

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Marginal costing

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 January February March
$ $ $
Sales 100000 80000 110000
Less: Variable cost of good
sold ($35) 35000 28000 385500
Product contribution margin 65000 52000 71500
Less: Variable selling overhead4000 3200 4400
Total contribution margin 61000 48800 67100
Less: Fixed Expenses
Fixed factory overhead 30000 30000 30000
Fixed selling overheads 1000 1000 1000
Net profit 30000 32800 30100

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Wk1:
Standard fixed overhead rate
= Budgeted total fixed factory overheads
Budgeted number of units produced

= $30000
1000 units
= $30 units
Wk 2:
Production cost per unit under absorption costing:
$
Direct materials 20
Direct labour 10
Fixed factory overhead absorbed 30
Variable factory overheads 5
65
Back
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Wk 3:
(Under-)/Over-absorption of fixed factory overheads:
January February March
$ $ $
Fixed overhead 30000 39000 27000
Fixed overheads incurred 30000 30000 30000
0 9000 (3000)
1000*$30 1300*$30 900*$30

Wk 4: No fixed factory overhead

Variable production cost per unit under marginal costing:
$
Direct materials 20
Direct labour 10
Variable factory overhead 5
Back 35 23
Difference between absorption
and marginal costing

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 Absorption costing Marginal costing
Treatment for Fixed Fixed manufacturing
fixed manufacturing overhead are treated
manufacturing overheads are as period costs. It is
overheads treated as product believed that only the
costing. It is variable costs are
believed that relevant to decision-
products cannot be making.
produced without Fixed manufacturing
the resources overheads will be
provided by fixed incurred regardless
manufacturing there is production or
overheads not
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 Absorption costing Marginal costing
Value of High value of Lower value of
closing stock closing stock will be closing stock that
obtained as some included the variable
factory overheads cost only
are included as
product costs and
carried forward as
closing stock

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 Absorption costing Marginal costing
Reported If the production = Sales, AC profit = MC Profit
profit
If Production > Sales, AC profit > MC profit
As some factory overhead will be deferred as
product costs under the absorption costing

If Production < Sales, AC profit < MC profit

As the previously deferred factory overhead
will be released and charged as cost of goods
sold

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FIFO
 assumes that materials are issued out of stock in the
order in which they were delivered into stock:
=> Issues are priced at the cost of the earliest delivery remaining in
stock.
Using FIFO, the cost of issues and the closing stock value
in the example

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FIFO (First in, First out)

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FIFO
 Advantages:
• It is a logical pricing method which probably represents what is
physically happening: in practice the oldest stock is likely to be
used first.
• It is easy to understand and explain to managers.
• The Stock valuation can be near to a valuation based on
replacement cost.
 Disadvantages
• FIFO can be cumbersome to operate because of the need to
identify each batch of material separately.
• Managers may find it difficult to compare costs and make
decisions when they are charged with varying prices for the same
materials.
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LIFO (Last In, First Out)
 LIFO assumes that material are issued out of stock in the
servers order to which they were delivered: the most recent
deliveries are issued before earlier ones, and are priced
accordingly.

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