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Chapter 4
McGraw-Hill Education (Asia) Garrison, Noreen, Brewer, Cheng & Yuen Slide 2
Marginal Costing
Marginal Cost is the variable cost of one
unit of product or service
A cost would be avoided if the unit was not
produced or provided
McGraw-Hill Education (Asia) Garrison, Noreen, Brewer, Cheng & Yuen Slide 3
Marginal costing and Contribution
Contribution = Sales Revenue – Variable cost (both production and non-production cost)
Profit = Contribution – Fixed cost (both fixed production and non-production cost)
McGraw-Hill Education (Asia) Garrison, Noreen, Brewer, Cheng & Yuen Slide 4
Marginal Costing
McGraw-Hill Education (Asia) Garrison, Noreen, Brewer, Cheng & Yuen Slide 5
Marginal Costing
McGraw-Hill Education (Asia) Garrison, Noreen, Brewer, Cheng & Yuen Slide 6
Marginal Costing
McGraw-Hill Education (Asia) Garrison, Noreen, Brewer, Cheng & Yuen Slide 7
Example of Marginal costing and contribution
ABC company makes 2 products: The Loo and the Wash. Information relating to each of these
products for April 20X1 is as follows:
Loo Wash
Opening inventory Nil Nil
Production (units) 15,000 6,000
Sale units 10,000 5,000
$ $
Unit price 20 30
Unit costs
- Variable materials 8 14
- Variable labor 4 2
- Variable production Overhead 2 1
- Variable Sales overhead 2 3
McGraw-Hill Education (Asia) Garrison, Noreen, Brewer, Cheng & Yuen Slide 8
Overview of Absorption and Marginal Costing
McGraw-Hill Education (Asia) Garrison, Noreen, Brewer, Cheng & Yuen Slide 9
Absorption costing Vs. Marginal costing
Product cost: Refers to the costs used to create a product. These costs
include: direct materials, direct labor, consumable production supplies, and
factory overhead
McGraw-Hill Education (Asia) Garrison, Noreen, Brewer, Cheng & Yuen Slide 10
Absorption and Marginal costing
Absorption Marginal
costing Costing
Valuing units Total production Marginal
cost (Variable)
production cost
Valuing inventory Opening and Opening and
closing inventory closing inventory
valued at total valued at
production cost marginal cost
Fixed production Carried forward Fixed costs
Overheads from one period charged in full
to the next as part against profit in
of the the period in
closing/opening which they are
inventory incurred
valuation. Only hit
profit when units
are sold
McGraw-Hill Education (Asia) Garrison, Noreen, Brewer, Cheng & Yuen Slide 11
Absorption and Marginal costing
McGraw-Hill Education (Asia) Garrison, Noreen, Brewer, Cheng & Yuen Slide 12
Absorption and Marginal costing
Profit Statement
Sale revenues Sale revenues
- -
Cost of Sales Cost of sales
- +/-
Variable non-production costs Over/under absorption
= =
CONTRIBUTION GROSS PROFIT
- -
Fixed costs Variable non-production costs
-
=
Fixed non-production costs
NET PROFIT/LOSS =
NET PROFIT/LOSS
McGraw-Hill Education (Asia) Garrison, Noreen, Brewer, Cheng & Yuen Slide 13
Absorption and Marginal Costing
RECONCILIATION
+/-
McGraw-Hill Education (Asia) Garrison, Noreen, Brewer, Cheng & Yuen Slide 14
Absorption vs. Marginal costing
McGraw-Hill Education (Asia) Garrison, Noreen, Brewer, Cheng & Yuen Slide 15
Example
A company commenced business on 1 Mar produces one product only, the cost
card of product is as follows
$
Direct Materials 8
Direct Labor 5
Variable production overhead 2
Fixed production overhead 5
Standard production cost 20
OAR = 15.000 * 12/36.000 = 5
Fixed production overhead figure has been calculated on the basis of a budget
normal output of 36,000 units per annum. The fixed production overhead incurred
in Mar was $15.000 each month
McGraw-Hill Education (Asia) Garrison, Noreen, Brewer, Cheng & Yuen Slide 16
Example
Selling, distribution and Administration expenses are
Fixed: $ 10,000 per month
Variable: 15% of the sales value
The selling price per unit is $35 and the number of units produced and sold was
March (units)
Production: 2,000
Sales: 1,500 * 35 = 52,500
Required:
- Prepare the absorption costing profit statement for Mar
- Prepare the marginal costing profit statement for Mar
- Comparison of the profits
- Reconcile the profits/loss between the 2 methods:
McGraw-Hill Education (Asia) Garrison, Noreen, Brewer, Cheng & Yuen Slide 17
Absorption and Marginal costing
Absorption cost in favor:
1. Fixed overhead incurred in order to make output, so it is FAIR to charge all
output with a share of fixed overhead
2. Absorption cost is used in inventory valuation under IAS 02 “Inventory”
3. Pricing can be misled when contribution is insufficient to cover fixed costs
4. In the long-run, all costs are variable, Absorption cost will give recognition to
these long-run variable costs
McGraw-Hill Education (Asia) Garrison, Noreen, Brewer, Cheng & Yuen Slide 18
Absorption and Marginal costing:
The overhead absorption rate for product X is $10 per machine hour. Each
unit of product X requires 5 machine hours.
Production of product X last period was 4,800 units and the sales volume
achieved was 4,750 units
Requirement:
1. The absorption costing profit would be :
a. Greater than
b. The same as
c. Less than the marginal costing profit
2. The differences between the reported profits would be: $?
McGraw-Hill Education (Asia) Garrison, Noreen, Brewer, Cheng & Yuen Slide 19
Absorption and Marginal costing
Example: Comparison of total profits:
Company ABC produces and sells a single product X. At the beginning
of period 1, there are no opening inventories of the product for which the
variable production cost is $4 per unit and the sales price is $6 per unit.
Fixed costs are $2,000 per period, of which $1,500 are fixed production
costs
Period 1 Period 2
Sales 1,200 units 1,800 units
Production 1,500 units 1,500 units
Requirement:
What profit would be reported in each period and in total using the following
costing systems?
1. Absorption costing. Assume normal output is 1,500 units per period
2. Marginal costing
McGraw-Hill Education (Asia) Garrison, Noreen, Brewer, Cheng & Yuen Slide 20
Quick Check
McGraw-Hill Education (Asia) Garrison, Noreen, Brewer, Cheng & Yuen Slide 21
Unit Cost Computations
Harvey Company produces a single product
with the following information available:
Number of units produced annually 25,000
Variable costs per unit:
Direct materials, direct labor,
and variable mfg. overhead $ 10
Selling & administrative expenses $ 3
McGraw-Hill Education (Asia) Garrison, Noreen, Brewer, Cheng & Yuen Slide 22
Unit Cost Computations
Unit product cost is determined as follows:
Absorption Variable
Costing Costing
Direct materials, direct labor,
and variable mfg. overhead $ 10 $ 10
Fixed mfg. overhead
($150,000 ÷ 25,000 units) 6 -
Unit product cost $ 16 $ 10
McGraw-Hill Education (Asia) Garrison, Noreen, Brewer, Cheng & Yuen Slide 23
Learning Objective 2
McGraw-Hill Education (Asia) Garrison, Noreen, Brewer, Cheng & Yuen Slide 24
Income Comparison of
Absorption and Variable Costing
McGraw-Hill Education (Asia) Garrison, Noreen, Brewer, Cheng & Yuen Slide 25
Absorption Costing
Absorption Costing
Sales (20,000 × $30) $ 600,000
Less cost of goods sold:
Beginning inventory $ -
Add COGM (25,000 × $16) 400,000
Goods available for sale 400,000
Ending inventory (5,000 × $16) 80,000 320,000
Gross margin 280,000
Less selling & admin. exp.
Variable (20,000 × $3) $ 60,000
Fixed 100,000 160,000
Net operating income $ 120,000
McGraw-Hill Education (Asia) Garrison, Noreen, Brewer, Cheng & Yuen Slide 27
Learning Objective 3
McGraw-Hill Education (Asia) Garrison, Noreen, Brewer, Cheng & Yuen Slide 28
Comparing the Two Methods
Cost of
Goods Ending Period
Sold Inventory Expense Total
Absorption costing
Variable mfg. costs $ 200,000 $ 50,000 $ - $ 250,000
Fixed mfg. costs 120,000 30,000 - 150,000
$ 320,000 $ 80,000 $ - $ 400,000
Variable costing
Variable mfg. costs $ 200,000 $ 50,000 $ - $ 250,000
Fixed mfg. costs - - 150,000 150,000
$ 200,000 $ 50,000 $ 150,000 $ 400,000
McGraw-Hill Education (Asia) Garrison, Noreen, Brewer, Cheng & Yuen Slide 29
Comparing the Two Methods
We can reconcile the difference between
absorption and variable income as follows:
McGraw-Hill Education (Asia) Garrison, Noreen, Brewer, Cheng & Yuen Slide 30
Extended Comparisons of Income Data
Harvey Company – Year Two
Number of units produced 25,000
Number of units sold 30,000
Units in beginning inventory 5,000
Unit sales price $ 30
Variable costs per unit:
Direct materials, direct labor
variable mfg. overhead $ 10
Selling & administrative
expenses $ 3
Fixed costs per year:
Manufacturing overhead $ 150,000
Selling & administrative
expenses $ 100,000
McGraw-Hill Education (Asia) Garrison, Noreen, Brewer, Cheng & Yuen Slide 31
Unit Cost Computations
Absorption Variable
Costing Costing
Direct materials, direct labor,
and variable mfg. overhead $ 10 $ 10
Fixed mfg. overhead
($150,000 ÷ 25,000 units) 6 -
Unit product cost $ 16 $ 10
McGraw-Hill Education (Asia) Garrison, Noreen, Brewer, Cheng & Yuen Slide 32
Absorption Costing Unit product
cost.Absorption Costing
Sales (30,000 × $30) $ 900,000
Less cost of goods sold:
Beg. inventory (5,000 × $16) $ 80,000
Add COGM (25,000 × $16) 400,000
Goods available for sale 480,000
Less ending inventory - 480,000
Gross margin 420,000
Less selling & admin. exp.
Variable (30,000 × $3) $ 90,000
Fixed 100,000 190,000
Net operating income $ 230,000
McGraw-Hill Education (Asia) Garrison, Noreen, Brewer, Cheng & Yuen Slide 34
Comparing the Two Methods
We can reconcile the difference between
absorption and variable income as follows:
McGraw-Hill Education (Asia) Garrison, Noreen, Brewer, Cheng & Yuen Slide 35
Comparing the Two Methods
McGraw-Hill Education (Asia) Garrison, Noreen, Brewer, Cheng & Yuen Slide 36
Summary of Key Insights
Relation between Effect Relation between
production on variable and
and sales inventories absorption income
Units produced No change Absorption
= In =
Units sold inventories Variable
Units produced Absorption
> Inventories >
Units sold Increase Variable
Units produced Absorption
< Inventories <
Units sold decrease Variable
McGraw-Hill Education (Asia) Garrison, Noreen, Brewer, Cheng & Yuen Slide 37
Learning Objective 4
Understand the
advantages and
disadvantages of both
variable and absorption
costing.
McGraw-Hill Education (Asia) Garrison, Noreen, Brewer, Cheng & Yuen Slide 38
Impact on the Manager
Opponents of absorption costing argue that
shifting fixed manufacturing overhead costs
between periods can lead to faulty decisions.
McGraw-Hill Education (Asia) Garrison, Noreen, Brewer, Cheng & Yuen Slide 39
CVP Analysis, Decision Making
and Absorption costing
Absorption costing does not dovetail with CVP analysis,
nor does it support decision making. It treats fixed
manufacturing overhead as a variable cost. It assigns per
unit fixed manufacturing overhead costs to production.
Treating fixed manufacturing overhead as a
variable cost can:
• Lead to faulty pricing decisions and faulty
keep-or-drop decisions.
McGraw-Hill Education (Asia) Garrison, Noreen, Brewer, Cheng & Yuen Slide 40
External Reporting and Income Taxes
To conform to
IFRS and US GAAP
requirements, absorption costing In many countries,
must be used for including US,
external financial reports. absorption costing must be
used when filling out
income tax returns.
Since top executives
are typically evaluated based on
earnings reported to shareholders
in external reports, they may feel that
decisions should be based on
absorption costing data.
McGraw-Hill Education (Asia) Garrison, Noreen, Brewer, Cheng & Yuen Slide 41
Advantages of Variable Costing
and the Contribution Approach
Consistent with
CVP analysis.
Management finds Net operating income
it more useful. is closer to
net cash flow.
Consistent with standard
costs and flexible budgeting.
Advantages
Easier to estimate profitability
of products and segments.
Impact of fixed
costs on profits Profit is not affected by
emphasized. changes in inventories.
McGraw-Hill Education (Asia) Garrison, Noreen, Brewer, Cheng & Yuen Slide 42
Variable versus Absorption Costing
Fixed manufacturing
costs must be assigned Fixed manufacturing
to products to properly costs are capacity costs
match revenues and and will be incurred
costs. even if nothing is
produced.
Absorption Variable
Costing Costing
McGraw-Hill Education (Asia) Garrison, Noreen, Brewer, Cheng & Yuen Slide 43
Variable Costing and the Theory of
Constraints (TOC)
Companies involved in TOC use a form of variable
costing. However, one difference of the TOC approach
is that it treats direct labor as a fixed cost for three
reasons:
Many companies have a commitment to guarantee
workers a minimum number of paid hours.
Direct labor is usually not the constraint.
TOC emphasizes the role direct laborers play in driving
continuous improvement. Since layoffs often devastate
morale, managers involved in TOC are extremely
reluctant to lay off employees.
McGraw-Hill Education (Asia) Garrison, Noreen, Brewer, Cheng & Yuen Slide 44
Impact of Lean Production
Production
tends to equal
sales . . .
McGraw-Hill Education (Asia) Garrison, Noreen, Brewer, Cheng & Yuen Slide 45
Learning Objective 8
McGraw-Hill Education (Asia) Garrison, Noreen, Brewer, Cheng & Yuen Slide 46
Creating Extra Profit Without Increase In Sales
Continue with the Harvey Fresh example (slides 54, and 58 to 64).
Assume the company had the same sales, revenue and cost structure
but produced 35,000 units (instead of 25,000 units) to increase ending
inventory
AbsorptionbyCosting
10,000(Year
units.1) Original New
Produced 25,000 units Produced 35,000 units
Sales (20,000 × $30) $ 600,000 600,000
Less cost of goods sold:
Beginning inventory $ - $ -
Add COGM (25,000 × $16) 400,000 560,000
Overapplied adjustment (30,000) (90,000)
Goods available for sale 370,000 470,000
Ending inventory (5,000 × $16) 80,000 290,000 240,000 230,000
Gross margin 310,000 370,000
Less selling & admin. exp.
Variable (20,000 × $3) $ 60,000 $ 60,000
Fixed 100,000 160,000 100,000 160,000
Net operating income $ 150,000 $ 210,000
McGraw-Hill Education (Asia) Garrison, Noreen, Brewer, Cheng & Yuen Slide 48
Profit Arising from Ending Inventory Value
McGraw-Hill Education (Asia) Garrison, Noreen, Brewer, Cheng & Yuen Slide 49
Value of Ending Inventory
Absorption Costing (Year 1) Original New
Produced 25,000 units Produced 35,000 units
Overapplied adjustment (30,000) (90,000)
Ending inventory (5,000 × $16) $ 80,000
(15,000 x $16) $ 240,000
McGraw-Hill Education (Asia) Garrison, Noreen, Brewer, Cheng & Yuen Slide 50
Use of Variable Costing
Continue with the Harvey Fresh example but presenting the results
using the variable costing format.
Variable Costing (Year 1) Original New
Produced 25,000 units Produced 35,000 units
Sales (20,000 × $30) $ 600,000 600,000
Less variable cost of goods sold:
Beginning inventory $ - $ -
Add COGM (25,000 × $10) 250,000 350,000
Overapplied adjustment - -
Goods available for sale 250,000 350,000
Ending inventory (5,000 × $10) 50,000 200,000 150,000 200,000
Less variable selling & admin. exp. 60,000 60,000
(20,000 × $3)
Contribution Margin 340,000 340,000
Less Fixed Manufacturing overhead $ 120,000 $ 120,000
Fixed selling & Admin exp. 100,000 220,000 100,000 220,000
Net operating income $ 120,000 $ 120,000
Profits remain the same despite of changing quantity in production and ending inventory
Use of Variable Costing can avoid Profit inflation through producing more inventories
McGraw-Hill Education (Asia) Garrison, Noreen, Brewer, Cheng & Yuen Slide 51
Overapplied and Underapplied Manufacturing
Overhead - Summary
Harvey Fresh’s
Method
Alternative 1 Alternative 2
If Manufacturing Close to Cost Proportional
Overhead is . . . of Goods Sold Allocation
McGraw-Hill Education (Asia) Garrison, Noreen, Brewer, Cheng & Yuen Slide 52
Quick Check
What effect will the overapplied overhead have
on Harvey’s net operating income?
a. Net operating income will increase.
b. Net operating income will be unaffected.
c. Net operating income will decrease.
McGraw-Hill Education (Asia) Garrison, Noreen, Brewer, Cheng & Yuen Slide 53
Quick Check
McGraw-Hill Education (Asia) Garrison, Noreen, Brewer, Cheng & Yuen Slide 54
Multiple Predetermined Overhead Rates
To this point, we have assumed that there is a single
predetermined overhead rate called a plantwide
overhead rate.
McGraw-Hill Education (Asia) Garrison, Noreen, Brewer, Cheng & Yuen Slide 55
End of Chapter 5
McGraw-Hill Education (Asia) Garrison, Noreen, Brewer, Cheng & Yuen Slide 56