Topic A08: Marginal and Absorption Costing
Topic Overview p.1
Topic Overview
Topic
BAFS Elective Part – Accounting Module – Cost Accounting
A08: Marginal and Absorption Costing
Level
S5 / S6
Duration
2 lessons (40 minutes per lesson)
Learning Objectives:
1.
2.
3.
To distinguish the difference between marginal and absorption costing;
To explain the profit impacts between marginal and absorption costing in profit
calculations; and
To state the advantages and disadvantages of a marginal and absorption costing
systems.
Overview of Contents:
Lesson 1
Lesson 2
Marginal and Absorption Costing
Arguments for and against Marginal and Absorption Costing
Prior Knowledge:
Student should know:
1. how to create a manufacturing account and income statement in financial
accounting;
2. the differences between prime / direct cost, factory overhead / indirect cost, and
non-production cost / administrative and selling overheads;
3. the allocation of cost / expenses to production cost and non-production cost; and
4. the calculation of production costs under an absorption costing system.
Resources:
„
„
„
Topic Overview, Teaching Plan and Answers to Student Worksheet
PowerPoint Presentation
Student Worksheet
Suggested Activities
„
„
„
Case Study
Group Debate
Crossword Puzzle
BAFS Learning and Teaching Example
As at April 2009
Topic A08: Marginal and Absorption Costing
Topic Overview p.2
Lesson 1
Theme
Marginal and Absorption Costing
Duration
40 minutes
Expected Learning Outcomes:
Upon completion of this lesson, students will be able to:
1.
2.
3.
4.
Define marginal and absorption costing;
Distinguish differences between marginal and absorption costing;
Prepare profit statements based on a marginal costing and an absorption costing
system; and
Explain the difference in profits between marginal and absorption costing profit
calculations.
Teaching Sequence and Time Allocation:
Activities
Reference
Time
Allocation
Part I: Introduction
—
Teacher reviews the definition of fixed and variable
costs and asks students to give examples in relation to
their family’s monthly expenses.
—
Activity 1 – Case Study
„ Teacher asks students to identify fixed and variable
costs, production and non-production costs in a
PPT#1-19
manufacturing account and income statement of
Pattie Company and calculate the unit product
Student
costs for the month of June Year 8 (Task 1 and 2).
Worksheet
„ Teacher informs students of two main accounting
pp.1-7
streams: financial accounting and cost accounting.
Financial accounting is concerned with the
provision of information to external parties. Cost
accounting is concerned with the provision of
information to internal parties. A number of
costing systems are being applied by organisations
15 minutes
BAFS Learning and Teaching Example
As at April 2009
Topic A08: Marginal and Absorption Costing
„
„
„
„
„
Topic Overview p.3
to provide relevant information to help managers
make better decisions.
Teacher uses flowchart to introduce the term
‘absorption costing system’ and its mechanism.
Teacher tells students the relationship between the
fixed cost and variable cost with absorption and
marginal costing systems.
Teacher uses flowchart to show the framework of
marginal costing system.
Teacher asks students to prepare the income
statement for Pattie Company, using marginal
costing method (Task 3)
Teacher asks students to determine the major effect
if marginal costing is used and explains the
meaning of contribution.
Part II: Content
—
Activity 2 – Case Study
PPT #20-32
„ Students form groups of four or five, read the case
concerning of a cyber-firm and complete the tasks.
Student
22 minutes
„ Teacher invites students to present their answers.
Worksheet
„ Teacher checks answers and draws conclusion for
pp.8-16
each task.
Part III: Conclusion
—
—
Teacher concludes lesson by highlighting the
differences between marginal and absorption costing.
Teacher asks students to consider the advantages and
disadvantages for marginal and absorption costing for
the upcoming lesson.
PPT #33-35
3 minutes
BAFS Learning and Teaching Example
As at April 2009
Topic A08: Marginal and Absorption Costing
Topic Overview p.4
Lesson 2
Theme
Arguments for and against Marginal and Absorption Costing
Duration
40 minutes
Expected Learning Outcomes:
Upon completion of this lesson, students will be able to:
1.
2.
3.
Explain the advantages and disadvantages of marginal costing;
Explain the advantages and disadvantages of absorption costing; and
Explain circumstances when suitable to use marginal or absorption costing.
Teaching Sequence and Time Allocation:
Activities
Reference
Time
Allocation
PPT #36
4 minutes
Part I: Introduction
—
Teacher starts the lesson by introducing the problem
faced by Alice, the Managing Director of Bullet
Manufacturing Company and asks students to set up a
debate on the adoption of a marginal costing system in
the company.
Part II: Content
—
—
Activity 3 – Preparation for the debate
„ Students are divided into two groups; one is the
affirmative side and the other is the negative side.
„ Students are required to discuss within their groups
and to develop arguments.
„ Each group nominates one representative to take
part in the debate.
Activity 3 – Debate
„ Each representative has 4 minutes to present their
group’s views and arguments.
„ Teacher decides winner, concludes the debate and
introduces suitable circumstances for using
marginal and absorption costing.
PPT #37
Student
Worksheet
pp.17-19
15 minutes
PPT #38-45 12 minutes
BAFS Learning and Teaching Example
As at April 2009
Topic A08: Marginal and Absorption Costing
Topic Overview p.5
Part III: Conclusion
—
—
Teacher concludes session by highlighting the
advantages of marginal and absorption costing and asks
PPT #46 – 48
students to choose the preferred costing methods under
different circumstances.
Student
9 minutes
Teacher asks students to complete the crossword puzzle
Worksheets
at home to check their understanding on the concepts of
pp.20-22
marginal and absorption costing. The answers will be
distributed during next lesson.
BAFS Learning and Teaching Example
As at April 2009
Topic A08: Marginal and Absorption Costing
Topic Overview p.6
Answer to Activity 1
Task 1: Cost Classification
Fixed Cost
Variable Cost
Production Cost
Direct Materials
Direct Materials
Direct Wages
Direct Wages
Direct Expenses
Direct Expenses
Factory Manager Salary
Factory Manager Salary
Factory Management
Factory Management
Fee
Fee
Factory Rent and Rates
Factory Rent and Rates
Factory Fire Insurance
Factory Fire Insurance
Factory Labour
Factory Labour
Insurance
Insurance
Provision for
Provision for
Depreciation –
Depreciation –
Machinery
Machinery
Non-Production Cost
Bank Loan Interest
Bank Loan Interest
Provision for
Provision for
Depreciation – Office
Depreciation –
Equipment
Office Equipment
Cleaning Expenses
Cleaning Expenses
Salesman’s Salaries
Salesman’s Salaries
Carriage
Outwards
Advertising
Advertising
Sales Commission
Office Rent and Rates
Carriage Outwards
Sales Commission
Office Rent and
Rates
BAFS Learning and Teaching Example
As at April 2009
Topic A08: Marginal and Absorption Costing
Topic Overview p.7
Task 2: Cost Computation
Total Production Cost: $76,200
Unit Produced: 2,540
Unit Product Cost = Total Production Cost ÷ Unit Produced
= $76,200 ÷ 2,540 units
= $30
Task 3: Income Statement
(a)Unit Selling Price
= Sales Revenue ÷ No of units sold
= $191,475 ÷ (57 + 2,540 – 44)
= $191,475 ÷ 2,553
= $75
Variable Production Cost
= $(30,600 + 20,800 + 5,000 + 1,800)
= $58,200
Closing Stock Value (44 units)
= $58,200 ÷ 2,540 x 44
= $1,008
Variable Non-production Cost
= $(195 + 445)
= $640
Fixed Production Cost
= $(9,000 + 500 + 7,000 + 600 + 900)
= $18,000
Fixed Non-production Cost
= $(750 + 250 + 159 + 12,643 + 190 + 7,905)
= $21,897
BAFS Learning and Teaching Example
As at April 2009
Topic A08: Marginal and Absorption Costing
Topic Overview p.8
Income Statement for the month ending 30 June Year 8 (Marginal Costing)
HK$
Sales
HK$
191,475
Less: Variable Production Cost of Goods Sold
Finished Goods Opening Stock
1,254
Add: Variable Production Cost
58,200
59,454
Less: Finished Goods Closing Stock
1,008
58,446
133,029
Less: Variable non-production cost
640
Contribution
132,389
Less: Fixed cost
Production
18,000
Non-production
21,897
Net profit
39,897
92,492
(b)
Major Effect:
Profit calculated under Marginal Costing is higher than that
of Absorption Costing.
Reason:
The closing inventory value calculated under the Absorption
Costing method is higher than Marginal Costing, as fixed
production costs are treated as product and costs will be carried
forward to the next accounting period if unsold. Therefore, a
decrease in the stock levels mean a larger portion of the fixed
costs will be charged to the current accounting period under
Absorption Costing and the profit calculated will be lower than
that of Marginal Costing.
BAFS Learning and Teaching Example
As at April 2009
Topic A08: Marginal and Absorption Costing
Topic Overview p.9
Answer to Activity 2
Task 1: Cost Classification
Examples of fixed cost:
z
Cost of setting up business on Yahoo Small Business Platform
z
Monthly service fee paid to Yahoo
z
Hire charges for heat transfer machines
z
Packaging tools and materials
Examples of variable cost:
z
T-shirt purchase cost
z
Transaction fee paid to Yahoo
z
Delivery charges
Task 2: Cost Estimation
Cost Items
Monthly service fee paid to Yahoo
HK$
Range from HK$160 to HK$320, depends on
plans selected
Hire charges for heat transfer
Machines with more functions are higher,
machines (Assuming 2 machines will
normally below HK$1,000 each
be hired)
T-shirt purchase cost
Range from a few dollars to hundreds,
depends on quality and quantity selected
Transfer paper for laser printer
Around HK$6 each
Packaging tools and materials
Range from few dollars to hundreds, depends
on materials and packaging
Printing charges (e.g. cartridge)
Range from a few dollars to hundreds,
depends on cartridge and number of colours
Transaction fee paid to Yahoo
Range from 1% - 2% of the monthly revenue,
depends on the plan selected
Delivery charges
Range from a few dollars to hundreds,
depends on location and delivery point
BAFS Learning and Teaching Example
As at April 2009
Topic A08: Marginal and Absorption Costing
Topic Overview p.10
Task 3: Cost Computation
(a)
Cost Items
Details
Cost Classification under
Fixed or
Variable
Production or
Non-production
$400/month
Fixed Cost
Non-production Cost
$1,500/
month
Fixed Cost
Production Cost
T-shirt purchase cost
$15/piece
Variable
Cost
Production Cost
Transfer paper
$4/sheet
Variable
Cost
Production Cost
Printing charges
$3/sheet
Variable
Cost
Production Cost
Packaging tools & materials
$2,000/
month
Fixed Cost
Production Cost
$300/month
Fixed Cost
Non-production Cost
Advertising fee (a fixed amount $1,000/month Fixed Cost
charged by an advertising firm)
Non-Production Cost
Transaction fee charged by
Yahoo
Service fee paid to Yahoo
Hire charges for 2 heat
transfer machines
Stationery expenses
Delivery charges
1.5% on sales
Variable
Cost
Non-Production Cost
1% on sales
Variable
Cost
Non-Production Cost
(b)
Under Marginal Costing:
T-shirt purchases cost
Transfer paper
Printing charges
$15
$4
$3
Unit product cost
$22
Under Absorption Costing:
T-shirt purchases
Transfer paper
Printing charges
Production overhead*
$15
$4
$3
$7
Unit product cost
$29
*($1,500 + $2,000) ÷ 500 = $7
BAFS Learning and Teaching Example
As at April 2009
Topic A08: Marginal and Absorption Costing
Topic Overview p.11
Task 4: Profit Computation
(a) Absorption Costing
1st month
2nd month
3rd month
Total
HK$
HK$
HK$
HK$
21,750.00
17,400.00
23,925.00
63,075.00
-
-
2,900.00
-
14,500.00
14,500.00
14,500.00
43,500.00
(2,900.00)
(1,450.00)
(1,450.00)
14,500.00
11,600.00
15,950.00
42,050.00
7,250.00
5,800.00
7,975.00
21,025.00
1,700.00
1,700.00
1,700.00
5,100.00
543.75
435.00
598.13
1,576.88
5,006.25
3,665.00
5676.87
14,348.12
1st month
2nd month
3rd month
Total
HK$
HK$
HK$
HK$
21,750.00
17,400.00
23,925.00
63,075.00
-
-
2,200.00
-
11,000.00
11,000.00
11,000.00
33,000.00
(2,200.00)
(1,100.00)
(1,100.00)
11,000.00
8,800.00
12,100.00
31,900.00
543.75
435.00
598.13
1,576.88
11,543.75
9,235.00
12,698.13
33,476.88
10,206.25
8,165.00
11,226.87
29,598.12
Production
3,500.00
3,500.00
3,500.00
10,500.00
Non-production
1,700.00
1,700.00
1,700.00
5,100.00
5,006.25
2,965.00
6,026.87
13,998.12
Sales
Less: Production cost of
sales
Opening stock
Production cost
Closing stock
Gross profit
-
Less: Non-production cost
Fixed
Variable
Net profit
(b) Marginal Costing
Sales
Less: Variable production
cost of sales
Opening stock
Variable production cost
Closing stock
Variable
non-production
-
cost
Contribution
Less: Fixed cost
Net profit
BAFS Learning and Teaching Example
As at April 2009
Topic A08: Marginal and Absorption Costing
Topic Overview p.12
Task 5: Method Selection
(a)
Profit earned
under:
Absorption costing
Marginal costing
Difference
2 nd month
3 rd month
$3,665
$2,965
$700
$5,676.87
$6,026.87
($350)
Reasons:
1.
2 nd month: profits calculated under absorption costing are higher
than marginal costing. This is because when production exceeds
sales, there is an increase in closing stock and a greater portion of
the fixed production overhead will be included in the closing stock
and carried forward to next period.
2.
3 rd month: profits calculated under absorption costing are lower
than marginal costing. This is because when sales exceeds
production, there will be a decline of closing stock and a greater
portion of the fixed production overhead is brought forward as an
expenses in the opening inventory.
(b)
Businesses relying on seasonal sales in which production is built up
outside the sales season to meet demand, the full amount of fixed
overhead will be charged against sales under the marginal costing
system. Then losses will be reported during out-of-season periods,
and large profits will be reported when the goods are sold.
Under absorption costing systems, fixed overheads are deferred and
included in the closing inventory valuation, and recorded as expenses
only in the period in which the goods are sold. Losses are therefore
unlikely to be reported in the periods when stock is built up.
Therefore, if more T-shirts are sold in summer, absorption costing
should be adopted to provide more logical profit calculations.
BAFS Learning and Teaching Example
As at April 2009
Topic A08: Marginal and Absorption Costing
Topic Overview p.13
Answer to Activity 3
Arguments for the proposition (hints: students are required to emphasise the
advantages of Marginal Costing and disadvantages of Absorption Costing)
Advantages of Marginal Costing
z
Easy to understand – avoids arbitrary allocation of fixed overheads.
z
Fixed overhead is excluded from inventory costs – avoids the varying
charges per unit and hence distortion in stock valuations.
z
Fixed overheads are NOT carried forward in stock valuations – avoids the
effect of changes in closing inventory level on profits.
z
Contribution and profits are directly driven by sales – shows clearly the
effect of sales on cash flows and relationships between cost, price and
volume.
z
Focuses on controllable business aspects – facilities execution of cost
controls.
Disadvantages of Absorption Costing
z
More complicated – have to make arbitrary assumptions on apportionment
of fixed overheads.
z
Fixed overheads are charged to production – unit inventory costs may vary
according to production.
z
Part of the current year’s fixed overhead is carried forward in closing
stock to the following year – management may manipulate profits by
building up inventories and hence deferring the fixed overheads to the
following years.
z
Profit is not a direct function of sales.
There’s a possibility that profit
may drop even though sales are up.
z
Relationships between cost, price and volume are ignored since the focus is
on total cost.
BAFS Learning and Teaching Example
As at April 2009
Topic A08: Marginal and Absorption Costing
Topic Overview p.14
Arguments against the proposition (hints: students are required to emphasise
the advantages of Absorption Costing and disadvantages of Marginal Costing)
Advantages of Absorption Costing
z
Fixed costs are absorbed in inventory – ensures all fixed costs will be
recovered and met in the long run.
z
Recognition of the importance of fixed overheads in production – finished
goods and work in progress stock will not be understated, giving a true and
fair view of the firm’s financial affairs.
z
Compliance with Accounting Standards – is useful for external reporting.
z
All costs are variable in the long run – recognises all “long run variable”
costs.
z
Less profit fluctuations when production remains constant but sales
fluctuate.
Disadvantages of Marginal Costing
z
It ignores that fixed costs must be recovered in the long run, so if selling
price is based only on marginal costs, it’s possible that a positive
contribution might NOT be sufficient to cover all fixed costs in the long
run.
z
Finished goods and work in progress stock will be understated.
z
Exclusion of fixed costs from stock valuations does not conform to
acceptable accounting practices.
z
It fails to recognise that all costs are variable in the long run.
z
For firms that have a seasonal sales pattern, profits tend to fluctuate
greatly.
Losses are reported during the slack season while huge profits
are reported during the peak session.
z
It’s not easy to establish the variability of costs, as variable costs are
rarely completely variable and fixed cost are rarely completely fixed.
BAFS Learning and Teaching Example
As at April 2009
Topic A08: Marginal and Absorption Costing
Topic Overview p.15
Summary for lesson 2
Marginal
Short run decision-making
Costing
Absorption Costing
3
Long run decision-making
3
When sales is subject to high
seasonal fluctuations
3
Comparison of performance
of different
departments/product lines
External reporting
3
3
BAFS Learning and Teaching Example
As at April 2009
Topic A08: Marginal and Absorption Costing
Topic Overview p.16
Answer to Activity 4
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BAFS Learning and Teaching Example
As at April 2009
D
BAFS Elective Part
Fixed Costs
Accounting Module –
Cost Accounting
Topic A08:
Marginal and Absorption Costing
Technology Education Section
Curriculum Development Institute
Education Bureau, HKSARG
April 2009
Topic A08
Marginal and Absorption Costing
2
BAFS Elective Part
Learning and Teaching Example
Introduction
Lesson 1
This session aims to help students distinguish between marginal and
absorption costing and their impact on profit calculations. Students will
build a solid understanding through active participation in debate and case
study.
Teacher starts the lesson by introducing the definition of fixed cost.
Definition of fixed cost: A cost which is incurred for a period, and which,
within certain output and turnover limits, tends to be unaffected by
fluctuations in the level of activity. (CIMA Official Terminology)
Duration
Two 40-minute lessons
Teacher provides examples of fixed costs. They include
• Business registration fee
Contents
• Factory/office rent
Lesson 1 – Marginal and Absorption Costing
• Factory/office rates
Lesson 2 – Arguments for and against Marginal and Absorption Costing
• Factory/office management fee
• Supervisors’/executives’ salaries
• Depreciation of factory building/equipment/machinery
• Fire insurance of factory building/equipment/machinery
1
2
Examples of fixed cost in
relation to your family’s
monthly expenses
Variable Costs
Total Variable Cost
($)
Output (units)
Topic A08
Marginal and Absorption Costing
3
BAFS Elective Part
Learning and Teaching Example
Topic A08
Marginal and Absorption Costing
Teacher asks students to give examples of fixed costs in relation to their
family’s monthly expenses.
4
BAFS Elective Part
Learning and Teaching Example
Teacher introduces the definition of variable costs.
Definition of variable costs: A cost which tends to vary with the level of
activity. (CIMA Official Terminology)
Examples are:
1. Monthly rent
2. Rates
Teacher provides examples of variable cost. They include:
3. Property insurance
• Direct materials
4. Life insurance
• Piecework labour wages
5. Management fee
• Royalty payments
6. School fee
• Power cost
7. Monthly wages to maid
• Sales commission
8. Residential telephone service fee (i.e. fixed line)
• Delivery charges
• Motor vehicle running expenses
3
4
Examples of variable cost in relation
to your family’s monthly expenses
Activity 1:
1:
Pattie Company
(Refer to Student Worksheet Page 1 to 3)
Topic A08
Marginal and Absorption Costing
5
BAFS Elective Part
Learning and Teaching Example
Topic A08
Marginal and Absorption Costing
Teacher asks students to give examples of variable costs in relation to their
family’s monthly expenses.
6
BAFS Elective Part
Learning and Teaching Example
Teacher asks students to read the case and pay special attention on the
questions raised by the owner, Pattie.
Examples are:
1. Traveling expenses
2. Food
3. Electricity charges
4. Gas fee
5. Clothing
6. Entertainment expenses
7. Water charges
8. Motor vehicle running expenses
5
6
Pattie Company
z
z
Pattie Company
Manufacturing Account
Income Statement
Topic A08
Marginal and Absorption Costing
7
BAFS Elective Part
Learning and Teaching Example
The manufacturing account and income statement of the Pattie Company
are given for information.
z
Except direct, indirect cost, what are fixed
and variable cost?
z
Are there any other ways to calculate the
production cost?
Topic A08
Marginal and Absorption Costing
8
BAFS Elective Part
Learning and Teaching Example
Highlights of the case:
- The owner, Pattie, has heard about fixed and variable costs from her
friends and wants to know their meanings.
- Pattie asks the accountant to propose an alternative method to calculate
the production costs and the unit product costs
Task 1 - Cost Classification (cont’d)
Task 1 - Cost Classification
Fixed Cost
Identify the fixed, variable, production and nonproduction cost from the Pattie Company’s
Manufacturing Account and Income Statement for
the month ended 30 June Year 8.
Variable Cost
Production Cost
Direct Materials
Direct Materials
Direct Wages
Direct Wages
Direct Expenses
Direct Expenses
Factory Manager Salary
Factory Manager Salary
Factory Management Fee
Factory Management Fee
Factory Rent and Rates
Factory Rent and Rates
Factory Fire Insurance
Factory Fire Insurance
Factory Labour
Insurance
Fixed Cost
Production
Cost
Variable Cost
e.g. Direct
Materials
Provision for Depreciation –
Machinery
Non-Production
Cost
e.g. Direct
Materials
Factory Labour Insurance
Provision for Depreciation –
Machinery
Bank Loan Interest
Bank Loan Interest
Provision for Depreciation –
Office Equipment
Provision for Depreciation –
Office Equipment
Cleaning Expenses
Cleaning Expenses
Salesman’s Salaries
Salesman’s Salaries
Carriage Outwards
Carriage Outwards
Sales Commission
Sales Commission
Advertising
Advertising
Office Rent and Rates
Topic A08
Marginal and Absorption Costing
9
BAFS Elective Part
Learning and Teaching Example
Topic A08
Marginal and Absorption Costing
Teacher asks students to identify the fixed, variable, production and nonproduction costs from the financial statements. Direct materials are used as
an example to guide students fill in the table.
Non-Production Cost
Office Rent and Rates
10
BAFS Elective Part
Learning and Teaching Example
Teacher invites students to give the answers before showing the table.
Teacher then checks the answer with students.
Teacher may prompt students to pay attention on the following two
questions in doing the classification:
- Will the costs/expenses be affected when activity levels fluctuate
within certain output and turnover limits? (If yes, it is a variable cost.
If no, it is a fixed cost.)
- Are the costs/expenses involved in the manufacturing process of the
product? (If yes, it is a production cost. If no, it is a non-production
cost.)
9
10
Task 2 - Cost Computation
(cont’d)
Task 2 - Cost Computation
Assuming 2,540 units of goods were produced by
Pattie Company for the month of June Year 8, the
production cost for each unit would be:
Total Production Cost: $76,200
Unit Produced: 2,540
Total Production Cost:
Unit Product Cost = Total Production Cost ÷ Unit Produced
Unit Produced:
= $76,200 ÷ 2,540 units
Unit Product Cost = Total Production Cost ÷ Unit
Produced
= $30
=
=
Topic A08
Marginal and Absorption Costing
11
BAFS Elective Part
Learning and Teaching Example
Topic A08
Marginal and Absorption Costing
Teacher asks students to compute the unit product for the month of June
Year 8.
12
BAFS Elective Part
Learning and Teaching Example
Teacher checks the answer with students.
Teacher explains there are two main streams in accounting: financial
accounting and cost accounting.
Total Production Cost refers to the “production cost of goods completed”
computed in the Manufacturing Account.
Financial accounting is concerned with the provision of information to
external parties, such as potential investors, creditors and government.
Financial accounting statements must be prepared in compliance with the
legal requirements and generally accepted accounting principles.
Cost accounting is concerned with the provision of information to internal
parties within the organisation, such as managers, to help them make
better decisions and improve the efficiency and effectiveness of operations.
Unlike financial accounting, there are no statutory requirements for cost
accountants to produce nor follow externally imposed rules. The
preparation of a cost accounting reports are optional and the information
should only be produced if the benefit obtained from the information
provided exceeds the cost of collecting it.
A number of costing systems are being applied by an organisation to
provide relevant information to help managers make better decisions. The
costing system used in task 2 for calculating the unit product cost is known
as absorption costing.
11
12
Cost Relationships
Absorption Costing
Cost
Direct costs
(Direct materials, direct labour and direct expenses)
Overheads
(Indirect materials, indirect labour and indirect expenses)
Production overheads
Work in progress stock
Topic A08
Marginal and Absorption Costing
Finished goods stock
13
Non-production overheads
Profit and loss account
BAFS Elective Part
Learning and Teaching Example
Topic A08
Marginal and Absorption Costing
Teacher explains the flowchart with students and shows them how cost is
charged under absorption costing.
14
BAFS Elective Part
Learning and Teaching Example
Teacher introduces another costing system: marginal costing.
Teacher tells students the relationship between the fixed costs and variable
costs within the two costing systems.
Costs build-up under absorption costing:
¾ Costs incurred by an enterprise can be classified into direct costs and
indirect costs/overheads. Direct costs are those costs which can be
directly identified with a product or service, such as direct materials,
direct labour and direct expenses. Indirect costs/overheads are those
costs which cannot be identified specifically and exclusively with a
product or service.
¾ Indirect costs/overheads can be further classified as production
overheads and non-production overheads. Overheads which occur in
production, such as factory rent and rates are called production
overheads. Those overheads, other than production overheads, such
as office rent and rates, are referred as non-production overheads.
¾ All production costs (direct/prime costs and production overheads)
are considered as product costs and are included in the (finished
goods and work in progress) stock valuation.
¾ Non-production overheads are excluded from the stock valuation.
They are charged directly to the profit and loss account.
¾ The unsold stock will therefore contain a share of the production
overheads incurred in the period.
Absorption costing is an accounting system in which all production costs
(i.e. both fixed and variable) are charged to cost units.
Marginal costing is an accounting system in which only variable
production costs are charged to cost units and the rest of the costs are
written off in the period incurred.
13
14
Marginal Costing
Task 3 – Income Statement
Cost
Direct costs*
(Direct materials, direct labour and direct expenses)
Suppose marginal costing system is used,
construct an income statement for Pattie
Company for the month ended 30 June
Year 8.
z
Refer to student worksheet p.5-6
Overheads
(Indirect materials, indirect labour and indirect expenses)
Production overheads
Non-production overheads
Fixed production overheads
Variable production overheads
Work in progress stock
z
Finished goods stock
Profit and loss account
* Direct costs behave as variable costs
Topic A08
Marginal and Absorption Costing
15
BAFS Elective Part
Learning and Teaching Example
Topic A08
Marginal and Absorption Costing
16
BAFS Elective Part
Learning and Teaching Example
Teacher asks students to prepare an income statement for Pattie Company for the month
ended 30 June Year 8, using the marginal costing method.
Teacher explains the flowchart and shows how costs are charged under
the marginal costing system.
Students are advised to compute the following revenue and cost items before completing
the statement:
Costs build-up under marginal costing:
- Under marginal costing, only variable production costs (direct/prime
costs and variable production overheads) are considered as product
costs and are included in the (finished goods and work in progress)
stock valuations.
- Fixed production overheads and non-production overheads are
excluded from stock valuations. They are regarded as expenses in
the period (i.e. period cost) in which they are incurred and charged
directly to the profit and loss account.
Unit Selling Price
= $191,475 ÷ (57 + 2,540 – 44)
= $191,475 ÷ 2,553
= $75
Opening Stock Value (57 units)
= $22 x 57
= $1,254
Variable Production Cost
= $(30,600 + 20,800 + 5,000) + 1,800
= $58,200
Closing Stock Value (44 units)
= $58,200 ÷ 2,540 x 44
= $1,008
Variable Non-production Cost
= $(195 + 445)
= $640
Fixed Production Cost
= $(9,000 + 500 + 7,000 + 600 + 900)
= $18,000
Fixed Non-production Cost
= $(750 + 250 + 159 + 12,643 + 190 + 7,905)
= $21,897
15
16
Task 3 – Income Statement
(cont’d)
Task 3 – Income Statement
(cont’d)
Income Statement for the month ended 30 June Year 8
HK$
Sales
Less: Variable Production Cost of Goods Sold
Finished Goods Opening Stock
Add: Variable Production Cost
Less: Finished Goods Closing Stock
Less: Variable non-production cost
Contribution
Less: Fixed cost
Production
Non-production
Net profit
Topic A08
Marginal and Absorption Costing
1,254
58,200
59,454
1,008
18,000
21,897
17
HK$
191,475
State the major effect of using marginal
costing in preparing the Income Statement
of Pattie Company and explain why this
happened.
58,446
133,029
640
132,389
39,897
92,492
BAFS Elective Part
Learning and Teaching Example
Topic A08
Marginal and Absorption Costing
Teacher checks the answer with students and explains the meaning of
what contribution is.
18
BAFS Elective Part
Learning and Teaching Example
Teacher asks students to compare the income statement prepared in part
(a) with that prepared under absorption costing and read the hints
provided. Students are required to state the major effect of using marginal
costing and explain why this happened.
Contribution is the difference between sales and all variable costs (both
production and non-production), from which fixed costs are deducted to
show net profit/loss. In general, if:
Inventory valuation
total contribution > fixed cost Î profit
The value of the closing inventory calculated under absorption costing
would be higher than that of marginal costing as fixed production costs are
treated as product cost and can be carried forward to the next period. For
marginal costing, it only includes variable production cost and the fixed
non-production costs are written off in the period incurred.
total contribution < fixed cost Î loss
Income determination
If opening stock is less than closing stock, there will be an increase in
closing stock. The profit calculated under absorption costing will be higher
as a larger portion of the fixed production overhead will be carried forward
to next accounting period. The profit calculated under marginal costing will
be lower as all fixed production costs incurred will not be carried forward
and are charged directly to the current profit.
Opposite result will be obtained if there is a decrease in closing stock.
17
18
Task 3 – Income Statement
(cont’d)
Absorption Costing
(a)
(b)
Differences in the 2
costing systems
Impact
on
Inventory
valuation
Income
determination
Topic A08
Marginal and Absorption Costing
Answers to task 3 (b)
Fixed production costs
are treated as
product cost.
If closing stockÇ, part
of the fixed production
cost is carried forward
to the next accounting
period.
(a)
(b)
Fixed production costs
are treated as period
cost.
If closing stockÇ, no
fixed production cost is
carried forward
because all fixed
production costs are
written off in the period
incurred.
Higher closing stock value
(reason (a) above)
Lower closing stock value
(reason (a) above)
Higher profit
(reason (b) above)
Lower profit
(reason (b) above)
19
Activity 2: Case Study
Marginal Costing
BAFS Elective Part
Learning and Teaching Example
z
z
Form groups of four to five
Read the case carefully, discuss and
complete Task 1 of Activity 2
Topic A08
Marginal and Absorption Costing
20
BAFS Elective Part
Learning and Teaching Example
Teacher asks students to form groups of four or five. Students must read
the case on setting up a cyber-firm to sell their own custom designed heattransfer print T-shirt on Yahoo and complete task 1.
20
Task 1 - Cost Classification
(cont’d)
Task 1 - Cost Classification
List the fixed and variable costs that would
incur in setting up a cyber-firm selling your
own designed heat-transfer print T-shirt on
the Internet.
Examples of fixed cost
• Cost of setting up a business on Yahoo
Small Business Platform
• Monthly service fee paid to Yahoo
• Hire charges for heat transfer machines
• Packaging tools and materials
Examples of Variable cost
• T-shirt purchase cost
• Transaction fee paid to Yahoo
• Delivery charges
Topic A08
Marginal and Absorption Costing
21
BAFS Elective Part
Learning and Teaching Example
Topic A08
Marginal and Absorption Costing
Teacher asks students to list the fixed and variable costs that would incur
in setting up a cyber-firm selling their own custom designed heat-transfer
print T-shirt on internet and invites volunteers to share their suggestions
with the class.
22
BAFS Elective Part
Learning and Teaching Example
Teacher concludes students’ suggestions and gives some examples for the
fixed and variable costs that would be incurred setting up a cyber-firm.
21
22
Task 3 (a) - Cost Computation
cont’d
Task 2 - Cost Estimation
Complete the following table based on the
characteristics of different cost items:
Estimate the monthly running cost of the business :
Cost Items:
Cost Items
HK$
Monthly service fee paid to Yahoo
Service fee paid to Yahoo
Hire charges for heat transfer machines
(Assuming 2 machines will be hired)
Transfer paper for laser printer
Packaging tools and materials
Printing charges (e.g. cartridge)
Others:
Delivery charges
23
$400/month
Cost Classification under
Fixed or
Production or
Variable
Non-production
Fixed Cost
Non-production
cost
Hire charges for 2 heat transfer
$1,500/ month
machines
T-shirt purchase cost
$15/piece
Transfer paper
$4/sheet
Printing charges
$3/sheet
Packaging tools & materials
$2,000/ month
Stationery expenses
$300/month
Advertising fee (a fixed amount
$1,000/month
charged by an advertising firm)
Transaction fee charged by Yahoo 1.5% on sales
T-shirt purchase cost
Topic A08
Marginal and Absorption Costing
Details
BAFS Elective Part
Learning and Teaching Example
Topic A08
Marginal and Absorption Costing
Teacher asks students to complete Task 2 and invites volunteers to share their answers with the
class. Here are some suggestions:
• Monthly service fee paid to Yahoo: express plan US$19.95 (~HK$160); starter plan
US$39.95 (~HK$320); standard plan US$99.95 (~HK$780)
• Hire charges for heat transfer machines: below HK$1,000 each
• T-shirt purchase cost: depends on the quality and quantity, it may range from a few dollars
to hundreds.
• Transfer paper for laser printer: around HK$6 each
• Packaging tools and materials: depends on the materials and types of packaging
• Printing charges: cartridge - HK$100-HK$200 per color, each cartridge can produce 40 50 A4 size copies.
• Others: Transaction fee paid to Yahoo – 2.0% for express plan; 1.5% for starter plan; 1.0%
for standard plan. Delivery charges – depends on the type of delivery mail or DHL.
Teacher may, at his/her own discretion, arouse students’ interest/attention on some cost items by
asking the following questions:
• How many service plans are provided by Yahoo? (Three service plans are provided –
express plan, starter plan and standard plan. Fees will be higher if more services are
provided)
ΠWhat is the size of a heat transfer machine? (The sizes are varied. Some of them may be
as small as a printer.)
ΠWill there be a need of leasing a flat to place the heat transfer machines? (If only 1 or 2
heat transfer machines are leased, there is no need to rent extra areas for storage.
Students should be able to store them at home.)
ΠWhere will they buy the T-shirt? (They can purchase directly from the T-shirt
manufacturer.)
ΠWhat is their target purchase price for the T-shirt? (Higher quality РHigher price; Lower
quality – Lower price; Larger quantity – Lower price; Smaller quantity – Higher price. The
price may be lower if they purchase from the manufacturer in China. However, it may incur
higher transportation cost.
ΠWho are their target customers, local or overseas? (The delivery and packaging charges
will be higher if they need to send the T-shirt to overseas customers.)
1% on sales
24
BAFS Elective Part
Learning and Teaching Example
Teacher asks student to complete Task 3(a).
Students are required to look at each cost item, then classify it into either:
(a) Fixed or variable cost; and
(b) Production or non-production overheads.
23
24
Task 3 (a) - Cost Computation
(cont’d)
Task 3 (b) - Cost
Computation
Suggested Answer:
Cost Items
Service fee paid to Yahoo
Hire charges for 2 heat transfer
machines
Details
Cost Classification under
(Marginal Costing)
(Absorption Costing)
Fixed or Variable
Production or Nonproduction
$400/month
Fixed Cost
Non-production Cost
$1,500/ month
Fixed Cost
Production Cost
Production Cost
T-shirt purchase cost
$15/piece
Variable Cost
Transfer paper
$4/sheet
Variable Cost
Production Cost
Printing charges
$3/sheet
Variable Cost
Production Cost
$2,000/ month
Fixed Cost
Production Cost
$300/month
Fixed Cost
Non-production Cost
Advertising fee (a fixed amount
charged by an advertising firm)
$1,000/month
Fixed Cost
Non-Production Cost
Transaction fee charged by Yahoo
1.5% on sales
Variable Cost
Non-Production Cost
1% on sales
Variable Cost
Non-Production Cost
Packaging tools & materials
Stationery expenses
Delivery charges
Topic A08
Marginal and Absorption Costing
25
Assuming 500 units of T-shirt will be produced
per month and production overhead will be
absorbed on unit basis, compute the production
cost for each unit based on the data in 3(a),
using
(i) Marginal Costing
(ii) Absorption Costing
BAFS Elective Part
Learning and Teaching Example
Topic A08
Marginal and Absorption Costing
26
BAFS Elective Part
Learning and Teaching Example
Teacher asks students to compute the unit product cost for each T-shirt, using marginal
costing and absorption costing methods.
Teacher invites students to give their answers before checking the answers
with them.
Teacher may, at own discretion, use the following questions to guide students to
complete the calculations:
For marginal costing
Teacher then checks students’ understanding of the difference between the
two costing methods by asking:
¾ Do we have to include fixed production cost in the computation of unit product cost?
(No. They are treated as period cost and charged directly to the profit and loss
account.)
• Under what costing method is cost separated into fixed and variable?
(answer: marginal costing)
¾ Do we need to include all variable cost in the computation of unit product cost?
(No. Only variable production costs e.g. direct materials, direct labor and variable
production overhead are included in stock valuation. Variable non-production
overheads, such as delivery charges and sales commission are not considered as
product cost but they must be used in calculation of contribution.)
• Under what costing method is cost separated into production and
non-production? (answer: absorption costing)
For absorption costing
¾ Should all cost items be included in the computation of unit product cost? (No.
Only production costs that are identified with goods produced for resale are
required to be included.)
¾ Do we have to separate the production cost into fixed and variable elements for
the computation? (In general, it is not required. Costs are only required to be
classified into production and non-production under absorption costing. However,
for better presentation, students may classify them into variable production cost
and fixed production cost.)
¾ How to treat a cost which is for both factory use and office use? (Apportionment
must be made.)
¾ How to determine the basis for apportionment (It depends on the cost driver and
there is opportunity for arbitrary assumption.)
25
26
Task 3 (b) - Cost
Computation (cont’d)
Task 4 - Profit Computation
Suggested Answers:
Under Marginal Costing:
T-shirt purchase cost
Transfer paper
Printing charges
Unit product cost
$15
$ 4
$ 3
$22
Under Absorption Costing:
T-shirt purchase cost
Transfer paper
Printing charges
Production overhead*
Unit product cost
$15
$ 4
$ 3
$ 7
$29
Based on the forecasted sales and the data in
Task 3(a), construct a profit statement for the
first three months of operation using:
(a) Absorption Costing (using a mark up of 50%)
(b) Marginal Costing (using the same selling price as
calculated under absorption costing)
*($1,500+$2,000) ÷500=$7
Topic A08
Marginal and Absorption Costing
27
BAFS Elective Part
Learning and Teaching Example
Topic A08
Marginal and Absorption Costing
Teacher checks answers with students.
28
BAFS Elective Part
Learning and Teaching Example
Teacher asks students to prepare profit statements for the first three
months of operation using marginal costing and absorption costing
methods.
The major difference between the 2 costing methods is the treatment of fixed
production overheads of $7*.
Under marginal costing, only variable production costs (i.e. T-shirt purchase cost,
transfer paper cost and printing charges) are considered as product cost. Nonproduction variable cost (i.e. transaction fees charged by Yahoo and delivery
charges) and all fixed costs (i.e. service fee paid to Yahoo, hire charges for 2 heat
transfer machines, packaging materials & tools, stationery expenses and
advertising fee) are excluded from the computation.
Under absorption costing, all production costs related to the product produced are
required to be included in the stock valuation (i.e. T-shirt purchase cost, transfer
paper cost, printing charges, hire charges of 2 heat transfer machines and
packaging tools and materials). Non-production cost (i.e. service fee paid to
Yahoo, stationery expenses, advertising fee, transaction fee charged by Yahoo
and delivery charges) are treated as period costs and excluded from the
computation.
* Referring to slide 13, fixed production overheads consist of hire charges of
$1,500 and packaging tools and materials costs of $2,000. The total amount of
$3,500 fixed production overheads are to be absorbed by the 500 T-shirts
produced (i.e.$7 per unit).
27
28
Task 4 - Profit Computation
(cont’d)
Task 4 - Profit Computation
(cont’d)
4(a) Suggested Answer (Absorption Costing):
Topic A08
Marginal and Absorption Costing
4(b) Suggested Answer (Marginal Costing):
BAFS Elective Part
Learning and Teaching Example
29
Topic A08
Marginal and Absorption Costing
BAFS Elective Part
Learning and Teaching Example
30
Teacher checks the answer with students.
Teacher checks the answers with students.
Workings:
Workings:
Selling price (50% mark up) = $29 x (1+50%) = $43.5
Sales: (using same selling price as calculated under absorption Costing )
Sales :
1st month
2nd
$43.5 x 500 units
= $21,750
month
$43.5 x 400 units
= $17,400
3rd month
$43.5 x 550 units
= $23,925
2nd
= $21,750
$43.5 x 400 units
= $17,400
3rd month
$43.5 x 550 units
= $23,925
1st month
month
nil
month
nil
3rd month
nd
rd
Production costs for 1 /2 /3 month:
$29 x 500 units = $14,500
nil
2nd month
$29 x 100 units =
$2,900
3rd month
$29 x 50 units
$1,450
=
nil
3rd month
$22 x 100 units = $2,200
= $11,000
Closing stock
Closing stock
month
nil
2nd month
Variable Production costs for 1st/2nd/3rd month: $22 x 500 units
$29 x 100 units = $2,900
st
1st
$43.5 x 500 units
2nd month
Opening stock
Opening stock
1st
1st month
1st month
nil
2nd month
$22 x 100 units =
$2,200
3rd
$22 x 50 units
$1,100
month
=
Variable non-production cost: (1.5% transaction fee + 1% delivery charge) x Sales
Fixed non-production cost: $400 (service fee to Yahoo) + $300 (stationery) +
$1,000 (advertising)
Variable non-production cost: (1.5% transaction fee + 1% delivery charge) x
Sales
1st month
2.5% x $21,750 =
2nd month
2.5% x $17,400 =
$435
3rd month
2.5% x $23,925 =
$598.13
$543.75
1st month
2.5% x $21,750 =
$543.75
Fixed production cost: $1,500 (hire charges) + $2,000 (packaging)
2nd month
2.5% x $17,400 =
$435
3rd month
2.5% x $23,925 =
$598.13
Fixed non-production cost : $400 (service fee to Yahoo) + $300 (stationery) +
$1,000 (advertising)
29
30
Task 5 (a) - Method Selection
Task 5 (b) – Method Selection
Based on the profit statements prepared in
Task 4, suggest two reasons for the
difference in net profits for the 2nd and 3rd
month of sales.
As more T-shirts will be sold in summer,
which costing method should be adopted?
Topic A08
Marginal and Absorption Costing
31
BAFS Elective Part
Learning and Teaching Example
Topic A08
Marginal and Absorption Costing
Profit earned
BAFS Elective Part
Learning and Teaching Example
Teacher invites volunteers to give their opinions on this question.
Absorption costing
2nd month $3,665 3rd month $5,676.87
Marginal costing
2nd month $2,965 3rd month $6,026.87
Difference
32
700
In a business that relies on seasonal sales and in which production is built
up outside the sales season to meet demand, the full amount of fixed
overhead incurred will be charged against sales under marginal costing
system. If so, losses will be reported during out-of-season period, and
large profit will be reported in the periods when the goods are sold. By
contrast, in an absorption costing system, fixed overheads will be deferred
and included in the closing inventory valuation, and will be recorded as an
expense only in the period in which the goods are sold. Losses are
therefore unlikely to be reported in the periods when stocks are being built
up. Therefore, if more T-shirt will be sold in summer, absorption costing
should be adopted to provide more logical profit calculation.
($350)
Reasons:
1. In 2nd month, the profit calculated under absorption costing is higher
than that of marginal costing. It is because when production exceeds
sales, there will be an increase in closing stock and a greater portion of
the fixed production overhead will be included in the closing stock and
carried forward to next period.
2. In 3rd month, the profit calculated under absorption costing is lower
than that of marginal costing. It is because when sales exceeds
production, there will be a decline of closing stock and a greater portion
of the fixed production overhead is brought forward as an expenses in
the opening inventory.
31
32
Summary for lesson 1
Summary for lesson 1
Major Differences in the 2 costing methods:
Major Differences in the 2 costing methods:
Marginal Costing Absorption Costing
5. Effect of changes in period-end closing stock level on profit:
(a) When closing inventory increases
(i.e. Production > Sales)
Marginal
costing profit
<
Absorption
costing profit
Full production costs
(Variable + Fixed)
(b) When closing inventory decreases
(i.e. Production < Sales)
Marginal
costing profit
>
Absorption
costing profit
3. Treatment of “fixed” Period expenses
production costs
(charged to P/L a/c)
Product cost
(absorbed into units produced)
(c) When closing inventory is unchanged
(i.e. Production = Sales)
Marginal
costing profit
=
Absorption
costing profit
4. Profit & sales
relationship
Profit is a function of
sales and production
1. Cost classification
Fixed vs. variable
Production vs. non-production
2. Inventory valuation
Variable production
costs only
Topic A08
Marginal and Absorption Costing
Profit is a function of
sales
33
BAFS Elective Part
Learning and Teaching Example
Topic A08
Marginal and Absorption Costing
34
BAFS Elective Part
Learning and Teaching Example
Teacher concludes the lesson and highlights the difference between
marginal and absorption costing.
Teacher concludes the lesson and highlights the difference between
marginal and absorption costing.
Rational behind marginal costing – Fixed costs relate to a period of time
and are the same irrespective of sales and production. They should be
charged directly to the P/L account as period expenses. On the other hand,
variable costs are the marginal costs incurred in production and stock is
therefore to be valued at VARIABLE production costs only.
Teacher may ask the following questions to test students’ understanding:
Q1: Why does profit calculated under marginal costing greater than
absorption costing when closing stock increases?
(Answer: It is because under absorption costing, a portion of the fixed
production overhead will be included in the closing stock and carried
forward to the following period. But under marginal costing, the total
amount of fixed production overhead is charged to the profit and loss
account in the period it incurs)
Rational behind absorption costing – All costs incurred in the production of
a product are required to be allocated/absorbed into the product. Stock is
therefore to be valued at FULL production costs.
Q2: Why does profit calculated under marginal costing less than absorption
costing when closing stock drops?
(Answer: It is because under absorption costing, a greater portion of the
fixed production overhead will be written off when the goods are sold.)
Q3: In the long run, which costing method will generate a higher profit?
(Answer: Both methods will give the same profit because the total costs
will be the same in the long run)
33
34
Preparation for next lesson
Marginal Costing
Absorption Costing
A Case study:
Bullet Manufacturing
Topic A08
Marginal and Absorption Costing
Advantages
Company
&
Disadvantages
(Refer to Student Worksheet p.10)
35
BAFS Elective Part
Learning and Teaching Example
Topic A08
Marginal and Absorption Costing
Teacher asks students to think over the advantages and disadvantages of
marginal costing and absorption costing for next lesson.
36
BAFS Elective Part
Learning and Teaching Example
Lesson 2
Teacher introduces the case to students and states the problem faced by
the Managing Director, Alice, of Bullet Manufacturing Company.
End of Lesson 1.
- Bullet has been using absorption costing for internal reporting
purpose.
- In the month of July, production of Bullet exceeded sales and the
profit statement showed a decline in profit margins despite a 20%
sales increase.
- The accounting manager was asked by the marketing manager to
explain this contradictory result.
- The issue of using marginal costing was brought up and Alice was
deciding whether to switch to marginal costing for internal reporting
purpose.
35
36
Activity 3: Debate
Each group nominates one
representative to present their views
and arguments.
“ Bullet Manufacturing Company should
use marginal costing instead of
absorption costing in preparing the
company’s accounting reports”
Topic A08
Marginal and Absorption Costing
37
Use absorption
costing as ….
Use marginal
costing as ….
BAFS Elective Part
Learning and Teaching Example
Topic A08
Marginal and Absorption Costing
Teacher divides students into 2 groups and sets up a topic for debate:
“Bullet Manufacturing Company should use marginal costing instead of
absorption costing in preparing the company’s accounting reports”
38
BAFS Elective Part
Learning and Teaching Example
Each group will name one representative who will be allowed 4 minutes to
present the group’s views and arguments.
After the presentation, teacher goes through the advantages and
disadvantages of each method, draws conclusion and decides the winner
based on students’ arguments and performance.
• Divide students into two groups. Assign one group as the affirmative side and
the other group as the opposition side.
• Remind students to read the case on Student Worksheet page 17.
• Give students 15 minutes to discuss and formulate their arguments. (Teacher
may guide students through their discussion by asking the following
questions. Answers can be found on slide 42-45)
x Which costing method is easier to use and understand?
x Which method better suits the need of management for cost control and
internal performance evaluation?
x Which method is required by current accounting standard for external
reporting?
x What are the pros and cons of including fixed overheads in stock
valuation?
x How would the changes of inventory level affect profits under each
method?
x In case of highly fluctuating levels of production, which costing method
will give a more realistic set of cost data?
x Which costing method will give a more accurate picture of how a firm’s
cash flows are affected by changes in sales volume?
x Which costing method will show a clearer relationship between cost,
price and volume?
37
38
“ Bullet Manufacturing Company should
“ Bullet Manufacturing Company should
use marginal costing instead of
absorption costing in preparing the
company’s accounting reports”
use marginal costing instead of
absorption costing in preparing the
company’s accounting reports”
Topic A08
Marginal and Absorption Costing
39
BAFS Elective Part
Learning and Teaching Example
Topic A08
Marginal and Absorption Costing
Some suggested arguments for the proposition (i.e. advantages of
marginal costing and disadvantages of absorption costing):
40
BAFS Elective Part
Learning and Teaching Example
Some suggested arguments against the proposition (i.e. advantages of absorption
costing and disadvantages of marginal costing):
1. Marginal costing is simple and easy to understand by people who
do/do not have knowledge on costing.
2. The effect of varying charges per unit is avoided if the fixed overhead
is not charged to cost of production. The effect of inventory changes
on profits is also removed.
3. Marginal costing prevents the illogical carry forward in stock valuation
of some proportion of current year’s fixed overheads.
4. With marginal costing, contribution varies in direct proportion to the
volume of units sold. Profits will increase as sales volume rises, by
the amount of extra contribution earned.
5. Marginal costing accounts for all fixed overhead in the period in which
they are incurred. Therefore, it gives an accurate picture of how a
firm’s cash flows are affected by changes in sales volume.
6. Marginal costing provides more useful information for decision making.
In the short run, fixed overhead is irrelevant cost for decision making
as it does not alter. With the help of breakeven and profitability
analysis, a comparison of profitability and performance between two
or more products and departments can easily be assessed and
brought to the notice of management for decision making.
7. Execution of cost control is greatly facilitated. Marginal costing helps
to avoid arbitrary allocation of fixed overhead (i.e. basis for calculating
the overhead absorption rate), efforts can be concentrated on
maintaining a uniform and consistent marginal cost. It is useful to
various levels of management.
1. Absorption costing does not understate the importance of fixed cost. By
allocating fixed costs to a product using absorption costing, all fixed costs will
be covered.
2. In the long run, all costs are variables, and inventory values based on
absorption costing will give recognition to these long run variable costs.
3. Selling price based on marginal costing might enable a firm to make
contribution on each unit of product sold, but the total contribution earned
might be insufficient to cover all fixed cost and caused it to suffer loss.
4. The exclusion of fixed costs from inventories under marginal costing will
affect profit. The true and fair view of financial affairs of a firm might also be
blocked.
5. In case of highly fluctuating levels of production, e.g. in case of seasonal
factories, cost data prepared under marginal costing will become unrealistic.
Fixed overhead will be deferred and included in the closing inventory
valuation and will only be recorded as an expenses in the period in which the
goods are sold under absorption costing. Therefore, losses are unlikely to be
reported in the periods when stock are being built up and provide more
logical profit calculation. As the sales for Bullet Manufacturing Company
increased 20% from June to July, it is likely that it has seasonal sales pattern.
6. The current Accounting Standard requires a firm to adopt absorption costing
for external reporting. The use of marginal costing for internal reporting will
induce more workload and different profit measurement for internal and
external reporting.
39
40
Advantages of Marginal
Costing
Conclusion
z
z
z
z
z
Topic A08
Marginal and Absorption Costing
41
BAFS Elective Part
Learning and Teaching Example
Easy to understand
Fixed overheads are excluded from
inventory costs
Fixed overheads are NOT carried forward in
stock valuation
Contribution and profits is directly driven by
sales
Focus on the controllable aspect of a
business
Topic A08
Marginal and Absorption Costing
Teacher concludes the debate by setting the scene:
42
BAFS Elective Part
Learning and Teaching Example
Teacher concludes the lesson by highlighting the advantages of marginal
costing.
- Management normally requires accounting reports, especially profit
statements, for each major product group or segment of the business for
evaluating the performance of divisional managers. In general, the
identification of variable costs and contribution will facilitate
management’s decision making (e.g. budget decision) and enable
management to easily see how contribution will be affected by changes
in sales volume.
Marginal costing can:
- avoid arbitrary allocation of fixed overheads.
- avoid the varying charges per unit and hence distortion in stock
valuation.
- avoid the effect of changes in closing inventory level on profits.
- On the other hand, absorption costing is useful of setting selling prices
as full production is covered.
- show clearly the effect of sales on cash flows and the relationship
between cost, price and volume.
- facilitate the execution of cost control.
41
42
Advantages of Absorption
Costing
Disadvantages of Marginal
Costing
z
z
z
z
z
Marginal costing ignores that fixed costs must
be recovered over the long run
Finished goods and work in progress stock
will be understated
It fails to recognise that all costs are variable
over the long run
Firms with seasonal sales patterns, profits will
fluctuate greatly
Not easy to establish the cost variabilities
Topic A08
Marginal and Absorption Costing
43
BAFS Elective Part
Learning and Teaching Example
z
Fixed costs are absorbed in inventory
z
Recognition of the importance of fixed
overheads in production
z
Compliance with Accounting Standards
z
All costs are variable over the long run
z
Less fluctuation in profits
Topic A08
Marginal and Absorption Costing
44
BAFS Elective Part
Learning and Teaching Example
Teacher concludes the lesson by highlighting the disadvantages of
marginal costing.
Teacher concludes the lesson by highlighting the advantages of absorption
costing.
In marginal costing,
Using absorption costing:
- selling price is based only on marginal cost, it’s possible that a
positive contribution earned might NOT be sufficient to cover all fixed
costs in the long run.
- can ensure all fixed costs will be recovered and met in the long run.
- will not understate the finished goods and work in progress stock
value and helps to give a true and fair view of the financial affairs of a
firm.
- the practice of exclusion of fixed cost from inventory valuation does
not conform to acceptable accounting practice.
- can comply with the external reporting requirement recommended by
the Accounting Standards.
- losses will be reported during the slack season while huge profits will
be reported in the peak season. This problem is avoided if absorption
costing is used because fixed overheads will be deferred in the
closing inventories and will only be expensed in the period they are
sold.
- can recognise all “long run variable” costs.
- there will be less fluctuation in profit when production remains
constant but sales fluctuate.
- variable costs are rarely completely variable and fixed costs are rarely
completely fixed.
43
44
Disadvantages of Absorption
Costing
z
More complicated
z
Fixed overheads are charged to production
z
Part of the current year’s fixed overheads
are carried forward in closing stock to the
following year
z
Profit is not a direct function of sales
z
Relationships between cost, price and
volume is ignored
Topic A08
Marginal and Absorption Costing
45
Summary for lesson 2
BAFS Elective Part
Learning and Teaching Example
z
Both marginal and absorption costing systems
have their own advantages and limitations.
z
Therefore, management must decide which
method provides more meaningful information
to meet planning, control and decision making
needs.
Topic A08
Marginal and Absorption Costing
Teacher concludes the lesson by highlighting the disadvantages of
absorption costing .
46
BAFS Elective Part
Learning and Teaching Example
Teacher concludes the lesson and highlights the main uses of marginal and
absorption costing.
In absorption costing,
- one has to make arbitrary assumptions on apportionment of fixed
overheads (based on overhead absorption rate).
- the unit inventory costs may vary according to production.
- management may manipulate profits by building up inventories and
hence deferring the fixed overheads to the following years.
- there’s possibility that profit may drop even though sales goes up.
- the relationships between cost, price and volume is ignored since the
focus is on total cost.
45
46
Summary for lesson 2
Which costing system would you choose?
Marginal
Costing
Absorption
Costing
Short run decision-making
The End
Long run decision-making
When sales is subject to high
seasonal fluctuations
Comparison of performance of
different departments/product lines
External reporting
Topic A08
Marginal and Absorption Costing
47
BAFS Elective Part
Learning and Teaching Example
Topic A08
Marginal and Absorption Costing
Teacher concludes the lesson by inviting students to choose the preferred costing
method under different circumstances, students can also mark the answer in student
worksheet p.20.
End of Lesson 2.
• Short-run decision making – fixed overheads are irrelevant for decision making
in the short run as it does not change. Marginal costing is preferred.
• Long-run decision making – all costs are variable and relevant in the long run;
and fixed costs must be met. Absorption costing is preferred.
• When sales is subject to high seasonal fluctuations – during the out-season
periods when production are greater than sales and inventories are built up,
huge losses will be reported under marginal costing because the full amount of
fixed overheads incurred in production will be expensed in that period.
• On the contrary, during high seasons when sales are greater than production,
huge profits will be reported under marginal costing because the amount of fixed
overheads written off to the profit and loss account remain the same.
• Comparison of performance of different departments and product line – marginal
costing provides information on contribution which enables management to
easily get a clear picture of performance.
• External reporting – the inclusion of fixed costs in inventories will give a true and
fair view and is required by accounting standards. Absorption costing is to be
used.
Teacher asks students to complete the crossword puzzle (Activity 4, Student
Worksheet page 20-21) at home so as to check their understanding on the concepts of
marginal and absorption costing. The answers will be distributed in next lesson.
47
48
BAFS Elective Part
Learning and Teaching Example
Topic A08: Marginal and Absorption Costing
Student Worksheet p.1
BAFS Elective Part – Accounting Module – Cost Accounting
Topic A08: Marginal and Absorption Costing
Activity 1: Case Study
Pattie, the owner of the Pattie Company is looking at the company’s
manufacturing account and income statement for the month of June Year
8. She asks her accountant what is meant by fixed and variable costs
which she heard about from her friends. She also asks the accountant to
propose an alternative method to calculate the production cost and the
unit product cost.
The Manufacturing Account and Income Statement of Pattie Company for
the month ended 30 June Year 8 are as follows:
Manufacturing Account for the month ended 30 June Year 8
HK$
Raw Materials Consumed
Direct Wages
Direct Expenses – Royalty
Prime/Direct Cost
HK$
30,600
20,800
5,000
56,400
Factory Overhead/Indirect Cost
Factory Manager Salary
Factory Management Fee
Factory Rent and Rates
Fire
Insurance –
Labour
Provision for Depreciation – Machinery
Production Cost of Goods Completed
9,000
500
7,000
600
1,800
900
19,800
76,200
BAFS Learning and Teaching Example
As at April 2009
Topic A08: Marginal and Absorption Costing
Student Worksheet p.2
Income Statement for the month ended 30 June Year 8
HK$
HK$
Sales
191,475
Less: Production Cost of Goods Sold
Finished Goods Opening Stock (57
1,710
units)
Add: Production Cost of Goods
76,200
Completed
77,910
Less: Finished Goods Closing Stock (44
1,320
76,590
units)
Gross Profit
114,885
Less: Expenses
Bank Loan Interest
Provision for Depreciation: Office Equipment
Cleaning Expenses
Salesmen’s Salaries
Carriage Outwards
Advertising
Sales Commission
Office Rent and Rates
Net Profit
750
250
159
12,643
195
190
445
7,905
22,537
92,348
BAFS Learning and Teaching Example
As at April 2009
Topic A08: Marginal and Absorption Costing
Student Worksheet p.3
You, as the accountant of the Pattie Company, decide to use the company’s
spending to explain to Pattie about the characteristics of fixed and
variable costs. To facilitate the calculation of unit product cost, you also
try to allocate the cost/expenses to production cost and non-production
cost.
Task 1: Cost Classification
Identify the fixed, variable, production and non-production costs from the
Pattie Company’s Manufacturing Account and Income Statement for the
month ended 30 Year 8. The first example is given for reference.
Fixed Cost
Variable Cost
Production Cost
Direct Materials
Direct
Materials
Non-Production
Cost
BAFS Learning and Teaching Example
As at April 2009
Topic A08: Marginal and Absorption Costing
Student Worksheet p.4
Task 2: Cost Computation
Assuming 2,540 units of goods were produced by the Pattie Company for
the month of June Year 8, the production cost for each unit would be:
Total Production Cost:
Unit Produced:
Unit Product Cost = Total Production Cost ÷ Unit Produced
=
=
BAFS Learning and Teaching Example
As at April 2009
Topic A08: Marginal and Absorption Costing
Student Worksheet p.5
You decide to recast the March Income Statement using Marginal Costing and
present it to Pattie to show the major effects when this method is used.
Task 3: Income Statement
(a)
Suppose Marginal Costing system is used. Construct an Income
Statement for the Pattie Company for the month ended 30 June Year
8. (Assuming variable production cost for opening stock is $22/unit
and the company uses First In-First Out method for stock valuation.)
Unit Selling Price
= Sales Revenue ÷ No of units sold
=
=
Opening Stock Value (57 units)
=
=
Variable Production Cost
=
=
Closing Stock Value (44 units)
=
=
Variable Non-production Cost
=
=
Fixed Production Cost
=
=
Fixed Non-production Cost
=
=
BAFS Learning and Teaching Example
As at April 2009
Topic A08: Marginal and Absorption Costing
Student Worksheet p.6
Income Statement for the month ended 30 June Year 8
HK$
HK$
Sales
Less: Variable Production Cost of Goods Sold
Finished Goods Opening Stock
Add: Variable Production Cost
Less: Finished Goods Closing Stock
Less: Variable non-production cost
Contribution
Less: Fixed cost
Production
Non-production
Net profit
(b) Compare the Income Statement prepared in part (a) with that
prepared under Absorption Costing. State the major effects of
using Marginal Costing and explain why this happened.
Hints: Differences of Absorption Costing and Marginal Costing and their
impacts on inventory valuation and profit determination.
Differences in the 2
costing systems
Impact
on
Inventory
valuation
Income
determination
Absorption Costing
(a) How are fixed
production costs
treated?
(b) If closing stockÇ,
what will happen
to part of the
fixed production
cost?
Marginal Costing
(a) How are fixed
production costs
treated?
(b) If closing stockÇ,
what will happen to
the fixed
production cost?
Higher / Lower
closing stock value
(reason (a) above)
Higher / Lower closing
stock value
(reason (a) above)
Higher / Lower profit
(reason (b) above)
Higher / Lower profit
(reason (b) above)
BAFS Learning and Teaching Example
As at April 2009
Topic A08: Marginal and Absorption Costing
Student Worksheet p.7
Major Effects:
Reasons:
BAFS Learning and Teaching Example
As at April 2009
Topic A08: Marginal and Absorption Costing
Student Worksheet p.8
Activity 2: Case Study
Form a group of four or five.
complete the tasks.
Read the following case carefully and
It’s the end of May and summer vacation is near. To gain practical
experience and make some pocket money, you and your classmates come up
with an idea to set up a cyber-firm to sell custom designed heat-transfer
print T-shirts on Yahoo.
Today, you and your classmates hold an informal meeting at the school
canteen to discuss and to work out a business plan.
BAFS Learning and Teaching Example
As at April 2009
Topic A08: Marginal and Absorption Costing
Student Worksheet p.9
After conducting market research and lengthy discussions, your group comes to
the consensus that the project is a feasible and could be a go-ahead.
Task 1: Cost Classification
List the fixed and variable costs incurred in setting up a cyber-firm selling your
own custom designed heat-transfer print T-shirts on the Internet:
Fixed Costs:
Variable Costs:
BAFS Learning and Teaching Example
As at April 2009
Topic A08: Marginal and Absorption Costing
Student Worksheet p.10
One of your classmates has the computer, laser printer and essential
software to custom design and print images. However, you are required
to forecast the monthly business operating costs for further discussion on
required initial capital.
Task 2: Cost Estimation
Estimate the monthly running cost of the business (assuming 500 T-shirt
will be produced per month) and complete the following table:
Cost Items:
HK$
Monthly service fee paid to Yahoo
Hire charges for heat transfer machines
(Assuming 2 machines will be hired)
T-shirt purchase cost
Transfer paper for laser printer
Packaging tools and materials
Printing charges (e.g. cartridge)
Others:
BAFS Learning and Teaching Example
As at April 2009
Topic A08: Marginal and Absorption Costing
Student Worksheet p.11
A list of costs related to the operating the business is created up after the
discussions. Your group would like to use cost-plus pricing to establish the selling
price. As you have learnt marginal and absorption costing in your previous
studies, you decide to apply your knowledge to compute the unit cost.
Task 3: Cost Computation
(a) Classify the following cost items according to the characteristics of
Marginal and Absorption costing systems and complete the table:
Cost Items
Service fee paid to Yahoo
Hire charges for 2 heat
transfer machines
Details
$400/month
$15/piece
Transfer paper
$4/sheet
Printing charges
$3/sheet
Packaging tools & materials
$2,000/
month
Advertising fee (a fixed
amount charged by an
advertising firm)
Transaction fee charged by
Yahoo
Delivery charges
Fixed or
Variable
Production or
Non-production
Fixed
Cost
Non-production
cost
$1,500/
month
T-shirt purchase cost
Stationery expenses
Cost Classification under
$300/month
$1,000/
month
1.5% on sales
1% on sales
BAFS Learning and Teaching Example
As at April 2009
Topic A08: Marginal and Absorption Costing
Student Worksheet p.12
(b) Assuming 500 units will be produced per month and the production
overhead will be absorbed on unit basis, the production costs for each
unit will be:
Under Marginal Costing:
Unit Product Cost = $
Show your workings below:
Under Absorption Costing:
Unit Product Cost = $
Show your workings below:
BAFS Learning and Teaching Example
As at April 2009
Topic A08: Marginal and Absorption Costing
Student Worksheet p.13
The following table shows the sales forecast for the first three months of
operations based on current market research data. A mark up of 50% will
be imposed on the unit product cost.
Forecasted sales for the first three months of operation (in units):
1st month
2nd month
3rd month
500
400
550
-
100
50
Sales
Closing stock
Task 4: Profit Computation
(a) Suppose absorption costing is adopted, construct a forecasted profit
statement for the first three months of operations.
Unit Selling Price =
x (1 + 50%)
=
1st month
2nd month
3rd month
Total
HK$
HK$
HK$
HK$
Sales
Less: Production cost of
sales
Opening stock
Production cost
Closing stock
Gross profit
Less: Non-production cost
Fixed
Variable
Net profit
BAFS Learning and Teaching Example
As at April 2009
Topic A08: Marginal and Absorption Costing
Student Worksheet p.14
(b) Suppose marginal costing is adopted, construct a forecasted profit
statement for the first three months of operations (using the selling
price set under absorption costing).
1st month
2nd month
3rd month
Total
HK$
HK$
HK$
HK$
Sales
Less: Variable production
cost of sales
Opening stock
Variable production cost
Closing stock
Variable
non-production
cost
Contribution
Less: Fixed cost
Production
Non-production
Net profit
BAFS Learning and Teaching Example
As at April 2009
Topic A08: Marginal and Absorption Costing
Student Worksheet p.15
Comparing the two profit statements prepared under absorption
costing and marginal costing methods, some group members noticed
that there is a difference in net profits for the 2nd and 3rd month.
They would like to choose the method which is more logical.
Task 5: Method Selection
(a) Suggest two reasons for the difference in net profits for the 2nd
and 3rd month of sales.
Reasons:
BAFS Learning and Teaching Example
As at April 2009
Topic A08: Marginal and Absorption Costing
Student Worksheet p.16
(b) According to the market research, more T-shirts will be sold in the
summer months. If so, which method is more useful when sales
fluctuate from month to month because of seasonal variations in sales
demand? Why?
Method to be used:
Reasons:
BAFS Learning and Teaching Example
As at April 2009
Topic A08: Marginal and Absorption Costing
Student Worksheet p.17
Activity 3: Debate
Bullet Manufacturing Company is engaged in the manufacturing and wholesaling of
sneakers.
A net profit of $30,400 and a loss of $68,800 were reported by the
chief accountant, James, for the month of June and July respectively in the
executive meeting in early August.
The following is the dialogue between the
Marketing Manager, Philip and the Chief Accountant, James:
It’s weird. July’s sales had increased by more than 20%
over June’s. Yet, the profit was less. I hope the
accounting department can explain.
Philip, please note that we are using absorption costing in
preparing the profit statements. Due to employee vacation,
the production in July was less than the standard volume
which caused a larger fixed overhead to be absorbed in each
unit. Therefore, the profit for July is lower than June despite
I still don’t get it. The unit cost should be the same for
both months as we use the same amount of materials and
labour per unit. Therefore, if sales went up, so should
profits.
It was at this point that the Managing Director, Alice stepped into the
conversation and requested James to recast the June and July profit statements
BAFS Learning and Teaching Example
As at April 2009
Topic A08: Marginal and Absorption Costing
Student Worksheet p.18
using Marginal Costing for presentation in the next meeting.
During the next meeting, James presented the recasted profit statements which
showed a loss of $105,600 in June and a profit of $13,200 in July.
Philip
gleefully remarked that Marginal Costing method would better reflect the actual
performance of his department.
James on the other hand insisted that
Absorption Costing is a more appropriate method for management accounting
purposes.
Alice has to decide which method is better.
Task:
Students are divided into two groups to debate on the topic “Bullet
Manufacturing Company should adopt Marginal Costing instead of Absorption
Costing in preparing the company’s profit reports”.
Write down the arguments of the proposition.
Arguments for the proposition:
1.
2.
3.
4.
5.
6.
7.
8.
9.
10.
BAFS Learning and Teaching Example
As at April 2009
Topic A08: Marginal and Absorption Costing
Student Worksheet p.19
Arguments against the proposition:
1.
2.
3.
4.
5.
6.
7.
8.
9.
10.
BAFS Learning and Teaching Example
As at April 2009
Topic A08: Marginal and Absorption Costing
Student Worksheet p.20
Summary for lesson 2
Which costing system would you choose?
Marginal
Costing
Absorption Costing
Short run decision-making
Long run decision-making
When sales is subject to high
seasonal fluctuations
Comparison of performance
of different
departments/product lines
External reporting
BAFS Learning and Teaching Example
As at April 2009
Topic A08: Marginal and Absorption Costing
Student Worksheet p.21
Activity 4: Crossword Puzzle
Read the hints and complete the puzzle.
3
4
1
A
8
B
S
7
O
1
5
R
2
3
P
6
6
T
7
I
4
O
5
2
N
8
HORIZONTAL
1.
2.
3.
4.
5.
6.
7.
8.
Costing method which takes account of the variable cost of products
rather than the full production cost is known as
costing.
Indirect expenses are collectively known as
.
A cost which tends to vary with the level of activity is known as
costs.
is the difference between sales and variable cost.
If absorbed overhead are less than actual overhead, it is known as
absorption.
When production is greater than sales in a given period, the net profit
calculated under absorption costing is
than
marginal costing.
When production is equal to sales, net profit calculated under
absorption costing and marginal costing will be
.
Under absorption costing, profit is a function of both sales and
.
BAFS Learning and Teaching Example
As at April 2009
Topic A08: Marginal and Absorption Costing
Student Worksheet p.22
VERTICAL
1.
2.
3.
4.
5.
6.
7.
8.
Costing method which includes allocating all indirect production costs
to products is known as
costing.
Those costs attributed to the unit of goods purchased/manufactured
are known as
costs.
A cost which is incurred for a period and tends to be unaffected by
fluctuations in the levels of activity in short term is known as
costs.
The closing inventory of one year is the
inventory of
next year.
When production is less than sales in a given period, the net profit
calculated under absorption costing is
than
marginal costing.
Over the long run, both absorption and marginal costing will give the
net profit.
Profits calculated under marginal costing are a better indicator of the
company’s
flow than absorption costing.
Marginal costing is widely used for managerial decision making and
.
BAFS Learning and Teaching Example
As at April 2009