Professional Development Programme on Enriching Knowledge of the
Business, Accounting and Financial Studies (BAFS) Curriculum
Course 1 : Contemporary Perspectives on Accounting
Unit 7 : Marginal and Absorption Costing
Technology Education Section, Curriculum Development Institute
Education Bureau, HKSARG
August 2008
Learning objectives
On completion of this unit, you should be able to:
1.
2.
3.
4.
5.
6.
2
Distinguish between direct and indirect costs, fixed
and variable costs, factory and administrative
overheads, product costs and period costs.
Understand the process of cost allocation and
apportionment in marginal and absorption costing.
Calculate stock valuations using marginal and
absorption costing.
Preparing operating statements using marginal and
absorption costing.
Reconcile the profits and losses from marginal and
absorption costing.
Compare the advantages and disadvantages using
marginal and absorption costing.
Content
1.
2.
3.
4.
5.
6.
Costs, cost unit and classification of costs
Absorption costing
Marginal costing
Illustrations of absorption costing and marginal costing
Illustration of multiple-period absorption costing and
marginal costing income statements
Advantages and disadvantages of absorption costing
and marginal costing
3
Organisation of Unit 7
Management Accounting
Costs, cost unit and classification of costs
Absorption
Costing
Illustration
Multiple Period Illustration
Advantages and
disadvantages
4
Marginal
Costing
Illustration
Multiple Period Illustration
Advantages and
disadvantages
Management accounting (1)
Units 1 to 4 deal with financial accounting.
The major purpose of financial accounting is to provide
investors and other external users with useful information
about the financial position, performance and changes in
financial position of a company.
Units 5 and 6 deal with two related topics, namely ICT
Applications in Accounting and Ethical Issues in
Accounting.
5
Management accounting (2)
To achieve a company’s objectives, management
accounting provides managers with reliable and timely
information for planning, evaluating and rewarding
performance.
This Unit, together with Units 8 and 9 introduce the
foundations of management accounting.
This Unit will deal with accounting for manufacturing
operations under both absorption costing and marginal
costing systems.
6
Management accounting (3)
Unit 8 explains how cost-volume-profit (CVP) analysis is
applied by managers to answer various operating
decisions, such as what level of sales is required to break
even, how many units of a product is to be sold in order to
earn a target level of operating profit, etc.
Unit 9 focuses on short-run decision making. The Unit
describes how relevant costs, such as opportunity costs
and incremental costs, are applied to specific decisions,
including hire, make or buy, special order decisions.
7
Management accounting (4)
Unit 10 will deal with the areas of knowledge in financial
management – a closely related business knowledge to
management accounting. The Unit describes how the
basic capital investment methods are applied to evaluate
capital projects: accounting rate of return, payback period,
net present value and internal rate of return.
8
1. Costs, cost unit and
classification of costs (1)
Costs are the amount of expenditure incurred as a result
of producing the goods for sale.
Total costs = Quantity x Unit cost of product
A cost unit is a unit of product in relation to which, costs
are ascertained. For example, it can be a car, a table, etc.
9
1. Costs, cost unit and
classification of costs (2)
Costing Process
- Raw input cost data are processed to become useful
cost information through the different costing systems,
e.g.:
i) absorption (or full) costing
ii) marginal (or variable) costing
10
1. Costs, cost unit and
classification of costs (3)
A. Costs can be classified by its relation to cost unit:
i) direct costs; and
ii) indirect costs.
B. Costs can be classified by its behavior to output:
i) variable costs; and
ii) fixed costs.
C. Costs can be classified by its presentation in financial
statements:
i) product costs; and
ii) period costs.
11
1. A. i) Direct costs (1)
Direct costs are costs that can be identified specifically
and directly traceable to a cost unit.
They include:
i) Direct materials – the materials that actually become
part of the cost unit, e.g. components in computers.
ii) Direct labour – the remuneration paid to workers
whose work is directly related to production, e.g.
sewing labour cost in garment factory.
iii) Direct expenses – other costs that are directly incurred
on a specific cost unit, e.g. hire of a special plant.
12
1. A. i) Direct costs (2)
Prime costs
Prime costs are the direct costs that are consumed in
production.
Prime costs = Direct materials + Direct labour
+ Direct expenses
13
1. A. ii) Indirect costs (1)
Indirect costs are costs that cannot be identified specifically
or directly traceable to a cost unit.
They include:
i) Indirect materials – materials that form part of the
products and that can be identified but are too
insignificant in value, e.g. spare parts for machinery.
ii) Indirect labour – salaries of factory supervision staff that
are not directly involved in the production of products,
e.g. wages of maintenance staff.
iii) Indirect expenses – other costs that are either
impossible or inconvenient to charge directly to a cost
unit, e.g. equipment repairs.
14
1. A. ii) Indirect costs (2)
Overheads include all indirect costs that cannot be
identified specifically or directly traceable to a cost unit.
Overheads = Indirect materials + Indirect labour
+ Indirect expenses
15
1. B. i) Variable cost
Variable cost is a cost that varies in approximate
proportion to changes in the level of activity, e.g. the
airline fuel expense is directly proportionate to the
passage miles.
The relationship between cost and output can often be
described as linear:
Total variable costs = b x
where b = a constant dollar amount,
representing the variable cost per unit
x = production volume in units
(Note: The graphical presentation of cost behavior will be
introduced in Unit 8.)
16
1. B. ii) Fixed cost
Fixed cost is a cost that remains unchanged or does not
change significantly in response to the level of activity, e.g.
depreciation of airplane does not vary with passage miles.
Total fixed costs = a
where a = a constant dollar amount
(Note: The graphical presentation of cost behavior will be
introduced in Unit 8.)
17
1. B. iii) Semi-variable cost
Semi-variable cost contains both fixed and variable
components.
It increases or decreases with activity levels but not in
direct proportion, e.g. the cost of telephone expense
comprises a fixed rental charge plus a variable charge for
long distance calls.
Total semi-variable costs = a + b x
where a = total fixed costs
b = variable cost per unit
x = production volume in units
18
1. C. Product costs and Period cost (1)
Product costs are those costs incurred to manufacture the
products and included in the stock valuation.
Period costs are those costs associated with time periods,
rather than with the manufacturing of the stock.
19
1. C. Product costs and Period costs (2)
Unsold
Product
Product
costs
costs
Balance
BalanceSheet:
Sheet:
record
recordas
as
Inventory
Inventory
Sold in
future
periods
Period
Period
costs
costs
20
Sold in same
period
Income
Income
Statement:
Statement:
record
recordas
ascost
costofof
goods
goodssold
soldand
and
operating
operating
expenses
expenses
1. C. Product costs and Period costs (3)
Example
Fortune Ltd has the following cost information for January:
Product costs
= $100,000
Period costs
= $80,000
50% of the output for January is sold and there are no
opening stock.
Required:
Calculate the total costs of output for January.
Answer in next page
21
1. C. Product costs and Period costs (4)
Answer
The total costs of output for January is:
Product costs
Less: Closing stock (50%)
50,000
Cost of goods sold
50,000
Period costs
80,000
Total costs of output for January
22
$
100,000
130,000
1. D. Total costs in a manufacturing firm (1)
Total costs = Total direct costs + Total indirect costs
= Prime costs + Factory overheads
+ Administrative expenses
+ Selling expenses
+ Finance expenses
Production costs are total of prime costs and indirect
production costs incurred during production.
A summary of the costs and their relationships is shown
in Figure 1 in next page.
23
1. D. Total costs in a manufacturing firm (2)
The flow of costs for a manufacturing firm is shown in Figure 1 below:
Direct
Directmaterials
materials
Direct
labour
Direct labour
Direct
Directexpenses
expenses
Indirect
Indirectmaterials
materials
Indirect
labour
Indirect labour
Indirect
Indirectexpenses
expenses
Prime
Primecosts
costs
+
Factory
Factory
overheads
overheads
Production
Production
costs
costs
Period
Periodcosts:
costs:
Administrative,
Administrative,
Selling
Sellingand
andFinance
Finance
expenses
expenses
24
Product
Productcosts:
costs:
Cost
of
goods
Cost of goods
sold
sold
+
Expenses
Expensesshown
shown
ininIncome
Income
Statement
Statement
Total
Totalcosts
costs
2. Absorption costing (1)
The principle of absorption costing is to attribute all costs,
including the application (or absorption) of overhead costs
to cost units according to the activity level.
Thus, under absorption costing, operating statements do
not distinguish between fixed and variable costs. Valuation
of stock and work-in-progress contains both fixed and
variable costs.
Absorption costing is the basis of preparing financial
statements for the external users.
25
2. Absorption costing (2)
The procedures of absorption costing are:
A. Ascertain and charge the prime costs:
i) Direct materials
Direct materials = Opening direct materials stock
+ Purchases
- Closing direct materials stock
= Cost of direct materials used
26
2. Absorption costing (3)
ii) Direct labour
Direct labour
= Labour rate applied x No. of
labour hours
iii) Direct expenses
Direct expenses = Expense rate per unit x Unit of
production
27
2. Absorption costing (4)
B. Absorption of factory overheads:
The objective of the overhead absorption process is to
take up in the total costs of a product a fair and
appropriate share of the company’s total factory
overheads.
Factory overheads are allocated to the cost centre of
the product. The quantity of outputs is used to absorb
the overheads.
28
2. Absorption costing (5)
If there are more than one cost centre and product,
factory overheads are firstly apportioned by a fair and
appropriate basis, e.g. floor areas, into the cost centre
of the product concerned. Then the quantity of outputs
in that centre is used to absorb the overheads.
C.
Production costs
= Prime costs + Absorbed factory overheads
29
3. Marginal costing (1)
Under marginal costing, only variable production costs
are charged to cost units. Fixed costs are recognised
as expenses when incurred.
Marginal costing is more easy to apply than
absorption costing since no absorption of fixed
overheads into cost of good sold is required.
30
3. Marginal costing (2)
The procedures of marginal costing are:
A.
Ascertain all variable costs and allocate them into
prime costs, variable factory overheads to arrive at
the variable cost of goods sold and together with the
other variable components grouped under the
“variable costs” item.
i) Prime costs
= Direct materials + Direct labour +
Direct expenses
31
3. Marginal costing (3)
ii) Factory overheads are divided into variable and fixed
components respectively.
Prime costs and variable factory overheads are added
up to give the variable cost of good sold; fixed factory
overheads are grouped under the “fixed costs” item.
iii) Selling, administrative and finance expenses are
divided into variable and fixed components and
grouped under their categories respectively.
32
3. Marginal costing (4)
B. Allocate all fixed overhead components under the
“fixed costs” item:
All fixed factory overheads, selling, administrative and
finance expenses are grouped under the “fixed costs”
item.
C. Total costs
= Variable costs of goods sold
+ Variable selling, administrative and finance
expenses
+ Fixed costs
33
4. Illustrations of absorption costing
and marginal costing (1)
Absorption costing and marginal costing do not usually
provide the same assessment of profit.
The different profit figures are due to the difference in the
net change in stock valuation between the beginning and
the end of that accounting period.
34
4. Illustrations of absorption costing
and marginal costing (2)
In a period, 40,000 units of goods were produced and sold.
The revenues and costs were as follows:
Sales (40,000 x $5)
Production costs:
Variable
Fixed
Administrative and selling overheads:
Fixed
$200,000
70,000
30,000
50,000
Required:
Prepare operating statements based on both absorption
costing and marginal costing.
35
4. Illustrations of absorption costing
and marginal costing (3)
Solution:
Operating statement – absorption costing
Sales
Less: Cost of goods sold
Gross profit
Less: Administrative and selling overheads
Net profit
36
$
200,000
100,000
100,000
50,000
50,000
4. Illustrations of absorption costing
and marginal costing (4)
Operating statement – marginal costing
$
Sales
Less: Variable cost of goods
sold
Contribution
Less: Fixed costs
Production
Administrative and selling
$
200,000
70,000
130,000
30,000
50,000
Net profit
80,000
50,000
37
4. Illustrations of absorption costing
and marginal costing (5)
In the above example when sales equal production and
so no stock exists at the end of the period, both
absorption costing and marginal costing systems
produce the same profit figure.
38
4. Illustrations of absorption costing
and marginal costing (6)
Further illustration
Assume the same data as in previous illustration except
that only 36,000 of the 40,000 units produced were sold,
and so 4,000 units being carried forward as stock to the
next period.
Required:
Prepare operating statements based on absorption
costing and marginal costing systems.
39
4. Illustrations of absorption costing
and marginal costing (7)
Solution:
Operating statement – absorption costing
Sales (36,000 x $5)
Less: Cost of goods sold
Production costs
Less: Closing stock (4,000 x 2.5*)
$
100,000
10,000
Gross profit
Less: Administrative and selling overheads
Net profit
* Unit absorption cost = Average production costs
= $100,000 / 40,000 units
= $2.5 per unit
40
$
180,000
90,000
90,000
50,000
40,000
4. Illustrations of absorption costing
and marginal costing (8)
Operating statement – marginal costing
Sales (36,000 x $5)
Less: Variable cost of goods sold
Less: Closing stock (4,000 x 1.75*)
Contribution
Less: Fixed costs
Production
Administrative and selling
$
70,000
7,000
30,000
50,000
Net profit
41
$
180,000
63,000
117,000
80,000
37,000
* Unit variable costs = $70,000 / 40,000 units
= $1.75 per unit
4. Illustrations of absorption costing
and marginal costing (9)
You may notice that the value of closing stock differs in
absorption costing and marginal costing.
This is because absorption costing transfers some of the
period’s fixed costs which are included in the closing
stock to the next period, but marginal costing recognises
all fixed costs as expenses in the period they are
incurred.
Therefore in a period with increasing stock, absorption
costing will show higher profit than marginal costing.
42
5. Illustration of multiple-period absorption costing
and marginal costing income statements (1)
In preparing accounts based on absorption costing and
marginal costing, you can see that the main difference
is how to handle the fixed factory overheads.
This can be shown in Figure 2 in next page.
43
5. Illustration of multiple-period absorption costing
and marginal costing income statements (2)
Absorption costing
Direct materials
+ Direct labour
+ Variable factory overheads
+ Fixed factory
overheads
Marginal costing
Direct materials
+ Direct labour
+ Variable factory
overheads
Stock
Variable cost of good sold
Stock
Cost of good sold
+
Selling, administrative &
finance expenses
44
+
Variable selling, administrative
& finance expenses
+
Fixed factory
overheads
+ Fixed selling, administrative &
finance expenses
5. Illustration of multiple-period absorption costing
and marginal costing income statements (3)
Since the stock values for absorption costing and marginal
costing are different, and stock is written off as cost of
good sold only when they are sold, the profits for
absorption costing and marginal costing will also be
different for each period.
The difference in reported profits between absorption
costing and marginal costing in a period is a timing
difference only. The overall profits remain the same across
the total multiple periods. This can be shown by the
illustration of multiple-period income statements in next
slide.
45
5. Illustration of multiple-period absorption costing
and marginal costing income statements (4)
Gambo Ltd manufactures only baby shampoo. The sales,
production and stock figures are as follows:
46
(bottle) \ ($)
Year 1
Year 2
Year 3
Year 4
Sales (bottle)
25,000
20,000
30,000
40,000
Production (bottle)
25,000
40,000
20,000
30,000
Opening stock (bottle)
0
0
20,000
10,000
Closing stock (bottle)
0
20,000
10,000
0
Selling price per bottle
15
15
15
15
5. Illustration of multiple-period absorption costing
and marginal costing income statements (5)
The following absorption rates are used:
Cost per bottle ($)
Direct materials
1.00
Direct labour
2.00
Production overheads (150% of direct labour rate)
3.00
6.00
Production cost
Gambo Ltd uses 25,000 bottles as the base for allocation of fixed costs.
Two-third of the production overheads are fixed costs.
All administrative and selling overheads of $80,000 are fixed costs.
Required:
Prepare multiple-period income statements for year 1 to 4 using absorption
costing and marginal costing.
Note: Reconcile the difference in profits arising from overhead absorption.
47
5. Illustration of multiple-period absorption costing
and marginal costing income statements (6)
Multiple-period income statements - absorption costing
Sales
Year 1
Year 2
Year 3
Year 4
($’
($’000)
($’
($’000)
($’
($’000)
($’
($’000)
375
300
450
600
0
0
120
60
150
240
120
180
0
120
60
0
150
120
180
240
225
180
270
360
80
80
80
80
145
100
190
280
Less: Cost of goods sold
Opening stock
Add: Production costs
Less: Closing stock
Gross profit
Less: Administrative and
selling overheads
Net profit
48
5. Illustration of multiple-period absorption costing
and marginal costing income statements (7)
Since the actual production differs from the planned production for year 2
to year 4, the fixed overheads that are absorbed into production costs are
different.
Unit absorbed fixed overheads
= 2/3 of production overheads
= 2/3 x $3 per bottle = $2 per bottle
Year 1
Year 2
Year 3
Year 4
Planned production (bottle)
25,000
25,000
25,000
25,000
Actual production (bottle)
25,000
40,000
20,000
30,000
Difference (bottle)
0
+15,000
-5,000
+5,000
Overhead over+ / under absorption ($) at $2.00 per bottle
0
+30,000
-10,000
+10,000
49
5. Illustration of multiple-period absorption costing
and marginal costing income statements (8)
Multiple-period income statements - marginal costing
Fixed production overheads:
Direct labour for 25,000 bottles = 25,000 x $2 per bottle = $50,000
Fixed production overheads = $50,000 x 150% x 2/3 = $50,000
Variable production overheads = $(3 - 2) per bottle = $1 per bottle
Cost per bottle ($)
50
Direct materials
1.00
Direct labour
2.00
Variable production overheads
1.00
Variable production cost
4.00
5. Illustration of multiple-period absorption costing
and marginal costing income statements (9)
Multiple-period income statements - marginal costing
Year 1
($’
($’000 )
Year 2
($’
($’000)
Year 3
($’
($’000)
Year 4
($’
($’000)
375
300
450
600
0
0
80
40
Add: Production costs
100
160
80
120
Less: Closing stock
__0
_80
_40
__0
100
80
120
160
275
220
330
440
Production
50
50
50
50
Administrative and selling
overheads
80
80
80
80
130
130
130
130
145
90
200
310
Sales
Less: Variable cost of goods sold
Opening stock
Contribution
Fixed costs
Net profit
51
5. Illustration of multiple-period absorption costing
and marginal costing income statements (10)
Reconciliation of net profit
Year \ Net profit ($’
($’000)
Absorption costing
Marginal costing
1
145
145
2
100
90
3
190
200
4
280
310
30
0
745
745
OverOver-absorbed production
overheads
Profits for year 1 are the same for marginal costing and absorption costing
because there is no opening stock or closing stock. All production overheads
absorbed to the cost units are the same. For year 2 to 4, the production outputs
are different and therefore the unit cost of stock and costs of goods sold are
different, and the net profits are also different.
After the over-absorbed overheads are accounted for, you can see that the total
net profits across the 4 years are the same for both the absorption costing and
marginal costing.
52
6. Advantages and disadvantages of absorption
costing and marginal costing (1)
Marginal costing
Advantages:
i) Simple to use. Only direct costs are used for
calculation. There is no need to apportion fixed costs
to products.
ii) When sales are constant, marginal costing shows a
constant net profit even production fluctuates.
However, absorption costing will show varying
amounts of net profit depending on the production
levels.
53
6. Advantages and disadvantages of absorption
costing and marginal costing (2)
Marginal costing
Advantages:
54
iii)
Fixed costs are accounted for in the period when
incurred and there is no need to relate them to the
level of activity.
iv)
The problem of under or over-absorption of
overheads is avoided because fixed costs are
treated as period costs.
6. Advantages and disadvantages of absorption
costing and marginal costing (3)
Marginal costing
Disadvantages
i)
Too much focus on marginal costing may mislead the
company to set a price below the total costs and
result in loss in the long run.
ii) If the production department runs in full capacity, the
marginal cost will become inaccurate to be reflected
as the cost to produce an additional unit.
55
6. Advantages and disadvantages of absorption
costing and marginal costing (4)
Absorption costing
Advantages
i)
Fixed costs are substantial portion of costs incurred
in most production plants, and should be absorbed in
cost of goods manufactured.
ii)
56
If production is constant and sales fluctuate, the net
profit figures for absorption costing fluctuate less
than marginal costing since part of the fixed costs
are absorbed into the stock.
6. Advantages and disadvantages of absorption
costing and marginal costing (5)
Absorption costing
Advantages
iii)
For industries requiring a significant amount of fixed
costs incurred in the early production stage like timber
building, firework manufacture, etc, absorption costing
will be a more appropriate system; otherwise a
fictitious loss will be shown at the beginning.
iv)
HKAS 2 “Inventories” requires the use of absorption
costing for financial statements prepared for external
use.
57
6. Advantages and disadvantages of absorption
costing and marginal costing (6)
Absorption costing
Disadvantages
58
i)
Even when sales are constant, absorption costing
shows various amount of net profits whenever
production fluctuates.
ii)
The cost absorbed may be inaccurate. Significant
over-absorption or under-absorption costs may arise.
iii)
If more than one products are produced, the
apportionment of fixed costs into the cost units may not
be fair enough to reflect their share of overheads.
6. Advantages and disadvantages of absorption
costing and marginal costing (7)
There is no general answer which costing system is
better.
Accountants should judge whether absorption
costing or marginal costing is more appropriate for
their particular uses.
59
7. Recapitulation
After reading the above materials, you should be able to:
•
Understand the concept of costs, cost unit and
classification of costs
•
Explain the process of absorption costing and marginal
costing.
•
Perform calculation on cost and stock valuation by
absorption costing and marginal costing.
•
Apply absorption costing and marginal costing to
preparing income statements.
•
Understand the effect of absorption costing and
marginal costing in multiple-period income statements.
•
Compare the advantages and disadvantages of
absorption costing and marginal costing.
60
8. Further readings
•
Lucey, T. (2002), Costing, London: Thomson, 6th Edition,
Chapter 19, Marginal and Absorption Costing. (ISBN 08264-5510-7)
•
Li, T. M. and Ng, P. H. (2007), HKAL - Principles of
Accounts (Volume 2), Pilot Publishing Company Ltd, 2nd
Edition, Chapter 23, Absorption and Marginal Costing.
(ISBN 962-397-772-7)
•
Jiambalvo, J. (2003), Managerial Accounting, New York:
John Wiley & Sons, 3rd Edition, Chapter 5, Variable
Costing. (ISBN 0-471-23823-6)
•
王怡心，管理會計，台北:三民書局〈二○○二年〉，修訂二
版，第八章，全部成本法與直接成本法，第225-246頁。
(ISBN 957-14-3525-2)
61
End of the Unit
End-of-unit Assessment
This is the end of Unit 7.
Please go to the Unit
Assessment before
attempting the next unit.
62