Marginal Costing Notes

Reminder

• PechaKucha presentation is scheduled for tutorial on 21 November 2024. Ensure your presentation is concise and visually engaging.

• Attendance is mandatory; a 20% penalty will be applied for absence. If you foresee any issues, contact the instructor beforehand.

Cost Flow Under Absorption Costing (Review)

• Example: Commuting to university 50 km away to illustrate cost components.

• Petrol cost: £5 for a 50 km trip, representing a direct variable cost.

• Absorption costing includes both product and period costs, providing a comprehensive view of all expenses.

• Product Cost:

  • Direct Material: Raw materials directly used in production.

  • Direct Labor: Wages paid to workers directly involved in production.

  • Variable Manufacturing Overhead: Costs that change with production volume (e.g., electricity, machine maintenance).

  • Fixed Manufacturing Overhead: Costs that remain constant regardless of production volume (e.g., rent, depreciation).

• Period Cost:

  • Selling & Administrative Expenses: Costs incurred in selling and managing the business (e.g., salaries, marketing costs).

• Example of other costs:

  • EMI (car): £300 per month, £10 per day. Represents a fixed cost converted to a daily rate.

  • Insurance: £60 per month, £2 per day. Another example of a fixed cost distributed daily.

• Cost flow:

  • Work in Process -> Cost of Goods Sold (COGS) -> Closing Stock: Illustrates how costs move through the production process to the income statement.

  • Expenses for the period: Costs directly expensed in the income statement.

Session Plan

• Topics:

  • Marginal costing method: An overview of the marginal costing approach.

  • Definition: A detailed explanation of what marginal costing entails.

  • Difference from absorption costing: Highlighting the key distinctions between the two methods.

  • Application with numerical examples: Practical examples to demonstrate the application of marginal costing.

  • Comparison of the two methods: A thorough comparison to understand the strengths and weaknesses of each.

Learning Objectives

• Understand absorption and marginal costing: To grasp the basics of both costing methods.

• Explain the difference between absorption and marginal costing: To articulate the key differences clearly.

• Calculate product cost using marginal costing: To compute product costs accurately using marginal costing.

• Prepare profit statements using marginal costing: To create income statements using the marginal costing approach.

• Understand implications of using marginal costing: To recognize the broader impacts of using marginal costing in decision-making.

Semester Plan

• Week 3: Management Accounting and its environment I

• Week 4: Management Accounting and its environment II

• Week 5: Cost classification I

• Week 6: Cost classification II

• Week 7: Indirect cost allocation - blanket rate

• Week 8: Indirect cost allocation - departmental rate

• Week 9: Indirect cost allocation - activity based costing

• Week 10: Costing methods - absorption costing

• Week 11: Costing methods - marginal costing

• Week 12: Cost-volume profit (CVP)

• Week 13: Performance measurement

• Week 14: Revision

Costing Building Blocks

• Organizations incur production costs, manufacturing costs and non-manufacturing costs which are classified as either product costs or period costs.

• Product Cost components:

  • Direct Material (DM): Raw materials that are directly traceable to the product.

  • Direct Labor (DL): Cost of labor directly involved in production.

  • Manufacturing Overhead (MOH): All manufacturing costs that are not direct materials or direct labor.

• Period Cost components:

  • Selling: Costs associated with selling the product.

  • Marketing: Costs associated with promoting the product.

  • Admin: Costs associated with managing the organization.

• Costs are either directly traceable or allocated. Direct costs can be traced directly to a product, while indirect costs need to be allocated.

• Costing Methods:

  • Absorption Costing: Includes all manufacturing costs (direct and indirect) in the product cost.

  • Marginal Costing: Includes only variable manufacturing costs in the product cost.

  • Job Order Costing: Used for unique or custom products.

  • Process Costing: Used for mass production of similar products.

• Indirect Cost Allocation:

  • Blanket Rate: A single overhead rate for the entire factory.

  • Departmental Rate: Separate overhead rates for each department.

  • ABC Method: Allocates overhead based on activities performed.

What is Marginal Costing?

• CIMA Definition: Marginal costing is an alternative method of costing to absorption costing; only variable costs are considered costs of sales, and a contribution is calculated. Closing stock/work in progress is calculated at marginal cost. Fixed costs are period costs and charged in full to the profit and loss account. It helps in making decisions related to pricing, product mix, and accepting special orders.

• Key points:

  • Only variable costs are considered: This includes direct materials, direct labor, and variable overhead.

  • Fixed costs are treated as expenses: They are charged in full to the profit and loss account in the period they are incurred.

  • Unit cost includes direct material, direct labor, and variable manufacturing overhead: This is used for inventory valuation and cost of goods sold calculation.

• Also known as variable costing or direct costing. These terms are often used interchangeably.

• Preferred for internal decision making: Provides a clearer view of cost-volume-profit relationships.

• Uses a contribution format for the profit and loss statement: Highlights the contribution margin, which is revenue less variable costs.

• Fixed manufacturing costs are not directly tied to specific products; they are capacity costs (e.g., depreciation, taxes, insurance, salaries) incurred regardless of production. Understanding this distinction is crucial for accurate financial analysis.

Cost Flow Under Marginal Costing

• Product Cost:

  • Direct Material: Cost of raw materials used in production.

  • Direct Labour: Cost of labor directly involved in production.

  • Variable Manufacturing Overhead: Manufacturing costs that vary with production volume.

• Period Cost:

  • Fixed Manufacturing Overhead: Manufacturing costs that remain constant regardless of production volume.

  • Selling & Administrative Expenses: Costs incurred in selling and managing the business.

• Flow:

  • Work in Process -> COGS -> Closing Stock: Variable production costs flow through these accounts.

  • Expenses for the period: Fixed costs and selling/administrative expenses are recognized in the period they occur.

Profit Statement (Marginal Costing)

• Revenue: Total income from sales.

• Less: Cost of Goods Sold

  • Opening Stock: Value of inventory at the beginning of the period.

  • Product Costs (variable only): Direct materials, direct labor, and variable overhead.

  • Closing Stock: Value of inventory at the end of the period.

• Contribution Margin: Revenue less variable costs (including cost of goods sold).

• Other variable expenses: Variable selling and administrative expenses.

• Adjusted Contribution Margin: Contribution margin less other variable expenses.

• Less: Fixed Expenses

  • Fixed MOH cost: Fixed manufacturing overhead costs.

  • Fixed S&A cost: Fixed selling and administrative costs.

• Operating Profits: Profit before interest and taxes.

• Closing stock = opening stock + production - sales: Basic inventory equation.

Numerical Exercise

• Minnesota Yorkers produces 25,000 units annually. This detailed example illustrates how to apply marginal costing in a practical scenario.

• Costs:

  • Direct material: £4/unit

  • Direct labor: £3/unit

  • Fixed manufacturing overhead: £150,000

  • Variable MOH: £3/unit

  • Variable selling & admin: £3/unit

  • Fixed selling & admin: £100,000

• Task: Calculate unit cost using marginal costing. This calculation is essential for inventory valuation and profitability analysis.

Numerical Exercise (cont’d)

• Data organization:

  • Variable Costs:

    • Direct material: £4/unit

    • Direct labor: £3/unit

    • Variable MOH: £3/unit

    • Variable selling & admin: £3/unit

  • Fixed costs:

    • Fixed MOH: £150,000

    • Fixed selling & admin: £100,000

• Marginal Costing Product Cost = Direct Material + Direct Labor + Variable MOH = £4 + £3 + £3 = £10

• Fixed costs and selling/admin costs are treated as period costs, not product costs. This distinction is fundamental to marginal costing.

Exam Question Example

• Cost item breakdown:

  • Direct material: £4

  • Direct labor: £3

  • Variable MOH: £3

  • Product cost/unit: £10

• Show all workings in exam questions. Clear and detailed workings are necessary to secure full marks.

Profit Statement Setup

• Product cost/unit calculated. This is the foundation for preparing the profit statement.

• Additional data:

  • No opening stock

  • Production: 25,000 units

  • Sales: 20,000 units

  • Selling price: £30

• Task: Prepare a profit statement using marginal costing. This exercise integrates all the concepts learned.

Profit Statement Solution (1/3)

• Revenue (£30 * 20,000): £600,000

• Less: Cost of Goods Sold

  • Opening stock: 0

  • Product costs (£10 * 25,000): £250,000

  • Closing stock (£10 * 5,000): £50,000

  • Total COGS: £200,000

• Contribution Margin: £400,000

• Closing Stock Calculation: $CB = 0 + 25,000 - 20,000 = 5,000$

Profit Statement Solution (2/3)

• Revenue (£30*20,000): £600,000

• Less: costs of Goods sold

  • Opening stock: 0

  • Product costs (£10*25,000): £250,000

  • Closing stock (£10*5,000): £50,000

  • Total COGS: £200,000

• Contribution Margin: £400,000

• Less: Variable selling & admin (£3*20,000): £60,000

• Adjusted Contribution Margin: £340,000

Profit Statement Solution (3/3)

• Revenue (£30*20,000): £600,000

• Less: costs of Goods sold

  • Opening stock: 0

  • Product costs (£10*25,000): £250,000

  • Closing stock (£10*5,000): £50,000

  • Total COGS: £200,000

• Contribution Margin: £400,000

• Less: Variable selling & admin (£3*20,000): £60,000

• Adjusted Contribution Margin: £340,000

• Less: Fixed expenses

  • Fixed MOH cost: £150,000

  • Fixed S&A cost: £100,000

  • Total Fixed Expenses: £250,000

• Operating Profits: £90,000

Numerical Exercise – Complicated

• Extend accounting to the next year. This tests the understanding of how marginal costing works over multiple periods.

• Next year: Sells 30,000 units, produces 25,000 units.

• Other cost figures remain unchanged.

• Required: Prepare a profit statement. Demonstrates the longitudinal application of marginal costing.

Numerical Exercise – Complicated – Solution

• Revenue (£30*30,000) = £900,000

• Less: Costs of Goods Sold

  • Opening Stock (£10*5,000) = £50,000

  • Product Costs (£10*25,000) = £250,000

  • Closing Stock = 0

  • Total COGS = £300,000

• Contribution Margin = £600,000

• Less: Variable Selling & Admin (£3*30,000) = £90,000

• Adjusted Contribution Margin = £510,000

• Less: Fixed Expenses

  • Fixed MOH Cost = £150,000

  • Fixed S&A Cost = £100,000

  • Total Fixed Expenses = £250,000

• Operating Profits = £260,000

Two Years Together

Income Comparison

Income Comparison Explanation

• Profit differences are due to how costs are treated and the resulting inventory valuation. Understanding these differences is crucial for financial analysis and decision-making.

• Production > Sales: Inventory increases; absorption costing shows higher profits. This is because fixed manufacturing overhead is included in the inventory value.

• Production < Sales: Inventory decreases; marginal costing shows higher profits. The fixed manufacturing overhead is expensed in the period.

• Production = Sales: No inventory change; both methods yield the same profit. Under this condition the treatment of fixed costs does not affect profit.

Unit Cost Breakdown

• Breaking down the product cost into fixed and variable elements allows for the split of costs of goods sold and ending inventory. This detailed breakdown aids in better cost management and decision-making.

COGS and EI (1/4)

COGS and EI (2/4)

Same Table as COGS and EI (1/4). Total costs are eventually the same; how to explain the profit difference? This question highlights the importance of understanding the nuances of each costing method.

COGS and EI (3/4)

Same Table as COGS and EI (1/4).

*Absorption costing formula: PC = DL+DM+VMOH+FMOH

*Marginal costing formula: PC = DL+DM+VMOH

COGS and EI (4/4)

Same Table as COGS and EI (1/4).

Reconciliation of Profit Difference

• The difference in profits between methods can be reconciled. Understanding this reconciliation is essential for financial reporting and analysis.

• Marginal costing operating profits: £90,000

• Rise/(fall) in stock * fixed MOH/unit: (5,000 * £6) = £30,000

• Absorption costing operating profits: £120,000

• Fixed MOH per unit calculation: $\frac{Fixed\ MOH}{Units\ produced} = \frac{£150,000}{25,000} = £6/unit$

Advantages of Marginal Costing and Contribution Margin (CM) Approach

• Easy to understand: Simplicity in calculation and concept.

• Consistent with CVP analysis: Facilitates cost-volume-profit analysis.

• Operating profit is closer to net cash flow: Provides a more accurate view of cash flows.

• Profit is not affected by inventory changes: Eliminates the impact of production levels on profits.

• Impact of fixed costs is emphasized: Highlights the importance of managing fixed costs.

• Consistent with standard costs and flexible budgeting: Aligns well with these management accounting techniques.

• Easier to estimate product and segment profitability: Simplifies profitability analysis for different products and segments.

Choosing a Method

• Both methods have pros and cons. The choice depends on the specific needs and context of the organization.

• Absorption costing differs from marginal costing by the treatment of fixed MOH cost. This is the fundamental difference between the two methods.

• Fixed MOH cost per unit behaves like a variable cost when production volume changes. This can distort decision-making under absorption costing.

• Absorption costing complies with the matching principle. This is a key advantage for external financial reporting.

• Marginal costing for external financial reporting may face auditor disapproval due to non-compliance with internationally accepted accounting principles. It is generally used for internal purposes.

• Marginal costing recognizes cost behaviors. Provides a clearer understanding of how costs change with volume.

• Marginal costing prevents profit manipulation through overproduction. Avoids artificially inflating profits by producing more than is sold.

Class Activity - Data

• Nandini Inc. manufactures NY34 and is setting up its management control system. This real-world scenario helps illustrate the application of costing methods.

• Considering marginal or absorption costing. The company needs to decide which method best suits its needs.

• Available information:

  • Direct material: £15

  • Direct labor: £10

  • Selling price: £100

  • Fixed production overheads: £400,000 per period

  • Normal production: 100,000 units per period

  • Expected sales: 100,000 units

  • Production: 110,000 units

  • Fixed selling costs: £200,000 per period

  • Variable selling costs: £2 per unit

  • No opening stock

Class Activity - Requirement

• Prepare a budgeted profit and loss account using absorption costing, showing stock valuation. This task requires applying absorption costing principles.

• Prepare a budgeted profit and loss account using marginal costing, showing stock valuation. This task requires applying marginal costing principles.

Class Activity - Solve Here

• Selling price: £100

• Normal production: 100,000 units

• Direct material: £15

• Direct labor: £10

• Variable MOH/unit: N/A

• Fixed MOH cost: £400,000 (£4.00 per unit)

• Variable S&A cost/unit:

• Fixed S&A cost:

• Opening stock:

• Actual production:

• Sales:

• Product Cost - Marginal

  • Direct Material

  • Direct Labour

  • Variable MOH/unit

• Product Cost -Absorption

  • Direct Material

  • Direct Labour

  • Variable MOH

  • Fixed MOH/unit

Class Activity - Solve Here 2

*Marginal Costing

• Revenue

• Less: costs of Goods sold

  • Opening stock

  • +Product costs [variable only]

  • -Closing stock

• Contribution Margin

  * -Other variable expenses

• Adjusted Contribution Margin
  * Less: Fixed expenses
  *Fixed MOH cost

• Fixed S&A cost

• Operating Profits

*Absorption Costing

• Revenue

• Less: costs of Goods sold

  • Opening stock

  • +Product costs

  • -Closing stock

• Gross profits

• +/-Over/under absorbed overhead cost

  *Adjusted profits

  *Less: Selling and admin costs

  *Variable S&A cost

  *Fixed S&A cost

  *Operating Profits

Summary and Way Forward

• Marginal costing method. Recap of the key concepts.

• How to calculate unit cost and profits. Review of the calculation