Chapter 22

Notes to teachers
1

Absorption and Marginal Costing

This chapter largely builds on the concepts of fixed costs vs. variable costs, manufacturing overheads vs. non-manufacturing overheads, and product costs vs. period costs introduced in Chapter 20, and the absorption of overheads introduced in Chapter 21. The curriculum only requires the preparation of manufacturing accounts and income statements under absorption costing and marginal costing, respectively. The preparation of other financial statements such as the balance sheet is not required. Note that the manufacturing account is a financial statement and not a ledger account. Teachers should ask students to identify on their own the differences between the financial statements prepared under the two costing methods, instead of just teaching the points stated in Section 22.5. The most difficult part of this chapter is reconciling and explaining the different net profits calculated under the two costing methods. The income statements prepared under marginal costing and the contribution margin concept involved are important for the break-even analysis and business decisions to be made in the subsequent chapters.

3 4 5 6

Q1 Q2

Product contribution margin refers to the excess of sales revenue over the variable cost of goods sold. Total contribution margin refers to the excess of sales revenue over all variable costs incurred.
Income Statement for the month
Sales (2,000 $50) Less Variable manufacturing cost of goods sold [2,000 ($8 + $6 + $5)] Product contribution margin (a) Less Variable selling overheads (2,000 $3) Total contribution margin (b) Less Fixed factory overheads Fixed selling overheads Administrative overheads Net profit $ 20,000 16,000 4,000 $ 100,000 (38,000) 62,000 (6,000) 56,000

(40,000) 16,000

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Q3

The differences between the income statements prepared under absorption and marginal costing include: The income statement prepared under absorption costing classifies costs by function: manufacturing and non-manufacturing. In contrast, the income statement prepared under marginal costing classifies costs into fixed and variable costs. Under absorption costing, all the manufacturing costs (variable and fixed) are included in the valuation of inventory. Under marginal costing, only variable manufacturing costs are included in the valuation of inventory. Under absorption costing, the cost of goods sold includes all the manufacturing costs (variable and fixed). Under marginal costing, only variable manufacturing costs are included in the cost of goods sold. The income statement prepared under absorption costing shows the gross profit, which is the excess of sales revenue over all the manufacturing costs (variable and fixed) of goods sold. The income statement prepared under marginal costing shows the total contribution margin, which is the excess of sales revenue over all the variable costs incurred, regardless of whether they are manufacturing or non-manufacturing. Net profit is both defined as the excess of revenues over all costs and expenses incurred in the same period under absorption costing and marginal costing. However, the resulting net profit figures are different. This is due to different costs being absorbed by inventory. The net profit reported under absorption costing will be higher when the inventory level increases during the accounting period. Conversely, the net profit reported under absorption costing will be lower when the inventory level decreases during the accounting period. Unit contribution margin = Total contribution margin Sales volume = $52,000 800 = $65 Change in net profit = Change in sales volume Unit contribution margin = 200 $65 = $13,000 Net profit will be reduced by $13,000 if the sales volume decreases by 200 units. See text, Section 22.6.

Q4

Q5 Q6

A1 A2

Cost of goods sold = $30,500 Gross profit = $49,500 Net profit = $30,500 The statement is incorrect. Under marginal costing, only variable manufacturing costs are absorbed by inventories.

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A3

Under absorption costing:

Baby Toys Income Statement for the year ended 31 March 2012
Sales Less Cost of goods sold: Opening inventory Add Manufacturing cost of goods completed Cost of goods available for sale Less Closing inventory ($40,000 200 1,000) Gross profit Less Marketing costs [(1,000 $5) + $15,000] Net profit $ 8,000 40,000 48,000 (8,000) $ 100,000

(40,000) 60,000 (20,000) 40,000

Under marginal costing:

Baby Toys Income Statement for the year ended 31 March 2012
Sales Less Variable cost of goods sold: Opening inventory Add Variable manufacturing cost of goods completed Variable cost of goods available for sale Less Closing inventory ($30,000 200 1,000) Product contribution margin Less Variable marketing costs (1,000 $5) Total contribution margin Less Fixed manufacturing costs Fixed marketing costs Net profit $ 6,000 30,000 36,000 (6,000) 10,000 15,000 $ 100,000

(30,000) 70,000 (5,000) 65,000 (25,000) 40,000

A4 A5 A6
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The net profit figures reported by both costing methods are the same. The net profit reported under absorption and marginal costing will be the same when the inventory level remains unchanged during the accounting period. Ways to prevent managers from manipulating profits by producing more units of output than needed include: Set a target inventory level for managers to achieve. Use the profits reported under marginal costing as the basis for performance evaluation. Use other criteria (other than reported profits) for performance evaluation. (Any other reasonable answer) Net profit under absorption costing Net profit under marginal costing = (Fixed manufacturing overheads included in closing inventory of work-in-progress under absorption costing Fixed manufacturing overheads included in opening inventory of work-in-progress under absorption costing) + (Fixed manufacturing overheads included in closing inventory of finished goods under absorption costing Fixed manufacturing overheads included in opening inventory of finished goods under absorption costing) = [($4,800 100 800) $0] + [($4,200* 50 700) $0] = $600 + $300 = $900 (i.e., $11,650 $10,750) * $4,800 ($4,800 100 800) (fixed manufacturing overheads absorbed by closing inventory of work-in-progress)

ASSESSMENT

Short Questions
22.1
(a) (b) Under absorption costing, inventories absorb all the costs of manufacturing, regardless of whether they are fixed or variable. Under marginal costing, inventories absorb only variable manufacturing costs. Reported profits under absorption costing and marginal costing will be the same when production volume equals sales volume. If production volume exceeds sales volume, reported profits under absorption costing will be higher. Conversely, if production volume is lower than sales volume, reported profits under marginal costing will be higher.

22.2X Absorption costing. Under absorption costing, all manufacturing costs (fixed or variable) that are incurred
to bring the goods into saleable condition are treated as product costs. They are written off to the profit and loss account when the goods are sold. If the goods remain unsold at the end of an accounting period, their product costs will be carried forward to the next period as inventories. However, under marginal costing, all fixed manufacturing costs are written off to the profit and loss account as they are incurred, regardless of whether the goods are sold or not.

Application Problems
22.3
Global Manufacturing Co Manufacturing Account for the year ended 31 March 2011
Opening inventory of raw materials Add Purchases Carriage inwards Less Closing inventory of raw materials Cost of raw materials consumed Manufacturing wages Prime cost Factory overheads: Factory water and electricity Factory rent Other manufacturing expenses Add Opening work-in-progress Less Closing work-in-progress Manufacturing cost of goods completed $ 213,400 3,210 23,000 62,200 14,300 $ 24,000 216,610 240,610 (26,200) 214,410 132,800 347,210

99,500 446,710 9,550 456,260 (8,700) 447,560

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22.4X

Best Toys Co Manufacturing Account for the year ended 31 August 2011
Opening inventory of raw materials Add Purchases Carriage inwards Less Closing inventory of raw materials Cost of raw materials consumed Manufacturing wages Prime cost Factory overheads: Factory rent ($80,000 70%) Factory utilities ($35,000 70%) General manufacturing expenses Add Opening work-in-progress Less Closing work-in-progress Manufacturing cost of goods completed $ 222,000 6,100 56,000 24,500 38,790 $ 56,200 228,100 284,300 (84,100) 200,200 145,220 345,420

119,290 464,710 8,110 472,820 (10,330) 462,490

22.5

Budgeted direct labour hours per unit Total budgeted direct labour hours Fixed production overheads Fixed production overheads per direct labour hour Production costs per unit: Direct materials cost Direct labour cost Variable production overheads Fixed production overheads

Product A 1.5 15,000 $ 8 9 5 6 28

Product B 2 16,000 $ 10 12 6 8 36

Total 31,000 $124,000 $4

(a)

(i) Under absorption costing:

Budgeted Income Statement for the year ended 31 December 2010
Sales (W1) Less Cost of goods sold: Manufacturing cost of goods completed (W2) Less Closing inventory (W3) Gross profit Less Fixed administrative overheads Net profit Product A $ 332,500 280,000 (14,000) 266,000 66,500 Product B $ 300,000 288,000 (18,000) 270,000 30,000 Total $ 632,500 568,000 (32,000) 536,000 96,500 (95,000) 1,500

Workings: (W1) Product A = 9,500 $35 = $332,500 (W2) (W3) Product A = 10,000 $28 = $280,000

Product B = 7,500 $40 = $300,000 Product B = 8,000 $36 = $288,000

Product A = $280,000 [(10,000 9,500) 10,000] = $14,000 Product B = $288,000 [(8,000 7,500) 8,000] = $18,000

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(ii) Under marginal costing:

Budgeted Income Statement for the year ended 31 December 2010
Sales Less Variable cost of goods sold: Variable manufacturing cost of goods completed (W4) Less Closing inventory (W5) Contribution margin Less Fixed production overheads Fixed administrative overheads Net loss Product A $ 332,500 220,000 (11,000) 209,000 123,500 Product B $ 300,000 224,000 (14,000) 210,000 90,000 Total $ 632,500 444,000 (25,000) 419,000 213,500 (124,000) (95,000) (5,500)

(b)

(W4) (W5)

Product A = 10,000 $22 = $220,000 Product B = 8,000 $28 = $224,000 Product A = $220,000 [(10,000 9,500) 10,000] = $11,000 Product B = $224,000 [(8,000 7,500) 8,000] = $14,000

Net profit under absorption costing Net profit under marginal costing

= Fixed production overheads included in closing inventory under absorption costing Fixed production costs included in opening inventory under absorption costing
= [(500 $6) $0] + [(500 $8) $0] = $7,000 [$1,500 ($5,500)]

22.6X
Production costs per unit:
Variable manufacturing costs Fixed manufacturing costs ($168,000 12,000) $ 18 14 32

(a)

(i) Under absorption costing:

Budgeted Income Statement for the year ended 31 December 2010
Sales (12,600 $38) Less Cost of goods sold: Opening inventory (1,000 $32) Add Manufacturing cost of goods completed (12,000 $32) Less Closing inventory [$384,000 (1,000 + 12,000 12,600) 12,000] Gross profit Less Fixed selling and distribution overheads Net loss $ 32,000 384,000 416,000 (12,800) $ 478,800

(403,200) 75,600 (78,000) (2,400)

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(ii) Under marginal costing:

Budgeted Income Statement for the year ended 31 December 2010
Sales Less Cost of goods sold: Opening inventory (1,000 $18) Add Variable manufacturing cost of goods completed (12,000 $18) Less Closing inventory [$216,000 (1,000 + 12,000 12,600) 12,000] Contribution margin Less Fixed manufacturing costs Fixed selling and distribution overheads Net profit $ 18,000 216,000 234,000 (7,200) 168,000 78,000 $ 478,800

(226,800) 252,000 (246,000) 6,000

(b)

Net profit under absorption costing Net profit under marginal costing = Fixed manufacturing costs included in closing inventory under absorption costing Fixed manufacturing costs included in opening inventory under absorption costing = (400 $14) (1,000 $14) = $8,400 (i.e., $2,400 $6,000)

22.7

In Question 22.5, marginal costing reports a lower net profit because of an increase in inventory. Under absorption costing, some fixed manufacturing costs are absorbed into the closing inventory. As a result, the net profit reported under absorption costing is higher. In Question 22.6X, marginal costing reports a higher net profit because of a decrease in inventory. Under absorption costing, some fixed manufacturing costs of the previous year are released from the opening inventory while a portion of fixed manufacturing costs incurred in the current year are absorbed by the closing inventory. When the inventory level falls, the amount of fixed manufacturing costs released exceeds the amount absorbed (assuming fixed manufacturing costs per unit remain the same). As a result, the net profit reported under absorption costing is lower.

22.8X
(a) Under marginal costing:
Budgeted Income Statement for the year ended 31 December 2011
Sales (38,000 $45) Less Variable cost of goods sold: Variable manufacturing cost of goods completed [40,000 ($8 + $10 + $6)] Less Closing inventory [$960,000 (40,000 38,000) 40,000] Contribution margin Less Fixed manufacturing overheads Non-manufacturing overheads Net profit $ 960,000 (48,000) 120,000 80,000 $ 1,710,000

(912,000) 798,000 (200,000) 598,000

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Budgeted Income Statement for the year ended 31 December 2012

Sales (42,000 $45) Less Variable cost of goods sold: Opening inventory Add Variable manufacturing cost of goods completed (40,000 $24) Contribution margin Less Fixed manufacturing overheads Non-manufacturing overheads Net profit $ 48,000 960,000 120,000 80,000 $ 1,890,000

(1,008,000) 882,000 (200,000) 682,000

(b)

Under absorption costing:

Budgeted Income Statement for the year ended 31 December 2011
Sales Less Cost of goods sold: Manufacturing cost of goods completed {40,000 [$24 + ($120,000 40,000)]} Less Closing inventory [$1,080,000 (40,000 38,000) 40,000] Gross profit Less Non-manufacturing overheads Net profit $ 1,080,000 (54,000) $ 1,710,000

(1,026,000) 684,000 (80,000) 604,000

Budgeted Income Statement for the year ended 31 December 2012

Sales Less Cost of goods sold: Opening inventory Add Manufacturing cost of goods completed (40,000 $27) Gross profit Less Non-manufacturing overheads Net profit $ 54,000 1,080,000 $ 1,890,000

(1,134,000) 756,000 (80,000) 676,000

22.9
$ per unit Selling price ($1,200,000 40,000) 30 Direct materials ($600,000 40,000) 15 Direct labour ($240,000 40,000) 6 Variable factory overheads ($120,000 40,000) 3 Fixed factory overheads ($100,000 40,000) 2.5

(a)

(i) Under absorption costing:

Income Statement for the year ended 31 March 2011
Sales (35,000 $30) Less Cost of goods sold: Manufacturing cost of goods completed (W1) Less Closing inventory (W2) Add Under-absorption of fixed factory overheads (W3) Gross profit Less Fixed administrative overheads Net profit $ 1,007,000 (79,500) 927,500 5,000 $ 1,050,000

(932,500) 117,500 (60,000) 57,500

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Workings: (W1) 38,000 ($15 + $6 + $3 + $2.5) = $1,007,000 (W2) (38,000 35,000) $26.5 = $79,500 (W3) $100,000 (38,000 $2.5) = $5,000 (ii) Under marginal costing:
Income Statement for the year ended 31 March 2011
Sales Less Variable cost of goods sold: Variable manufacturing cost of goods completed (W4) Less Closing inventory (W5) Contribution margin Less Fixed factory overheads Fixed administrative overheads Net profit $ 912,000 (72,000) 100,000 60,000 $ 1,050,000

(840,000) 210,000 (160,000) 50,000

(b)

(W4) (W5)

38,000 ($15 + $6 + $3) = $912,000 (38,000 35,000) $24 = $72,000

Difference in net profit = $80,000 $50,000 = $30,000 lower This is due to: 5,000 (Budgeted 40,000 Actual 35,000) units Contribution of $6 ($30 $24) per unit = $30,000

22.10X
(a)

Absorption costing. When the inventory level increases during the year, a higher net profit figure would be reported under absorption costing than under marginal costing. This is because with absorption costing, some of the fixed manufacturing costs of the previous year are released from the opening inventory while a portion of fixed manufacturing costs incurred during the current year are absorbed by the closing inventory. In our case, the amount of fixed manufacturing costs released is lower than the amount absorbed. This leads to a higher net profit figure. Net profit under absorption costing Net profit under marginal costing

(b)

= Fixed manufacturing costs included in closing inventory under absorption costing Fixed manufacturing costs included in opening inventory under absorption costing
(c) = ($240,000 5,800 50,000) ($240,000 4,600 50,000) = $27,840 $22,080 = $5,760 Net profit reported under marginal costing = $66,000 $5,760 = $60,240 Under absorption costing, the net profit figure can be manipulated by changing the inventory level. Managers who are evaluated on the basis of profits earned using the absorption cost approach may be tempted to produce more units of output than needed. This will result in an undesirable buildup of inventories, which will in turn hurt a companys profitability and liquidity in the long term.

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22.11
(a)
Sales Less Variable cost of goods sold: Variable manufacturing cost of goods completed (W1) Less Closing inventory (W2) Product contribution margin Less Variable selling and distribution expenses (W3) Contribution margin Less Fixed manufacturing costs Fixed administrative expenses Fixed selling and distribution expenses (W4) Net profit $ 160,000 (40,000) 120,000 100,000 28,000 $ 600,000

(120,000) 480,000 (72,000) 408,000

(248,000) 160,000

(b)

Workings: (W1) $280,000 $120,000 = $160,000 (W2) $160,000 25% (i.e., $70,000 $280,000) = $40,000 (W3) Units sold = Sales Unit price = $600,000 $100 = 6,000 6,000 $12 = $72,000 (W4) $100,000 $72,000 = $28,000 Net profit under absorption costing Net profit under marginal costing

= Fixed manufacturing costs included in closing inventory under absorption costing

(c)

Fixed manufacturing costs included in opening inventory under absorption costing = ($120,000 25%) $0 = $30,000 Fixed costs will not be affected by the acceptance of the special order. Therefore, only variable costs should be considered when making the decision. Contribution margin per unit = $408,000 6,000 = $68 This means that variable costs per unit = $100 $68 = $32 As the unit price offered ($40) exceeds the variable costs per unit, the special order should be accepted. Alternative answer:
Sales (W1) Less Variable manufacturing cost of goods sold (W2) Less Variable selling and distribution expenses (W3) Contribution margin $ 20,000 (10,000) 10,000 (6,000) 4,000

Workings: (W1) 500 $40 = $20,000 (W2) Variable manufacturing costs per unit = $120,000 6,000 = $20 500 $20 = $10,000 (W3) 500 $12 = $6,000 As the special order has a positive contribution margin, this order should be accepted.

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(d)

Non-financial factors that should be considered include: Relationship with the customer Pressure from other customers to cut prices (Any other reasonable answer)

22.12X
(a)
Sales (W1) Less Variable cost of goods sold: Variable manufacturing cost of goods completed (W4) Less Closing inventory (balancing figure) Variable marketing costs (W3) Contribution margin (W2) Less Fixed manufacturing costs Fixed marketing costs Net profit (balancing figure) $ 10,000 (1,000) 9,000 11,000 12,000 10,000 $ 60,000

(20,000) 40,000 (22,000) 18,000

Workings: (W1)
Balance b/f Sales (balancing figure)

Total Accounts Receivable

$ 8,000 60,000 68,000 Cash/Bank Balance c/f $ 58,000 10,000 68,000

(b)

(W2) (W3) (W4)

$60,000 2 3 = $40,000 $21,000 $10,000 = $11,000 $22,000 $12,000 = $10,000

(c)

Break-even point in sales revenue = Fixed costs Contribution margin ratio = $22,000 2/3 = $33,000 Net profit under absorption costing Net profit under marginal costing = Fixed manufacturing costs included in closing inventory under absorption costing Fixed manufacturing costs included in opening inventory under absorption costing = ($12,000 1,000 10,000) $0 = $1,200 Net profit under absorption costing = $18,000 + $1,200 = $19,200 Alternative answer:
Sales Less Cost of goods sold: Manufacturing cost of goods completed ($10,000 + $12,000) Less Closing inventory (Workings) Gross profit Less Marketing costs ($11,000 + $10,000) Net profit $ 22,000 (2,200) $ 60,000 (19,800) 40,200 (21,000) 19,200

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(d) (e)

Workings: $22,000 10% (i.e., $1,000 $10,000) = $2,200 Net profit would increase by $4,000 (Contribution margin $40,000 10%), assuming the unit price and existing cost behaviour remain unchanged. The net profit would be reduced, but not as much as $100,000. Investment in plant and equipment is a capital expenditure and should not be wholly written off in the period in which it is incurred. Only a portion, known as depreciation, is to be written off in each period the plant and equipment is in use.

Past Exam Questions

22.14
(a)
Direct manufacturing labour ($20 1.5 hrs) Direct materials Variable manufacturing overhead Fixed manufacturing overhead ($176,000 12,800) Total cost per unit Opening inventory Cost of goods manufactured: 12,800 $67.5 12,800 $53.75 Cost of goods available for sale Cost of goods sold: 9,600 $67.5 9,600 $53.75 Closing inventory Absorption $ 30.00 13.25 10.50 13.75 67.50 Absorption $ 864,000 864,000 (648,000) 216,000 Marginal $ 30.00 13.25 10.50 53.75 Marginal $ 688,000 688,000 (516,000) 172,000

(b)

(c)

Absorption costing income statement:

Sales (9,600 $85.5) Cost of goods sold (9,600 $67.5) Gross margin Less Variable selling expenses (9,600 $4.8) Fixed selling and administrative costs Operating income $ 46,080 86,500 $ 820,800 (648,000) 172,800 (132,580) 40,220

Marginal costing income statement:

Sales (9,600 $85.5) Variable cost of goods sold (9,600 $53.75) Variable selling expenses (9,600 $4.8) Contribution margin Fixed costs: Manufacturing overhead Selling and administrative costs Operating income $ 516,000 46,080 176,000 86,500 $ 820,800 (562,080) 258,720 (262,500) (3,780)

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(d)

(i) When sales are equal to production, net income will be the same in both the absorption costing and marginal costing systems. (ii) When production exceeds sales, the absorption costing system will show a higher profit than the marginal costing system. (iii) When sales exceed production, the marginal costing system will show a higher profit than the absorption costing system.

22.15X

(a)

Jimmy Company Profit and Loss Account for the year ended 30 June 2005
Sales (18,750 units) Less Cost of sales: Variable costs ($575,000 30,000 15,000) Fixed costs Less Closing stock ($1,850,000 11,250 30,000) Gross profit Selling and administration ($325,000 + $100,000) Salary package of Benny Tunner {$200,000 + [($718,750 $425,000 $200,000) 20%]} Net profit $ 1,150,000 700,000 1,850,000 (693,750) $ 1,875,000

(1,156,250) 718,750 (425,000) (218,750) 75,000

(b)

Change in profitability:
Loss in 2003/04 Profit in 2004/05 Increase in profit ($100,000) $75,000 $175,000

The main causes for the changes are: (i) Deferring fixed costs through accumulation of stock ($700,000 11,250 30,000) (ii) Increase in contribution from sales increase {3,750 [($1,500,000 $575,000) 15,000]} (c) (d) Offset by: (i) Increase in fixed costs (ii) Salary package of Benny Tunner No. Fixed costs and salary package increased by $318,750. Increase in amount of closing stock.

$262,500 $231,250 ($100,000) ($218,750)

Key features of marginal costing: (i) Variable production costs are charged to cost units. (ii) All fixed costs of the period are written off in full against the aggregate contribution. Key features of absorption costing: (i) All manufacturing costs, variable or fixed, are considered as costs of production and inventories. (ii)  Fixed manufacturing costs are charged to the units produced on the basis of the per unit fixed manufacturing overhead rate.

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22.16
(a)
Operating Statement (Using Absorption Costing) for the year ended 31 December
Sales Less Production costs of sales: Opening inventory Add Variable production costs and overhead costs Fixed production overhead costs Less Closing inventory ($4,200,000 7,000 42,000) Under-/(Over-) absorbed fixed production costs Gross profit Less Variable non-production overhead costs Fixed non-production overhead costs Net profit 2006 $000 6,300 3,360 840 4,200 (700) 3,500 (40) 3,460 2,840 280 150 430 2,410 2007 $000 8,100 700 3,040 760 4,500 4,500 40 4,540 3,560 360 150 510 3,050

Operating Statement (Using Marginal Costing) for the year ended 31 December
Sales Less Variable production costs of sales: Opening inventory Add Variable production costs and overhead costs Less Closing inventory ($3,360,000 7,000 42,000) Variable non-production overhead costs Contribution Less Fixed production overhead costs Fixed non-production overhead costs Net profit 2006 $000 6,300 3,360 3,360 (560) 2,800 280 3,080 3,220 800 150 950 2,270 2007 $000 8,100 560 3,040 3,600 3,600 360 3,960 4,140 800 150 950 3,190

(b)

The profits reported for 2006 and 2007 are reconciled as follows:
Absorption costing profit 2006 Decrease in closing inventory valuation (7,000 units $20) 2007 Decrease in opening inventory valuation (7,000 units $20) Marginal costing profit 2006 $000 2,410 (140) 2,270 2007 $000 3,050 140 3,190

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(c)

The reasons for using marginal costing system in preparing management accounts include: Marginal costing is simple to operate as it does not require complex apportionments and calculation of overhead absorption rates. Fixed costs are incurred on a time basis and are thus charged wholly as expenses in the period they occur rather than as part of the product cost. Changes in production volume do not affect the unit cost of inventory which comprises only variable production costs. Marginal costing operating statements are more useful for making short-term decisions as they provide better information about expected profit which is obtained from the use of contribution margin. (Any two)

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