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Before we allocate all manufacturing costs to products

regardless of whether they are fixed or variable. This approach is known as absorption costing/full costing However, only variable costs are relevant to decisionmaking. This is known as marginal costing/variable costing

Absorption costing Marginal costing

It is costing system which treats all manufacturing

costs including both the fixed and variable costs as product costs

It is a costing system which treats only the variable

manufacturing costs as product costs. The fixed manufacturing overheads are regarded as period cost

Absorption Costing
Manufacturing cost

Cost Non-manufacturing cost

Direct Materials

Direct Labour

Overheads

Period cost

Finished goods

Cost of goods sold

Profit and loss account

Marginal Costing
Manufacturing cost

Cost
Non-manufacturing cost

Direct Materials

Direct Labour

Variable Overheads

Fixed overhead

Period cost

Finished goods

Cost of goods sold

Profit and loss account

Trading and profit and loss account


Absorption costing
Sales Less: Cost of goods sold $ X X

Marginal costing
Sales Less: Variable cost of Goods sold Product contribution margin $ X X X

Gross profit
Less: Expenses Selling expenses X Admin. expenses Other expenses X
Variable and fixed manufacturing

X X

Less: variable non- manufacturing expenses Variable selling expenses X Variable admin. expenses X Other variable expenses X Total contribution expenses X Less: Expenses Fixed selling expenses Fixed admin. expenses Other fixed expenses Net Profit

Net Profit

X X X X
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A company started its business in 2005. The following information Was available for January to March 2005 for the company that produced A single product: $ Selling price pre unit 100 Direct materials per unit 20 Direct Labour per unit 10 Fixed factory overhead per month 30000 Variable factory overhead per unit 5 Fixed selling overheads 1000 Variable selling overheads per unit 4
Budgeted activity was expected to be 1000 units each month Production and sales for each month were as follows: Jan Feb Unit sold 1000 800 Unit produced 1000 1300

March 1100 900

Required: Prepare absorption and marginal costing statements for the three months
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Absorption costing
January $ 100000 65000 February $ 80000 52000 28000 9000 35000 1000 4000 30000 37000 1000 3200 32800 March $ 110000 71500 38500 (3000) 35500 1000 4400 30100

Sales Less: cost of good sold ($65) Adjustment for Over-/(under) Absorption of factory overhead Gross profit Less: Expenses Fixed selling overheads Variable selling overheads Net profit

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Marginal costing
January Rs. 100000 February Rs. 80000 28000 52000 3200 48800 March Rs. 110000 38550 71500 4400 67100

Sales Less: Variable cost of good sold (Rs.35) 35000 Product contribution margin 65000 Less: Variable selling overhead 4000 Total contribution margin 61000 Less: Fixed Expenses Fixed factory overhead 30000 Fixed selling overheads 1000 Net profit 30000

30000 1000 17800

30000 1000 36100

Wk1:
Standard fixed overhead rate = Budgeted total fixed factory overheads Budgeted number of units produced = 30000 1000 units =30 units

Wk 2:
Production cost per unit under absorption costing: Direct materials Direct labour Fixed factory overhead absorbed Variable factory overheads 20 10 30 5 65

Wk 3: (Under-)/Over-absorption of fixed factory overheads: January February Fixed overhead Fixed overheads incurred 30000 30000 0

March

1000*30

39000 27000 30000 30000 9000 (3000) 1300*30 900*30

No fixed factory overhead Wk 4: Variable production cost per unit under marginal costing: Direct materials Direct labour Variable factory overhead 20 10 5 35

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Absorption costing Treatment for Fixed fixed manufacturing manufacturing overheads are overheads treated as product costing. It is believed that products cannot be produced without the resources provided by fixed manufacturing overheads

Marginal costing Fixed manufacturing overhead are treated as period costs. It is believed that only the variable costs are relevant to decisionmaking. Fixed manufacturing overheads will be incurred regardless there is production or not
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Value of closing stock

Absorption costing High value of closing stock will be obtained as some factory overheads are included as product costs and carried forward as closing stock

Marginal costing Lower value of closing stock that included the variable cost only

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Absorption costing Marginal costing Reported If the production = Sales, AC profit = MC Profit profit If Production > Sales, AC profit > MC profit As some factory overhead will be deferred as product costs under the absorption costing If Production < Sales, AC profit < MC profit As the previously deferred factory overhead will be released and charged as cost of goods sold
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Advantages of Absorption Costing:


It recognizes the importance of fixed costs in production;

This method is always used to prepare financial accounts

When production remains constant but sales fluctuate absorption costing will show less fluctuation in net profit .

Disadvantages of Absorption Costing:

As absorption costing emphasized on total cost namely both variable and fixed, it is not so useful for management to use to make decision, planning and control; As the managers emphasis is on total cost, the cost volume profit relationship is ignored. The manager needs to use his intuition to make the decision.

Advantages of Marginal Costing:


Cost Control Simplicity Elimination of varying charge per unit Aid to Profit Planning Helps in managerial decisions Valuable adjunct to the other techniques Maximum return to the business

Disadvantages of Marginal Costing


Difficult analysis Ignorance of Time Factor Difficult in application

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