Week 2

• Marginal costing (also called variable costing)

  Only direct costs and indirect variable costs are included in product cost. Fixed costs are treated as a period cost (like admin and selling expenses) and charged off against revenue each period in one lump – not allocated to products
• •Selling and Admin costs, whether they’re fixed or variable, are NOT production costs so are never included in unit product costs
• Profit is lower under marginal costing as ALL the fixed overheads got charged in the year.  Under absorption costing only those that were ‘attached’ to products actually sold got included in cost of sales.  The rest are carried forward in the valuation of the 1000 hats still in stock.
• ●No – not creating profits but just moving them about a bit from year to year.  In this case your opening stock next year will be bigger under abs than marginal, so if you end next year having sold everything you’ve made over the two years, the profit under absorption will be smaller than under marginal, but taking the two years together will be the same.
• Production = sales AC = VC
• Production > sales AC > VC
• Production < sales AC < VC
• •Businesses usually work out the amount of fixed overhead to add to each product (the overhead absorption rate) at the start of each year based on estimates of:

  •What they  think fixed costs will be; and

  •What they think production quantities will be (ie how many products to split the fixed costs between) – known as budgeted production
• •What happens if more units (hats) are produced than budgeted?

  •More overheads are included in the profit statement as part of the cost of goods manufactured than are actually incurred.

  • This is over-absorption of overheads

  •Profit statement is adjusted by deducting the over-absorption from cost of goods produced
• •What happens if fewer units (hats) are produced than budgeted?

  •Not enough of the fixed production overheads actually incurred by the business get included in the cost of each hat

  •This is under-absorption of overheads

  •Profit statement is adjusted by adding the under-absorption to the cost of goods produced
• AC

  •Is acceptable for external reporting purposes whereas marginal costing is not
• AC

  •Better matches costs with revenues because all production costs are charged to products
• AC

  •Profits are more stable because it smoothes out fluctuations in sales levels
• AC

  •When overhead costs are high in relation to direct costs, and fixed overheads are high in relation to variable costs, absorption costing provides better information
• MC

  •The data required for CVP analysis can be taken directly from a contribution margin format profit and loss account
• MC

  •Profit not affected by changes in stock, i.e. profits tend to move in the same direction as sales
• MC

  •Managers often assume that unit product costs are variable costs. This is not true under absorption costing as fixed costs are mingled with variable costs
• MC

  •Marginal costing avoids the arbitrary allocations of absorption costing, which may be misleading for short-term decision making
• MC

  •The impact of fixed costs is emphasised under marginal costing as they appear explicitly on the P&L account
• MC

  •Where sales volumes are declining but output is sustained, marginal costing provides the profit warning more rapidly than does absorption costing
• •In absorption costing, all production costs are absorbed into products – whether they are fixed or variable
• •In marginal costing, only variable costs are allocated to product.
• •Profits reported under both methods differ when production and sales level differ (although over years it all evens out….)
• •Marginal costing is more useful for decision making•However, most companies use absorption costing for external and internal reports because only absorption costing is acceptable under financial accounting standards
• •Don’t forget we’re only talking about production costs – sales and admin costs ARE NEVER ABSORBED INTO PRODUCTS
• • In absorption costing (full costing), all production costs are absorbed into products. The unsold inventory is measured at total cost of production. Fixed production overhead costs are treated as a product cost.
• • In marginal costing (variable costing), only variable costs of production are allocatec to products. The unsold inventory is measured at variable cost of production. Fixed production overhead costs are treated as a period cost of the period in which they are incurred.
• Under-absorbed or over-absorbed fixed overhead cost may arise in absorption cost- ing. It is reported in the profit and loss statement as an adjustment to cost of sales.
• Profit under absortion costing differs from profit under marginal costing when inventory levels are changing. If total production equals total sales there is no difference in total profit
• When inventory levels are falling, profit under absorption costing is lower than profit under marginal costing. The difference is equal to the decrease in inventory levels multiplied by the fixed overhead cost rate.
• When inventory levels are rising, profit under absorption costing is higher than profit under marginal costing. The difference is equal to the increase in inventory levels multiplied by the fixed overhead cost rate.
• Absorption costing is usually required for inventory valuation in financial accounting standards or other regulations. Those using such financial statements need to be aware that reported profit can be affected by the change in the volume of inventory over the period.
• Marginal costing may be more useful for decision making because it treats fixed production overhead costs as a cost of the period. Reported profit is not affected by the changes in inventory held.