Marginal and absorption costing
Topic list 1 Marginal cost and marginal costing 2 The principles of marginal costing 3 Marginal costing and absorption costing and the calculation of profit 4 Reconciling profits 5 Marginal costing versus absorption costing
Syllabus reference D4 (a) D4 (a) D4 (b), (c) D4 (d) D4 (e)
This chapter defines marginal costing and compares it with absorption costing. Whereas absorption costing recognises fixed costs (usually fixed production costs) as part of the cost of a unit of output and hence as product costs, marginal costing treats all fixed costs as period costs. Two such different costing methods obviously each have their supporters and so we will be looking at the arguments both in favour of and against each method. Each costing method, because of the different inventory valuation used, produces a different profit figure and we will be looking at this particular point in detail.
COST ACCOUNTING TECHNIQUES
Intellectual level D4 (a) (b) (c) (d) (e) Marginal and absorption costing Explain the importance and apply the concept of contribution Demonstrate and discuss the effect of absorption and marginal costing on inventory valuation and profit determination Calculate profit or loss under absorption and marginal costing Reconcile the profits or losses calculated under absorption and marginal costing Describe the advantages and disadvantages of absorption and marginal costing 1 2 2 2 1
Look out for questions in your examination which require you to calculate profit or losses using absorption and marginal costing.
1 Marginal cost and marginal costing
Marginal cost is the variable cost of one unit of product or service. Marginal costing is an alternative method of costing to absorption costing. In marginal costing, only variable costs are charged as a cost of sale and a contribution is calculated (sales revenue minus variable cost of sales). Closing inventories of work in progress or finished goods are valued at marginal (variable) production cost. Fixed costs are treated as a period cost, and are charged in full to the profit and loss account of the accounting period in which they are incurred. The marginal production cost per unit of an item usually consists of the following. • • • Direct materials Direct labour Variable production overheads
Direct labour costs might be excluded from marginal costs when the work force is a given number of employees on a fixed wage or salary. Even so, it is not uncommon for direct labour to be treated as a variable cost, even when employees are paid a basic wage for a fixed working week. If in doubt, you should treat direct labour as a variable cost unless given clear indications to the contrary. Direct labour is often a step cost, with sufficiently short steps to make labour costs act in a variable fashion. The marginal cost of sales usually consists of the marginal cost of production adjusted for inventory movements plus the variable selling costs, which would include items such as sales commission, and possibly some variable distribution costs.
Contribution is an important measure in marginal costing, and it is calculated as the difference between sales value and marginal or variable cost of sales. Contribution is of fundamental importance in marginal costing, and the term 'contribution' is really short for 'contribution towards covering fixed overheads and making a profit'.
9: MARGINAL AND ABSORPTION COSTING
2 The principles of marginal costing
The principles of marginal costing are as follows. (a) Period fixed costs are the same, for any volume of sales and production (provided that the level of activity is within the 'relevant range'). Therefore, by selling an extra item of product or service the following will happen. • • • (b) (c) Revenue will increase by the sales value of the...
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