Topic A08: Marginal and Absorption Costing Topic Overview p.1. Topic Overview. BAFS Elective Part Accounting Module Cost Accounting

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1 : Topic Overview p.1 Topic Level Duration Topic Overview Accounting Module Cost Accounting A08: S5 / S6 2 lessons (40 minutes per lesson) Learning Objectives: 1. To distinguish the difference between marginal and absorption costing; 2. To explain the profit impacts between marginal and absorption costing in profit calculations; and 3. To state the advantages and disadvantages of a marginal and absorption costing systems. Overview of Contents: Lesson 1 Lesson 2 Arguments for and against Prior Knowledge: Student should know: 1. how to create a manufacturing account and income statement in financial accounting; 2. the differences between prime / direct cost, factory overhead / indirect cost, and non-production cost / administrative and selling overheads; 3. the allocation of cost / expenses to production cost and non-production cost; and 4. the calculation of production costs under an absorption costing system. Resources: Topic Overview, Teaching Plan and Answers to Student Worksheet PowerPoint Presentation Student Worksheet Suggested Activities Case Study Group Debate Crossword Puzzle BAFS

2 : Topic Overview p.2 Theme Duration Lesson 1 40 minutes Expected Learning Outcomes: Upon completion of this lesson, students will be able to: 1. Define marginal and absorption costing; 2. Distinguish differences between marginal and absorption costing; 3. Prepare profit statements based on a marginal costing and an absorption costing system; and 4. Explain the difference in profits between marginal and absorption costing profit calculations. Teaching Sequence and Time Allocation: Activities Part I: Introduction Teacher reviews the definition of fixed and variable costs and asks students to give examples in relation to their family s monthly expenses. Activity 1 Case Study Teacher asks students to identify fixed and variable costs, production and non-production costs in a manufacturing account and income statement of Pattie Company and calculate the unit product costs for the month of June Year 8 (Task 1 and 2). Teacher informs students of two main accounting streams: financial accounting and cost accounting. Financial accounting is concerned with the provision of information to external parties. Cost accounting is concerned with the provision of information to internal parties. A number of costing systems are being applied by organisations Reference PPT#1-19 Student Worksheet pp.1-7 Time Allocation 15 minutes BAFS

3 : Topic Overview p.3 to provide relevant information to help managers make better decisions. Teacher uses flowchart to introduce the term absorption costing system and its mechanism. Teacher tells students the relationship between the fixed cost and variable cost with absorption and marginal costing systems. Teacher uses flowchart to show the framework of marginal costing system. Teacher asks students to prepare the income statement for Pattie Company, using marginal costing method (Task 3) Teacher asks students to determine the major effect if marginal costing is used and explains the meaning of contribution. Part II: Content Activity 2 Case Study Students form groups of four or five, read the case concerning of a cyber-firm and complete the tasks. Teacher invites students to present their answers. Teacher checks answers and draws conclusion for each task. Part III: Conclusion Teacher concludes lesson by highlighting the differences between marginal and absorption costing. Teacher asks students to consider the advantages and disadvantages for marginal and absorption costing for the upcoming lesson. PPT #20-32 Student Worksheet pp.8-16 PPT # minutes 3 minutes BAFS

4 : Topic Overview p.4 Theme Duration Lesson 2 Arguments for and against 40 minutes Expected Learning Outcomes: Upon completion of this lesson, students will be able to: 1. Explain the advantages and disadvantages of marginal costing; 2. Explain the advantages and disadvantages of absorption costing; and 3. Explain circumstances when suitable to use marginal or absorption costing. Teaching Sequence and Time Allocation: Activities Part I: Introduction Teacher starts the lesson by introducing the problem faced by Alice, the Managing Director of Bullet Manufacturing Company and asks students to set up a debate on the adoption of a marginal costing system in the company. Part II: Content Activity 3 Preparation for the debate Students are divided into two groups; one is the affirmative side and the other is the negative side. Students are required to discuss within their groups and to develop arguments. Each group nominates one representative to take part in the debate. Reference PPT #36 PPT #37 Student Worksheet pp Time Allocation 4 minutes 15 minutes Activity 3 Debate Each representative has 4 minutes to present their group s views and arguments. Teacher decides winner, concludes the debate and introduces suitable circumstances for using marginal and absorption costing. PPT # minutes BAFS

5 : Topic Overview p.5 Part III: Conclusion Teacher concludes session by highlighting the advantages of marginal and absorption costing and asks students to choose the preferred costing methods under PPT #46 48 different circumstances. Teacher asks students to complete the crossword puzzle at home to check their understanding on the concepts of marginal and absorption costing. The answers will be Student Worksheets pp minutes distributed during next lesson. BAFS

6 : Topic Overview p.6 Answer to Activity 1 Task 1: Cost Classification Fixed Cost Variable Cost Production Cost Non-Production Cost Direct Materials Direct Wages Direct Expenses Direct Materials Direct Wages Direct Expenses Factory Manager Salary Factory Management Fee Factory Rent and Rates Factory Fire Insurance Factory Manager Salary Factory Management Fee Factory Rent and Rates Factory Fire Insurance Factory Labour Insurance Factory Labour Insurance Provision for Depreciation Machinery Provision for Depreciation Machinery Bank Loan Interest Provision for Depreciation Office Equipment Cleaning Expenses Salesman s Salaries Bank Loan Interest Provision for Depreciation Office Equipment Cleaning Expenses Salesman s Salaries Carriage Outwards Carriage Outwards Advertising Advertising Sales Commission Sales Commission Office Rent and Rates Office Rent and Rates BAFS

7 : Topic Overview p.7 Task 2: Cost Computation Total Production Cost: $76,200 Unit Produced: 2,540 Unit Product Cost = Total Production Cost Unit Produced = $76,200 2,540 units = $30 Task 3: Income Statement (a)unit Selling Price = Sales Revenue No of units sold = $191,475 (57 + 2,540 44) = $191,475 2,553 = $75 Variable Production Cost = $(30, , , ,800) = $58,200 Closing Stock Value (44 units) = $58,200 2,540 x 44 = $1,008 Variable Non-production Cost = $( ) = $640 Fixed Production Cost = $(9, , ) = $18,000 Fixed Non-production Cost = $( , ,905) = $21,897 BAFS

8 : Topic Overview p.8 Income Statement for the month ending 30 June Year 8 (Marginal Costing) HK$ HK$ Sales 191,475 Less: Variable Production Cost of Goods Sold Finished Goods Opening Stock 1,254 Add: Variable Production Cost 58,200 59,454 Less: Finished Goods Closing Stock 1,008 58, ,029 Less: Variable non-production cost 640 Contribution 132,389 Less: Fixed cost Production 18,000 Non-production 21,897 39,897 Net profit 92,492 (b) Major Effect: Profit calculated under Marginal Costing is higher than that of Absorption Costing. Reason: The closing inventory value calculated under the Absorption Costing method is higher than Marginal Costing, as fixed production costs are treated as product and costs will be carried forward to the next accounting period if unsold. Therefore, a decrease in the stock levels mean a larger portion of the fixed costs will be charged to the current accounting period under Absorption Costing and the profit calculated will be lower than that of Marginal Costing. BAFS

9 : Topic Overview p.9 Answer to Activity 2 Task 1: Cost Classification Examples of fixed cost: Cost of setting up business on Yahoo Small Business Platform Monthly service fee paid to Yahoo Hire charges for heat transfer machines Packaging tools and materials Examples of variable cost: T-shirt purchase cost Transaction fee paid to Yahoo Delivery charges Task 2: Cost Estimation Cost Items Monthly service fee paid to Yahoo Hire charges for heat transfer machines (Assuming 2 machines will be hired) T-shirt purchase cost Transfer paper for laser printer Packaging tools and materials Printing charges (e.g. cartridge) Transaction fee paid to Yahoo Delivery charges HK$ Range from HK$160 to HK$320, depends on plans selected Machines with more functions are higher, normally below HK$1,000 each Range from a few dollars to hundreds, depends on quality and quantity selected Around HK$6 each Range from few dollars to hundreds, depends on materials and packaging Range from a few dollars to hundreds, depends on cartridge and number of colours Range from 1% - 2% of the monthly revenue, depends on the plan selected Range from a few dollars to hundreds, depends on location and delivery point BAFS

10 : Topic Overview p.10 Task 3: Cost Computation (a) Cost Items Details Cost Classification under Fixed or Variable Production or Non-production Service fee paid to Yahoo $400/month Fixed Cost Non-production Cost Hire charges for 2 heat transfer machines $1,500/ month Fixed Cost T-shirt purchase cost $15/piece Variable Cost Transfer paper $4/sheet Variable Cost Printing charges $3/sheet Variable Cost Production Cost Production Cost Production Cost Production Cost Packaging tools & materials $2,000/ month Fixed Cost Production Cost Stationery expenses $300/month Fixed Cost Non-production Cost Advertising fee (a fixed amount charged by an advertising firm) $1,000/month Fixed Cost Non-Production Cost Transaction fee charged by Yahoo 1.5% on sales Variable Cost Delivery charges 1% on sales Variable Cost (b) Non-Production Cost Non-Production Cost Under Marginal Costing: T-shirt purchases cost $15 Transfer paper $ 4 Printing charges $ 3 Unit product cost $22 Under Absorption Costing: T-shirt purchases $15 Transfer paper $ 4 Printing charges $ 3 Production overhead* $ 7 Unit product cost $29 *($1,500 + $2,000) 500 = $7 BAFS

11 : Topic Overview p.11 Task 4: Profit Computation (a) Absorption Costing 1 st month 2 nd month 3 rd month Total HK$ HK$ HK$ HK$ Sales 21, , , , Less: Production cost of sales Opening stock - - 2, Production cost 14, , , , Closing stock - (2,900.00) (1,450.00) (1,450.00) 14, , , , Gross profit 7, , , , Less: Non-production cost Fixed 1, , , , Variable , Net profit 5, , , (b) Marginal Costing 1 st month 2 nd month 3 rd month Total HK$ HK$ HK$ HK$ Sales 21, , , , Less: Variable production cost of sales Opening stock - - 2, Variable production cost 11, , , , Closing stock - (2,200.00) (1,100.00) (1,100.00) 11, , , , Variable non-production , cost 11, , , , Contribution 10, , , , Less: Fixed cost Production 3, , , , Non-production 1, , , , Net profit 5, , , , BAFS

12 : Topic Overview p.12 Task 5: Method Selection (a) Profit earned 2 nd month 3 rd month under: Absorption costing $3,665 $5, Marginal costing $2,965 $6, Difference $700 ($350) Reasons: 1. 2 nd month: profits calculated under absorption costing are higher than marginal costing. This is because when production exceeds sales, there is an increase in closing stock and a greater portion of the fixed production overhead will be included in the closing stock and carried forward to next period rd month: profits calculated under absorption costing are lower than marginal costing. This is because when sales exceeds production, there will be a decline of closing stock and a greater portion of the fixed production overhead is brought forward as an expenses in the opening inventory. (b) Businesses relying on seasonal sales in which production is built up outside the sales season to meet demand, the full amount of fixed overhead will be charged against sales under the marginal costing system. Then losses will be reported during out-of-season periods, and large profits will be reported when the goods are sold. Under absorption costing systems, fixed overheads are deferred and included in the closing inventory valuation, and recorded as expenses only in the period in which the goods are sold. Losses are therefore unlikely to be reported in the periods when stock is built up. Therefore, if more T-shirts are sold in summer, absorption costing should be adopted to provide more logical profit calculations. BAFS

13 : Topic Overview p.13 Answer to Activity 3 Arguments for the proposition (hints: students are required to emphasise the advantages of Marginal Costing and disadvantages of Absorption Costing) Advantages of Marginal Costing Easy to understand avoids arbitrary allocation of fixed overheads. Fixed overhead is excluded from inventory costs avoids the varying charges per unit and hence distortion in stock valuations. Fixed overheads are NOT carried forward in stock valuations avoids the effect of changes in closing inventory level on profits. Contribution and profits are directly driven by sales shows clearly the effect of sales on cash flows and relationships between cost, price and volume. Focuses on controllable business aspects facilities execution of cost controls. Disadvantages of Absorption Costing More complicated have to make arbitrary assumptions on apportionment of fixed overheads. Fixed overheads are charged to production unit inventory costs may vary according to production. Part of the current year s fixed overhead is carried forward in closing stock to the following year management may manipulate profits by building up inventories and hence deferring the fixed overheads to the following years. Profit is not a direct function of sales. There s a possibility that profit may drop even though sales are up. Relationships between cost, price and volume are ignored since the focus is on total cost. BAFS

14 : Topic Overview p.14 Arguments against the proposition (hints: students are required to emphasise the advantages of Absorption Costing and disadvantages of Marginal Costing) Advantages of Absorption Costing Fixed costs are absorbed in inventory ensures all fixed costs will be recovered and met in the long run. Recognition of the importance of fixed overheads in production finished goods and work in progress stock will not be understated, giving a true and fair view of the firm s financial affairs. Compliance with Accounting Standards is useful for external reporting. All costs are variable in the long run recognises all long run variable costs. Less profit fluctuations when production remains constant but sales fluctuate. Disadvantages of Marginal Costing It ignores that fixed costs must be recovered in the long run, so if selling price is based only on marginal costs, it s possible that a positive contribution might NOT be sufficient to cover all fixed costs in the long run. Finished goods and work in progress stock will be understated. Exclusion of fixed costs from stock valuations does not conform to acceptable accounting practices. It fails to recognise that all costs are variable in the long run. For firms that have a seasonal sales pattern, profits tend to fluctuate greatly. Losses are reported during the slack season while huge profits are reported during the peak session. It s not easy to establish the variability of costs, as variable costs are rarely completely variable and fixed cost are rarely completely fixed. BAFS

15 : Topic Overview p.15 Summary for lesson 2 Marginal Costing Absorption Costing Short run decision-making Long run decision-making When sales is subject to high seasonal fluctuations Comparison of performance of different departments/product lines External reporting BAFS

16 : Topic Overview p.16 Answer to Activity 4 3 V 1 A R I A B L E 4 C O N T R I B U T I O N 8 C S O O 7 C N 1 M A R G I N A 5 L T 2 P P S O R 3 F 6 G R E A T E R H W 6 S O I O I 7 E Q U A L 4 O X D O R M P E U 5 U N D E R 2 O V E R H E A D C N T I 8 P R O D U C T I O N G BAFS

17 Accounting Module Cost Accounting Fixed Costs : Technology Education Section Curriculum Development Institute Education Bureau, HKSARG April Introduction This session aims to help students distinguish between marginal and absorption costing and their impact on profit calculations. Students will build a solid understanding through active participation in debate and case study. Duration Two 40-minute lessons Contents Lesson 1 Lesson 2 Arguments for and against Lesson 1 Teacher starts the lesson by introducing the definition of fixed cost. Definition of fixed cost: A cost which is incurred for a period, and which, within certain output and turnover limits, tends to be unaffected by fluctuations in the level of activity. (CIMA Official Terminology) Teacher provides examples of fixed costs. They include Business registration fee Factory/office rent Factory/office rates Factory/office management fee Supervisors /executives salaries Depreciation of factory building/equipment/machinery Fire insurance of factory building/equipment/machinery 1 2

18 Examples of fixed cost in relation to your family s monthly expenses Variable Costs Total Variable Cost ($) Output (units) 3 4 Teacher asks students to give examples of fixed costs in relation to their family s monthly expenses. Examples are: 1. Monthly rent 2. Rates 3. Property insurance 4. Life insurance 5. Management fee 6. School fee 7. Monthly wages to maid 8. Residential telephone service fee (i.e. fixed line) Teacher introduces the definition of variable costs. Definition of variable costs: A cost which tends to vary with the level of activity. (CIMA Official Terminology) Teacher provides examples of variable cost. They include: Direct materials Piecework labour wages Royalty payments Power cost Sales commission Delivery charges Motor vehicle running expenses 3 4

19 Examples of variable cost in relation to your family s monthly expenses Activity 1: 1 Pattie Company (Refer to Student Worksheet Page 1 to 3) 5 6 Teacher asks students to give examples of variable costs in relation to their family s monthly expenses. Teacher asks students to read the case and pay special attention on the questions raised by the owner, Pattie. Examples are: 1. Traveling expenses 2. Food 3. Electricity charges 4. Gas fee 5. Clothing 6. Entertainment expenses 7. Water charges 8. Motor vehicle running expenses 5 6

20 Pattie Company Manufacturing Account Income Statement Pattie Company Except direct, indirect cost, what are fixed and variable cost? Are there any other ways to calculate the production cost? 7 8 The manufacturing account and income statement of the Pattie Company are given for information. Highlights of the case: - The owner, Pattie, has heard about fixed and variable costs from her friends and wants to know their meanings. - Pattie asks the accountant to propose an alternative method to calculate the production costs and the unit product costs

21 Task 1 - Cost Classification Task 1 - Cost Classification (cont d) Fixed Cost Variable Cost Production Cost Non-Production Cost Direct Materials Direct Materials Direct Wages Direct Wages Identify the fixed, variable, production and nonproduction cost from the Pattie Company s Manufacturing Account and Income Statement for the month ended 30 June Year 8. Factory Manager Salary Factory Management Fee Factory Rent and Rates Factory Fire Insurance Direct Expenses Direct Expenses Factory Manager Salary Factory Management Fee Factory Rent and Rates Factory Fire Insurance Factory Labour Insurance Factory Labour Insurance Fixed Cost Variable Cost Production Cost e.g. Direct Materials e.g. Direct Materials Non-Production Cost Provision for Depreciation Machinery Bank Loan Interest Provision for Depreciation Office Equipment Cleaning Expenses Salesman s Salaries Provision for Depreciation Machinery Bank Loan Interest Provision for Depreciation Office Equipment Cleaning Expenses Salesman s Salaries Carriage Outwards Carriage Outwards Advertising Advertising Sales Commission Sales Commission Office Rent and Rates Office Rent and Rates 9 10 Teacher asks students to identify the fixed, variable, production and nonproduction costs from the financial statements. Direct materials are used as an example to guide students fill in the table. Teacher invites students to give the answers before showing the table. Teacher then checks the answer with students. Teacher may prompt students to pay attention on the following two questions in doing the classification: - Will the costs/expenses be affected when activity levels fluctuate within certain output and turnover limits? (If yes, it is a variable cost. If no, it is a fixed cost.) - Are the costs/expenses involved in the manufacturing process of the product? (If yes, it is a production cost. If no, it is a non-production cost.) 9 10

22 Task 2 - Cost Computation Assuming 2,540 units of goods were produced by Pattie Company for the month of June Year 8, the production cost for each unit would be: Task 2 - Cost Computation (cont d) Total Production Cost: $76,200 Unit Produced: 2,540 Total Production Cost: Unit Produced: Unit Product Cost = Total Production Cost Unit Produced Unit Product Cost = Total Production Cost Unit Produced = $76,200 2,540 units = $30 = = Teacher asks students to compute the unit product for the month of June Year 8. Total Production Cost refers to the production cost of goods completed computed in the Manufacturing Account. Teacher checks the answer with students. Teacher explains there are two main streams in accounting: financial accounting and cost accounting. Financial accounting is concerned with the provision of information to external parties, such as potential investors, creditors and government. Financial accounting statements must be prepared in compliance with the legal requirements and generally accepted accounting principles. Cost accounting is concerned with the provision of information to internal parties within the organisation, such as managers, to help them make better decisions and improve the efficiency and effectiveness of operations. Unlike financial accounting, there are no statutory requirements for cost accountants to produce nor follow externally imposed rules. The preparation of a cost accounting reports are optional and the information should only be produced if the benefit obtained from the information provided exceeds the cost of collecting it. A number of costing systems are being applied by an organisation to provide relevant information to help managers make better decisions. The costing system used in task 2 for calculating the unit product cost is known as absorption costing

23 Absorption Costing Cost Relationships Cost Direct costs (Direct materials, direct labour and direct expenses) Overheads (Indirect materials, indirect labour and indirect expenses) Production overheads Non-production overheads Work in progress stock Finished goods stock Profit and loss account Teacher explains the flowchart with students and shows them how cost is charged under absorption costing. Costs build-up under absorption costing: Costs incurred by an enterprise can be classified into direct costs and indirect costs/overheads. Direct costs are those costs which can be directly identified with a product or service, such as direct materials, direct labour and direct expenses. Indirect costs/overheads are those costs which cannot be identified specifically and exclusively with a product or service. Indirect costs/overheads can be further classified as production overheads and non-production overheads. Overheads which occur in production, such as factory rent and rates are called production overheads. Those overheads, other than production overheads, such as office rent and rates, are referred as non-production overheads. All production costs (direct/prime costs and production overheads) are considered as product costs and are included in the (finished goods and work in progress) stock valuation. Non-production overheads are excluded from the stock valuation. They are charged directly to the profit and loss account. The unsold stock will therefore contain a share of the production overheads incurred in the period. Teacher introduces another costing system: marginal costing. Teacher tells students the relationship between the fixed costs and variable costs within the two costing systems. Absorption costing is an accounting system in which all production costs (i.e. both fixed and variable) are charged to cost units. Marginal costing is an accounting system in which only variable production costs are charged to cost units and the rest of the costs are written off in the period incurred

24 Marginal Costing Task 3 Income Statement Cost Direct costs* (Direct materials, direct labour and direct expenses) Production overheads Overheads (Indirect materials, indirect labour and indirect expenses) Non-production overheads Suppose marginal costing system is used, construct an income statement for Pattie Company for the month ended 30 June Year 8. Variable production overheads Fixed production overheads Refer to student worksheet p.5-6 Work in progress stock Finished goods stock Profit and loss account * Direct costs behave as variable costs Teacher explains the flowchart and shows how costs are charged under the marginal costing system. Costs build-up under marginal costing: - Under marginal costing, only variable production costs (direct/prime costs and variable production overheads) are considered as product costs and are included in the (finished goods and work in progress) stock valuations. - Fixed production overheads and non-production overheads are excluded from stock valuations. They are regarded as expenses in the period (i.e. period cost) in which they are incurred and charged directly to the profit and loss account. Teacher asks students to prepare an income statement for Pattie Company for the month ended 30 June Year 8, using the marginal costing method. Students are advised to compute the following revenue and cost items before completing the statement: Unit Selling Price = $191,475 (57 + 2,540 44) = $191,475 2,553 = $75 Opening Stock Value (57 units) = $22 x 57 = $1,254 Variable Production Cost = $(30, , ,000) + 1,800 = $58,200 Closing Stock Value (44 units) = $58,200 2,540 x 44 = $1,008 Variable Non-production Cost = $( ) = $640 Fixed Production Cost = $(9, , ) = $18,000 Fixed Non-production Cost = $( , ,905) = $21,

25 Task 3 Income Statement (cont d) Income Statement for the month ended 30 June Year 8 HK$ HK$ Sales 191,475 Less: Variable Production Cost of Goods Sold Finished Goods Opening Stock 1,254 Add: Variable Production Cost 58,200 59,454 Less: Finished Goods Closing Stock 1,008 58, ,029 Less: Variable non-production cost 640 Contribution 132,389 Less: Fixed cost Production 18,000 Non-production 21,897 39,897 Net profit 92,492 Task 3 Income Statement (cont d) State the major effect of using marginal costing in preparing the Income Statement of Pattie Company and explain why this happened Teacher checks the answer with students and explains the meaning of what contribution is. Contribution is the difference between sales and all variable costs (both production and non-production), from which fixed costs are deducted to show net profit/loss. In general, if: total contribution > fixed cost profit total contribution < fixed cost loss Teacher asks students to compare the income statement prepared in part (a) with that prepared under absorption costing and read the hints provided. Students are required to state the major effect of using marginal costing and explain why this happened. Inventory valuation The value of the closing inventory calculated under absorption costing would be higher than that of marginal costing as fixed production costs are treated as product cost and can be carried forward to the next period. For marginal costing, it only includes variable production cost and the fixed non-production costs are written off in the period incurred. Income determination If opening stock is less than closing stock, there will be an increase in closing stock. The profit calculated under absorption costing will be higher as a larger portion of the fixed production overhead will be carried forward to next accounting period. The profit calculated under marginal costing will be lower as all fixed production costs incurred will not be carried forward and are charged directly to the current profit. Opposite result will be obtained if there is a decrease in closing stock

26 Task 3 Income Statement (cont d) Differences in the 2 costing systems Impact on Inventory valuation Income determination (a) (b) Absorption Costing Fixed production costs are treated as product cost. If closing stock, part of the fixed production cost is carried forward to the next accounting period. Higher closing stock value (reason (a) above) Higher profit (reason (b) above) Marginal Costing (a) Fixed production costs are treated as period cost. (b) If closing stock, no fixed production cost is carried forward because all fixed production costs are written off in the period incurred. Lower closing stock value (reason (a) above) Lower profit (reason (b) above) Activity 2: Case Study Form groups of four to five Read the case carefully, discuss and complete Task 1 of Activity Answers to task 3 (b) Teacher asks students to form groups of four or five. Students must read the case on setting up a cyber-firm to sell their own custom designed heattransfer print T-shirt on Yahoo and complete task 1. 20

27 Task 1 - Cost Classification List the fixed and variable costs that would incur in setting up a cyber-firm selling your own designed heat-transfer print T-shirt on the Internet. Task 1 - Cost Classification (cont d) Examples of fixed cost Cost of setting up a business on Yahoo Small Business Platform Monthly service fee paid to Yahoo Hire charges for heat transfer machines Packaging tools and materials Examples of Variable cost T-shirt purchase cost Transaction fee paid to Yahoo Delivery charges Teacher asks students to list the fixed and variable costs that would incur in setting up a cyber-firm selling their own custom designed heat-transfer print T-shirt on internet and invites volunteers to share their suggestions with the class. Teacher concludes students suggestions and gives some examples for the fixed and variable costs that would be incurred setting up a cyber-firm

28 Task 2 - Cost Estimation Estimate the monthly running cost of the business : Cost Items: Monthly service fee paid to Yahoo Hire charges for heat transfer machines (Assuming 2 machines will be hired) T-shirt purchase cost Transfer paper for laser printer Packaging tools and materials Printing charges (e.g. cartridge) Others: HK$ Task 3 (a) - Cost Computation cont d Complete the following table based on the characteristics of different cost items: Cost Items Details Cost Classification under Fixed or Variable Production or Non-production Service fee paid to Yahoo $400/month Fixed Cost Non-production cost Hire charges for 2 heat transfer $1,500/ month machines T-shirt purchase cost $15/piece Transfer paper $4/sheet Printing charges $3/sheet Packaging tools & materials $2,000/ month Stationery expenses $300/month Advertising fee (a fixed amount $1,000/month charged by an advertising firm) Transaction fee charged by Yahoo 1.5% on sales Delivery charges 1% on sales Teacher asks students to complete Task 2 and invites volunteers to share their answers with the class. Here are some suggestions: Monthly service fee paid to Yahoo: express plan US$19.95 (~HK$160); starter plan US$39.95 (~HK$320); standard plan US$99.95 (~HK$780) Hire charges for heat transfer machines: below HK$1,000 each T-shirt purchase cost: depends on the quality and quantity, it may range from a few dollars to hundreds. Transfer paper for laser printer: around HK$6 each Packaging tools and materials: depends on the materials and types of packaging Printing charges: cartridge - HK$100-HK$200 per color, each cartridge can produce A4 size copies. Others: Transaction fee paid to Yahoo 2.0% for express plan; 1.5% for starter plan; 1.0% for standard plan. Delivery charges depends on the type of delivery mail or DHL. Teacher may, at his/her own discretion, arouse students interest/attention on some cost items by asking the following questions: How many service plans are provided by Yahoo? (Three service plans are provided express plan, starter plan and standard plan. Fees will be higher if more services are provided) What is the size of a heat transfer machine? (The sizes are varied. Some of them may be as small as a printer.) Will there be a need of leasing a flat to place the heat transfer machines? (If only 1 or 2 heat transfer machines are leased, there is no need to rent extra areas for storage. Students should be able to store them at home.) Where will they buy the T-shirt? (They can purchase directly from the T-shirt manufacturer.) What is their target purchase price for the T-shirt? (Higher quality Higher price; Lower quality Lower price; Larger quantity Lower price; Smaller quantity Higher price. The price may be lower if they purchase from the manufacturer in China. However, it may incur higher transportation cost. Who are their target customers, local or overseas? (The delivery and packaging charges will be higher if they need to send the T-shirt to overseas customers.) Teacher asks student to complete Task 3(a). Students are required to look at each cost item, then classify it into either: (a) Fixed or variable cost; and (b) Production or non-production overheads

29 Task 3 (a) - Cost Computation (cont d) Suggested Answer: Cost Items Details Cost Classification under (Marginal Costing) Fixed or Variable (Absorption Costing) Production or Nonproduction Service fee paid to Yahoo $400/month Fixed Cost Non-production Cost Hire charges for 2 heat transfer machines $1,500/ month Fixed Cost Production Cost T-shirt purchase cost $15/piece Variable Cost Production Cost Transfer paper $4/sheet Variable Cost Production Cost Printing charges $3/sheet Variable Cost Production Cost Packaging tools & materials $2,000/ month Fixed Cost Production Cost Stationery expenses $300/month Fixed Cost Non-production Cost Advertising fee (a fixed amount charged by an advertising firm) $1,000/month Fixed Cost Non-Production Cost Transaction fee charged by Yahoo 1.5% on sales Variable Cost Non-Production Cost Delivery charges 1% on sales Variable Cost Non-Production Cost 25 Task 3 (b) - Cost Computation Assuming 500 units of T-shirt will be produced per month and production overhead will be absorbed on unit basis, compute the production cost for each unit based on the data in 3(a), using (i) Marginal Costing (ii) Absorption Costing 26 Teacher invites students to give their answers before checking the answers with them. Teacher then checks students understanding of the difference between the two costing methods by asking: Under what costing method is cost separated into fixed and variable? (answer: marginal costing) Under what costing method is cost separated into production and non-production? (answer: absorption costing) Teacher asks students to compute the unit product cost for each T-shirt, using marginal costing and absorption costing methods. Teacher may, at own discretion, use the following questions to guide students to complete the calculations: For marginal costing Do we have to include fixed production cost in the computation of unit product cost? (No. They are treated as period cost and charged directly to the profit and loss account.) Do we need to include all variable cost in the computation of unit product cost? (No. Only variable production costs e.g. direct materials, direct labor and variable production overhead are included in stock valuation. Variable non-production overheads, such as delivery charges and sales commission are not considered as product cost but they must be used in calculation of contribution.) For absorption costing Should all cost items be included in the computation of unit product cost? (No. Only production costs that are identified with goods produced for resale are required to be included.) Do we have to separate the production cost into fixed and variable elements for the computation? (In general, it is not required. Costs are only required to be classified into production and non-production under absorption costing. However, for better presentation, students may classify them into variable production cost and fixed production cost.) How to treat a cost which is for both factory use and office use? (Apportionment must be made.) How to determine the basis for apportionment (It depends on the cost driver and there is opportunity for arbitrary assumption.) 25 26

30 Task 3 (b) - Cost Computation (cont d) Suggested Answers: Under Marginal Costing: T-shirt purchase cost $15 Transfer paper $ 4 Printing charges $ 3 Unit product cost $22 Under Absorption Costing: T-shirt purchase cost $15 Transfer paper $ 4 Printing charges $ 3 Production overhead* $ 7 Unit product cost $29 Task 4 - Profit Computation Based on the forecasted sales and the data in Task 3(a), construct a profit statement for the first three months of operation using: (a) Absorption Costing (using a mark up of 50%) (b) Marginal Costing (using the same selling price as calculated under absorption costing) *($1,500+$2,000) 500=$ Teacher checks answers with students. The major difference between the 2 costing methods is the treatment of fixed production overheads of $7*. Teacher asks students to prepare profit statements for the first three months of operation using marginal costing and absorption costing methods. Under marginal costing, only variable production costs (i.e. T-shirt purchase cost, transfer paper cost and printing charges) are considered as product cost. Nonproduction variable cost (i.e. transaction fees charged by Yahoo and delivery charges) and all fixed costs (i.e. service fee paid to Yahoo, hire charges for 2 heat transfer machines, packaging materials & tools, stationery expenses and advertising fee) are excluded from the computation. Under absorption costing, all production costs related to the product produced are required to be included in the stock valuation (i.e. T-shirt purchase cost, transfer paper cost, printing charges, hire charges of 2 heat transfer machines and packaging tools and materials). Non-production cost (i.e. service fee paid to Yahoo, stationery expenses, advertising fee, transaction fee charged by Yahoo and delivery charges) are treated as period costs and excluded from the computation. * Referring to slide 13, fixed production overheads consist of hire charges of $1,500 and packaging tools and materials costs of $2,000. The total amount of $3,500 fixed production overheads are to be absorbed by the 500 T-shirts produced (i.e.$7 per unit)

31 Task 4 - Profit Computation (cont d) 4(a) Suggested Answer (Absorption Costing): Task 4 - Profit Computation (cont d) 4(b) Suggested Answer (Marginal Costing): Teacher checks the answer with students. Workings: Selling price (50% mark up) = $29 x (1+50%) = $43.5 Sales : 1 st month $43.5 x 500 units = $21,750 2 nd month $43.5 x 400 units = $17,400 3 rd month $43.5 x 550 units = $23,925 Opening stock 1 st month nil 2 nd month nil 3 rd month $29 x 100 units = $2,900 Production costs for 1 st /2 nd /3 rd month: $29 x 500 units = $14,500 Closing stock 1 st month nil 2 nd month $29 x 100 units = $2,900 3 rd month $29 x 50 units = $1,450 Fixed non-production cost: $400 (service fee to Yahoo) + $300 (stationery) + $1,000 (advertising) Variable non-production cost: (1.5% transaction fee + 1% delivery charge) x Sales 1 st month 2.5% x $21,750 = $ nd month 2.5% x $17,400 = $435 3 rd month 2.5% x $23,925 = $ Teacher checks the answers with students. Workings: Sales: (using same selling price as calculated under absorption Costing ) 1 st month $43.5 x 500 units = $21,750 2 nd month $43.5 x 400 units = $17,400 3 rd month $43.5 x 550 units = $23,925 Opening stock 1 st month nil 2 nd month nil 3 rd month $22 x 100 units = $2,200 Variable Production costs for 1 st /2 nd /3 rd month: $22 x 500 units = $11,000 Closing stock 1 st month nil 2 nd month $22 x 100 units = $2,200 3 rd month $22 x 50 units = $1,100 Variable non-production cost: (1.5% transaction fee + 1% delivery charge) x Sales 1 st month 2.5% x $21,750 = $ nd month 2.5% x $17,400 = $435 3 rd month 2.5% x $23,925 = $ Fixed production cost: $1,500 (hire charges) + $2,000 (packaging) Fixed non-production cost : $400 (service fee to Yahoo) + $300 (stationery) + $1,000 (advertising) 29 30

32 Task 5 (a) - Method Selection Based on the profit statements prepared in Task 4, suggest two reasons for the difference in net profits for the 2nd and 3rd month of sales. Task 5 (b) Method Selection As more T-shirts will be sold in summer, which costing method should be adopted? Profit earned Teacher invites volunteers to give their opinions on this question. Absorption costing 2nd month $3,665 3rd month $5, Marginal costing 2nd month $2,965 3rd month $6, Difference 700 ($350) Reasons: 1. In 2nd month, the profit calculated under absorption costing is higher than that of marginal costing. It is because when production exceeds sales, there will be an increase in closing stock and a greater portion of the fixed production overhead will be included in the closing stock and carried forward to next period. 2. In 3rd month, the profit calculated under absorption costing is lower than that of marginal costing. It is because when sales exceeds production, there will be a decline of closing stock and a greater portion of the fixed production overhead is brought forward as an expenses in the opening inventory. In a business that relies on seasonal sales and in which production is built up outside the sales season to meet demand, the full amount of fixed overhead incurred will be charged against sales under marginal costing system. If so, losses will be reported during out-of-season period, and large profit will be reported in the periods when the goods are sold. By contrast, in an absorption costing system, fixed overheads will be deferred and included in the closing inventory valuation, and will be recorded as an expense only in the period in which the goods are sold. Losses are therefore unlikely to be reported in the periods when stocks are being built up. Therefore, if more T-shirt will be sold in summer, absorption costing should be adopted to provide more logical profit calculation

33 Summary for lesson 1 Summary for lesson 1 Major Differences in the 2 costing methods: Marginal Costing Absorption Costing 1. Cost classification Fixed vs. variable Production vs. non-production 2. Inventory valuation Variable production Full production costs costs only (Variable + Fixed) 3. Treatment of fixed Period expenses Product cost production costs (charged to P/L a/c) (absorbed into units produced) Major Differences in the 2 costing methods: 5. Effect of changes in period-end closing stock level on profit: (a) When closing inventory increases Marginal < Absorption (i.e. Production > Sales) costing profit costing profit (b) When closing inventory decreases Marginal > Absorption (i.e. Production < Sales) costing profit costing profit (c) When closing inventory is unchanged Marginal = Absorption (i.e. Production = Sales) costing profit costing profit 4. Profit & sales Profit is a function of Profit is a function of relationship sales sales and production Teacher concludes the lesson and highlights the difference between marginal and absorption costing. Teacher concludes the lesson and highlights the difference between marginal and absorption costing. Rational behind marginal costing Fixed costs relate to a period of time and are the same irrespective of sales and production. They should be charged directly to the P/L account as period expenses. On the other hand, variable costs are the marginal costs incurred in production and stock is therefore to be valued at VARIABLE production costs only. Rational behind absorption costing All costs incurred in the production of a product are required to be allocated/absorbed into the product. Stock is therefore to be valued at FULL production costs. Teacher may ask the following questions to test students understanding: Q1: Why does profit calculated under marginal costing greater than absorption costing when closing stock increases? (Answer: It is because under absorption costing, a portion of the fixed production overhead will be included in the closing stock and carried forward to the following period. But under marginal costing, the total amount of fixed production overhead is charged to the profit and loss account in the period it incurs) Q2: Why does profit calculated under marginal costing less than absorption costing when closing stock drops? (Answer: It is because under absorption costing, a greater portion of the fixed production overhead will be written off when the goods are sold.) Q3: In the long run, which costing method will generate a higher profit? (Answer: Both methods will give the same profit because the total costs will be the same in the long run) 33 34

34 Preparation for next lesson Marginal Costing Absorption Costing A Case study: Bullet Manufacturing Advantages & Disadvantages Company (Refer to Student Worksheet p.10) Teacher asks students to think over the advantages and disadvantages of marginal costing and absorption costing for next lesson. End of Lesson 1. Lesson 2 Teacher introduces the case to students and states the problem faced by the Managing Director, Alice, of Bullet Manufacturing Company. - Bullet has been using absorption costing for internal reporting purpose. - In the month of July, production of Bullet exceeded sales and the profit statement showed a decline in profit margins despite a 20% sales increase. - The accounting manager was asked by the marketing manager to explain this contradictory result. - The issue of using marginal costing was brought up and Alice was deciding whether to switch to marginal costing for internal reporting purpose

35 Activity 3: Debate Bullet Manufacturing Company should use marginal costing instead of absorption costing in preparing the company s accounting reports Each group nominates one representative to present their views and arguments. Use marginal costing as. Use absorption costing as Teacher divides students into 2 groups and sets up a topic for debate: Bullet Manufacturing Company should use marginal costing instead of absorption costing in preparing the company s accounting reports Divide students into two groups. Assign one group as the affirmative side and the other group as the opposition side. Remind students to read the case on Student Worksheet page 17. Each group will name one representative who will be allowed 4 minutes to present the group s views and arguments. After the presentation, teacher goes through the advantages and disadvantages of each method, draws conclusion and decides the winner based on students arguments and performance. Give students 15 minutes to discuss and formulate their arguments. (Teacher may guide students through their discussion by asking the following questions. Answers can be found on slide 42-45) Which costing method is easier to use and understand? Which method better suits the need of management for cost control and internal performance evaluation? Which method is required by current accounting standard for external reporting? What are the pros and cons of including fixed overheads in stock valuation? How would the changes of inventory level affect profits under each method? In case of highly fluctuating levels of production, which costing method will give a more realistic set of cost data? Which costing method will give a more accurate picture of how a firm s cash flows are affected by changes in sales volume? Which costing method will show a clearer relationship between cost, price and volume? 37 38

36 Bullet Manufacturing Company should use marginal costing instead of absorption costing in preparing the company s accounting reports Bullet Manufacturing Company should use marginal costing instead of absorption costing in preparing the company s accounting reports Some suggested arguments for the proposition (i.e. advantages of marginal costing and disadvantages of absorption costing): 1. Marginal costing is simple and easy to understand by people who do/do not have knowledge on costing. 2. The effect of varying charges per unit is avoided if the fixed overhead is not charged to cost of production. The effect of inventory changes on profits is also removed. 3. Marginal costing prevents the illogical carry forward in stock valuation of some proportion of current year s fixed overheads. 4. With marginal costing, contribution varies in direct proportion to the volume of units sold. Profits will increase as sales volume rises, by the amount of extra contribution earned. 5. Marginal costing accounts for all fixed overhead in the period in which they are incurred. Therefore, it gives an accurate picture of how a firm s cash flows are affected by changes in sales volume. 6. Marginal costing provides more useful information for decision making. In the short run, fixed overhead is irrelevant cost for decision making as it does not alter. With the help of breakeven and profitability analysis, a comparison of profitability and performance between two or more products and departments can easily be assessed and brought to the notice of management for decision making. 7. Execution of cost control is greatly facilitated. Marginal costing helps to avoid arbitrary allocation of fixed overhead (i.e. basis for calculating the overhead absorption rate), efforts can be concentrated on maintaining a uniform and consistent marginal cost. It is useful to various levels of management. Some suggested arguments against the proposition (i.e. advantages of absorption costing and disadvantages of marginal costing): 1. Absorption costing does not understate the importance of fixed cost. By allocating fixed costs to a product using absorption costing, all fixed costs will be covered. 2. In the long run, all costs are variables, and inventory values based on absorption costing will give recognition to these long run variable costs. 3. Selling price based on marginal costing might enable a firm to make contribution on each unit of product sold, but the total contribution earned might be insufficient to cover all fixed cost and caused it to suffer loss. 4. The exclusion of fixed costs from inventories under marginal costing will affect profit. The true and fair view of financial affairs of a firm might also be blocked. 5. In case of highly fluctuating levels of production, e.g. in case of seasonal factories, cost data prepared under marginal costing will become unrealistic. Fixed overhead will be deferred and included in the closing inventory valuation and will only be recorded as an expenses in the period in which the goods are sold under absorption costing. Therefore, losses are unlikely to be reported in the periods when stock are being built up and provide more logical profit calculation. As the sales for Bullet Manufacturing Company increased 20% from June to July, it is likely that it has seasonal sales pattern. 6. The current Accounting Standard requires a firm to adopt absorption costing for external reporting. The use of marginal costing for internal reporting will induce more workload and different profit measurement for internal and external reporting