Professional Development Programme on Enriching Knowledge of the Business, Accounting and Financial Studies (BAFS) Curriculum

Professional Development Programme on Enriching Knowledge of the Business, Accounting and Financial Studies (BAFS) Curriculum Course 1 : Contemporary Perspectives on Accounting Unit 7 : Marginal and Absorption Costing Technology Education Section, Curriculum Development Institute Education Bureau, HKSARG August 2008 Learning objectives On completion of this unit, you should be able to: 1. Distinguish between direct and indirect costs, fixed and variable costs, factory and administrative overheads, product costs and period costs. 2. Understand the process of cost allocation and apportionment in marginal and absorption costing. 3. Calculate stock valuations using marginal and absorption costing. 4. Preparing operating statements using marginal and absorption costing. 5. Reconcile the profits and losses from marginal and absorption costing. 6. Compare the advantages and disadvantages using marginal and absorption costing. 2

Content 1. Costs, cost unit and classification of costs 2. Absorption costing 3. Marginal costing 4. Illustrations of absorption costing and marginal costing 5. Illustration of multiple-period period absorption costing and marginal costing income statements 6. Advantages and disadvantages of absorption costing and marginal costing 3 Organisation of Unit 7 Management Accounting Costs, cost unit and classification of costs Absorption Costing Illustration Multiple Period Illustration Advantages and disadvantages Marginal Costing Illustration Multiple Period Illustration Advantages and disadvantages 4

Management accounting (1) Units 1 to 4 deal with financial accounting. The major purpose of financial accounting is to provide investors and other external users with useful information about the financial position, performance and changes in financial position of a company. Units 5 and 6 deal with two related topics, namely ICT Applications in Accounting and Ethical Issues in Accounting. 5 Management accounting (2) To achieve a company s s objectives, management accounting provides managers with reliable and timely information for planning, evaluating and rewarding performance. This Unit, together with Units 8 and 9 introduce the foundations of management accounting. This Unit will deal with accounting for manufacturing operations under both absorption costing and marginal costing systems. 6

Management accounting (3) Unit 8 explains how cost-volume volume-profit (CVP) analysis is applied by managers to answer various operating decisions, such as what level of sales is required to break even, how many units of a product is to be sold in order to earn a target level of operating profit, etc. Unit 9 focuses on short-run run decision making. The Unit describes how relevant costs, such as opportunity costs and incremental costs, are applied to specific decisions, including hire, make or buy, special order decisions. 7 Management accounting (4) Unit 10 will deal with the areas of knowledge in financial management a closely related business knowledge to management accounting. The Unit describes how the basic capital investment methods are applied to evaluate capital projects: accounting rate of return, payback period, net present value and internal rate of return. 8

1. Costs, cost unit and classification of costs (1) Costs are the amount of expenditure incurred as a result of producing the goods for sale. Total costs = Quantity x Unit cost of product A cost unit is a unit of product in relation to which, costs are ascertained. For example, it can be a car, a table, etc. 9 1. Costs, cost unit and classification of costs (2) Costing Process - Raw input cost data are processed to become useful cost information through the different costing systems, e.g.: i) absorption (or full) costing ii) marginal (or variable) costing 10

1. Costs, cost unit and classification of costs (3) A. Costs can be classified by its relation to cost unit: i) direct costs; ; and ii) indirect costs. B. Costs can be classified by its behavior to output: i) variable costs; ; and ii) fixed costs. C. Costs can be classified by its presentation in financial statements: i) product costs; ; and ii) period costs. 11 1. A. i) Direct costs (1) Direct costs are costs that can be identified specifically and directly traceable to a cost unit. They include: i) Direct materials the materials that actually become part of the cost unit, e.g. components in computers. ii) Direct labour the remuneration paid to workers whose work is directly related to production, e.g. sewing labour cost in garment factory. iii) Direct expenses other costs that are directly incurred on a specific cost unit, e.g. hire of a special plant. 12

1. A. i) Direct costs (2) Prime costs Prime costs are the direct costs that are consumed in production. Prime costs = Direct materials + Direct labour + Direct expenses 13 1. A. ii) Indirect costs (1) Indirect costs are costs that cannot be identified specifically or directly traceable to a cost unit. They include: i) Indirect materials materials that form part of the products and that can be identified but are too insignificant in value, e.g. spare parts for machinery. ii) Indirect labour salaries of factory supervision staff that are not directly involved in the production of products, e.g. wages of maintenance staff. iii) Indirect expenses other costs that are either impossible or inconvenient to charge directly to a cost unit, e.g. equipment repairs. 14

1. A. ii) Indirect costs (2) Overheads include all indirect costs that cannot be identified specifically or directly traceable to a cost unit. Overheads = Indirect materials + Indirect labour + Indirect expenses 15 1.. B. i) Variable cost Variable cost is a cost that varies in approximate proportion to changes in the level of activity, e.g. the airline fuel expense is directly proportionate to the passage miles. The relationship between cost and output can often be described as linear: Total variable costs = b x where b = a constant dollar amount, representing the variable cost per unit x = production volume in units (Note: The graphical presentation of cost behavior will be introduced in Unit 8.) 16

1. B. ii) Fixed cost Fixed cost is a cost that remains unchanged or does not change significantly in response to the level of activity, e.g. depreciation of airplane does not vary with passage miles. Total fixed costs = a where a = a constant dollar amount (Note: The graphical presentation of cost behavior will be introduced in Unit 8.) 17 1. B. iii) Semi-variable cost Semi-variable cost contains both fixed and variable components. It increases or decreases with activity levels but not in direct proportion, e.g. the cost of telephone expense comprises a fixed rental charge plus a variable charge for long distance calls. Total semi-variable costs = a + b x where a = total fixed costs b = variable cost per unit x = production volume in units 18

1. C. Product costs and Period cost (1) Product costs are those costs incurred to manufacture the products and included in the stock valuation. Period costs are those costs associated with time periods, rather than with the manufacturing of the stock. 19 1. C. Product costs and Period costs (2) Product costs costs Unsold Balance Sheet: Sheet: record record as as Inventory Sold in future periods Period Period costs costs Sold in same period Income Income Statement: record record as as cost cost of of goods goods sold sold and and operating expenses 20

1. C. Product costs and Period costs (3) Example Fortune Ltd has the following cost information for January: Product costs = $100,000 Period costs = $80,000 50% of the output for January is sold and there are no opening stock. Required: Calculate the total costs of output for January. Answer in next page 21 Answer 1. C. Product costs and Period costs (4) The total costs of output for January is: Product costs Less: Closing stock (50%) Cost of goods sold Period costs Total costs of output for January $ 100,000 50,000 50,000 80,000 130,000 22

1. D. Total costs in a manufacturing firm (1) Total costs = Total direct costs + Total indirect costs = Prime costs + Factory overheads + Administrative expenses + Selling expenses + Finance expenses Production costs are total of prime costs and indirect production costs incurred during production. A summary of the costs and their relationships is shown in Figure 1 in next page. 23 1. D. Total costs in a manufacturing firm (2) The flow of costs for a manufacturing firm is shown in Figure 1 below: Direct Direct materials Direct Direct labour labour Direct Direct expenses Indirect Indirect materials Indirect labour labour Indirect Indirect expenses Prime Prime costs costs + Factory overheads Production costs costs Product costs: costs: Cost Cost of of goods goods sold sold + Expenses shown shown in in Income Income Statement 24 Period Period costs: costs: Administrative, Selling Selling and and Finance expenses Total Total costs costs

2. Absorption costing (1) The principle of absorption costing is to attribute all costs, including the application (or absorption) of overhead costs to cost units according to the activity level. Thus, under absorption costing, operating statements do not distinguish between fixed and variable costs. Valuation of stock and work-in in-progress contains both fixed and variable costs. Absorption costing is the basis of preparing financial statements for the external users. 25 2. Absorption costing (2) The procedures of absorption costing are: A. Ascertain and charge the prime costs: i) Direct materials Direct materials = Opening direct materials stock + Purchases - Closing direct materials stock = Cost of direct materials used 26

2. Absorption costing (3) ii) Direct labour Direct labour = Labour rate applied x No. of labour hours iii) Direct expenses Direct expenses = Expense rate per unit x Unit of production 27 2. Absorption costing (4) B. Absorption of factory overheads: The objective of the overhead absorption process is to take up in the total costs of a product a fair and appropriate share of the company s s total factory overheads. Factory overheads are allocated to the cost centre of the product. The quantity of outputs is used to absorb the overheads. 28

2. Absorption costing (5) If there are more than one cost centre and product, factory overheads are firstly apportioned by a fair and appropriate basis, e.g. floor areas, into the cost centre of the product concerned. Then the quantity of outputs in that centre is used to absorb the overheads. C. Production costs = Prime costs + Absorbed factory overheads 29 3. Marginal costing (1) Under marginal costing,, only variable production costs are charged to cost units. Fixed costs are recognised as expenses when incurred. Marginal costing is more easy to apply than absorption costing since no absorption of fixed overheads into cost of good sold is required. 30

3. Marginal costing (2) The procedures of marginal costing are: A. Ascertain all variable costs and allocate them into prime costs, variable factory overheads to arrive at the variable cost of goods sold and together with the other variable components grouped under the variable costs item. i) Prime costs = Direct materials + Direct labour + Direct expenses 31 3. Marginal costing (3) ii) Factory overheads are divided into variable and fixed components respectively. Prime costs and variable factory overheads are added up to give the variable cost of good sold; ; fixed factory overheads are grouped under the fixed costs item. iii) Selling, administrative and finance expenses are divided into variable and fixed components and grouped under their categories respectively. 32

3. Marginal costing (4) B. Allocate all fixed overhead components under the fixed costs item: All fixed factory overheads, selling, administrative and finance expenses are grouped under the fixed costs item. C. Total costs = Variable costs of goods sold + Variable selling, administrative and finance expenses + Fixed costs 33 4. Illustrations of absorption costing and marginal costing (1) Absorption costing and marginal costing do not usually provide the same assessment of profit. The different profit figures are due to the difference in the net change in stock valuation between the beginning and the end of that accounting period. 34

4. Illustrations of absorption costing and marginal costing (2) In a period, 40,000 units of goods were produced and sold. The revenues and costs were as follows: Sales (40,000 x $5) $200,000 Production costs: Variable 70,000 Fixed 30,000 Administrative and selling overheads: Fixed 50,000 Required: Prepare operating statements based on both absorption costing and marginal costing. 35 Solution: 4. Illustrations of absorption costing and marginal costing (3) Operating statement absorption costing Sales Less: Cost of goods sold Gross profit Less: Administrative and selling overheads Net profit $ 200,000 100,000 100,000 50,000 50,000 36

4. Illustrations of absorption costing and marginal costing (4) Operating statement marginal costing Sales Less: Variable cost of goods sold Contribution Less: Fixed costs Production Administrative and selling Net profit $ 30,000 50,000 $ 200,000 70,000 130,000 80,000 50,000 37 4. Illustrations of absorption costing and marginal costing (5) In the above example when sales equal production and so no stock exists at the end of the period, both absorption costing and marginal costing systems produce the same profit figure. 38

4. Illustrations of absorption costing and marginal costing (6) Further illustration Assume the same data as in previous illustration except that only 36,000 of the 40,000 units produced were sold, and so 4,000 units being carried forward as stock to the next period. Required: Prepare operating statements based on absorption costing and marginal costing systems. 39 4. Illustrations of absorption costing and marginal costing (7) Solution: Operating statement absorption costing $ Sales (36,000 x $5) Less: Cost of goods sold Production costs 100,000 Less: Closing stock (4,000 x 2.5*) 10,000 Gross profit Less: Administrative and selling overheads Net profit * Unit absorption cost = Average production costs = $100,000 / 40,000 units = $2.5 per unit $ 180,000 90,000 90,000 50,000 40,000 40

4. Illustrations of absorption costing and marginal costing (8) Operating statement marginal costing Sales (36,000 x $5) Less: Variable cost of goods sold Less: Closing stock (4,000 x 1.75*) Contribution Less: Fixed costs Production Administrative and selling Net profit $ 70,000 7,000 30,000 50,000 $ 180,000 63,000 117,000 80,000 37,000 41 * Unit variable costs = $70,000 / 40,000 units = $1.75 per unit 4. Illustrations of absorption costing and marginal costing (9) You may notice that the value of closing stock differs in absorption costing and marginal costing. This is because absorption costing transfers some of the period s s fixed costs which are included in the closing stock to the next period, but marginal costing recognises all fixed costs as expenses in the period they are incurred. Therefore in a period with increasing stock, absorption costing will show higher profit than marginal costing. 42

5. Illustration of multiple-period period absorption costing and marginal costing income statements (1) In preparing accounts based on absorption costing and marginal costing, you can see that the main difference is how to handle the fixed factory overheads. This can be shown in Figure 2 in next page. 43 5. Illustration of multiple-period period absorption costing and marginal costing income statements (2) Absorption costing Direct materials + Direct labour + Variable factory overheads + Fixed factory overheads Stock Cost of good sold + Selling, administrative & finance expenses Marginal costing Direct materials + Direct labour + Variable factory overheads Stock Variable cost of good sold + Variable selling, administrative & finance expenses + Fixed factory overheads + Fixed selling, administrative & finance expenses 44

5. Illustration of multiple-period period absorption costing and marginal costing income statements (3) Since the stock values for absorption costing and marginal costing are different, and stock is written off as cost of good sold only when they are sold, the profits for absorption costing and marginal costing will also be different for each period. The difference in reported profits between absorption costing and marginal costing in a period is a timing difference only. The overall profits remain the same across the total multiple periods. This can be shown by the illustration of multiple-period period income statements in next slide. 45 5. Illustration of multiple-period period absorption costing and marginal costing income statements (4) Gambo Ltd manufactures only baby shampoo. The sales, production and stock figures are as follows: (bottle) \ ($) Year 1 Year 2 Year 3 Year 4 Sales (bottle) 25,000 20,000 30,000 40,000 Production (bottle) 25,000 40,000 20,000 30,000 Opening stock (bottle) 0 0 20,000 10,000 Closing stock (bottle) 0 20,000 10,000 0 Selling price per bottle 15 15 15 15 46

5. Illustration of multiple-period period absorption costing and marginal costing income statements (5) The following absorption rates are used: Direct materials Direct labour Production overheads (150% of direct labour rate) Cost per bottle ($) 1.00 2.00 3.00 Production cost 6.00 Gambo Ltd uses 25,000 bottles as the base for allocation of fixed costs. Two-third of the production overheads are fixed costs. All administrative and selling overheads of $80,000 are fixed costs. Required: Prepare multiple-period period income statements for year 1 to 4 using absorption costing and marginal costing. Note: Reconcile the difference in profits arising from overhead absorption. 47 5. Illustration of multiple-period period absorption costing and marginal costing income statements (6) Multiple-period period income statements - absorption costing Year 1 ($ 000) Year 2 ($ 000) Year 3 ($ 000) Year 4 ($ 000) Sales 375 300 450 600 Less: Cost of goods sold Opening stock 0 0 120 60 Add: Production costs 150 240 120 180 Less: Closing stock 0 120 60 0 150 120 180 240 Gross profit 225 180 270 360 Less: Administrative and selling overheads 80 80 80 80 Net profit 145 100 190 280 48

5. Illustration of multiple-period period absorption costing and marginal costing income statements (7) Since the actual production differs from the planned production for year 2 to year 4, the fixed overheads that are absorbed into production costs are different. Unit absorbed fixed overheads = 2/3 of production overheads = 2/3 x $3 per bottle = $2 per bottle Year 1 Year 2 Year 3 Year 4 Planned production (bottle) 25,000 25,000 25,000 25,000 Actual production (bottle) 25,000 40,000 20,000 30,000 Difference (bottle) 0 +15,000-5,000 +5,000 Overhead over+ / under - absorption ($) at $2.00 per bottle 0 +30,000-10,000 +10,000 49 5. Illustration of multiple-period period absorption costing and marginal costing income statements (8) Multiple-period period income statements - marginal costing Fixed production overheads: Direct labour for 25,000 bottles = 25,000 x $2 per bottle = $50,000 Fixed production overheads = $50,000 x 150% x 2/3 = $50,000 Variable production overheads = $(3-2) per bottle = $1 per bottle Direct materials Direct labour Variable production overheads Variable production cost Cost per bottle ($) 1.00 2.00 1.00 4.00 50

5. Illustration of multiple-period period absorption costing and marginal costing income statements (9) Multiple-period period income statements - marginal costing Sales Less: Variable cost of goods sold Contribution Fixed costs Production Administrative and selling overheads Net profit Opening stock Add: Production costs Less: Closing stock Year 1 ($ 000 ) 375 0 100 0 100 275 50 80 130 145 Year 2 ($ 000) 300 0 160 _80 80 220 50 80 130 90 Year 3 ($ 000) 450 80 80 _40 120 330 50 80 130 200 Year 4 ($ 000) 600 40 120 0 160 440 50 80 130 310 51 5. Illustration of multiple-period period absorption costing and marginal costing income statements (10) Reconciliation of net profit Year \ Net profit ($ 000) Over-absorbed production overheads 1 2 3 4 Absorption costing 745 745 Profits for year 1 are the same for marginal costing and absorption costing because there is no opening stock or closing stock. All production on overheads absorbed to the cost units are the same. For year 2 to 4, the production outputs are different and therefore the unit cost of stock and costs of goods sold are different, and the net profits are also different. After the over-absorbed overheads are accounted for, you can see that the total net profits across the 4 years are the same for both the absorption costing and marginal costing. 145 100 190 280 30 Marginal costing 145 90 200 310 0 52

6. Advantages and disadvantages of absorption costing and marginal costing (1) Marginal costing Advantages: i) Simple to use. Only direct costs are used for calculation. There is no need to apportion fixed costs to products. ii) When sales are constant, marginal costing shows a constant net profit even production fluctuates. However, absorption costing will show varying amounts of net profit depending on the production levels. 53 6. Advantages and disadvantages of absorption costing and marginal costing (2) Marginal costing Advantages: iii) iv) Fixed costs are accounted for in the period when incurred and there is no need to relate them to the level of activity. The problem of under or over-absorption of overheads is avoided because fixed costs are treated as period costs. 54

6. Advantages and disadvantages of absorption costing and marginal costing (3) Marginal costing Disadvantages i) Too much focus on marginal costing may mislead the company to set a price below the total costs and result in loss in the long run. ii) If the production department runs in full capacity, the marginal cost will become inaccurate to be reflected as the cost to produce an additional unit. 55 6. Advantages and disadvantages of absorption costing and marginal costing (4) Absorption costing Advantages i) Fixed costs are substantial portion of costs incurred in most production plants, and should be absorbed in cost of goods manufactured. ii) If production is constant and sales fluctuate, the net profit figures for absorption costing fluctuate less than marginal costing since part of the fixed costs are absorbed into the stock. 56

6. Advantages and disadvantages of absorption costing and marginal costing (5) Absorption costing Advantages iii) For industries requiring a significant amount of fixed costs incurred in the early production stage like timber building, firework manufacture, etc, absorption costing will be a more appropriate system; otherwise a fictitious loss will be shown at the beginning. iv) HKAS 2 Inventories requires the use of absorption costing for financial statements prepared for external use. 57 6. Advantages and disadvantages of absorption costing and marginal costing (6) Absorption costing Disadvantages i) Even when sales are constant, absorption costing shows various amount of net profits whenever production fluctuates. ii) iii) The cost absorbed may be inaccurate. Significant over-absorption or under-absorption costs may arise. If more than one products are produced, the apportionment of fixed costs into the cost units may not be fair enough to reflect their share of overheads. 58

6. Advantages and disadvantages of absorption costing and marginal costing (7) There is no general answer which costing system is better. Accountants should judge whether absorption costing or marginal costing is more appropriate for their particular uses. 59 7. Recapitulation After reading the above materials, you should be able to: Understand the concept of costs, cost unit and classification of costs Explain the process of absorption costing and marginal costing. Perform calculation on cost and stock valuation by absorption costing and marginal costing. Apply absorption costing and marginal costing to preparing income statements. Understand the effect of absorption costing and marginal costing in multiple-period period income statements. Compare the advantages and disadvantages of absorption costing and marginal costing. 60

8. Further readings Lucey, T. (2002), Costing, London: Thomson, 6th Edition, Chapter 19, Marginal and Absorption Costing. (ISBN 0-8264-5510-7) Li, T. M. and Ng, P. H. (2007), HKAL - Principles of Accounts (Volume 2), Pilot Publishing Company Ltd, 2nd Edition, Chapter 23, Absorption and Marginal Costing. (ISBN 962-397-772-7) Jiambalvo, J. (2003), Managerial Accounting, New York: John Wiley & Sons, 3rd Edition, Chapter 5, Variable Costing. (ISBN 0-471-23823-6) 王 怡 心, 管 理 會 計, 台 北 : 三 民 書 局 二 二 年, 修 訂 二 版, 第 八 章, 全 部 成 本 法 與 直 接 成 本 法, 第 225-246 頁 (ISBN 957-14-3525-2) 61 End of the Unit End-of of-unit Assessment This is the end of Unit 7. Please go to the Unit Assessment before attempting the next unit. 62