MARGINAL COSTING

Any costing accounting system in which variable costs are charged to cost units and fixed costs are written off against contribution.

1.1 Marginal cost

The part of unit cost which would increase if one extra unit were produced (or be avoided if that unit were not produced).

• Costs generated solely by a given cost unit, ie
  all unit direct costs + variable overhead per unit.

1.2 Contribution

Sales value less variable cost of sales. May be expressed per unit or in total.

• Unit contribution = Unit selling price – marginal cost per unit
• Total contribution = Total revenue – marginal cost

1.3 In summary

• Each unit of stock is valued at MC.
• Production cost is MC per unit number of units produced.
• Fixed costs are excluded from production cost and are charged as an expense (or period cost) in the P&L a/c.

2 ABSORPTION COSTING

In addition to direct costs, all production overheads are assigned to cost units by means of overhead absorption rates.

2.1 Principle

• Costs should be charged to (ie "absorbed into") whatever is being costed.
• Therefore each unit of stock is valued at AC.
• Production cost is AC per unit number of units produced.

3 STANDARD COST CARD

• MC = all variable production costs.
• AC = all variable production costs + a share of fixed production cost.

Example 1

Production data for 1 gromit

The variable overhead rate is £4 per direct labour hour.

The fixed overhead absorption rate is £7 per direct labour hour.

Budgeted production is 5,000 gromits.

Required

(a) Calculate the budgeted fixed overheads for the period.

(b) Determine the cost of a gromit on

     (i) a marginal costing basis
     (ii) an absorption costing basis.

4 IMPACT ON STOCKS AND PROFIT

Example 2

Required

If, in Example 1, budgeted sales are 4,300 gromits at £40 each, calculate the budgeted profit for the period using

(i) marginal costing
(ii) absorption costing.

Example 3

Required

If all budgeted information is as in Example 2, calculate the actual profit, using AC, if actual production and sales were

(i) 4,500 gromits
(ii) 5,500 gromits.

4.1 The effect of changing stock levels on profit

Under AC opening and closing stock values will be higher than under MC because of the inclusion of fixed production costs.

• If stock levels do not change (ie opening and closing stock are valued equally) this will not affect profit.
• If stock levels fall (ie opening stock is greater than closing stock) the decrease in stock under AC will cause a bigger increase in cost of goods sold then it will under MC.

As a result, the AC profit will be less than the MC profit.

• If stock levels rise, the opposite effect will occur.

In summary

4.2 Profit reconciliation

	£
Marginal cost profit
Add: Increase/Less: decrease in profit
(Increase/(decrease) in stock level Fixed production overhead per unit)
	^_____
Absorption cost profit
	^_____

Example 4

Required

Reconcile the profits in Example 2.

Solution

	£
Marginal cost profit (per Solution 2 (i))	30,490
Increase/(decrease) in profit
	______
Absorption cost profit (per Solution 2 (ii))	37,840
	______

5 COMPARISON OF METHODS

Absorption costing

Marginal costing

5.1 Stock valuation

Conforms to IAS 2 Inventory for preparation of published financial a/cs

Over prudent valuation (not permitted by IAS 2)

5.2 Profit

Depends on sales volume and production therefore can manipulate by overstocking. Must adjust for any over /(under) absorption

Depends only on sales

5.3 Cost ascertainment

Avoids need to split semi-variable costs

Avoids allocation, apportionment and absorption

5.4 Decision-making

Fixed costs are normally irrelevant (as incurred anyway)

Contribution relevant

5.5 Cost control

Focuses on all costs therefore a reminder that all costs have to be covered in long term.

Focuses on controllable costs

EXAMPLE SOLUTIONS

Solution 1 – Standard cost cards

(a) Budgeted fixed overheads

Units × no of hours per unit × hourly rate

5,000 × 1.5 hrs × £7 = £52,500

(b)(i) Marginal cost (MC)

		£
Materials	2.4 kg @ £3 per kg	7.20
Direct labour	1.5 hrs @ £5 per hour	7.50
Variable overheads	1.5 hrs @ £4 per hour	6.00
		_____
		20.70
		_____

(ii) Absorption cost (AC)

	£
Marginal cost (as above)	20.70
Plus: Fixed overheads 1.5 hrs @ £7 per hour	10.50
	_____
	31.20
	_____

Solution 2 – Budgeted profits

(i) Marginal cost

Note SP per unit – MC per unit = Unit contribution

Total contribution – total fixed overheads = Profit

			£
Sales revenue (4,300 × £40)			172,000
Less:	Opening stock	–
	Marginal cost of production
	(5,000 £20.70)	103,500
	Closing stock (700 £20.70)	14,490
		_______
	Cost of goods sold (ie 4,300 × £20.70)		89,010
			______
Total contribution (4,300 × £19.30)			82,990
Less:	Total fixed overheads		52,500
			______
Profit			30,490
			______

Alternatively

		£	£
Sales revenue			172,000
Less:	Total cost of production
	(5,000 × £31.20)	156,000
	Closing stock (@ MC)
	(700 × £20.70)	(14,490)
		_______
			141,510
			_______
			30,490
			_______

Note When MC is used, no element of fixed overheads is included in the stock valuation stock is valued at MC and no fixed overheads are c/fwd, hence all fixed overheads are written off.

(ii) Absorption cost

		£
Sales revenue (4,300 × £40)		172,000
Less:	Opening stock	–
	Absorption cost of production (5,000 £31.20)	156,000
	Closing stock (700 £31.20)	21,840
		_______
	Cost of goods sold (4,300 × £31.20)	134,160
		_______
Profit		37,840
		_______

Note As stock valuation includes an element of fixed overheads, not all fixed overheads are being written off.

Solution 3 – Changing stock levels

(i) Actually produce and sell 4,500 gromits

	£
Sales revenue (4,500 @ £40)	180,000
Less: Total cost of production (@ AC) (4,500 @ £31.20)	140,400 †
	______
	39,600
Adjustment: Less fixed overheads under-absorbed	5,250
	______
Profit	34,350
	______

† includes a total of 4,500 × £10.50 = £47,250 of fixed overheads. Fixed overheads remain fixed at £52,500 therefore £5,250 of fixed overheads is underabsorbed.

(ii) Actually produce and sell 5,500 gromits

	£
Sales revenue (5,500 @ £40)	220,000
Less: Total cost of production (@ AC) (5,500 @ £31.20)	171,600 *
	_______
	48,400
Adjustment: Add fixed overheads over-absorbed	5,250
	______
Profit	53,650
	______

* includes a total of 5,500 × £10.50 = £57,750 of fixed overheads. These remain fixed at £52,500 therefore £5,250 of fixed overheads is overabsorbed.

Solution 4 – Profit reconciliation

	£
Marginal cost profit (per Solution 2 (i))	30,490
Increase/(decrease) in profit
700 units £10.50	7,350
	^______
Absorption cost profit (per Solution 2 (ii))	37,840
	^______

COST BOOKKEEPING/COST ACCOUNTS

1.1 Description

• Those accounts which relate to all the transactions involving the entity’s costs (and related revenues) and are physically held in the cost ledger.
• Cost accounts are essentially the same whichever cost bookkeeping system is adopted.

1.2 Control accounts

Control a/cs with subsidiary records can be used for materials and wages in particular (also overheads) in just the same way, that a subsidiary trade receivables’ ledger supports a "trade receivable ledger control a/c" in the general (nominal) ledger.

1.3 Manufacturing overheads

• A "total fixed overhead a/c" simplifies the entries that are made in the WIP a/c.
• Production fixed overheads (rent, supervisor’s salary, depreciation, etc) are transferred to the "total fixed overhead a/c" so that only one entry needs to be made in the WIP a/c for all the production fixed overheads absorbed.

1.4 Non-manufacturing overheads

• If there are fixed overheads that do not relate to production (eg fixed salaries of a sales force which would be a "selling and distribution" fixed overhead) it is usual to transfer production fixed overheads to a "total production fixed overhead a/c" (and then to WIP)
• Selling and distribution fixed overheads would be transferred to the "total selling and distribution fixed overhead a/c" then to the cost of goods sold a/c and then to the I&E (or P&L) a/c.
• The selling and distribution fixed overheads would not be entered in WIP as they relate to the selling of the goods and not their production.

2 INTEGRATED SYSTEMS

2.1 Description

A single set of accounting records providing both financial and cost accounts using a common input of data.

• All information, both financial and costing, is kept in one set of books.
• Double-entry is simply the normal double-entry for writing up a set of books.

2.2 Basic cost a/c entries

3 AN INTERLOCKING SYSTEM

3.1 Description

Cost accounts are distinct from financial accounts but kept continually in agreement using control accounts (or reconciled by other means).

• System may be used where it is inconvenient to maintain all the accounts in a single set of books.
• A "cost ledger control a/c" is kept to summarise individual cost accounts in the "cost ledger". (Analogous to maintaining a "sales ledger control a/c" in the general ledger with the individual debtors’ accounts in the "sales ledger").

3.2 Comparison interlocking v integrated system

Interlocking – the books are divided into two ledgers: "the financial ledger" and the "cost ledger"
· The "cost ledger control a/c" in the cost ledger is used to control the entries in the cost ledger and to make it self-balancing. · A "financial ledger control a/c" in the financial ledger is used to make the financial ledger self-balancing.
The profit & loss a/c in the cost ledger is called a "cost profit & loss a/c".

3.3 Cost bookkeeping flowchart

Notes

• This flowchart assumes an absorption costing system.
• All costs of selling an item have been accumulated in the cost of goods sold a/c.
• The over- or under-recovery of overheads that will result from the use of a predetermined overhead recovery rate has been ignored.
• The cost ledger control a/c may be called the financial ledger control a/c.

In view of the difficulties of separating semi-variable overheads into their fixed and variable elements, a single (combined) production overhead (ie control) a/c and a single selling and administration overhead a/c may be used.

Question

• Where would over or under-absorption of production overheads be posted?

Answer

• Under-absorption – Dr costing P & L a/c (ie additional cost)
• Over absorption – Cr costing P & L a/c (ie cost "saving")

4 COST LEDGER V FINANCIAL LEDGER

4.1 Comparison

• Cost ledger is not concerned with personal a/cs, capital and reserves, and asset a/cs other than a/cs showing items of stock (ie raw materials, WIP and finished goods).
• Entries appearing in nominal a/cs for items of income and expenditure in the financial ledger form the principal data for the entries in the cost a/cs. In costing, the aim is to charge all costs to the end products, either
• directly (through individual job a/cs) or
• indirectly (by means of suitable absorption systems).

4.2 Financial matters not reflected in cost a/cs

Examples

• Receipts from customers or payments to suppliers
• Discounts allowed or received
• Purchases and sales of fixed assets
• Interest received and paid
• Dividends, issues of shares or debentures.

4.3 Cost items not in financial a/cs

Cost a/cs may include "notional" amounts for internal transactions.

Examples

• Notional interest on capital employed in production departments
• Notional rent
• Management charges
• Transfer prices.

4.4 Reconciliation of financial and cost profits

• Reasons for differences
• stock valued more prudently in financial a/cs than in cost a/cs
• items not in one ledger
• different accounting policies (eg in respect of depreciation).
• Purpose of reconciliation
• To highlight differences in accounting treatments
• To check the correctness of the system.