BAFS Elective Part -...

BAFS Elective PartAccounting Module –

Cost Accounting

Topic A08: Marginal and Absorption Costing

Technology Education SectionCurriculum Development Institute

Education Bureau, HKSARGApril 2009

2Topic A08Marginal and Absorption Costing

BAFS Elective PartLearning and Teaching Example

Fixed Costs



Examples of fixed cost in relation to your family’s monthly expenses



Variable Costs

Total Variable Cost($)

Output (units)



Examples of variable cost in relation to your family’s monthly expenses



AActivity 1ctivity 1::

Pattie Pattie CompanyCompany

(Refer to Student Worksheet Page 1 to 3)



Pattie Company

Manufacturing AccountIncome Statement



Pattie Company

Except direct, indirect cost, what are fixed and variable cost?

Are there any other ways to calculate the production cost?



Task 1 - Cost Classification

Identify the fixed, variable, production and non-production cost from the Pattie Company’s Manufacturing Account and Income Statement for the month ended 30 June Year 8.

Fixed Cost Variable Cost ProductionCost

Non-Production Cost

e.g. Direct Materials

e.g. Direct Materials



Fixed Cost Variable Cost Production Cost Non-Production CostDirect Materials Direct Materials

Direct Wages Direct Wages

Direct Expenses Direct Expenses

Factory Manager Salary Factory Manager Salary

Factory Management Fee Factory Management Fee

Factory Rent and Rates Factory Rent and Rates

Factory Fire Insurance Factory Fire Insurance

Factory LabourInsurance Factory Labour Insurance

Provision for Depreciation –Machinery Provision for Depreciation –Machinery

Bank Loan Interest Bank Loan Interest

Provision for Depreciation –Office Equipment Provision for Depreciation –Office Equipment

Cleaning Expenses Cleaning Expenses

Salesman’s Salaries Salesman’s Salaries

Carriage Outwards Carriage Outwards

Advertising Advertising

Sales Commission Sales Commission

Office Rent and Rates Office Rent and Rates

Task 1 - Cost Classification (cont’d)



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

Total Production Cost:

Unit Produced:

Unit Product Cost = Total Production Cost ÷ Unit Produced

=

=



Total Production Cost: $76,200

Unit Produced: 2,540

Unit Product Cost = Total Production Cost ÷ Unit Produced

= $76,200 ÷ 2,540 units

= $30

Task 2 - Cost Computation(cont’d)



Absorption Costing

Cost

Work in progress stock

Production overheads Non-production overheads

Overheads(Indirect materials, indirect labour and indirect expenses)

Direct costs(Direct materials, direct labour and direct expenses)

Finished goods stock Profit and loss account



Cost Relationships



Marginal Costing

Cost

Finished goods stockWork in progress stock

Fixed production overheads

Production overheads Non-production overheads

Profit and loss account

Overheads(Indirect materials, indirect labour and indirect expenses)

Direct costs*(Direct materials, direct labour and direct expenses)

Variable production overheads

* Direct costs behave as variable costs



Task 3 – Income Statement

Suppose marginal costing system is used, construct an income statement for Pattie Company for the month ended 30 June Year 8.

Refer to student worksheet p.5-6



Task 3 – Income Statement (cont’d)

Income Statement for the month ended 30 June Year 8

HK$ HK$ Sales 191,475Less: Variable Production Cost of Goods Sold Finished Goods Opening Stock 1,254Add: Variable Production Cost 58,200

59,454Less: Finished Goods Closing Stock 1,008 58,446

133,029Less: Variable non-production cost 640Contribution 132,389Less: Fixed costProduction 18,000Non-production 21,897 39,897Net profit 92,492




State the major effect of using marginal costing in preparing the Income Statement of Pattie Company and explain why this happened.




Absorption Costing Marginal Costing

Differences in the 2 costing systems

(a) Fixed production costs are treated as product cost.

(b) If closing stock , part of the fixed production cost is carried forward to the next accounting period.

(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.

Impact on

Inventory valuation

Higher closing stock value(reason (a) above)

Lower closing stock value(reason (a) above)

Income determination

Higher profit(reason (b) above)

Lower profit(reason (b) above)



Activity 2: Case Study

Form groups of four to fiveRead the case carefully, discuss and complete Task 1 of Activity 2



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



Task 2 - Cost EstimationEstimate the monthly running cost of the business :

Cost Items: HK$

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:



Task 3 (a) - Cost Computation cont’dComplete the following table based on the characteristics of different cost items:

Cost Items Details Cost Classification underFixed 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

T-shirt purchase cost $15/pieceTransfer paper $4/sheetPrinting charges $3/sheetPackaging tools & materials $2,000/ monthStationery expenses $300/monthAdvertising fee (a fixed amount charged by an advertising firm)

$1,000/month

Transaction fee charged by Yahoo 1.5% on sales

Delivery charges 1% on sales



Task 3 (a) - Cost Computation (cont’d)

Suggested Answer:

Cost Items Details Cost Classification under(Marginal Costing)Fixed or Variable

(Absorption Costing)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 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 CostAdvertising 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



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



Task 3 (b) - Cost Computation (cont’d)

Suggested Answers:

Under Marginal Costing:T-shirt purchase cost $15Transfer paper $ 4Printing charges $ 3Unit product cost $22

Under Absorption Costing:T-shirt purchase cost $15Transfer paper $ 4Printing charges $ 3Production overhead* $ 7Unit product cost $29

*($1,500+$2,000) ÷500=$7



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)



Task 4 - Profit Computation (cont’d)

4(a) Suggested Answer (Absorption Costing):



Task 4 - Profit Computation (cont’d)4(b) Suggested Answer (Marginal Costing):



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?



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 costproduction costs (charged to P/L a/c) (absorbed into units produced)

4. Profit & sales Profit is a function of Profit is a function of relationship sales sales and production




Major DifferencesMajor Differences in the 2 costing methods: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



Preparation for next lesson

Marginal CostingMarginal Costing Absorption CostingAbsorption Costing

Advantages

& Disadvantages



A Case study:A Case study:

Bullet Manufacturing Bullet Manufacturing

CompanyCompany(Refer to Student Worksheet p.10)



Activity 3: Debate

“ Bullet Manufacturing Company should use marginal costing instead of

absorption costing in preparing the company’s accounting reports”



Each group nominates onerepresentative to present their views and arguments.

Use marginal costing as ….

Use absorption costing as ….



Conclusion



Advantages of Marginal Costing

Easy to understand Fixed overheads are excluded from inventory costs Fixed overheads are NOT carried forward in stock valuation Contribution and profits is directly driven by salesFocus on the controllable aspect of a business



Disadvantages of Marginal Costing

Marginal costing ignores that fixed costs must be recovered over the long runFinished goods and work in progress stock will be understatedIt fails to recognise that all costs are variable over the long runFirms with seasonal sales patterns, profits will fluctuate greatlyNot easy to establish the cost variabilities



Advantages of Absorption Costing

Fixed costs are absorbed in inventoryRecognition of the importance of fixed overheads in productionCompliance with Accounting StandardsAll costs are variable over the long run Less fluctuation in profits



Disadvantages of Absorption Costing

More complicated Fixed overheads are charged to production Part of the current year’s fixed overheads are carried forward in closing stock to the following year Profit is not a direct function of salesRelationships between cost, price and volume is ignored




Both marginal and absorption costing systems have their own advantages and limitations.

Therefore, management must decide which method provides more meaningful information to meet planning, control and decision making needs.



Summary for lesson 2Which costing system would you choose?

Marginal Costing

Absorption Costing

Short run decision-making

Long run decision-making

When sales is subject to high seasonal fluctuationsComparison of performance of different departments/product linesExternal reporting



The End

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