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CLEANLINESS IS NEXT TO GODLINESS

Duration: 60 mins
Slides: 12

LMT SCHOOL OF MANAGEMENT, THAPAR INSTITUTE OF


ENGINEERING & TECHNOLOGY
Masters of Business Administration

Course: Managerial Accounting


Faculty: Dr. Sonia Garg (Email: sonia.garg@thapar.edu)

Session 7: Marginal and Absorption Costing


Session Learning Objectives
• Identify what distinguishes marginal costing from
absorption costing

• Compute income under marginal and absorption


costing and explain the difference

• Differentiate throughput costing from marginal and


absorption costing

• Compute breakeven points for marginal and absorption


costing

Marginal and Absorption Costing


Marginal costing v/s Absorption
costing
• Marginal costing is a method of inventory costing in which only variable
manufacturing costs are included as inventoriable costs

• Absorption costing is a method of inventory costing in which all variable


manufacturing costs and all fixed manufacturing costs are included as
inventoriable costs

• Operating Income will differ between Absorption and Marginal Costing

• The amount of the difference represents the amount of Fixed Product


Costs capitalized as Inventory under Absorption costing, and expensed as
a period costs under Marginal Costing

Marginal and Absorption Costing


Example
April May
Beginning Inventory 0 150
Production 500 400
Sales 350 520

Variable Costs
Manufacturing costs per unit produced Rs. 1,00,000 Rs. 1,00,000
Operating costs per unit sold Rs. 30,000 Rs. 30,000
Fixed Costs
Manufacturing costs Rs. 2,00,00,000 Rs. 2,00,00,000
Operating costs Rs. 60,00,000 Rs. 60,00,000

The selling price is Rs. 2,40,000


Marginal and Absorption Costing
April May
Beginning Inventory 0 150

Solution Production
Goods available for
500
500
400
550
sale
Units sold 350 520
Marginal Costing Ending inventory 150 30

April May
Revenue 2,40,000*350 = 8,40,00,000 2,40,000*520 = 12,48,00,000
Costs:
Beginning Inventory 0 1,00,000*150 = 1,50,00,000
Variable manufacturing costs 1,00,000*500 = 5,00,00,000 1,00,000*400 = 4,00,00,000

Variable cost of goods available 5,00,00,000 5,50,00,000


for sale
Deduct Ending Inventory (1,00,000*150 = 1,50,00,000) (1,00,000*30 = 30,00,000)
Variable COGS 3,50,00,000 5,20,00,000
Variable operating costs 30,000*350 = 1,05,00,000 30,000*520 = 1,56,00,000
Fixed Manufacturing costs 2,00,00,000 2,00,00,000
Fixed operating costs 60,00,000 60,00,000
Marginal and Absorption Costing
Operating Income 1,25,00,000 3,12,00,000
April May
Fixed manufacturing costs 2,00,00,000 2,00,00,00
0
Absorption costing Units produced 500 400
Fixed manufacturing cost per unit 40,000 50,000
Variable manufacturing cost per unit 1,00,000 1,00,000
Total manufacturing cost per unit 1,40,000 1,50,000

April May
Revenue 2,40,000*350 = 8,40,00,000 2,40,000*520 = 12,48,00,000
Costs:
Beginning Inventory 0 2,10,00,000
Variable manufacturing costs 1,00,000*500 = 5,00,00,000 1,00,000*400 = 4,00,00,000
Fixed Manufacturing costs 2,00,00,000 2,00,00,000
Cost of goods available for sale 7,00,00,000 8,10,00,000
Deduct Ending Inventory (1,40,000*150 = 2,10,00,000) (1,50,000*30= 45,00,000)
COGS 4,90,00,000 7,65,00,000
Variable operating costs 30,000*350 = 1,05,00,000 30,000*520 = 1,56,00,000
Fixed operating costs 60,00,000 60,00,000
Operating Income 1,85,00,000 2,67,00,000

Marginal and Absorption Costing


Operating income difference
• Absorption costing operating income – Marginal
costing operating income = fixed manufacturing costs
in ending inventory – fixed manufacturing costs in
beginning inventory

• April:
 1,85,00,000 – 1,25,00,000 = (40,000*150)-0
 60,00,000 = 60,00,000

• May:
 2,67,00,000 – 3,12,00,000 = (50,000*30) – (40,000*150)
 -45,00,000 = -45,00,000

Marginal and Absorption Costing


How do changes in unit inventory cost
affect operating income

Marginal Costing Absorption Costing

Production = Sales Equal Equal


Production > Sales Lower Higher
Production < Sales Higher Lower

Marginal and Absorption Costing


Performance Issues and Absorption Costing
• Managers may seek to manipulate income by producing too many units

• Production beyond demand will increase the amount of inventory on hand

• This will result in more fixed costs being capitalized as inventory

• That will leave a smaller amount of fixed costs to be expensed during the
period

• Profit increases, and potentially so does a manger’s bonus

• REMEDY: base manager’s bonuses on profit calculated using Marginal Costing

Marginal and Absorption Costing


Other Issues
• Deciding to manufacture products that absorb the highest amount of fixed
costs, regardless of demand (“cherry-picking”)

• Accepting an order to increase production, even though another plant in


the same firm is better suited to handle that order

• Deferring maintenance

• REMEDIES
o Careful budgeting and inventory planning
o Incorporate an internal carrying charge for inventory
o Change (lengthen) the period used to evaluate performance
o Include nonfinancial as well as financial variables in the measures to evaluate
performance

Marginal and Absorption Costing


Extreme Variable Costing: Throughput
Costing
• Throughput costing (super-variable costing) is a method of
inventory costing in which only direct material costs are
included as inventory costs.

• All other product costs are treated as operating expenses

Marginal and Absorption Costing


Break even point
For Marginal costing: Break even point is unique
– Break even point (in units) = total fixed cost/contribution margin per
unit

– No. of units sold = (total fixed cost + target operating


income)/contribution margin per unit

For Absorption costing: Break even point is not unique


– No. of units sold =(total fixed cost + target operating income+ [fixed
manufacturing cost rate*(breakeven sales in units – units
produced)])/contribution margin per unit

– The term fixed manufacturing cost rate*(breakeven sales in units –


units produced) reduces the fixed costs that need to be recovered
when units produced are more than breakeven sales quantity
Marginal and Absorption Costing