# 1. To distinguish the difference between marginal and absorption costing;

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Topic A08: Marginal and Absorption Costing Topic Overview p.1

BAFS Learning and Teaching Example As at April 2009

### Duration 2 lessons (40 minutes per lesson)

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BAFS Learning and Teaching Example As at April 2009

### 15 minutes

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BAFS Learning and Teaching Example As at April 2009

### PPT #33-35 3 minutes

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BAFS Learning and Teaching Example As at April 2009

### PPT #38-45 12 minutes

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### 9 minutes

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### Rates

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BAFS Learning and Teaching Example As at April 2009

### = \$21,897

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BAFS Learning and Teaching Example As at April 2009

### that of Marginal Costing.

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### Delivery charges Range from a few dollars to hundreds, depends on location and delivery point

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Topic A08: Marginal and Absorption Costing Topic Overview p.10

BAFS Learning and Teaching Example As at April 2009

### *(\$1,500 + \$2,000) ÷ 500 = \$7

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BAFS Learning and Teaching Example As at April 2009

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### Net profit 5,006.25 2,965.00 6,026.87 13,998.12

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BAFS Learning and Teaching Example As at April 2009

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### should be adopted to provide more logical profit calculations.

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BAFS Learning and Teaching Example As at April 2009

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### Relationships between cost, price and volume are ignored since the focus is on total cost.

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### rarely completely variable and fixed cost are rarely completely fixed.

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BAFS Learning and Teaching Example As at April 2009

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BAFS Learning and Teaching Example As at April 2009

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## BAFS Elective Part

### Marginal and Absorption Costing

Technology Education Section Curriculum Development Institute

Education Bureau, HKSARG April 2009

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 – Marginal and Absorption Costing

Lesson 2 – Arguments for and against Marginal and Absorption Costing

2

2 Topic A08

Marginal and Absorption Costing

BAFS Elective Part Learning and Teaching Example

### Fixed Costs

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

• 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

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3 Topic A08

Marginal and Absorption Costing

BAFS Elective Part Learning and Teaching Example

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

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)

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4 Topic A08

Marginal and Absorption Costing

BAFS Elective Part Learning and Teaching Example

### Variable Costs

Total Variable Cost (\$)

Output (units)

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

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5 Topic A08

Marginal and Absorption Costing

BAFS Elective Part Learning and Teaching Example

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

Teacher asks students to give examples of variable costs in relation to their family’s monthly expenses.

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

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6 Topic A08

Marginal and Absorption Costing

BAFS Elective Part Learning and Teaching Example

### (Refer to Student Worksheet Page 1 to 3)

Teacher asks students to read the case and pay special attention on the questions raised by the owner, Pattie.

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7 Topic A08

Marginal and Absorption Costing

BAFS Elective Part Learning and Teaching Example

z

z

### Income Statement

The manufacturing account and income statement of the Pattie Company are given for information.

8 Topic A08

Marginal and Absorption Costing

BAFS Elective Part Learning and Teaching Example

z

z

### Are there any other ways to calculate the production cost?

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

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9 Topic A08

Marginal and Absorption Costing

BAFS Elective Part Learning and Teaching Example

### Manufacturing Account and Income Statement for the month ended 30 June Year 8.

Fixed Cost Variable Cost Production Cost

Non-Production Cost e.g. Direct

Materials

e.g. Direct Materials

Teacher asks students to identify the fixed, variable, production and non- production costs from the financial statements. Direct materials are used as an example to guide students fill in the table.

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.)

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10 Topic A08

Marginal and Absorption Costing

BAFS Elective Part Learning and Teaching Example

Fixed Cost Variable Cost Production Cost Non-Production Cost

Direct 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 Labour

Insurance 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

Sales Commission Sales Commission

Office Rent and Rates Office Rent and Rates

### Task 1 - Cost Classification (cont’d)

Teacher invites students to give the answers before showing the table.

Teacher then checks the answer with students.

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11 Topic A08

Marginal and Absorption Costing

BAFS Elective Part Learning and Teaching Example

### Task 2 - Cost Computation

Total Production Cost:

Unit Produced:

Unit Product Cost = Total Production Cost ÷ Unit Produced

=

=

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.

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12 Topic A08

Marginal and Absorption Costing

BAFS Elective Part Learning and Teaching Example

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)

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.

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13 Topic A08

Marginal and Absorption Costing

BAFS Elective Part Learning and Teaching Example

### Absorption Costing

Cost

Work in progress stock

(Indirect materials, indirect labour and indirect expenses) Direct costs

(Direct materials, direct labour and direct expenses)

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:

¾ 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.

¾ 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.

¾ 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.

¾ Non-production overheads are excluded from the stock valuation.

They are charged directly to the profit and loss account.

¾ The unsold stock will therefore contain a share of the production overheads incurred in the period.

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14 Topic A08

Marginal and Absorption Costing

BAFS Elective Part Learning and Teaching Example

### Cost Relationships

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.

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15 Topic A08

Marginal and Absorption Costing

BAFS Elective Part Learning and Teaching Example

### Marginal Costing

Cost

Finished goods stock Work in progress stock

(Indirect materials, indirect labour and indirect expenses) Direct costs*

(Direct materials, direct labour and direct expenses)

* 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.

16 Topic A08

Marginal and Absorption Costing

BAFS Elective Part Learning and Teaching Example

z

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### Refer to student worksheet p.5-6

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

= \$(30,600 + 20,800 + 5,000) + 1,800

= \$58,200

Closing Stock Value (44 units)

= \$58,200 ÷ 2,540 x 44

= \$1,008

Variable Non-production Cost

= \$(195 + 445)

= \$640

Fixed Production Cost

= \$(9,000 + 500 + 7,000 + 600 + 900)

= \$18,000

Fixed Non-production Cost

= \$(750 + 250 + 159 + 12,643 + 190 + 7,905)

= \$21,897

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17 Topic A08

Marginal and Absorption Costing

BAFS Elective Part Learning and Teaching Example

### 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

59,454

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

133,029

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

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 Î profit total contribution < fixed cost Î loss

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18 Topic A08

Marginal and Absorption Costing

BAFS Elective Part Learning and Teaching Example

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

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.

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19 Topic A08

Marginal and Absorption Costing

BAFS Elective Part Learning and Teaching Example

### Task 3 – Income Statement (cont’d)

Absorption Costing Marginal Costing

Differences in the 2 costing systems

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

(b) If closing stockÇ, 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 stockÇ, 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)

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20 Topic A08

Marginal and Absorption Costing

BAFS Elective Part Learning and Teaching Example

z

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### Read the case carefully, discuss and complete Task 1 of Activity 2

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 heat- transfer print T-shirt on Yahoo and complete task 1.

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21 Topic A08

Marginal and Absorption Costing

BAFS Elective Part Learning and Teaching Example

### 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.

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.

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22 Topic A08

Marginal and Absorption Costing

BAFS Elective Part Learning and Teaching Example

### 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 concludes students’ suggestions and gives some examples for the fixed and variable costs that would be incurred setting up a cyber-firm.

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23 Topic A08

Marginal and Absorption Costing

BAFS Elective Part Learning and Teaching Example

### Task 2 - Cost Estimation

Estimate 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:

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 40 - 50 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.)

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24 Topic A08

Marginal and Absorption Costing

BAFS Elective Part Learning and Teaching Example

### 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

machines

\$1,500/ month

T-shirt purchase cost \$15/piece

Transfer paper \$4/sheet

Printing charges \$3/sheet

Packaging tools & materials \$2,000/ month

Stationery expenses \$300/month

\$1,000/month

Transaction fee charged by Yahoo 1.5% on sales

Delivery charges 1% on sales

Students are required to look at each cost item, then classify it into either:

(a) Fixed or variable cost; and

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25 Topic A08

Marginal and Absorption Costing

BAFS Elective Part Learning and Teaching Example

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

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 Cost

\$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

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?

• Under what costing method is cost separated into production and non-production? (answer: absorption costing)

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26 Topic A08

Marginal and Absorption Costing

BAFS Elective Part Learning and Teaching Example

### 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

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

¾ 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.)

¾ 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

¾ 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.)

¾ 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.)

¾ How to treat a cost which is for both factory use and office use? (Apportionment must be made.)

¾ How to determine the basis for apportionment (It depends on the cost driver and there is opportunity for arbitrary assumption.)

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27 Topic A08

Marginal and Absorption Costing

BAFS Elective Part Learning and Teaching Example

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

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

Unit product cost \$29

*(\$1,500+\$2,000) ÷500=\$7

The major difference between the 2 costing methods is the treatment of fixed production overheads of \$7*.

Under marginal costing, only variable production costs (i.e. T-shirt purchase cost, transfer paper cost and printing charges) are considered as product cost. Non- production 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).

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28 Topic A08

Marginal and Absorption Costing

BAFS Elective Part Learning and Teaching Example

### 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)

Teacher asks students to prepare profit statements for the first three months of operation using marginal costing and absorption costing methods.

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29 Topic A08

Marginal and Absorption Costing

BAFS Elective Part Learning and Teaching Example

### Task 4 - Profit Computation (cont’d)

Teacher checks the answer with students.

Workings:

Selling price (50% mark up) = \$29 x (1+50%) = \$43.5 Sales :

1stmonth \$43.5 x 500 units = \$21,750 2ndmonth \$43.5 x 400 units = \$17,400 3rdmonth \$43.5 x 550 units = \$23,925 Opening stock

1stmonth nil 2ndmonth nil

3rdmonth \$29 x 100 units = \$2,900

Production costs for 1st/2nd/3rdmonth: \$29 x 500 units = \$14,500 Closing stock

1stmonth nil

2ndmonth \$29 x 100 units = \$2,900

3rdmonth \$29 x 50 units = \$1,450

Fixed non-production cost: \$400 (service fee to Yahoo) + \$300 (stationery) +

Variable non-production cost: (1.5% transaction fee + 1% delivery charge) x Sales

1stmonth 2.5% x \$21,750 = \$543.75

2ndmonth 2.5% x \$17,400 = \$435

3rdmonth 2.5% x \$23,925 = \$598.13

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30 Topic A08

Marginal and Absorption Costing

BAFS Elective Part Learning and Teaching Example

### Task 4 - Profit Computation (cont’d)

Teacher checks the answers with students.

Workings:

Sales: (using same selling price as calculated under absorption Costing ) 1stmonth \$43.5 x 500 units = \$21,750 2ndmonth \$43.5 x 400 units = \$17,400 3rdmonth \$43.5 x 550 units = \$23,925 Opening stock

1stmonth nil 2ndmonth nil

3rdmonth \$22 x 100 units = \$2,200

Variable Production costs for 1st/2nd/3rdmonth: \$22 x 500 units = \$11,000 Closing stock

1stmonth nil

2ndmonth \$22 x 100 units = \$2,200

3rdmonth \$22 x 50 units = \$1,100

Variable non-production cost: (1.5% transaction fee + 1% delivery charge) x Sales

1stmonth 2.5% x \$21,750 = \$543.75

2ndmonth 2.5% x \$17,400 = \$435

3rdmonth 2.5% x \$23,925 = \$598.13

Fixed production cost: \$1,500 (hire charges) + \$2,000 (packaging)

Fixed non-production cost : \$400 (service fee to Yahoo) + \$300 (stationery) +

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31 Topic A08

Marginal and Absorption Costing

BAFS Elective Part Learning and Teaching Example

### difference in net profits for the 2nd and 3rd month of sales.

Profit earned

Absorption costing 2nd month \$3,665 3rd month \$5,676.87 Marginal costing 2nd month \$2,965 3rd month \$6,026.87

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.

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32 Topic A08

Marginal and Absorption Costing

BAFS Elective Part Learning and Teaching Example

### As more T-shirts will be sold in summer, which costing method should be adopted?

Teacher invites volunteers to give their opinions on this question.

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.

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33 Topic A08

Marginal and Absorption Costing

BAFS Elective Part Learning and Teaching Example

### Summary for lesson 1

Major Differencesin 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)

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.

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.

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34 Topic A08

Marginal and Absorption Costing

BAFS Elective Part Learning and Teaching Example

### Summary for lesson 1

Major Differences

Major Differencesin 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

Teacher concludes the lesson and highlights the difference between marginal and absorption costing.

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)

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## References

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