Criticism of Marginal Costing
In recent years, there has been a huge interest in marginal costing. Still as a method of accounting for cost, very few have adopted the same. Main points of criticism are:
- For the determination of product cost & valuation of inventory, the disregard
of fixed cost is not proper.
- The use of recovering fixed cost through product pricing is disregarded by marginal
costing technique, which is not good for long term continuity of business. In the
long run, assets have to be recovered.
- Accepted accounting practice is not confirmed by excluding fixed cost from valuation
of inventory.
- In short-run profit planning & decision-making, marginal costing is especially
useful. But for far-reaching importance, rather than on variability on costs, one
will be interested in special purpose cost.
- Variability of costs establishment is not an easy task. In real life situations,
fixed costs are rarely completely fixed & variable costs are rarely completely
variable.
- For the valuation of inventory, the marginal cost does not get recognized by the income tax authorities.
Limitations of Absorption Costing:
- Highly arbitrary method of apportionment of overhead is employed by this method,
in practice. Thus for control purpose, the practical utility of cost data gets
reduced.
- Under absorption costing, for the purpose of decision making, the collection & presentation
of cost data is not very useful, because cost-volume-profit relationship gets obscured
by a reasonable share of fixed overhead through the process of assigning product
cost.
- Under absorption costing, to the next year, fixed cost relating to closing stock
is carried forward. Similarly, instead of previous year, to the current year, fixed
cost relating to opening stock is charged. Thus, in this method, all the fixed
cost that has been incurred is not charged against the revenue of the year in which
the same has been incurred, which is an unsound practice.
- Behavioral pattern of costs does not highlight under this method & thereby many situations get unnoticed in absorption costing which can be utilized under marginal costing.
Problem 2:
Profitability statement under Marginal Costing & Absorption costing
A company has a capacity to produce 200000 units of product B per annum. The normal capacity utilization estimated by the company for 2010-11 is 90%. The variable costs are $ 66 per unit & the fixed factory overheads were budgeted at $ 2160000 per annum. The variable selling overheads is $ 18 per unit & the fixed selling overheads were budgeted at $ 1512000. The operating data for 2010-11 are as under:
Production 160000 units Sales @ $ 120 per unit 150000 units Opening stock of finished goods 10000 units
To the extent of $ 240000 is revealed by the cost analysis as an excess spending of variable factory overheads. In respect of other items of cost, there are no variances.
(1) Determine the budgeted break-even point for 2010-11
(2) To achieve the budgeted profit, what increase in price would have been necessary?
(3) Present the profitability statement for 2010-11 using:
(a) Marginal Costing basis. (b) Absorption costing basis.
Solution: (1) Budgeted BEP $ $
Sale price 120 Variable cost 66 Variable selling overhead 18 84 Contribution per unit as per budget 36
Fixed cost = $2160000 + $1512000 = $3672000
Thus BEP as per budget = Fixed Overhead / Contribution per unit = 3672000/36 = 102000 units.
Note: Variable overhead expenditure variance is irrelevant to budgeted break-even point.
(2) Sales as per budget (180000 units @ $120) $ 21600000 Less: Variable cost as per budget (180000 units @ $84) 15120000 Contribution as per budget 6480000 Less: Fixed cost 3672000 Profit as per budget 2808000
(3) Statement of profitability for 2010-11 using Marginal Costing Method
Variable Production Overhead (160000 * $66) 10560000 Excess spending of Variable Production Overhead 240000 Total Variable Production Overhead 10800000 Less: Closing stock (10800000/160000) * 20000 1350000 9450000 Add: Opening Stock (10000 * 66) 660000 Variable Production Cost of goods sold 10110000 Selling & Distribution Overhead (150000*18) 2700000 Total Variable cost 12810000 Sales (150000 * 120) 18000000 Contribution 5190000
Less: Fixed Cost: Factory 2160000 S& D 1512000 3672000 Profit 1518000
Statement of profitability for 2010-11 using Absorption Costing Method
Production Cost $
Variable cost (160000 * $66) 10560000 Excess cost 240000 Fixed cost [160000 * (2160000/180000)] 1920000 Total Cost of Production 12720000 Less: Closing stock (12720000/160000) * 20000 1590000 11130000 Add: Opening Stock 10000 * [66+12 (Note 1)] 780000 Production Cost of goods sold 11910000
Selling & Distribution Overheads
Variable (150000* 18) 2700000 Fixed [150000 * (1512000 / 180000) 1260000 3960000 Total Cost of Sales 15870000 Sales (150000 * 120) 18000000 Profit 2130000
Notes: (1) Valuation of Opening Stock: = $2160000/180000 units = $ 12
Reconciliation:
Profit as per Absorption Costing 2130000
Less: Closing stock under-valuation 240000
(1590000-1350000) 1890000
Add: Opening stock overvalued in absorption costing 120000
(780000-660000) 2010000
Less: Selling & Distribution Overhead over-recovered in
Marginal
costing (1512000-1260000) 252000
1758000
Less: Production fixed cost less charged in Absorption costing
(2160000 -1920000) 80000
Profit as per Marginal costing 1518000
Problem 3:
Variable costing Vs. Absorption costing
Information relating to a company XYZ ltd for September & October, 2011 is:
September October
Unit data:
Opening Inventory 0 300
Production 1000 800
Sales 700 1040
Variable Cost data: $ $
Manufacturing cost
as per unit produced 20000 20000
Distribution
cost per unit sold 6000 6000
Fixed Cost data:
Manufacturing cost 8000000 8000000
Marketing cost 2400000 2400000
The selling price per unit is $ 48000.
Required: (i) For XYZ Company, present income statement in September & October 2011
under (a) variable costing & (b) absorption costing.
(ii) For September & October, explain the difference between (a) & (b).
Solution: (i) Income statement of XYZ under Variable costing
September October
(1)Sales (700 units * $48000) 33600000
(1040 units * $48000) 49920000
(2)Cost of goods sold
Opening stock (300 * 26000) - 7800000
Production (1000 * 26000) 26000000
(800
* 26000) 20800000
Less: Closing stock
(300
* 26000) 7800000
(60
* 26000) __ 18200000 1560000 27040000
(3) Contribution (1-2) 15400000 22880000
(4) Less: Fixed cost
Production cost 8000000 8000000
Marketing cost 2400000 2400000
(5) Profit 5000000 12480000
(ii) Income statement of XYZ under Absorption costing
September October
(1)Sales (700 units * $48000) (A) 33600000
(1040 units * $48000) 49920000
(2)Cost of goods sold
Opening stock (300 units * $ 28000) - 8400000
Manufacturing cost:
Variable (1000 unit * $ 20000) 20000000
(800
unit * $ 20000) 16000000
Fixed (1000 * $ 8000) 8000000
(800 * $ 10000) __ 8000000
28000000 32400000
Less: Closing Stock
(300 units * $ 28000) 8400000
(60 units * $ 30000) __ 1800000
19600000 30600000
Add: Variable Distribution cost
(700 units * 6000) 4200000
(1040 units * $
6000) 6240000
Fixed Marketing
cost 2400000 2400000
(B) 26200000 39240000
Profit (A-B) 7400000 10680000
(iii) Due to the difference in fixed manufacturing cost in opening & closing stock, the difference between operating income under variable costing & marginal costing arises.
September October
As per Marginal costing (A) 5000000 12480000 As per Absorption costing (B) 7400000 10680000 Excess / (Shortage) (B-A) 2400000 (1800000)
September 2011: Under variable costing method, to the profit & loss account, as a part of closing inventory, fixed manufacturing overhead @ $ 8000 per unit was not credited because valuation of inventory is done at variable cost only under variable costing. On the other hand, under absorption costing system, in fixed manufacturing overhead @ $ 8000 per unit, closing inventory is included. 300 units were in closing stock. Therefore, results of absorption costing showed profit in excess by $2400000 (300 units & $8000).
October 2011: In absorption costing only, fixed manufacturing cost of
opening stock is debited to profit & loss account (i.e. profit was reduced) (300
* $8000) $ 2400000
In absorption costing only, fixed manufacturing cost of closing stock is credited to
profit &
loss account (i.e. profit was increased) (60 units * $ 10000) $
600000
Excess debit to P/L account in Absorption costing $
1800000
Due to this reason, in comparison to profit shown by absorption costing, profit as
per marginal costing was in excess by $ 450000.
Problem 4:
For each area, Budgeted Profit & Loss account using absorption costing & marginal costing
An organization sells 3 products X, Y & Z in 2 areas which are designated as Area A & Area B. Following information are given below:
Data Product X Product Y Product Z
Selling price per unit $
120 $
144 $
180
Purchase price per unit 96 108 132
Sales in units:
Area A 276000 120000 84000
Area B 90000 120000 120000
Number of orders:
Area A 360000 180000 90000
Area B 54000 90000 72000
Volume in cubic meters per unit 6.0 4.50 3.00
Costs: Variable Fixed Basis of apportionments
$ ‘000 $ ‘000
Selling 1692 3384 No.
of orders
Warehousing 3888 5832 Volume
sold
Advertising 2430 4860 Units
sold
Administration 576 2304 Sales
value
(a)Using Absorption costing, prepare a budget showing profit or loss for each are & in total; and
(b) Using Marginal costing, prepare a budget for Area A only, & for each product & the total profit or loss for that are, show relevant information.
Solution: (a) Absorption Costing ($ in ‘000) Sales Area A Area B Total X 33120 10800 43920 Y 17280 17280 34560 Z 15120 21600 36720 65520 49680 115200
Less: Purchases
X 26496 8640 35136
Y 12960 12960 25920
Z 11088 50544 15840 37440 26928 87984
Gross Profit 14976 12240 27216
Less: Selling costs
(70:24) 3780 1296 5076
Warehousing
(272:160) 6120 3600 9720
Advertising
(160:110) 4320 2970 7290
Administration
(728:552) 1638 15858 1242 9108 2880 24966
Profit/ (Loss) (882) 3132 2250
Both fixed & variable costs are shown under total of selling costs, warehousing, advertising & administration. (b) Area A – Marginal costing Statement ($ in ‘000)
X Y Z Total
Sales 33120 17280 15120 65520
Less: Cost of sales 26496 12960 11088 50544
Gross Contribution 6624 4320 4032 14976
Less: Variable costs
Selling 720 360 180 1260
Warehousing 1656 540 252 2448
Advertising 828 360 252 1440
Administration 165.60 86.40 75.60 327.60
Net Contribution 3254.40 2973.60 3272.40 9500.40
Less: Fixed cost (15858-5475.6) 10382.40
Loss 882.00
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