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Marginal costing
Marginal costing is a costing method that uses only variable costs to calculate the costs of
production and excludes the fixed production overhead costs in the calculation of cost of
production i.e. it uses only the direct costs (which are also called variable costs, prime costs or
relevant costs) to calculate the cost of production.
The marginal costing method is based on the following fundamental principles: Cost of production only includes all variable costs i.e. all costs that can be traced directly to the production units, because without those costs production is not possible and hence, those costs are very important to the goods produced. Fixed overhead costs (also known as production overhead costs) are costs that must be incurred with or without production activities, and are excluded when calculating the cost of production because the overhead cost do not affect the production decision on goods to be produced, especially in the short run. Under marginal costing, the fixed production overhead costs are written off in full as an overhead period expense, when preparing the profit or loss statement to derive the profit or loss at the end of the period. See preparation of profit or loss statement later The key element in marginal costing is the assertive treatment and clear distinction between variable and fixed production overhead costs. Under the marginal costing method, unit cost of production is calculated as below:
Marginal unit cost of production
Direct material Direct labour Direct expenses i.e. any other variable cost
£ xx xx Marginal cost of production is also xx called^ variable cost^ of production, and also known as Prime cost (i.e. total variable cost of production) xx^
contributory method
The marginal costing method is always used in the decision-making process such as make or buy decisions, deciding on number of goods to produce in the presence of a limiting factor and to derive minimum contract price. (See chapter 5 later)
3.1 Illustrative Q
Azeez plc wishes to estimate the unit cost of a proposed new product based on the following information
- Estimated costs
Direct material 3.5 kg per unit at £4.00 per kg
Direct labour 0.45 hour per unit at £9.00 per hour
Other direct expenses £1.5 per unit
- Fixed production overhead costs are budgeted at £80,000 for the next period with a budgeted activity level of 7,500 direct labour hours.
Required:
Calculate the unit cost of the proposed new product using a marginal costing approach.
3.1b ACCA CAT Paper B2 Cost Accounting Systems J
A company uses marginal costing. In valuing stocks of finished goods which of the following would NOT be included in the valuation? A. Machine operator’s wages B. Factory rent C. Royalty fees per unit D. Raw materials
Benefits of marginal costing method (advantages)
Helps in product decision making process: Marginal costing is useful in the short-term decision-making on product, such as product mix decision, discontinued decision etc. All these areas of decision are always based on analysis of costs that directly affect the production of goods. Useful in the calculation of the minimum price: It is very useful in calculating relevant costs of a product when deriving minimum price charged for a product, as the calculation of the minimum price is always based on the analysis of all direct costs of production Usefulness in other areas of study: marginal costing method is useful in other areas of study such as cost-volume-profit analysis (popularly known as CVP analysis). The analysis makes use of contribution to calculate the breakeven sales i.e. a level of activity where there is neither profit nor loss. In the analysis, contribution is calculated as “selling price less variable costs” hence, knowledge of marginal costing will be of help in gathering the variable costs elements. Meeting profit target: marginal costing method is also useful when using CVP analysis to calculate the volume of sales required to meet a target profit
Criticisms of marginal costing (disadvantages)
Planning and controlling of cost problem: Marginal costing places too much emphasis on direct costs and pays cursory attention to the fixed production overhead costs which may not be of help to the managers in planning and controlling of fixed production overhead costs from the beginning of the production process. In reality, all costs must be planned and
controlled. (^) Problem of application in an automated production environment: marginal costing
method is not appropriate in an automated production system where fixed production overhead costs are far higher than the direct costs. Since the method does not consider the fixed production overhead cost at the beginning, when gathering the costs of production, important costs may be considered too late. (^) Confusion on treatment of overhead cost: The management team may be under the
illusion that the marginal costing method completely ignores fixed production overhead costs, which may lead to confusion and argument later when calculating the profit or loss at the end of the period.
Price quotation problem: the marginal costing method may not be suitable for price quotation of jobs or contracts that involve huge overhead cost, since the overhead costs are ignored at the early stage of the calculation of the total costs
(^) Conflict with the reporting standard International Accounting Standard 2 (IAS 2):
The accounting standard on inventory requires companies to include elements of fixed production overhead costs in the valuation of inventories and the marginal costing method does not include the fixed production overhead cost in the calculation of unit cost of production used in valuing inventories. Hence, inventories valued at marginal unit cost of production will be inconsistent with the International Accounting Standard 2.
Determinant of budgeted level of activities
The absorption costing method uses an arbitrary method to determine the budgeted level of
activities based on the types of production activities in place, if the company uses more labour
hours compared to machine hours, the total budgeted labour hours is used as budgeted level
of activities when calculating the overhead absorption rate and vice versa, an organisation can
also decide to use a volume-related measure such as production units Exam: the question will
always indicate the level of activities
It should be noted that the absorption rate is calculated based on the budgeted information, comparing the overhead cost absorbed with the actual cost incurred will result in under/over absorption of overhead, which must be adjusted for when preparing income statement to calculate the final profit or loss figure.
Calculation of absorption unit cost of production (Proforma)
Absorption unit cost of production (^) Absorption unit cost of production £ Direct material xx is also called^ “full or total”^ unit Direct labour xx cost of production Direct expenses i.e. variable overhead xx Prime cost xx = overhead absorption rate per machine Production overhead absorbed at (^) xx^ hour^ x^ number of machine hour Or^ per unit overhead absorption rate (^) = overhead absorption rate per labour hour Total (full) cost of production xx x number of labour hour per unit Or = overhead absorption rate per any other measure x specified level of activity per unit (e.g. overhead can be absorbed by production unit) Overhead absorption rate is calculated as follows:
This is the budgeted total production overhead cost or fixed production cost
Overhead
Budgeted production overhead =
xxx = £xx absorption rate Budgeted level of activities xx
This is the total budgeted machine hours or labour hours depending on the type of the organisation’s production operation, labour or machine intensive. Two main points to understand in applying absorption rate correctly in any given units can also be used if the organisation uses production units to absorb The total production
fixed production situation overhead cost
- Calculation of the overhead absorption rate using the previous page formula: this should be straight forward.
It is calculated and called overhead absorption rate (OAR) per level of activities i.e. overhead absorption rate per machine hour or per labour hour or per production unit, depending on the denominator used in the calculation
- Calculation of the production overhead cost per unit i.e. amount absorbed or included in the calculation of the total production cost The overhead absorption rate (OAR) calculated is not inserted straight into the calculation of the total production cost, instead it is multiplied by either machine hours per unit or labour hours per unit , or simply multiplied by one unit, depending on the denominator used in the calculation of the overhead absorption rate
Hence, students should know how to calculate the overhead absorption rate and be able to derive the number of machine hours and number of labour hours per unit, in order to calculate
the production overhead cost absorbed, the above points can be summarised as follows:
Fixed production overhead cost =
Overhead absorption rate calculated x level of activities per unit (e.g. labour hours per unit, machine hour per unit etc.)
Warning
The production overhead costs are often absorbed based on machine or labour hours’, however, they can also be absorbed by other measures of level of activities such as production units.
In a situation where the production overhead costs are absorbed based on production units, the overhead absorption rate (OAR) calculated will simply be multiplied by 1.
This is the case when the overhead absorption rate calculated is inserted in the calculation of the total cost of production. Student often expect to derive labour hours per unit or machine hours per unit, but if the question does not give such information, such question must have indicated that the absorption of overhead cost be based on production unit.
Great attention to detail is always required in all situations
Calculation of absorption production cost per unit steps
1. Identify the total budgeted overhead cost: the overhead costs are added together if
given separately.
- Identify the total budgeted level of activities: this is the total budgeted machine hours or total budgeted labour hours depending on whether the company’s production operation is more of labour or more of machine intensive operations.
^ ^ Other levels of activities may be used, read the question carefully. The question will always give an indication of the level of activity to absorb fixed
production overhead costs See previous page on how to calculate total hours if it is not given directly.
- Calculate the overhead absorption rate as follows:
As identified in step 1 above
Overhead Budgeted^ production overhead^ (£) =
£xxx =^ = £ xx absorption rate Budgeted level of activities xx
As identified in step 2 above
- Calculate fixed production overhead cost per unit as follows:
= overhead absorption rate per machine hour x number of machine hours per unit Or = overhead absorption rate per labour hour x number of labour hours per unit Or = overhead absorption rate per any other measure x specified level of activity per unit
- Calculate the absorption total unit cost as follows:
Absorption unit cost of production £ Direct material xx Direct labour xx Direct expenses i.e. variable overhead xx Prime cost xx (^) = as calculated in Production overhead cost per unit xx step 4 above Total (full) cost of production xx
3.2 ACCA Q Pilot Paper 2007
Triple Limited makes three types of gold watch – the Diva (D), the Classic (C) and the Poser (P). A traditional product costing system is used at present; although an activity based costing (ABC)
system is being considered. Details of the three products for a typical period are:
Hours per unit Labour hours Machine hours Product D ½ 1 ½ Product C 1 ½ 1 Product P 1 3
Materials Cost Production per unit (£) Units
20 750 12 1, 25 7,
Direct labour costs is £6 per hour and production overheads are absorbed on a machine hour basis. Total production overheads are £654,
Required:
Calculate the cost per unit for each product using: A. Marginal costing method B. Absorption costing method, absorbing overheads on the basis of machine hours
Workings
1. Calculation of labour cost per unit
Labour cost per unit = hourly rate x labour hour per unit
Hourly Labour hours cost perLabour rate (^) per unit unit (£)
Product D = £6 x ½ = 3 Product C = £6 x 1½ = (^) 9 Product P = £6 x 1 = 6
2. Calculation of overhead cost per unit based on machine hours
Total number of machine hours = ∑ (machine hours per unit x units produced)
= (1½ x 750) + (1 x 1,250) + 3 x 7,000) = 23,375 machine hours
Overhead absorption (^) =^ Budgeted production overhead^ = 654,500^ = £28 per rate (OAR) Budgeted level of activities^ 23,375^ machine hour
Overhead cost absorbed per unit = Overhead absorption rate x machine hours per unit
Overhead Machine Overhead absorption hours cost per rate per unit unit Product D = £28 x 1½ = £ Product C = £28 x 1 = (^) £ Product P = £28 x 3 = (^) £
3.3 Model solution
Product A^ B^ C Cost per thousand metres £ Direct materials 120 Direct labour 42 Prime cost 162
- Overhead cost (see below) 240 Total cost 402
Workings
Overhead
Budgeted total overhead cost absorption rate Budgeted total machine hours
Overhead
absorption rate 1,
= £40 per machine hour
Budgeted overhead cost per thousand =
Machine hours per thousand x overhead absorption rate Product A: 6 hours x £40 = £ Product B: 6 hours x £40 = £ Product C: 4 hours x £40 = 160
3.4: Model solution
A. Calculation of absorption rate
Cost centre T: Budgeted production overhead =
780,000 (^) = £48 per Overhead = absorption rate^ Budgeted level of activities^ 16,250^ machine hour
Cost centre W: Budgeted production overhead =
173,400 (^) = £12 per Overhead = absorption rate Budgeted level of activities 14,450 labour hour
B. Total production cost for one unit of product PP £ Direct material 10 Direct labour: Cost centre T 14 Cost centre W 21 Prime cost 45 Production overhead cost (see below) Cost centre T 28 Cost centre W 42 Total full cost of production 115 Workings
Production overhead cost per unit
Cost centre T is a machine intensive operation: the production overhead cost per unit will be calculated as follow:
Cost centre T: Overhead cost = 35 x £48 = £28 per unit per unit^60
Cost centre W is a labour-intensive operation: The production overhead cost will be calculated as follows: Cost centre W:^21 Overhead cost = x £12 = £42 per unit per unit 6
Advantages of absorption costing method
Planning and controlling of production cost: the use of budgeted cost information helps the management to plan and control production cost, using current information may not be appropriate due to the fluctuating pattern or nature of some overhead costs i.e. overhead costs may be very high in some months and relatively low in other months, using current information may result in fluctuating product costs and would make planning difficult.
It enhances performance measurement: the use of budgeted information to calculate the overhead absorption rate makes the comparison of the budgeted and the actual information possible, which is used to measure the performance of the production department.
Useful in price quotation: Absorption costing method is more useful in price quotation as it covers all the production costs, and the use of budgeted information based on organisation’s experience will enhance the accuracy of the price quotation.
Conformity with accounting standard: the accounting reporting standard allows the inclusion of the fixed production overhead costs in the valuation of inventories; hence, the use of the absorption costing method will be of help in the preparation of financial statements.
Criticisms of absorption costing (disadvantages)
(^) Subjectivity and judgemental problems: the level of activities used in absorbing the
production overhead costs is based on a judgemental selection between levels of activities involved in the production process. This may be exposed to manipulation by the managers especially when there is no clear cut between the usages of the levels of activities involved. Problems of application in an automated production environment: It may not be appropriate in an automated production environment to absorb fixed production costs based on either machine or labour hours, because in most situations, the machine and labour hours are based on direct costs, and in an automated production environment, direct costs may be negligible compare to the production overhead cost. (^) Not suitable for product decision making process: It is not useful in the decision-making
process because the decision making process is predominantly based on relevant costing principles which will only include directly traceable costs in making decisions i.e. variable costs. Production overhead costs are not directly traceable to units produced i.e. largely, production overhead costs are costs that will be incurred with or without production activities and hence are not relevant.
