Management Accounting

Session 4 & 5

Difference between absorption and marginal costing

Treatment for
fixed
manufacturing
overheads

Absorption costing

Marginal costing

Fixed manufacturing
overheads are treated as
product costing. It is
believed that products
cannot be produced without
the resources provided by
fixed manufacturing
overheads

Fixed manufacturing overhead

are treated as period costs. It is
believed that only the variable
costs are relevant to decisionmaking.
Fixed manufacturing overheads
will be incurred regardless there
is production or not

Value of closing High value of closing stock

stock
will be obtained as some
factory overheads are
included as product costs
and carried forward as
closing stock

Lower value of closing stock that

included the variable cost only

Relevant Costing
An avoidable cost is a cost that can be eliminated, in whole or in part,
by choosing one alternative over another. Avoidable costs are relevant
costs. Unavoidable costs are irrelevant costs.
Two broad categories of costs are never relevant in any decision.
They include:
Sunk costs.
Future costs that do not differ between the alternatives.
Costs that are relevant in one decision situation may not be relevant in another
context. Thus, in each decision situation, the manager must examine the data at
hand and isolate the relevant costs.
Relevant Cost Analysis: A Two-Step Process
Step-1:Eliminate costs and benefits that do not differ between alternatives.
Step-2:Use the remaining costs and benefits that differ between alternatives in making
the decision. The costs that remain are the differential, or avoidable, costs.

Standard Costing

Absorption Costing and

Marginal Costing
Few More Examples

Note:
Adjustment for Over or Under absorption of factory overheads
in absorption costing:
1. Income under absorption costing is to be adjusted upwards
for favorable capacity variance (over absorption is to be
adjusted upwards when the actual production exceeds the
normal capacity)
2. Income under absorption costing needs to be adjusted
downwards for unfavorable capacity variance ( under
absorption of factory overheads when the actual production
is less than the normal capacity.

Example
The Hind General Corporation Ltd. Produces a product,
which has the following costs:
Variable manufacturing costs
Fixed Manufacturing costs
The normal capacity is set at
Work in progress inventories

Rs. 4 per unit

2,00,000 per year
2,00,000 units
0

Last year, the company produced 2,00,000 units and sold

90 per cent at a price of Rs. 7 per unit.
In the current year the company produced 2,10,000 units
and 2,15,000 units at the same price.
Prepare income statement for both the years based on (a)
Absorption costing and (b). Variable costing.

Example
Hilton Ltd. had the following relevant information for years 1 and 2.
Rs.
Standard variable cost per unit

Sales price per unit

10

Fixed manufacturing over head (at normal capacity of 1,50,000 units)

3,00,000

Selling and administrative expenses

Fixed

1,30,000

Variable ( per cent of sales)

Production Volume

Units

Sales volume

Units

Year 1

1,70,000

Year 1

1,40,000

Year 2

1,40,000

Year 2

1,60,000

There was no inventory at the beginning of year 1. Income tax rate is

35 per cent.
Prepare the income statement under both Absorption costing and
Variable costing and show the reconciliation.

Example
Agarwal Industries Ltd. Has a standard variable manufacturing
costs of Rs. 8 per unit produced.
Fixed production costs are Rs. 1,10,000 per month (for standard
volume of 11,000 units per month)
Fixed selling and administrative expenses are Rs. 70,000 per
month.
Following data have been available for the months January, February
and March. In January there is no opening inventory.
January

February

March

Production (units)

12,000

10,000

11,000

Sales (units)

10,000

11,000

11,000

Selling Price

Rs. 30

Rs. 30

Rs. 30

Prepare the income statement under both Absorption costing and

Variable costing and show the reconciliation.

Kronecker Company, a growing mail order clothing and

accessory company, is concerned about its growing
marketing, distribution, selling and administration expenses. It
therefore examined its customer ordering patterns for the past
year and identified four different types of customers, as
illustrated in the following table. Kronecker sends catalogs
and flyers to all its customers several times a year. Orders are
taken by mail or over the phone by the toll free number.
Kronecker prides it self on the personal attention it provides
shoppers who order over the phone. All purchases are paid for
by check or credit card. It also maintains a very generous
return policy if customers are not satisfied with the product.
Customers must pay return shipping charges, but their
purchase price is then fully refunded.

Customer 1

Customer 2

Customer 3

Customer 4

Initial Sales

Rs. 1000

Rs. 1000

Rs. 2,500

Rs. 3,000

Number of items returned

24

Dollar value of items returned

Rs. 200

Rs. 500

Rs. 1,500

Number of orders per year

12

Number of phone orders per year

12

Time spent on phone placing

orders

0.25 hour

1 hour

Number of overnight delivery

12

Number of regular delivery

Prices are set so that cost of goods sold is on

average about 75% of the sales price.
Customers pay actual shipping charges, but
extra processing is required for overnight
delivery. The company has developed the
following activity cost driver rates for its
support costs.

Process mail orders

Process phone orders

80

Process returns

Process over night delivery request

What advice will you give to the company.

Maintain customer relations

50

Activity

Activity Cost Driver

Rate (Rs.)