Absorption and marginal costing Learning objectives

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Absorption and marginal costing

chapter

36

Learning objectives

After you have studied this chapter, you should be able to:

l explain why the costs relevant for decision making are often different from thoseused for the calculation of net profit

l explain the difference between fixed, variable, semi-variable, and step-variablecosts

l explain the difference between absorption and marginal costing

l discuss various factors underlying the pricing policy adopted by an organisation

l explain why marginal costing, not absorption costing, should be used whendeciding how to utilise spare capacity through additional production

l explain what is meant by ‘full cost pricing’

l explain the importance of contribution to pricing, production, and sellingdecisions

l explain what is meant by activity-based costing (ABC)

l discuss the advantages and limitations of ABC

Introduction

In this chapter, you’ll learn more about the nature of different types of costs, includingfixed, variable and semi-variable costs. You will also learn how to arrive at a costper unit that can then be used to set an appropriate selling price for a good or ser-vice. Two contrasting approaches – absorption (or ‘full’) costing and marginal cost-ing – are reviewed; and the concept of contribution is introduced and its importancein pricing and production decisions is explored. Finally, you will learn about anotherapproach to cost attribution: activity-based costing.

36.1 Allocation of indirect manufacturing costs

As you learnt in the previous chapter, all indirect manufacturing costs are allocated to the prod-ucts manufactured. Indirect manufacturing costs, therefore, add to the value of work in progressand, so, to the value of finished goods stock. After apportioning all indirect manufacturing coststo the products produced, the production cost of any item comprises direct materials, directlabour, any direct expenses, plus a share of indirect manufacturing costs.

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Exhibit 36.1

Donald Ltd’s factory has been making 100,000 units annually of a particular product for the pastfew years. Last year, costs were:

£ Direct labour 200,000Direct materials 300,000Indirect manufacturing costs 400,000Production cost 900,000Administration and other expenses 150,000

1,050,000

The 100,000 units were sold for £12 each = £1,200,000

The production cost per unit can be seen to be = £9

The current year is following exactly the same pattern of production and costs. Suddenly, part-waythrough the year, a foreign buyer sends a request for 20,000 units if the price per unit can be cutfrom £12 to £8. A meeting is held and the managing director says, ‘What a pity. This could havebeen our first export order, something we have been waiting to happen for several years. The sell-ing price overseas has no bearing on our selling price at home. But it costs us £9 to produce a unit,so we would lose £1 per unit if we accepted this order. We just cannot afford to lose money inorder to achieve some export sales. Our shareholders would not tolerate the annual profit of thecompany falling below £150,000.’

‘I think you’re wrong,’ says John, the accountant. ‘Let’s look at this year’s results (a) if we do notaccept the order and (b) if the order is accepted’:

£900,000100,000

36.2

After a financial period has ended, it is possible to look back and accurately calculate the indir-ect costs. It is this figure that is used when calculating the valuation of closing stock. Consider acompany which had produced 1,000 units, of which 200 units have not yet been sold, at a totalproduction cost of £100,000. The closing stock valuation becomes:

× Production cost of goods completed = × £100,000

= £20,000 closing stock valuation

The method we have just used above, which includes allocating all indirect manufacturingcosts to products, is known as ‘absorption costing’, sometimes called ‘full costing’. While youproceed through the rest of this chapter, try to decide for yourself whether or not it wouldalways be appropriate to use absorption costing in order to determine the cost of something pro-duced (a good) or provided (a service).

Absorption costing: effect upon future action

Let’s consider a decision you may have to make concerning a future action. Exhibit 36.1 concernsa decision about whether or not to take on an extra order, something that arises from time totime in all forms of business.

2001,000

Unsold unitsTotal units produced

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(a) Order not taken (b) Order taken£ £ £ £

Sales 100,000 × £12 1,200,000100,000 × £12 + 20,000 × £8 1,360,000

Less Expenses:Direct labour 200,000 240,000Direct materials 300,000 360,000Indirect manufacturing costs 400,000 420,000Other expenses 150,000 150,000

(1,050,000) (1,170,000)Net profit 150,000 190,000

‘More profit. This means that we take the order,’ says the sales director enthusiastically.‘Surely you’ve got your figures wrong, John,’ says the managing director. ‘Check your arithmetic.’‘There’s nothing wrong with my arithmetic,’ says John; ‘all I’ve done is to illustrate the benefits

of using a different approach to product costing in these circumstances compared to the one weuse when valuing our stock. It is known as ‘marginal costing’. Perhaps it will be a little clearer if Iadd some more details:

(a) Order not taken (b) Order takenSales £ £ £ £

1,200,000 1,360,000

200,000 240,000

300,000 360,000

100,000 120,000(600,000) (720,000)

600,000 640,000

300,000 300,000150,000 150,000

(450,000) (450,000)150,000 190,000

‘We can do all this without borrowing any money,’ says the managing director, ‘so I’ll phone nowto tell them we will start production immediately. By the way, John, come to my office this after-noon and tell me more about variable and fixed costs.’

Less Costs which vary with production: Direct labour. The workers are on piece-work (i.e.they are paid according to how much they produce.In this case, this means 20 per cent more produc-tion brings 20 per cent more wages (i.e. £200,000for 100,000 units; £240,000 for 120,000 units)Direct materials. 20 per cent greater productiongives 20 per cent more materials (£300,000 +£60,000)Indirect manufacturing costs: Some would notchange at all, e.g. factory rent, factory rates. Somewould alter, e.g. cost of electric power becausemachines are used more. Of the indirect manu-facturing costs, one-quarter is variable. For thisvariable part, £100,000 costs for 100,000 unitsbecomes £120,000 costs for 120,000 units.

Marginal costSales Less Variable costs

Fixed costs (i.e. costs which will not alter at all if20,000 more units are produced):Indirect manufacturing costs; fixed partAdministration and other expenses

Net profit

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Exhibit 36.2

36.3

36.4

36.5

The lesson to be learnt

We must not get lost in the technicalities of accounting. It is easy to think that calculations whichlook complicated must give the right answer. Logic must be brought to bear on such problems.This last example shows that the costs needed when making decisions about the future will oftenbe different from those which were used for calculating profit earned in the past. In the example,£9 per unit had been used for stock valuation, but this example demonstrates how an organisa-tion can manufacture units and sell them for less than their cost, as calculated using absorptioncosting, and still increase its profit. The reason for this is the very essence of the differencesbetween fixed and variable costs which we will now consider.

Fixed and variable costs

The division of costs into those that are fixed and those that are variable is not always straight-forward. Even something often assured to be a fixed cost, such as factory rent, is not always‘fixed’. For example, if production had to be increased above a certain figure, the business mighthave to rent additional premises. Such a change would not usually happen in the short term: itwould take a while to rent and set up a new factory or extra premises before production couldstart. When fixed costs are mentioned it is normally assumed that this means costs which arefixed in the short term.

In the Donald Ltd example, it was assumed that variable costs were 100 per cent variable.That is, if production rose 20 per cent then the cost would rise 20 per cent; if the production rose47 per cent then the cost would also rise 47 per cent. This is not necessarily true. The cost ofpower may rise 20 per cent if production rose 20 per cent, but the cost of repairing and main-taining the machines may rise by only 10 per cent if production rose 20 per cent. In this case, themachine maintenance would be a ‘semi-variable cost’, this being the term for a cost which varieswith changes in the level of production, but not at the same rate as the changes in the level ofproduction.

Cost behaviour

Appropriate cost planning and control is dependent on possessing sound knowledge of how indi-vidual costs behave under certain conditions. In particular, how costs behave in the organisation

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36.6

in question. There is no substitute for experience when it comes to understanding cost behaviour.As a result, accountants often require the assistance of specialists in other aspects of the businesswhen endeavouring to understand the nature of cost behaviour.

Raw materials are an example of a variable cost which normally varies in total in strict pro-portion to the units manufactured. Labour costs, on the other hand, usually move in steps, thusthe term ‘step-variable’ cost. For instance, a job may be done by two people, and then a slightincrease in production activity means that the two people cannot manage it so that a third per-son is added. In fact, the increase in production activity may only represent 21/3 people’s work,but the acquisition of workers comes in indivisible chunks. There can still be a further increase inactivity without any more workers, but then the time will come when a fourth person is needed.This is illustrated in the two graphs in Exhibit 36.2.

Marginal costing and absorption costing contrasted

Where costing is used which takes account of the variable cost of products rather than the fullproduction cost, this is known as ‘marginal costing’. We have seen that a marginal costingapproach to the decision whether or not to accept the foreign order by Donald Ltd gave ananswer which increased the firm’s profitability, whereas blindly using absorption costing of £9 aunit would have meant the order being rejected and the opportunity presented to increase profitsand break into the foreign market being lost.

Let’s look now at what would happen to gross profit if we used either marginal costing orabsorption costing for a whole organisation.

Exhibit 36.3

The calculations of the annual gross profit of Burke Ltd are shown drafted as if (A) marginal costinghad been used, and (B) absorption costing had been used. The following information is available:

1 Fixed manufacturing costs amounted to £400,000 per annum.2 Variable overheads amounted to £2 per unit.3 Direct labour and direct materials total £3 per unit.4 Sales remain constant at 100,000 units per annum at £13 per unit.5 Production in year 1 is 120,000 units, year 2 is 150,000 units and year 3 is 90,000 units.

Year 1 (A) Marginal costing (B) Absorption costing£ £ £ £

Sales 1,300,000 1,300,000Less Variable costs:

Direct labour and material: 120,000 × £3 360,000 360,000Variable overheads: 120,000 × £2 240,000 240,000

Total variable cost 600,000Less in (A) Valuation of closing stock

× £600,000 (100,000)*

Marginal cost of goods sold 500,000Fixed manufacturing costs 400,000 400,000

(900,000)Total production costs 1,000,000Less in (B) Valuation of closing stock

× £1,000,000 ( 166,667)*

(833,333)Gross profit 400,000 466,667

20,000120,000

20,000120,000

‘

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*Note:The closing stock each year for (A) is made up of:

× Total variable cost of that year

Units produced year 1 120,000 − 100,000 = Closing stock 20,000 unitsUnits produced year 2 150,000 + 20,000 opening stock – sales 100,000 = Closing stock 70,000 unitsUnits produced year 3 90,000 + 70,000 opening stock – sales 100,000 = Closing stock 60,000 units

Unsold unitsNumber of units produced in year



Direct labour and material 150,000 × £3 450,000 450,000Variable overheads, 150,000 × £2 300,000 300,000

Total variable cost 750,000Add in (A) Opening stock b/d 100,000

850,000Less in (A) Closing stock

× £750,000 (350,000)*


( 900,000)Total production costs 1,150,000Add opening stock in (B) b/d 166,667

1,316,667Less Closing stock in (B)

× £1,150,000 ( 536,667)*

( 780,000)Gross profit 400,000 520,000



Direct labour and material, 90,000 × £3 270,000 270,000Variable overheads, 90,000 × £2 180,000 180,000

Total variable cost 450,000Add in (A) Opening stock b/d 350,000

800,000

Less in (A) Closing stock × £450,000 (300,000)*


( 900,000)850,000

Add in (B) Opening stock b/d 536,6671,386,667

Less in (B) Closing stock × 850,000 566,667*( 820,000)

Gross profit 400,000 480,000

60,00090,000

60,00090,000

70,000150,000

70,000150,000

‘

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So in year 1 unsold units are 20,000 units; units produced 120,000; total variable cost is £600,000;therefore stock valuation is:

× £600,000 = £100,000

and the cost per unit is £5.The closing stock each year for (B) is made up of:

× Total production cost of that year

So in year 1 stock valuation becomes × £1,000,000 = £166,667 and the cost per unit is £8.33.

Exhibit 36.4 shows in diagrammatic form the reported gross profits shown in Exhibit 36.3.

20,000120,000

Unsold unitsNumber of units produced in year

20,000120,000

Exhibit 36.4

36.7

You can see from the note that if ‘cost’ is used to set selling prices, under absorption costing,selling prices would be much higher than under marginal costing.

Comparison of reported profits – constant sales and uneven production

Exhibits 36.3 and 36.4 have illustrated that Burke Ltd, a business which had the same volume ofsales each year at the same prices, and the same variable cost per unit, shows quite different grossprofit figures using marginal costing compared with the gross profits under absorption costing.As these were the gross profits that were calculated let us assume that the selling, distribution,administration and finance expenses were £100,000 for each of these years. The net profitswould therefore be as follows:

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Activity36.1

36.8

(A) Marginal costing (B) Absorption costing£ £

Year 1 300,000 366,667Year 2 300,000 420,000Year 3 300,000 380,000

Under absorption costing, Year 2 shows the biggest profit. As sales etc. are the same, only pro-duction being different, this means that the year which has the greatest closing stock has shownthe greatest profit. Because of greater production, the amount of fixed factory manufactury costper unit is less. For instance, in Year 1 with 120,000 units produced and £400,000 fixed manu-facturing costs this means fixed manufacturing costs in Year 1 are £3.33 per unit:

= £3.33 per unit; Year 2 = £2.67 per unit; Year 3 = £4.44

Under absorption costing, the value of closing stock includes the fixed indirect manufacturingcosts and less gets charged per unit for fixed indirect manufacturing costs when productionincreases, and vice versa. Also, as shown in Exhibits 36.3 and 36.4, a greater gross profit isshown under absorption costing than under marginal costing.

Of course, the situation gets more complicated because the closing stock of one year is theopening stock of the next year and, under absorption costing, the value of each unit of stock willvary from one year to the next. For example, in Year 3, the opening stock of 70,000 units isshown as £536,667 = £7.67 per unit; the value of the closing stock of 60,000 units is shown as£566,667 = £9.44 per unit. Yet these units are of exactly the same product and costs have beenkept the same each year. This type of change in unit value can be confusing and showing a higherprofit in a year when the closing stock is higher than usual can give a false sense of security.

Why?

Many experts have argued for or against each of these approaches – marginal and absorption– in the context of profit calculation. The marginal approach assumes that fixed manufacturingcosts are a function of time and should not be carried forward to the next period in stock valu-ations. The absorption approach assumes that such overhead is concerned with production and,therefore, that the goods produced in that year but not yet sold should include the expense in thecalculation of their value carried forward to the next period.

Do such costs ‘attach’ to the product or to time? They attach to time. Consequently, it doesseem that the marginal approach is more appropriate for closing stock valuation.

Of course, during the life of a business, the recorded profits of a firm will be the same in totalwhichever method is in use. If Burke Ltd exists for 20 years before it closes down, the profits ascalculated for each year using the different methods will result in different recorded profits yearby year (except by coincidence). The total profit during the complete life of the business of (say)£20 million will be the same. However, the intermediate reporting of profits may induce decisionswhich change the pattern of activities and, therefore, affect the future profitability of the busi-ness. Use of an inappropriate basis for calculating profits can lead to inappropriate decisionsbeing made.

Pricing policy

One thing is clear: in the long term, revenues must exceed costs or else the entity will fail and goout of business. If it was a company, it would have to be liquidated. If it was a business run by a

£400,00090,000

£400,000150,000

£400,000120,000

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Activity36.2

36.9

sole trader, she could be declared bankrupt. On the other hand, businesses may find that, in theshort term, costs sometimes exceed revenues. In other words, the business makes a net loss.Many do make losses from time to time without being forced out of business because, in otherperiods, they make sufficient profits to offset those losses.

This being so, the way in which prices are determined for the goods or services sold by a busi-ness is of great importance. You may well expect that there are some definite rules which will beobserved by a business when it fixes its prices, and that these rules are followed by all businesses.Your expectations would, however, be quite wrong.

With pricing, each business is unique. That is, each business has certain features that do notapply to other businesses. These differences affect pricing policy. For instance, let’s look at theprice of sugar sold by three different businesses. The first (A) is a grocer’s shop in a village, it isthe only grocer’s shop, and the next shop at which the villagers can buy sugar is thirty milesaway. The second (B) is a grocer’s shop in a town where there are plenty of other shops sellingsugar. The third (C) is a very large supermarket in a city, in a street where there are other largesupermarkets. For a bag of sugar, you have to pay at (A) 90p; (B) 80p; (C) 60p. The sugar is ofexactly the same quality and is manufactured by the same company. (A) buys in small quantities;consequently it pays a higher price than (B) or (C) for its sugar, but it knows that none of its cus-tomers want to go thirty miles for sugar. The owner does not want to lose self-respect by over-charging anyway, so he settles for 90p. He always reflects that if he charged more, his customersmight decide to buy sugar in larger quantities when they went to the nearest town to shop. (B)makes hardly any profit at all out of its sugar sales. It fears that if its regular customers were togo elsewhere for their sugar they might well decide to buy other things as well, resulting in (B)losing not only its sugar sales but also a great deal of its other sales as well. (C) sells sugar at aloss – it does this quite deliberately to tempt customers who come to buy cheap sugar, and thenbuy other items on which the supermarket makes reasonable profits.

If there can be such differences in the selling price of a bag of sugar when sold by three differ-ent businesses, none of which had, in fact, produced the sugar, then how much more complex isthe position where businesses manufacture goods and then each have to decide the prices to sellthem at? This is where a study of economics helps to get this in better perspective. Along withother economic factors, the elasticity of demand (i.e. the impact upon demand of a change inprice) must be considered as well as whether or not the business has a dominant position in themarket. Knowledge of economics provides a framework for your thinking but it is not the pur-pose of this book to be an economics text. Nevertheless, pricing relies on economic analysis asmuch as on infomation about costs. We will content ourselves with accepting that this is so, andwill focus upon how accounting information impacts upon pricing.

Full cost pricing

Although there may be no clearly defined rules on pricing, it can at least be said that views ofpricing can be traced to one of two attitudes. These are:

1 Ascertain the cost of the product and then add something to that for profit, the sum being theselling price. This is usually known as full cost pricing.

2 Ascertain the price at which similar products are selling, and then attempt to keep costs belowthat level so as to make an acceptable profit.

Many of the problems connected with full cost pricing are the same as those that arise withabsorption costing and marginal costing.

What are these problems of absorption costing and marginal costing?

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Despite the inflexibility of the approach, many businesses use the full cost basis to price theirgoods and services, very probably because it is easy to apply and guarantees an acceptable profiton each unit of product or service that it manages to sell; and is easy to explain, justify, andunderstand. This is not meant as a criticism – after all, the accounting process it requires is thesimplest one available. There is no advantage to be gained by using complicated methods whensimple ones will meet the needs of the end users of the accounting information.

The more complicated the costing (and thus pricing) approach adopted, the greater will be thecosts of creating it and of maintaining it. If the benefits to be obtained from a complex approachdo not exceed the costs of the additional complexity in the approach, a simpler, more cost-effectiveapproach should be adopted. On the other hand, using a simple approach because it is simpleand, therefore, cheap to operate, can be extremely costly in the long run if the information itproduces and provides is less accurate than is required for effective decision making. Both theseaspects need to be considered when selecting the accounting approach to adopt.

The information shown in Exhibit 36.5 has been drawn up on a full cost basis. Full cost pricingfinds the cost of direct materials and direct labour and then adds relevant amounts to representindirect manufacturing costs, selling, admin and finance expenses, and profit. The selling price iscalculated as follows:

Exhibit 36.5

£ Cost of direct materials and direct labour 10Add Variable manufacturing costs 5Add Share of fixed manufacturing costs 1Absorption cost 16Add Percentage (50 per cent in this case) for selling, administration and finance expenses 8Full cost 24Add Percentage for profit (in this case, 25 per cent) 6Selling price 30

36.10

The 50 per cent for selling, administration and finance costs is probably based on the figuresfor the previous year, when, as a total for the year, they would have approximated to 50 per centof the total of direct materials + direct labour + variable manufacturing costs + fixed manufac-turing costs (i.e. in this case it would have amounted to £16 for one unit). Therefore, taking 50per cent of that figure (£8) as an addition is really saying that it is assumed that the pattern ofcosts incurred is similar to that of the previous year.

Remember that this was just an example of how full cost pricing may be applied. In other situations and even in the same situation but in another business, differences in the way thefigures used are found will be commonplace. As you have already seen earlier in this book, the allocation of fixed costs is very arbitrary, yet when full cost pricing is adopted, the sellingprice is based upon figures produced as a direct consequence of such arbitrary allocation. Unsur-prisingly, sometimes the price arrived at turns out to have been incorrect.

Example of full cost pricing

In Exhibit 36.6, three businesses are making identical products. For the purpose of illustration,we will assume that the variable and fixed costs for each of them are the same. Different account-ants use different methods of allocating fixed costs between products even though, in each case,the allocation may seem to be quite rational. There is usually no one ‘right’ way of allocatingfixed costs. Instead, there are ‘possible’ ways. In this exhibit, each of them manufactures twoproducts and, because of the different ways in which they have allocated fixed costs, they haveeach come up with different selling prices for their products.

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In real life, once selling prices have been calculated the market prices of similar goods arelooked at, and the price is arrived at after taking account of what competitors are charging. Inthis case, the prices set by Red Ltd might well have been the result of its having calculated theaverage market price as given by finding the average of the prices set by Blue Ltd and Green Ltd.

Suppose Blue Ltd and Green Ltd placed their faith in their full cost pricing-based sellingprices but now realise they also need to set their selling prices at £45. Blue might think that asthe full cost of product B is £48, it would lose £3 for every unit sold of product B. Green Ltdmight, on the other hand, think that as the full cost of product A is £48, it would lose £3 onevery unit sold of product A. If they rigidly apply full cost pricing, Blue Ltd might decide to ceaseproduction of B, and Green Ltd decide to cease production of A. This is unlikely to be a wisedecision for either company.

If the plans had been for each company to sell 100 of each of products A and B, then the planshave now altered to Blue Ltd producing and selling 100 of A only, Green Ltd producing and sell-ing 100 of B only, and Red Ltd producing and selling 100 of A and 100 of B. The summarisedprofit and loss accounts of the three companies will now be as shown in Exhibit 36.7.

Exhibit 36.7

Blue Ltd Green Ltd Red Ltd£ £ £

Sales: 100 of A @ £45 4,500 4,500100 of B @ £45 4,500 4,500

Total revenue 4,500 4,500 9,000Less Costs: Direct labour and materialsProduct A 100 × £10 1,000 1,000Product B 100 × £12 1,200 1,200Variable manufacturing costsProduct A 100 × £16 1,600 1,600Product B 100 × £10 1,000 1,000Fixed manufacturing costs: does not change

as a consequence of cessation of production in Blue Ltd and Green Ltd as it is a fixed cost. 3,200 3,200 3,200

Total costs (5,800) (5,400) (8,000)

Net profit 1,000Net loss (1,300) ( 900)

Exhibit 36.6

Blue Ltd Green Ltd Red Ltd Products Products Products

A B A B A B

£ £ £ £ £ £Direct labour and materials 10 12 10 12 10 12Variable manufacturing costs 16 10 16 10 16 10Marginal cost 26 22 26 22 26 22Fixed manufacturing costs 6 26 22 10 14 18Full cost 32 48 48 32 40 40Add Profit: 12.5 per cent of full cost 4 6 6 4 5 5

36 54 54 36 45 45

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Exhibit 36.8

Product A Product B£ £

Selling price 45 45Less Marginal cost (26) (22)Contribution towards fixed costs and profit 19 23

Either product could be usefully considered, both make a positive contribution towards fixedcosts. However, all other things being equal, product B appears to be the better option. Thus, ifthere is spare capacity, and an opportunity arises to use some of it, marginal costing can be usedin order to determine whether the projected income arising from ‘extra’ sales exceeds themarginal cost of the ‘extra’ items produced. If it does, it is worthwhile considering taking on the work. This is based on an important rule:

Contribution == Selling Price −− Variable Cost

Contribution is also the basis of another important rule for decision making:

Break-even point ==

Break-even point is the volume of sales required in order to make neither a profit nor a loss.

See Chapter 44 to learn more about these rules when you will look at break-even analysis (also called cost–volume–profit analysis).

Note: Marginal costing uses variable costs. The variable cost is often referred to as the marginalcost. They are, effectively, the same thing.

Fixed costsSelling price per unit – Variable cost per unit

36.11

Exhibit 36.7 shows that Blue Ltd and Green Ltd would incur losses if they ceased productionof product B and product A respectively. Yet, if they had not ceased production they would bothhave made profits of £1,000 (as Red Ltd has done). After all, they are similar organisations withexactly the same costs – the only difference was the way they allocated fixed costs. The fixedcosts in each company totalled £3,200. Blue allocated this between products as A £6, B £26.Green allocated it A £22, B £2. Red allocated it A £14, B £18. With 100 units of each productbeing produced, this amounted to an allocation overall apportionment of fixed costs of £3,200by each company. Fixed overhead does not change just because of ceasing production of onetype of product. The factory rent and rates will remain the same, as will the secretaries’ salariesand other fixed costs.

Contribution

The question arises therefore as to which costing approach, absorption costing or marginal cost-ing, is more appropriate when deciding whether or not to continue manufacturing a product or providing a service. The answer to this is that it is the marginal cost – i.e. the variable cost – whichis relevant and so should be used. If marginal cost is less than selling price, the difference willmake a contribution towards fixed costs, thus reducing the burden of the fixed costs on the otherproducts.

This can be seen in the following example concerning which of the two products we intro-duced in Section 36.10, A and B, to make when there is some spare production capacity.Remember, as absorption costing includes an element of fixed cost, it is not appropriate to use itwhen considering decisions of this type:

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On the full cost basis, only A and D appear to be profitable. Should production of B, C and Ebe discontinued? You know that production should cease only when the selling price is less thanmarginal cost. In Exhibit 36.10, you can see if following this brings more profit than followingthe result of the full cost calculation. You can also see what would have happened if productionlevels of all products continued as before.

Exhibit 36.9

Violet Ltd Products

A B C D E

Cost per unit: £ £ £ £ £Direct labour and materials 8 9 16 25 11Variable manufacturing costs 7 8 10 13 14

Marginal cost 15 17 26 38 25Fixed costs 5 7 11 15 10Full cost 20 24 37 53 35

Selling price per unit 30 21 31 80 20

Exhibit 36.10

(1) (2) (3)Following Using marginal Ignore costing

full-cost pricing, costing, cease altogether and cease producing producing E produce all

B, C and E only items

£ £ £Sales: A 100 × £30 3,000 3,000 3,000

B 100 × £21 2,100 2,100C 100 × £31 3,100 3,100D 100 × £80 8,000 8,000 8,000E 100 × £20 2,000

Total revenue 11,000 16,200 18,200Less Costs:Direct labour and materials:

100 × cost per product (£33) 3,300 (£58) 5,800 (£69) 6,900Variable manufacturing costs: (£20) 2,000 (£38) 3,800 (£52) 5,200

100 × cost per productFixed costs (do not change) 4,800 4,800 4,800Total costs (10,100) (14,400) (16,900)

Net profit 900 1,800 1,300

36.12 Using marginal costs

Let’s test what you’re just learnt in another example. A company produces five products and hasthe following cost and sales data. It can sell exactly 100 of each product it manufactures. Totalfixed costs are £4,800, apportioned: A £5 (100), B £7 (100), C £11 (100), D £15 (100), E £10(100), i.e. £4,800 total. Exhibit 36.9 presents this in a table.

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The £s figures in brackets show the cost of each product, e.g. in (1) the direct labour andmaterials are A £8 + D £25 = £33.

As you can see from Exhibit 36.10, it would be just as well if we followed our own advice.This would give a profit of £1,800 compared with £900 using the full cost approach or £1,300 ifwe disregarded costing altogether. Sometimes the full cost approach will give far better resultsthan ignoring costing altogether, but this case shows that using an inappropriate costing base canbe even worse than having no costing system at all. Marginal costing always gives the mostappropriate answer in this sort of situation.

There is, however, a danger in thinking that if the marginal cost of each product is less thanthe selling price then all products produced will be profitable. This is not the case, and full consid-eration must be given to the fact that the total contribution from all the products must exceedthe fixed costs, otherwise there will be an overall loss. Different volumes of activity on eachproduct will also affect this. Exhibit 36.11 looks at a two-product firm making products A and Bat different volumes of activity. Product A has a marginal cost of £10 and a selling price of £14.Product B has a marginal cost of £6 and a selling price of £8. Fixed costs are £1,400.

Exhibit 36.11

Profit, or loss, at different volumes of activity

A B A B A B A B

Units sold 100 100 200 200 300 300 400 400£ £ £ £ £ £ £ £

Contribution (Selling priceless Marginal cost) A £4 per unit, B £2 per unit 400 200 800 400 1,200 600 1,600 800

Total contributions 600 1,200 1,800 2,400 Fixed costs (1,400) (1,400) (1,400) (1,400)Net loss ( 800) ( 200)

Net profit 400 1,000

36.13

Here the selling price always exceeds marginal cost, but if activity is low the firm will incur aloss. This is shown where activity is only 100 or 200 units of each product.

To summarise, the main lessons to be learned about selling prices are:

(a) a product should make a positive contribution (unless there is some overriding matter whichmakes the product a viable loss-leader, as in the case of the supermarket’s sugar price inSection 36.8). That is, selling prices should exceed marginal costs; and

(b) the volume of sales should be sufficient so that, in the long term (it may be different in theshort term) the fixed costs are less than the total of the contributions from all the products.

Maximisation of total contribution

It is the maximisation of the total contribution from a product that is important. Because of this,the volumes of activity cannot be ignored. Suppose, for instance, that a company could only manu-facture two products in future whereas, to date, it had manufactured three. It may be that perunit the contribution may well have been (A) £10, (B) £8 and (C) £6. If a decision was made on

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36.14

this basis only then (C) would be discontinued. However, if the volumes were (A) 20, (B) 15 and(C) 30, the total contributions would be (A) 20 × £10 = £200; (B) 15 × £8 = £120; (C) 30 × £6 =£180. As (B) has the lowest total contribution it should be (B) that is discontinued, not (C).

Where there is a limit of one of the items used in production of the product, the contribution per product per unit of that limiting factor (or ‘key factor’) should be used as the basis for thedecision taken. (Note: this topic appears frequently in examinations.)

Take, for example, a situation where there are 200 spare hours of machine capacity availableand a decision has to made concerning which, if any, of its products should have their produc-tion levels increased. The contribution per machine hour of each product is: A £2; B £3; C £5; D £1. Based on this information, more of product C should be produced. It will generate thegreatest amount of contribution. If there is any spare capacity remaining after all of product Chas been produced (for example, if there is only enough material available to make a few moreof product C) then product B should be produced, etc.

Activity-based costing (ABC)

A single measure of volume is used for each production/service cost centre when apportioningindirect costs under traditional absorption costing. For example:

l machine hoursl direct labour hoursl direct materials costl direct labour cost.

These bases are often difficult to justify when the nature of the activity at the cost centre and,more particularly, the nature of the item that is absorbing the cost is considered. In reality, theamount of overhead incurred may depend on any of a range of factors. An appropriate basis forcost absorption ought to adopt a basis that as truly as possible reflects the changes in overheadarising from the activities undertaken.

Unfortunately, traditional cross-activity bases such as these can only be truly appropriate toall production when either the nature of the products produced and their production processesare virtually identical or when only a small range of products are produced.

Let’s look now at an approach to cost apportionment that is considered far more ‘accurate’than the traditional marginal and absorption costing bases.

Cost driversCost drivers are activities that generate cost. They are the factors that cause variable manufac-turing costs to be incurred. A cost driver may be related to a short-term variable expense (e.g.machine running costs) – where the cost is driven by production volume and the cost driver willbe volume-based (e.g. machine hours). Alternatively, it could be related to a long-term variableoverhead (e.g. quality inspection costs) – where the cost is driven by the number of occasions therelevant activity occurs and where the cost driver will be transaction-based (e.g. the number ofquality inspections).

Activity-based costing is the process of using cost drivers as the basis for the apportionmentof indirect manufacturing costs to individual products. Costs are attributed to cost units on thebasis of the benefit received from indirect activities, e.g. ordering, setting up equipment so thatthe item to be produced can be manufactured, and assuring quality.

While this sounds more appropriate than absorption costing, the information required toapply ABC is not generally available from traditional accounting records and organisations thatembrace ABC often require to develop a new accounting information system in order to providethat information.

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Cost poolsA cost pool is a collection of individual costs within a single heading. In traditional marginal andabsorption costing, cost pools are simply another term for production cost centres. This is notthe case under ABC, where a cost pool is created for each activity area. Then, in order toattribute costs held in a cost pool to an item, the amount in the cost pool is divided by the quan-tity of the related cost driver. This process of cost attribution is very similar to that used in tradi-tional costing – it is the terminology, the manner in which costs are built up, and the type ofbasis used for cost apportionment that differ.

ABC vs. traditional costingIt is claimed that traditional marginal and absorption costing underapportions indirect costs tolower-volume products and overapportions them to higher-volume products – that is, they pro-duce potentially misleading information at the two extremes. ABC does not suffer from thesedefects. As a result, it directs attention to matters of interest that traditional overhead allocationand apportionment is insufficiently sensitive to identify. It should, therefore, be capable of pro-ducing more useful information for decision making.

Because administration, selling and distribution overheads are excluded from both financialaccounting stock values and cost of sales calculations, traditional indirect cost apportionmentstops at the edge of the factory floor. A full analysis of product profitability requires considera-tion of these non-production overheads, which is one reason why some organisations have chosen to adopt ABC, which does include these indirect costs. When companies that use ABC toevaluate stock and cost of sales have to produce their financial statements, it is not difficultremoving these non-production costs from the calculated amounts.

Limitations of ABCWhile it is possible to implement an ABC system in most organisations, in many cases it is notworthwhile:

1 The costs of implementing and operating such a system often outweigh the benefits, especiallyfor smaller organisations.

2 It can often be the case that the additional precision and accuracy that ABC brings is immater-ial in the context of managerial decision making.

3 For single-product or single-service organisations, ABC is of little benefit. 4 Because of the need to exclude adminstration, selling and distribution costs from the calcula-

tion of stock and cost of sales in financial statements, many organisations that implementABC operate a more traditional costing accounting system in parallel with it. This simplyadds to the complexity of the accounting system and can confuse non-accounting-aware man-agers when they have two different ‘cost’ figures for the same product or item of stock.

However, where organisations have multiple products or services, ABC can prove to be aworthwhile and cost-effective way of increasing the reliability of managerial decision makingconcerning product pricing.

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Review questions

36.1 Raleigh Ltd’s costs and revenues for the current year are expected to be:

£ £ Direct labour 600,000Direct materials 700,000Indirect manufacturing costs:

Variable 450,000Fixed 50,000

500,000Administration expenses 120,000Selling and distribution expenses 60,000Finance expenses 20,000

2,000,000

Learning outcomes

You should now have learnt:

1 Why different costs are often relevant for decision making rather than those used for the calculation of net profit.

2 The costs needed when making decisions about the future will often be differentfrom those used when calculating profit in the past.

3 The difference between fixed, variable, semi-variable and step-variable costs.

4 The difference between absorption and marginal costing.

5 How various factors underlie the pricing policy adopted by an organisation.

6 Why marginal cost, not full (or absorption cost), is the relevant cost whenconsidering a change in what and/or how much is produced.

7 What is meant by full cost pricing.

8 The importance of contribution to pricing, production and selling decisions.

9 That selling prices should exceed marginal costs. (Almost the only exception to this would be where a product was being promoted as a loss-leader.)

10 That, in the long term, the total contributions at given volumes must exceed thefixed costs of the firm.

12 What is meant by activity-based costing (ABC).

13 The advantages and limitations of ABC.

Answers to activities

36.1 The stock may be rising because we cannot sell the goods, i.e. the business is getting into trouble,yet the financial statements sublimely show a higher profit.

36.2 In absorption costing, the whole of the fixed costs were allocated to products, whereas inmarginal costing the ‘contribution’ was found (i.e. revenue less variable cost) out of which fixedcosts would have to come, leaving the profit as the difference. The problem is how to decide theamount of fixed cost per unit to arrive at ‘full cost’.

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It was expected that 200,000 units would be manufactured and sold, the selling price being £12 each.Suddenly during the year two enquiries were made at the same time which would result in

extra production being necessary. They were:

(A) An existing customer said that he would take an extra 10,000 units, but the price would haveto be reduced to £10 per unit on this extra 10,000 units. The only extra costs that would beinvolved would be in respect of variable costs.

(B) A new customer would take 15,000 units annually. This would mean extra variable costs and anextra machine would have to be bought costing £15,000 which would last for 5 years beforebeing scrapped. It would have no scrap value. Extra running costs of this machine would be£6,000 per annum. The units are needed for an underdeveloped country and owing to cur-rency difficulties the highest price that could be paid for the units was £9.25 per unit.

On this information, and assuming that there are no alternatives open to Raleigh Ltd, shouldthe company accept or reject these orders? Draft the memo that you would give to the managingdirector of Raleigh Ltd.

36.2A Jack Ltd expects its cost per unit, assuming a production level of 200,000 units per annum,to be:

£Direct materials 3.2Direct labour 4.8Indirect manufacturing costs: Variable 1.6

Fixed 0.8Selling and distribution expenses 0.4Administration expenses 0.6Finance 0.2

14.0Selling price is £15 per unit.

The following propositions are put to the managing director. Each proposition is to be con-sidered on its own without reference to the other propositions.

(a) If the selling price is reduced to £14.80 per unit, sales could be raised to 240,000 units perannum instead of the current 200,000 units. Apart from direct materials, direct labour and indirect fixed manufacturing costs, there would be no change in costs.

(b) If the selling price is put up to £15.40 per unit, sales would be 160,000 per annum instead of 200,000.Apart from variable costs, there would also be a saving of £4,000 per annum in finance costs.

(c) To satisfy a special order, which would not be repeated, 10,000 extra units could be sold at£9.80 each. This would have no effect on fixed expenses.

(d) To satisfy a special order, which would not be repeated, 6,000 extra units could be sold for£9.20 each. This would have no effect on fixed expenses.

Draft a memo stating what you would advise the managing director to do, giving your reasons andworkings.

36.3 Assume that two companies have exactly the same pattern of costs and revenue and bothuse FIFO when valuing stock, but that Columbus Ltd uses a marginal costing approach to the valu-ation of stock in its financial statements, while Steel Ltd values its stock using absorption costing.Calculate the gross profits for each company for each of their first three years in business from thefollowing information:

(a) Total fixed indirect manufacturing cost is £90,000 per year.(b) Direct labour costs over each of the three years were £9 per unit.(c) Direct material costs over each of the three years were £15 per unit.(d) Variable expenses which vary in direct ratio to production were £6 per unit.(e) Sales were: Year 1: 2,700 units; Year 2: 3,600 units; Year 3: 3,300 units.

The selling price remained constant at £87 per unit.(f ) Production is at the rate of: Year 1: 3,600 units; Year 2: 3,900 units; Year 3: 3,750 units.

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36.4A Your company has been trading for three years. It has used a marginal costing approachto value its stock in its financial statements. The directors are interested to know what therecorded profits would have been if absorption costing had been used instead. Using the follow-ing information, prepare a statement for each of the three years comparing both methods.

(a) Fixed indirect manufacturing costs are £64,000 per year.(b) Direct labour costs per unit over each of the three years were £16 per unit.(c) Direct material costs over each of the three years were £12 per unit.(d) Variable expenses which vary in direct ratio to production were £20 per unit.(e) Sales are: Year 1: 36,000 units; Year 2: 40,000 units; Year 3: 60,000 units. All at £64 per unit.(f ) Production volumes were: Year 1: 40,000 units; Year 2: 48,000 units; Year 3: 51,000 units.

36.5 Greatsound Ltd manufactures and sells compact disc players, the cost of which is made upas follows:

£Direct material 74.80Direct labour 18.70Variable overhead 7.50Fixed overhead 30.00Total cost 131.00

The current selling price is £187.Greatsound Ltd works a day shift only, at present producing 120,000 compact disc players per

annum, and has no spare capacity.Market research has shown that there is a demand for an additional 60,000 compact disc players

in the forthcoming year. However, these additional sales would have a selling price of £150 each.One way of achieving the extra production required is to work a night shift. However, this wouldincrease fixed costs by £2,500,000 and the labour force would have to be paid an extra 20 per centover the day shift rate.

The company supplying the materials to Greatsound Ltd has indicated that it will offer a specialdiscount of 10 per cent on total purchases if the annual purchases of materials increase by 50 per cent.

The selling price and all other costs will remain the same.Assuming that the additional purchases will only be made if the night shift runs, you are

required to:

(a) Advise Greatsound Ltd whether it should proceed with the proposal to commence the nightshift, based on financial considerations.

(b) Calculate the minimum increase in sales and production required to justify the night shift.(c) Give four other matters which should be taken into consideration when making a decision of

this nature.

(AQA (Northern Examinations and Assessment Board): GCE A-level)

36.6A(a) What is meant by the terms contribution and marginal cost?

(b) Barton & Co Ltd make and sell 2,000 units per month of a product ‘Barco’. The selling price is£65 per unit, and unit costs are: direct labour £8; direct materials £17; variable overheads £11.Fixed costs per month are £29,400.

The company receives two export orders for completion in September 20X2. Order A requests600 items at a special total price of £20,000; order B requires 750 items at a total price of £34,000.Order A will require no special treatment, but order B will demand extra processing at a cost of£6 per item. The company has sufficient capacity to undertake either A or B in addition to its cur-rent production, but only by paying its direct labour force an overtime premium of 25 per cent.

Calculate the company’s contribution and the profits for the month if:(i) normal production only takes place(ii) order A is accepted in addition to normal production(iii) order B is accepted in addition to normal production.

(c) Use your answer to (b) to demonstrate that a company will normally accept an order whichproduces a contribution towards overheads.

(Edexcel: GCE A-level ) ‘

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36.7 Arncliffe Limited manufactures two types of product marketed under the brand names of‘Crowns’ and ‘Kings’. All the company’s production is sold to a large firm of wholesalers.

Arncliffe is in something of a crisis because the chief accountant has been taken ill just as thecompany was about to begin negotiating the terms of future contracts with its customer. You havebeen called in to help and are given the following information relating to each product for the lastyear. This information has been prepared by a junior assistant.

Report on revenues/costs for the year just ended:

Crowns Kings£ £

Sales 60,000 25,000

Floor space costs (rent and rates) 10,000 5,000Raw materials 8,000 2,000Direct labour 20,000 10,000Insurances 400 200Machine running costs 12,000 3,000Net profit 9,600 4,800

The junior assistant says in his report, ‘As you can see, Crowns make twice as much profit asKings and we should therefore stop manufacturing Kings if we wish to maximise our profits. I haveallocated floor space costs and insurances on the basis of the labour costs for each product. Allother costs/revenues can be directly related to the individual product.’

Further investigation reveals the following information:

(i) The wholesaler bought all the 20,000 Crowns and 10,000 Kings produced last year, sellingthem to his customers at £4 and £3 each respectively. The wholesaler is experiencing anincreasing demand for Crowns and intends to raise his price next year to £4.50 each.

(ii) Crowns took 8,000 hours to process on the one machine the company owns, whereas Kingstook 2,000 hours. The machine has a maximum capacity of 10,000 hours per year.

(iii) Because all production is immediately sold to the wholesaler no stocks are kept.

Required:(a) Prepare the revenue/cost statement for the year just ended on a marginal cost basis, and calcu-

late the rate of contribution to sales for each product.(b) You are told that in the coming year the maximum market demand for the two products will

be 40,000 Crowns and 36,000 Kings and that the wholesaler wishes to sell a minimum of 6,000units of each product. Calculate the best product mix and resulting profit for Arncliffe Limited.

(c) Calculate the best product mix and resulting profit for Arncliffe Limited if another machinewith identical running costs and capacity can be hired for £20,000 per annum. Floor space andinsurance costs would not change and the maximum and minimum conditions set out in (b) abovecontinue to apply.

(d) What points does Arncliffe Limited need to bear in mind when negotiating next year’s contractwith the wholesaler?

(Reproduced with the kind permission of OCR: from the University of Cambridge Local ExaminationsSyndicate)

36.8A Reed Ltd manufactures three products A, B and C. Budgeted costs and selling prices forthe three months ending 30 September 20X2 are as follows:

A B CSales (units per month) 6,000 8,000 5,000

£ £ £Selling price per unit 45 44 37 Unit costsDirect labour 6 9 6Direct materials* 20 24 16 Variable overhead 4 3 2Fixed overhead 5 5 6

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Labour costs are £3 per hour, and material costs are £4 per kilo for all products. The total fixedcosts are of a general factory nature, and are unavoidable.

The company has been advised by its supplier that due to a material shortage, its material require-ment for the month of September will be reduced by 15 per cent. No other changes are anticipated.

Required:A A statement to show the maximum net profit for the three months ending 30 September 20X2,

taking into account the material shortage for the month of September.B Explain how the fixed cost element is dealt with in marginal costing and in absorption costing.

Briefly explain how this affects any closing stock valuation.

(Reproduced with the kind permission of OCR – University of Oxford Delegacy of Local Examinations:GCE A-level )

Authors’ note: Assume that the materials used in each product are of the same kind.

36.9 Paul Wagtail started a small manufacturing business on 1 May 20X8. He has kept hisrecords on the double entry system, and has drawn up a trial balance at 30 April 20X9 beforeattempting to prepare his first final accounts.

Extract from the Trial Balance of Paul Wagtail at 30 April 20X9

£ £Purchases of raw materials 125,000Sales 464,360Selling expenses 23,800Insurance 4,800Factory repairs and maintenance 19,360Carriage on raw materials 1,500Heating and lighting 3,600Direct factory power 12,430Distribution expenses 25,400Production wages 105,270Factory supervisor’s wages 29,600Administration expenses 46,700Plant and machinery at cost 88,000Delivery vehicles at cost 88,000Raw materials returned to supplier 2,100

At 30 April 20X9, he has closing stocks of raw materials costing £8,900. He has manufactured9,500 completed units of his product, and sold 8,900. He has a further 625 units that are 80 percent complete for raw materials and production labour, and also 80 per cent complete for factoryindirect costs.

He has decided to divide his insurance costs and his heating and lighting costs 40 per cent forthe factory and 60 per cent for the office/showroom.

He wishes to depreciate his plant and machinery at 20 per cent p.a. on cost, and his deliveryvehicles using the reducing balance method at 40 per cent p.a.

He has not yet made up his mind how to value his stocks of work in progress and finishedgoods. He has heard that he could use either marginal or absorption costing to do this, and hasreceived different advice from a friend running a similar business and from an accountant.

Required:(a) Prepare Paul Wagtail’s manufacturing, trading and profit and loss accounts for the year ended

30 April 20X9 using both marginal and absorption costing methods, preferably in columnar format.(b) Advise Paul Wagtail of the advantages and disadvantages of using each method.

(Reproduced with the kind permission of OCR – University of Oxford Local Delegacy Examinations:GCE A-level ) ‘

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36.10A The figures given below are all that could be salvaged from the records after a recentfire in the offices of Firelighters Limited. The company manufactures a single product, has no rawmaterials or work in progress and values its stocks at marginal cost (i.e. at variable manufacturingcost) using the FIFO basis. It is known that the unit closing stock valuation in 20X0 was the same asin 20X9.

20X0 20X1Selling price per unit £10.00 £10.00Variable manufacturing cost (per unit produced) £4.00 £4.00Variable selling cost (per unit sold) £1.25 ?Quantity sold (units) 100,000 ?Quantity manufactured (units) 105,000 130,000Contribution ? £585,000Fixed manufacturing costs £105,000 £117,000Other fixed costs £155,000 ?Operating profit before interest charges ? £292,000Interest charges £70,000 ?Opening finished stock (units) ? ?Closing finished stock (units) 20,000 20,000Net profit for the year ? £210,000

Required:Prepare a revenue statement for management showing contribution, operating profit and netprofit for each year in as much detail as the information given above permits.

(Reproduced with the kind permission of OCR: from the University of Cambridge Local ExaminationsSyndicate)

36.11A Gainford Ltd is a manufacturing company which produces three specialist products – A,B and C. For costing purposes the company’s financial year is divided into thirteen periods of fourweeks. There is always sufficient raw material in stock to meet any planned level of production butthere is a maximum number of labour hours available to the company. The production of eachproduct requires a different physical layout of the factory equipment although the labour tasks arebroadly similar. For this reason the company only produces one type of product at any time, and thedecision as to which product to manufacture is taken before each four week period commences.

A forty hour working week is in operation and the following factory staff are employed:

Grade 1 28 staff paid at a rate of £8 per hourGrade 2 12 staff paid at a rate of £6 per hour

In addition, a limited number of qualified part-time staff can be employed when required. Bothfull-time and part-time staff are paid at the same rate. The next four week period is number 7 andthe following maximum part-time hours are available for that period:

Grade 1 2,240 hoursGrade 2 1,104 hours

The production costs and selling costs per unit for each product are:

A B C£ £ £

Direct raw material 147 87 185Direct labour: Grade 1 64 56 60

Grade 2 24 27 21Variable overheads 15 10 15Fixed overheads 12 12 12Selling price of each product 400 350 450

There is a strong demand for all three products and every unit produced is sold.

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Required:(a) Explain the terms:

(i) ‘contribution’(ii) ‘key factor’

(b) Calculate the contribution and profit obtained when each product is sold.(c) Prepare a statement from the available information, for period number 7 which will assist man-

agement to decide which product to produce in order to maximise contribution. This statementshould include details of the:(i) total production labour hours available(ii) number of hours required to produce one unit of each type of product(iii) maximum production (in units) possible of each type of product(iv) product which will give the greatest contribution in period number 7

(d ) Outline the main steps in the manufacturing decision-making process which ought to beadopted by a business.

(AQA (Associated Examining Board): GCE A-level)

36.12A Vale Manufacturing started in business on 1 April 20X3, and incurred the following costsduring its first three years.

Year ending 31 March 20X4 20X5 20X6£ £ £

Direct materials 60,000 49,900 52,200Direct labour 48,000 44,000 45,000Variable overheads 24,000 30,000 40,000Fixed costs 40,000 40,600 41,300

Sales during the first three years were all at £20 per unit.

Production each year (units) 16,000 14,000 14,000Sales each year (units) 14,000 14,000 15,000

Required:(a) Prepare a statement showing the gross profit for each of the three years if the company used:

(i) the marginal costing approach to valuing stock;(ii) the absorption costing approach to valuing stock.

(b) Advise the company of the advantages and disadvantages of using each method.

(Reproduced with the kind permission of OCR – University of Oxford Delegacy of Local Examinations:GCE A-level )

36.13 Frames Ltd make four different products: K, L, M and N. They have ascertained the cost ofdirect materials and direct labour and the variable overhead for each unit of product. An attempt ismade to apportion the other costs in a logical manner. When this is done, 20 per cent is added forprofit. The cost of direct labour and materials per unit is K: £28; L: £56; M: £120; N: £64. Variableoverheads per unit are K: £8; L: £16; M: £26; N: £24. Fixed overhead costs of £3,800 are allocatedper unit as K: £4; L: £8; M: £14; N: £12.

You are required to:(a) Calculate the prices at which the units would be sold by Frames Ltd if the full cost system of

pricing was adhered to.(b) What would you advise the company to do if, because of market competition, prices had to be

fixed at K: £66; L: £78; M: £140; N: £98?(c) Assuming production of 100 units of each item per accounting period, what would be the net

profit (i) if your advice given in your answer to (b) was followed; (ii) if the company continuedto produce all of the items?

(d) What would you advise the company to do if, because of market competition, prices had to befixed at K: £34; L: £96; M: £280; N: £78? ‘

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(e) Assuming production of 100 units of each item per accounting period, what would be the netprofit (i) if your advice given in your answer to (d) was followed; (ii) if the company continuedto produce all of the items?

36.14A Lenses Ltd makes six different products: P, Q, R, S, T and U. An analysis of costs ascer-tains the following:

Per unit P Q R S T U£ £ £ £ £ £

Direct labour and direct materials 45 51 114 147 186 342Variable manufacturing expenses 18 33 30 63 66 69

Fixed costs of £34,200 are allocated per unit as P: £12; Q: £21; R: £21; S: £30; T: £48; U: £39. Usingfull cost pricing, 10 per cent is to be added per unit for profit.

You are required to:(a) Calculate the prices that would be charged by Lenses Ltd if full cost pricing was adhered to.(b) What advice would you give the company if a survey of the market showed that the prices

charged could be P: £78; Q: £78; R: £198; S: £225; T: £240; U: £660?(c) Assuming production of 600 units per period of each unit manufactured, what would be the

profit of the firm (i) if your advice in (b) was followed, (ii) if the company continued to produceall of the items?

(d) Suppose that in fact the market survey had revealed instead that the prices charged could be P: £90; Q: £99; R: £225; S: £198; T: £435; U: £390, what would your advice have been to thecompany?

(e) Assuming that production of each item manufactured was 600 units per month, then whatwould have been the profit (i) if your advice in (d) had been followed, (ii) if the companychose to continue manufacturing all items?

36.15A(a) What are the differences between marginal cost pricing and full cost pricing?(b) How far is it true to state that marginal cost pricing is a short-term strategy?(c) A.S. Teriod Ltd makes five different products – Ceres, Eros, Hermes, Icarus and Vesta. The various

costs per unit of the products are respectively: direct labour, £14, £8, £22, £18 and £26; directmaterials, £8, £10, £13, £12 and £17; variable overheads, £11, £9, £16, £15 and £19.

The fixed expenses for the month of February 20X1 are estimated at £8,200, and this has beenallocated to the units produced as Ceres £17, Eros £13, Hermes £19, Icarus £15 and Vesta £18. Thecompany adds 20 per cent on to the total cost of each product by way of profit.

(i) Calculate the prices based upon full cost pricing.(ii) Advise the company on which products to produce, if competition forces the prices to: Ceres

£59, Eros £25, Hermes £80, Icarus £44 and Vesta £92.(iii) Assuming that output for the month amounts to 100 units of each model, that fixed costs remain

the same irrespective of output and that unused capacity cannot be used for other products:calculate the profit or loss if the company continued to produce the whole range at the newprices; AND if the company followed your advice in (ii) above.

(Edexcel: GCE A-level)

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You can find a range of additional self-test questions, as well as material to help you withyour studies, on the website that accompanies this book at www.pearsoned.co.uk/wood

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Absorption and marginal costing Learning objectives