Absorption Versus Marginal Costing

IG Ltd: performance of ‘Gillo’ trainers by model

                                   Jumper           Leaper          Runner               Hiker

                                        £                    £                     £                      £

Sales                         13 525               5 850               5 475               7 850

Fixed costs                  3 900                1 400               2 150               1 900

Variable costs              6 225                4 475               4 775               6 025

Profit / (Loss)              3 400                 (25)               (1 450)               (75)

Fixed costs have been 'apportioned' or allocated to the three products produced by this firm.

This could have been done by:

1. Sales

The product that sells the most has to cover the most fixed costs.

2. Factory floor space

The product that takes up the most room in the factory covers the most fixed costs.

3. The number of employees making each product.

The product that has most employees producing it covers the most fixed costs.

Because of this method of 'absorption' costing thee products appear to be making a loss.

Is this fair?

Advantages and disadvantages of absorption costing here:

An alternative approach is called Marginal Costing

Marginal costing looks to see if a product makes a positive 'contribution' to fixed costs.

Formula: Sales revenue of product minus variable cost (direct cost) of making the product.
Advantages / disadvantages of marginal costing here.

Complete this table:


                                   Jumper           Leaper          Runner               Hiker

                                        £                    £                     £                      £

Sales                         13 525               5 850               5 475               7 850

Minus
Variable costs              6 225                4 475               4 775               6 025
Equals
Contribution
Total contribution minus total fixed costs (£9 350) equals profit.

Calculate the profit if the business makes all four products.

Now calculate the profit if the business only makes the 'Jumper' trainer.
What you should have worked out:

Contributions:  Jumper £7300 (1)  Leaper  £1375 (1)  Runner   £700 (1)  Hiker    £1825 (1) Profit with all four models: £1850 (1) Just the Jumper model: contribution £7300 less        FC £9350 (1)  a loss of £2050 (1) a £3900 fall (1) All make a positive contribution (1) – but if the three are discontinued the Jumper model has to carry the total fixed costs (1)

To what extent should the decision to make only the 'Jumper' trainer be made using only marginal costing information only?

Marginal costing /contribution analysis can be used in whether to stop 'unprofitable' products by exploring

the effect of the change in contribution.

Marginal costing gives information not available through more traditional costing approaches (e.g. absorption).

Existing analysis for Gillo Ltd is based on an unknown method of apportionment of fixed costs.
This apportionment may not be fair/may disadvantage the three products seemingly making a loss.
Contribution analysis ignores other factors e.g. actions of competitors, existing and likely future market conditions.

Stopping production of the three products may allow competitors to enter this segment.

There will be spare capacity if the three products are no longer made: can this be used?

Conclusion that financial analysis alone using marginal costing/contribution analysis is of limited value only. The points above must be considered.