Explain the nature of and difference between marginal, standard and absorption costing, and between direct and indirect costs.

For obvious reasons it is important that a business does not sell its products and make a loss.

In 1960, Ford dismantled a Mini, examined every nut and bolt, and correctly concluded that Austin-Morris, as it then was, must have been producing the car at a loss. Each Mini sold in the first decade cost its makers £8.

This was obviously poor business practice and why you are learning three costing methods.

Methods of costing you need to know:

1. Marginal costing

Put simply a firm should consider whether a product makes a positive 'contribution' towards the organisations fixed costs.

So what is 'contribution'?

Thinking back to the Mini, lets imagine the selling price was £1000 and the variable or direct cost to make each car was £1008.

In this case there is a negative contribution to fixed costs of £8.

But if they had sold each car for £1250 then there would have been a positive contribution of £242.

Contribution per unit: Selling price minus variable costs per unit

Total contribution: Total revenue minus total variable costs

The question below should help you see what might come up in the exam.

2. Standard costing

Within the business production experts, accountants and others will try to work out what the standard cost of a product should be.

They will consider per product or batch:

Direct labour costs

Direct materials costs

Manufacturing costs (variable)

Manufacturing costs (fixed)

After production the actual costs can be compared to the budget costs to work out the variances.

3. Absorption costing
This is best explained by looking at the blog entry below.
Difference between direct and indirect costs:

Direct costs are immediately associated with the production of a product or service, while indirect costs include such things as rent — which may be associated with many products.

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.

Marginal Costing Question (Thanks Rushad)

A company makes a certain range of products.

They are considering discontinuing the products that make a loss.

Analyse the impact on the company if they stop selling these products.

Answer: £’s

Total profit: 6,270

Contribution:

Contribution = Total revenue – Variable costs.

A 32,664

B 5,960

C 3,147

D 10,537

E 11,132

Total contribution – Fixed costs = profit (63,440 – 57,170 = 6,270)

For only products A and D:

Profit = Total contribution – total fixed costs

43,201 – 57,170 = (13,969)

A fall of £20,239 from the total profit. (The difference between £6,270 and (13,969).

All make a positive contribution, but if the three are discontinued, products A and D will have to carry the total fixed costs.

Marginal costing gives information not available through more traditional costing approaches (1) – e.g. absorption costing (1) 

But contribution analysis ignores factors such as market conditions and competitor actions (1) 

Other factors need to be considered (1) – e.g. the five products cover a range of situations or tastes (1) (Give examples about the type of products in the question) (2)

So discontinuing may affect sales of other products (1) 

Reduced product range allows competitors to step in (1) 

Special order decisions
Click on the picture:

Special order question here.

What is the Difference Between Variable Costs and Direct Costs?

Direct costs are linked to a product, department or region within a business.


Direct product costs such as raw materials are variable costs.
In the case of a printing business this would include the ink and the paper.
It would also include hourly paid labour.


Variable product costs increase in total as more units of products are manufactured.

Costs that are direct to a department could be variable or fixed.


For example, a supervisor in the printing department would be a direct cost to the printing department. 


Since the supervisor's salary is likely to be the same amount each month regardless of the quantity of products manufactured, it is a fixed cost to the department.

A direct product cost is the electricity used to operate a printing machine. The cost of the electricity is variable because the total electricity used is greater when more products are manufactured on the machine.


Depreciation on the printing machine is also a direct product cost, except it is usually a fixed cost.

Calculate and analyse the following variances: materials (total, usage and price)

Formulae for calculating variances

Direct materials

Material total cost variance

• the difference between the total actual material cost and the total standard material cost for the actual quantity 

Material price variance:

• Difference between standard price and actual price, for the actual quantity of material
AQ x (AP – SP) 

Material usage variance:

• Difference between standard quantity required for actual production and the actual quantity used, at standard purchase price:
SP x (AQ – SQ)

Razi’s Pie Shop

Standard Cost Card for Plum Pie

5kg flour:            £3.00 (60p per kg)
0.6 kg butter       £3.00 (£5 per kg)
4 litres milk         £2.00 (50p per litre)
200 grams sugar £0.20 (£1 per kg)
0.5 kg plums       £1.00 (£2 per kg)
Standard cost:    £9.20 per batch

Last month, 20 batches of pies were made using the following amounts of materials (ingredients)

Ingredient           Quantity              Cost (£)

Flour                    120kg                  66

Butter                  12kg                    60

Milk                     75 litres               31.50

Sugar                   4.0 kg                  4.40

Plums                  12kg                    24

1.Calculate materials price variances for each ingredient.

Flour: AQ x (AP – SP)

120kg x (£0.55 - £0.60)

So.. 120 x £0.05 = £6.00 FAV

I calculated the £0.55 by the total cost of the flour (£66.00) divided by the quantity bought (120kg)

The variance is favourable because the business spent less than the standard cost card would suggest it should for flour.

Why? Perhaps a different supplier or a special offer from our existing supplier. Or the price of flour could have fallen since the standard cost card was produced.

Can you calculate the other material price variances?.

2. Calculate materials usage variances for each ingredient.

Flour: SP x (AQ – SQ)

£0.60 x (120kg - 100kg)

So.. £0.60 x 20 = £12 ADV

The £0.60 came from the standard cost card.

The 100kg came from multiplying the standard quantity per batch (5kg) by the number of batches made (20).

The variance is adverse because we used more flour than the standard cost card suggested.

Why? Perhaps someone burnt a batch of pies and they had to be made again. We call this wastage.

Phil’s Meat Pie Shop

Standard Cost Card for batch of Meat Pies

3kg flour:                       £1.80 (60p per kg)
0.3 kg butter:                 £1.50 (£1.50 per kg)
2 litres milk:                   £1.00 (50p per litre)
800 grams meat:            £0.80 (£1 per kg)
0.5 kg vegetables:          £1.00 (£2 per kg)
Standard cost:               £5.50 per batch

Last month, 20 batches of pies were made using the following amounts of materials (ingredients)

Ingredient           Quantity              Cost (£)

Flour                    61 kg                  12.20

Butter                     6 kg                  30.60

Milk                     50 litres              17.50

Meat                    16 kg                   16.00

Vegetables           12 kg                   21.00

1. Calculate materials price variances for each ingredient.

2. Calculate materials usage variances for each ingredient.

3. Calculate total materials variance.

Calculate and analyse the following variances: labour (total, rate and efficiency).

Labour total cost variance:
Difference between standard labour cost and actual labour cost, incurred for the actual production

Labour rate variance:

Difference between standard and actual labour rate per hour for the actual hours worked
AH x (AR – SR)

Labour efficiency variance:

Difference between standard hours for actual production and the hours actually worked, valued at the standard rate
SR x (AH – SH)

Example:

Standard labour hours per unit of output: 2.8

Standard labour rate per hour: £11.50
Operations for the last month:
Actual hours worked: 6900
Actual total labour cost: £80,385
Actual output: 2300 units

What is the labour rate variance for the month?
AH x (AR – SR)

6900 hrs x (£11.65 - £11.50)

So.. 6900 x £0.15 = £1035 ADV

The £11.65 was calculated by dividing the actual total labour cost (£80,385) with the number of hours worked (6900).

The variance was adverse because the business was paying £0.15p more an hour than the standard cost card suggested?

Why? Perhaps a pay rise since the standard cost card was produced, or the business was using more experienced labour.

What is the labour efficiency variance for the month?

SR x (AH – SH)

£11.50 x (6900hrs - 6440hrs)

Can you work out where the 6400hrs came from?

Clue: Multiply the number of items made by the expected standard hours to make them.

Nice link here.

Labour and Materials Variances

Big Al's Diner makes the biggest burger in the world

Calculate materials price variance, materials usage variance & material total cost variance.

Calculate labour rate variance, labour efficiency variance & labour total cost variance.

The burger has the following standard costs:

Materials:10 kg at £16 per kg          £160

Labour: 4 hours @ £15 per hour

Budgeted production is 1 200 products a month

Actual production for a month:

Number made and sold 1 260

Materials             13 000 kg                      £207 000

Labour                  5 100 hours                  £ 77 000