Question

1. Mr. Zakariya the new junior cost accountant joined your company and wants to follow ‘Absorption costing’, but you as a senior cost manager rely on ‘Marginal costing’. How would you convince Mr. Zakariya in this situation? Explain.

2. Use the below numerical figures of your company’s production unit along with the theoretical aspects during the convincing process to Mr. Zakariya about marginal costing.

Particulars	Products
	A	B	C
	OMR	OMR	OMR
Direct material	30,000	120,000	12,000
Direct wages	36,000	36,000	6,000
Factory overheads: Fixed Variable	12,000 15,600	6,000 36,000	6,000 18,000
Selling overheads: Fixed Variable	6,000 8,400	3,600 24,000	2,400 12,000
Sales	128,000	204,000	64,000

Answer 1

Statement of Income under Marginal Costing:

Particulars	A	B	C
Sales	128,000	204,000	64,000
Less: Variable Costs:
Direct Materials	30,000	120,000	120,000
Direct Wages	36,000	36,000	6,000
Factory Overheads	15,600	36,000	18,000
Selling Overheads	8,400	24,000	12,000
Total Variable Costs	90,000	216,000	48,000
Contribution (Sales - VC)	38,000	(12,000)	16,000
Less: Fixed Costs:
Factory Overheads	12,000	6,000	6,000
Selling Overheads	6,000	3,600	2,400
Net Income / (Loss)	20,000	(21,600)	7,600

Statement of Income under Absorption Costing:

Particulars	A	B	C
Sales	128,000	204,000	64,000
Less: Direct Costs:
Direct Materials	30,000	120,000	120,000
Direct Wages	36,000	36,000	6,000
Gross Profit	62,000	48,000	46,000
Less: Indirect Costs:
Factory Overheads	27,600	42,000	24,000
Selling Overheads	14,400	27,600	14,400
Net Profit / (Loss)	20,000	21,600	7,600

As seen in the numericals above, both Marginal Costing and Absorption Costing result in the same Net Profit / (Loss). However, the Contribution computed as per Maginal Costing and the Gross Profit computed as per Absorption Costing varies significantly. The reason behind this is the difference in consideration / classification of costs under both the methods.

Under Marginal Costing, it classifies costs as variable costs and fixed costs. It applies all variable costs, i.e., costs which vary based on the level of output, and computes contribution derived from the product. Further, fixed costs are applied to compute the Net Profit / (Loss)

Whereas, under Absorption Costing, it classifies costs as direct costs and indirect costs. Direct costs, i.e., costs which are directly related to manufacturing are applied to compute Gross Profit derived from the product. Indirect costs include all other production costs which are incurred but not related to manufacturing.

Marginal / Variable Costing give a better analysis of the net result from producing the products because, it considers on the variable costs. Fixed costs are incurred irrespective of whether there is any production / sale or not. Hence, it is desriable to follow Marginal Costing to understand whether a particular product should be produced by the business or not. If the Contribution is positive, it is worthwile to produce that product. But if the contribution is negative, it is better to scrap that product line. This analysis cannot be made from Absorption Costing.

In the given question, Product B has a negative contribution, however it shows a positive gross profit under absorption costing system. Hence, it may be suggested to follow Marginal Costing System to understand and evaluate the performance of each product.