Marginal Costing

a) Limitations of marginal costing system.  The separation of costs into fixed and variable presents technical difficulties and no variable cost is completely variable nor is a fixed cost completely fixed.  Under the marginal cost system, stock of finished goods and work-in-progress are understated. After all, fixed costs are incurred in order to manufacture products and as such, these should form a part of the cost of the products. It is, therefore, not correct to eliminate fixed costs from finished stock and work-in- progress.  The exclusion of fixed overhead from the inventories affects the Profit and Loss Account and produces an unrealistic and conservative Balance Sheet, unless adjustments are made in the financial accounts at the end of the period.  In marginal costing system, marginal contribution and profits increase or decrease with changes in sales volume. Where sales are seasonal, profits fluctuate from period to period. Monthly operating statements under the marginal costing system will not, therefore, be as realistic or useful as in absorption costing.  During the earlier stages of a period of recession, the low profits or increase in losses, as revealed in a magnified way in the marginal costs statements, may unduly create panic and compel the management to take action that may lead to further depression of the market.  Marginal costing does not give full information. For example, increased production and sales may be due to extensive use of existing equipment (by working overtime or in shifts), or by an expansion of the resources, or by the replacement of labour force by machines. The marginal contribution fails to reveal these.  Though for short-term assessment of profitability marginal costs may be useful, long term profit is correctly determined on full costs basis only.  Although marginal costing eliminates the difficulties involved in the apportionment and under and over-absorption of fixed overhead, the problem still remains so far as the variable overhead is concerned.  With increased automation and technological developments, the impact on fixed costs on products is much more than that of variable costs. A system which ignores fixed costs is therefore, less effective because a major portion of the cost, such as not taken care of.  Marginal costing does not provide any standard for the evaluation of performance. A system of budgetary control and standard costing provides more effective control than that obtained by marginal costing. b) Grate Ltd (i) Marginal costing technique. Solution Basic workings 1. Marginal cost per unit = 60 + 120+40 = Sh. 220 2. Full production cost per unit Variable + fixed = 220 + 80 = Sh. 300 3. Inventory Period Jan. 2023 Feb. 2023 Units Units Opening inventory 0 4000 Production 30,000 30,000 30,000 34,000 Less sales 26,000 34000 Closing inventory 4,000 0 4. Over (Under) absorption of fixed production overheads Period Jan. 2023 Feb.2023 Sh. „000‟ Sh. „000‟ Actual 2,400 2,400 Absorbed (30,000 × 80) 2,400 2,400 Over (under) absorption 0 0 Month January 2023 February 2023 Sh. „000‟ Sh. „000‟ Sh. „000‟ Sh. „000‟ Sales [ ] 10,400 13,600 Less marginal production cost: Opening inventory [ ] 0 880 Production [ ] 6,600 6,600 Closing inventory [ ] (880) (5,720) (0) (7,480) Gross contribution 4,680 6,120 Less other variable overheads Selling overheads [ ] (780) (1020) Net contribution 3,900 5,100 Less total fixed costs Production overheads 2400 2400 Selling overheads 1800 (4,200) 1800 (4,200) Net profit (loss) (300) 900 (ii) Absorption costing profit or loss statement. Month Jan 2023 Feb 2023 Sh. „000‟ Sh. „000‟ Sh. „000‟ Sh. „000‟ Sales 10400 13,600 Less full production cost: Opening inventory 0 1200 [ ] Production [ ] 9000 9000 Closing inventory [ ] (1200) (7800) (0) (10,200) Gross profit 2,600 3,400 Less other costs: Variable selling overheads 780 1020 Fixed selling overheads 1,800 (2,580) 1,800 (2,820) Net profit (loss) 20 580