Accounting Methods: Marginal vs. Absorption Costing

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Table of Contents
INTRODUCTION............................................................................................................................. 2
PART 1............................................................................................................................................3
PART 2............................................................................................................................................9
CONCLUSION............................................................................................................................... 13
References................................................................................................................................... 14
1

INTRODUCTION
A complete portfolio is prepared by demonstrating the calculations using ratio analysis as well
as variable costing. In the first part, Eymen Ltd is taken into account to prepare a simple
statement of profit or loss by using marginal and absorption costing principles. In the second
part, the financial statement of the company Fulham Shores Plc is undertaken to identify its
financial performance.
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PART 1
MARGINAL COSTING METHOD: it is a costing method that imposes a variable or marginal cost
to cost units. This method set off the fixed cost for a particular time period against the
contribution. An alternative outline is offered to the traditional income statement in
comparison to absorption costing (DRURY, 2013). It separately treats the variable and fixed
costs. Marginal cost implies the additional cost involved in the production or manufacturing of
extra output. It is calculated by summing the total variable and allocating the cost to one unit.
Marginal costs=direct material+direct Labour+direct expenses+ variable overheads
ABSORPTION COSTING METHOD: it is a costing method that outlays all the fixed and variable
cost in manufacturing a specific product. It requires external financial reporting under Generally
Accepted Accounting Principles (Garrison et al., 2010). Also, it is required in income tax
reporting. It is a method that determines the overall cost of the product by adding direct and
amount of overhead production cost through a means of more than one adsorption rate of
overhead.
Absorption costs=direct material+ direct Labour +direct expenses+variable manufact uring overheads+ ¿
DIFFERENCE BETWEEN ABSORPTION AND MARGINAL COSTING METHOD
Basis for difference Marginal costing Absorption costing
Meaning It is a decision-making
technique to ascertain the
total production cost (DRURY,
2013).
It apportions the total cost to
the cost centre to determine
the total production cost.
Cost recognition It considers variable cost as
product cost and considers
fixed cost as period costs.
It considers both fixed and
variable cost as product cost
(DRURY, 2013)
Overhead classification It classifies the overheads into
fixed and variable
It classifies the overheads into
administration, production,
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selling and distribution
Profitability It measures profitability
through profit volume ratio
(Garrison et al., 2010)
It includes a fixed cost that
affects profitability (Garrison
et al., 2010)
Highlights Contribution per unit is
highlighted
Net profit per unit is
highlighted.
PREPARATION OF INCOME STATEMENT USING ABSORPTION AND MARGINAL COSTING
METHODS FOR EYMEN LTD
Calculation of direct material and direct labour per unit
I)
Direct Material=550,000
400,000
Direct Material( per unit)=£ 1.375
II)
Direct Labour= 750,000
400,000
Direct Labour ( per unit )=£ 1.875
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INCOME STATEMENT OF MARGINAL COSTING FOR THE MONTH OF MAY
Particulars Amount (in £) Amount(in £)
Sales (400,000*10.50) 4,200,000
Less: Cost Of Sales:
Opening Inventory --
Direct Material 550,000
Direct Labour 750,000
Less: Closing Inventory --
(1,300,000)
2,900,000
Less: Other Variable Costs --
Contribution 2,900,000
Less: Fixed Costs 600,000 (600,000)
Profit/ Loss 2,300,000
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INCOME STATEMENT OF MARGINAL COSTING FOR THE MONTH OF JUNE
Particulars Amount (in £) Amount(in £)
Sales (360,000*10.50) 3,780,000
Less: Cost Of Sales:
Opening Inventory --
Direct Material 550,000
Direct Labour 750,000
Less: Closing Inventory (40,000* (1.375 +1.875)) (130,000)
(1,170,000)
2,610,000
Less: Other Variable Costs --
Contribution 2,610,000
Less: Fixed Costs 600,000 (600,000)
Profit/ Loss 2,010,000
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INCOME STATEMENT OF ABSORPTION COSTING FOR THE MONTH OF MAY
Particulars Amount (in £) Amount(in £)
Sales (400,000*10.50) 4,200,000
Less: Cost Of Sales
Opening Inventory --
Direct Material 550,000
Direct Labour 750,000
Fixed Overhead 600,000
Less: Close Inventory --
(1,900,000)
2,300,000
Under/ Over Absorption -- --
Gross Profit At Actual 2,300,000
Less: Non-Production Costs -- --
Profit/Loss 2,300,000
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INCOME STATEMENT OF ABSORPTION COSTING FOR THE MONTH OF JUNE
Particulars Amount (in £) Amount(in £)
Sales (360,000*10.50) 3,780,000
Less: Cost Of Sales
Opening Inventory --
Direct Material 550,000
Direct Labour 750,000
Fixed Overhead 600,000
Less: Closing Inventory (40,000* (1.375 +1.875)) (130,000)
(1,770,000)
2,010,000
Under/ Over Absorption -- --
Gross Profit At Actual 2,010,000
Less: Non-Production Costs -- --
Profit/Loss 2,010,000
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PART 2
Fulham is one of the growth of restaurant businesses in the UK. The final statement of Fulham
Shores for the financial years 2017 and 2018 is undertaken to carry out ratio analysis. Being an
external financial consultant, their financial performance is to be analysed independently on
the basis of the latest financial statements of Fulham Shores.
Key financial data of Fulham Shores plc are given below:
Key financial data (in
‘000£)
2018 2017
Working capital 17,510 17,970
Cost of goods sold 32,039 22,553
Fixed Assets 59,735 57,033
Inventories 1,490 1,052
Capital employed 77,245 75,003
Net sales 54,695 40,441
Net income (565) 969
Net operating profits 142 1,507
Revenue 54,695 40,441
Current assets 5,503 3,925
Current liabilities (12,007) (14,045)
Total assets 65,238 60,958
Debt (27,606) (22,310)
Equity 37,632 38,648
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Ratio analysis of Fulham Shores Plc
S.
No.
Ratio Formula 2018 2017 Analysis and
interpretation
1 Quick ratio Quick assets/
Current liabilities
-0.33 -0.22 The quick ratio is slightly
increased by 0.11 in 2018
as compared to 2017
(Fulham Shore Plc, 2018)
2 Current ratio Current assets /
current liabilities
-0.47 -0.27 The current ratio is
increased is 0.20 in 2018
than in 2017
3 Gross profit
margin
(Revenue- Cost of
Goods sold)/
revenue
0.41 0.43 Gross profit margin is
slightly declined by 0.02
in 2018 than in 2017
(Fulham Shore Plc, 2018)
4 Return on net
assets
Net income/ (Fixed
Assets + Working
capital)
0.007 0.012 Return on net asset is
declined by 0.005 while
comparing the same
between 2017 and 2018.
5 Return on
capital
employed
Net operating
profit/ (Total assets
– Current liabilities)
0.002 0.022 Return on capital
employed is negatively
impacted in 2018 by
0.020 in comparison to
2017 (Fulham Shore Plc,
2018)
6 Net profit/loss
margin
(Net income or loss/
Net sales) * 100
-
1.03%
3.37% Net profit margin is
steeply declined by 1.04
in 2018 than in 2017.
7 Capital gearing Equity/ debt -1.36 -1.72 The capital gearing ratio
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ratio was declined by 0.66 in
2018 as compared to
that of in 2017 (Fulham
Shore Plc, 2018)
The discussion regarding the ratios in the above table and the financial position and liquidity
position of Fulham Shores Plc is given below:
QUICK RATIO: the ability of the company is measured by this quick ratio by measuring the
paying current liabilities with quick assets such as short-term investments, cash and cash
equivalents, current account receivables and marketable securities (Creel et al., 2015). This
ratio indicates the liquidity position of the company. The quick ratio of Fulham Shores Plc in
2017 is -0.22 and in 2018 is -0.33 (Fulham Shore Plc, 2019). It signifies that the negative value of
Fulham Shores Plc describes the fast-moving trends in inventories fails to convert the quick
assets into cash.
CURRENT RATIO: the current ratio defines the ability of the company in making current debt
payments easily (Creel et al., 2015). The current ratio of Fulham Shores Plc in 2017 is -0.27 and
in 2018 is -0.47. It represents that the company fails to pay current liabilities by using current
assets in 2017 and 2018 demonstrating their poor liquidity position.
GROSS PROFIT MARGIN: this ratio is used to assess the financial health as well as a business
model by revealing the amount of money available from sales after deducting the cost of goods
sold (Creel et al., 2015). The gross profit margin of the company in 2017 and 2018 is 0.43 and
0.41 respectively (Fulham Shore Plc, 2019). It indicates that the company is unable to manage
the cost of sales thus declining in their gross profit.
RETURN ON NET ASSETS: the earning per currency of assets invested by the company is
represented in this ratio (Creel et al., 2015). The ratios of the return on assets of Fulham shore
plc in 2017 is 0.012 and in 2018 is 0.007. The performance of the company is declining as
measured in this ratio.
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