Magazine article Financial Management (UK)

Management Accounting-Performance Evaluation: In Their Second of Two Articles on Constructing a Budget for a Business, Tim Thompson and Vaughn White Use a Marginal Costing Approach

Magazine article Financial Management (UK)

Management Accounting-Performance Evaluation: In Their Second of Two Articles on Constructing a Budget for a Business, Tim Thompson and Vaughn White Use a Marginal Costing Approach

Article excerpt

In our article in the previous issue, we used absorption costing principles to construct a detailed budget for a fictitious manufacturing company. Now we will follow the same basic worked example as before, but this time using marginal costing. Again, we will be preparing the budget for the months of January to April inclusive, but we will also have to process some data from before and after these months.

As before, the sales volume in our company is forecast to be 10,000 units for January, which is expected to grow by 200 units a month. The selling price is 2 [pounds sterling] per unit, which means that we can construct the sales budget for January to June in both units and money (see panel 1). These calculations are identical to those that we did under absorption costing, because the costing method that we use does not affect sales volumes or prices.

Other information given in the first article was that the company's inventory policy is to hold sufficient units of finished goods at the end of each month to meet 40 per cent of the forecast sales for the following month. Also, each unit of finished goods requires 3kg of raw material, which costs 0.15 [pounds sterling] per kg and 0.1 hours of direct labour, which costs 7.50 [pounds sterling] per hour.

The finished goods inventory budget, in terms of units, will be identical to that calculated under absorption costing, because the costing method we use does not affect inventory quantities. But the monetary values of these inventories will be different because, under marginal costing, the product cost includes variable production costs only. Here is the product cost calculation:

Material: 3.0kg x 0.15 [pounds sterling] per kg = 0.45 [pounds sterling]

Labour: 0.1 hours x 7.50 [pounds sterling] per hour = 0.75 [pounds sterling]

Total: 1.20 [pounds sterling]

With these figures we can prepare the full finished goods inventory budget (see panel 2).

The production budget, expressed in units, will be identical to that calculated under absorption costing, because the costing method we use does not affect production quantities. For completeness, this budget is again shown in panel 3.

The raw material inventory budget, the purchases budget and the direct labour budget will all be identical to those calculated under absorption costing. For completeness, these budgets are again shown in panel 4, above, and in panels 5 and 6 on the next page.

From the changes we have identified in our detailed budget preparation, we can evaluate how these affect the three elements of the master budget: the budgeted income statement, the cash budget and the budgeted balance sheets.

For the budgeted income statement, because we are now using marginal costing we must deduct variable costs from sales to give us the contribution and then deduct all of the fixed costs to arrive at the profit (see panel 7). We can now compare these budgeted monthly profits using absorption costing with those using marginal costing that we prepared in the previous article (see panel 8). It's clear that there is a difference in the budgeted profit for each month between the costing methods we have used.

Panel 8 indicates that the total profit for the period under absorption costing would be 528 [pounds sterling] higher than under marginal costing. This is caused by the change in finished goods inventory figure over the period in question. It increased by 1,320 units during the period (3,000 units at the start of January; 4,320 units at the end of April). The value of each of these extra units includes 0.40 [pounds sterling] of absorbed overheads under absorption costing that wouldn't be included under marginal costing. This amounts to 1,320 units x 0.40 [pounds sterling] per unit = 528 [pounds sterling]. Under absorption costing this 528 [pounds sterling] is carried forward on the balance sheet as an asset (inventory), whereas under marginal costing it's taken to the income statement as a cost for the period. …

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