Marginal Costing and Absorption Costing Technique

 

Impact on Profit under Marginal and Absorption Costing Technique

The concept of Marginal & Absorption costing plays a significant role in the field of management accounting. The main difference between marginal costing and absorption costing lies in how they treat fixed manufacturing overhead costs. This difference can lead to varying profits for a company under the two techniques, particularly when there are changes in production volume and inventory levels. Let us discuss the impact on profit under both techniques:

 

1. Marginal Costing:

Under marginal costing, fixed manufacturing overhead costs are treated as period costs and are not allocated to products. Only variable manufacturing costs (direct materials, direct labor, and variable manufacturing overhead) are considered as part of the product cost.

Profit is calculated as the difference between total revenue and total variable costs (both direct and variable overhead costs).

The closing stock value is valued at its variable production cost only (i.e., direct materials, direct labor, and variable overhead).

Marginal costing provides a clearer view of the contribution margin of each product and helps in making short-term decisions, as it isolates the impact of changing production levels on profitability.

 

2. Absorption Costing:

Under absorption costing, both variable and fixed manufacturing overhead costs are included in the product cost. Fixed overhead costs are absorbed into the cost of units produced.

Profit is calculated as the difference between total revenue and total cost of goods sold (which includes both variable and fixed manufacturing costs).

The closing stock value includes both variable and fixed production costs.

Absorption costing is required for external financial reporting purposes and is often used for inventory valuation.

Impact on Profit:

In periods of stable production and sales levels, both methods generally yield the same profit result.

·       If there is an increase in production levels and inventory builds up (closing stock increases), absorption costing typically results in higher reported profits compared to marginal costing. This is because fixed overhead costs get spread over more units, reducing the cost per unit.

·       On the other hand, if production levels decrease and inventory reduces (closing stock decreases), absorption costing may report lower profits than marginal costing due to the higher fixed overhead costs being allocated to fewer units.

·       If a company faces a temporary downturn in sales and has a buildup of closing stock, absorption costing may show higher profits compared to marginal costing, as fixed overhead costs get absorbed into closing stock, reducing the expense in the income statement.

In summary, the choice between marginal costing and absorption costing can significantly impact reported profits, especially when production levels and inventory levels change. Companies should be aware of these differences and use the appropriate costing method based on their reporting needs and the decision-making context. Absorption costing is generally used for external financial reporting, while marginal costing is useful for internal decision-making and short-term planning.

 

Difference between marginal costing and absorption costing

Marginal costing and absorption costing are two different methods of cost accounting used to determine the cost of production, valuation of inventory, and calculation of profit. The main difference between the two lies in the treatment of fixed manufacturing overhead costs. Let's explore the key distinctions between marginal costing and absorption costing:

1. Treatment of Fixed Manufacturing Overhead:

Marginal Costing: Under marginal costing, fixed manufacturing overhead costs are considered as period costs and are not allocated to products. These costs are treated as expenses in the period they are incurred, and they do not form a part of the product cost. Only variable manufacturing costs (direct materials, direct labor, and variable overhead) are considered as product costs.

Absorption Costing: In absorption costing, both variable and fixed manufacturing overhead costs are included in the product cost. Fixed overhead costs are absorbed into the cost of units produced and are considered as part of the inventory valuation. As a result, fixed overhead costs are recognized as expenses only when the finished goods are sold.

2. Inventory Valuation:

Marginal Costing: Closing stock (ending inventory) is valued at variable production cost only, which includes direct materials, direct labor, and variable manufacturing overhead.

Absorption Costing: Closing stock (ending inventory) is valued at both variable and fixed production costs, including direct materials, direct labor, variable manufacturing overhead, and the allocated fixed manufacturing overhead.

3. Profit Calculation:

Marginal Costing: Profit is calculated as the difference between total revenue and total variable costs (both direct and variable overhead costs). Fixed manufacturing overhead costs are not included in the cost of goods sold.

Absorption Costing: Profit is calculated as the difference between total revenue and total cost of goods sold, which includes both variable and fixed manufacturing costs.

  

4. Decision Making:

Marginal Costing: Marginal costing is useful for short-term decision-making and determining the contribution margin of each product. It helps in assessing the impact of changes in production volume on profitability.

Absorption Costing: Absorption costing is typically used for external financial reporting purposes and is required for inventory valuation under accounting standards. It may not provide the most relevant information for short-term decision-making due to the impact of fixed overhead costs on inventory valuation.

 

5. Cost Behavior Analysis:

Marginal Costing: Marginal costing segregates costs into fixed and variable components, making it easier to analyze cost behavior and perform cost-volume-profit (CVP) analysis.

Absorption Costing: Absorption costing does not clearly distinguish between fixed and variable costs within the product cost, which can make cost behavior analysis more complex.

In summary, the primary difference between marginal costing and absorption costing lies in the treatment of fixed manufacturing overhead costs and the resulting impact on inventory valuation and profit calculation. Each method has its advantages and is suited to different purposes. Marginal costing is more focused on short-term decision-making and cost behavior analysis, while absorption costing is essential for external financial reporting and inventory valuation compliance.

 

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MBA Case Study on Financial Planning

MBA Case Study Question and Answer

You are a Financial Planner. Your client Prashant Pandey aged 35 years and works with an IT company earning Rs 15 lakhs per year. His wife Priti, aged 32 years, is a homemaker. They have one daughter aged 5 years. The couple requires your help to make some financial decisions. (You can make any assumptions to further build up your case.)

a) Prashant wants to buy a Pure Risk Life Insurance cover of Rs 1.5 crore. He is confused about whether he should buy a ULIP or a Term Plan. Recommend the product best suited for his requirement

Based on Prashant's requirement for a Pure Risk Life Insurance cover of Rs 1.5 crore, I would recommend that he opt for a Term Plan rather than a ULIP (Unit Linked Insurance Plan). Here's why: Term Plan:

Coverage: A term plan offers pure life insurance coverage without any investment component. It provides a high sum assured for a specified term or duration.

Affordability: Term plans are generally more affordable compared to ULIPs as they don't have investment-related charges or fees.

Higher Coverage: Term plans allow individuals to secure a higher life cover at a relatively lower premium cost, ensuring adequate financial protection for their family in case of any unfortunate event.

Simplicity: Term plans are straightforward and easy to understand. The focus is solely on providing life insurance coverage, without the complexity of investment options or associated market risks.

Flexibility: Term plans offer flexibility in choosing the policy term, premium payment frequency, and additional riders for enhanced coverage (e.g., critical illness rider, accidental death benefit, etc.).

Financial Independence: By opting for a term plan, Prashant can allocate his resources separately for investments and ensure that his family's financial needs are adequately covered in the event of his demise.

ULIP (Unit Linked Insurance Plan):

Investment Component: ULIPs combine life insurance coverage with an investment component. A portion of the premium paid is allocated to various investment funds (equity, debt, or balanced), allowing policyholders to potentially earn returns.

Market-Linked Returns: ULIPs offer the opportunity for market-linked returns based on the performance of the chosen investment funds. However, this also exposes the policyholder to market volatility and associated risks.

Lock-in Period: ULIPs typically have a lock-in period of five years, during which the policyholder cannot withdraw funds without penalties. This limits liquidity and may not be suitable for Prashant's immediate life insurance coverage needs.

Charges and Fees: ULIPs often have various charges, including premium allocation charges, fund management charges, policy administration charges, and mortality charges. These charges can significantly impact the returns and reduce the overall value of the investment.

Complexity: ULIPs can be more complex compared to term plans, as they involve investment decisions and the need to monitor and manage the investment component of the policy.

Considering Prashant's primary objective of obtaining a Pure Risk Life Insurance cover of Rs 1.5 crore, a term plan would be the most suitable product for him. It provides cost-effective coverage, simplicity, flexibility, and a higher sum assured, ensuring financial security for his family in case of any unfortunate event. Prashant can separately allocate his resources for investment purposes, considering his long-term financial goals and risk tolerance. It's always advisable to carefully read and understand the policy terms and conditions, compare different insurers, and consult a financial advisor or insurance expert before making a final decision.

MBA Case Study assignment with solution

MBA Case study based question and answers

Amit Chopra, (age 31 years) works with a pharmaceutical company and has not yet started to invest for his retirement. Amit is married to Neelam (age 28 years) and they have one son aged 2 years. Amit wants you to prepare a plan for him to retire by age 60. (You can make any assumptions to further build up your case).

To help Amit Chopra prepare a retirement plan, let's consider the following assumptions:

Retirement Age: Amit aims to retire at the age of 60, providing him with a retirement period of 29 years.

Life Expectancy: We'll assume a life expectancy of 85 years for Amit and Neelam, considering they might need funds to sustain themselves for a potential 25 years in retirement.

Risk Profile: Considering Amit's age and the long-term nature of his retirement goal, we'll assume a moderate to high-risk tolerance, allowing for a diversified investment portfolio with potentially higher returns.

Inflation: We'll consider an average inflation rate of 4% per year, which is the historical average in India. This ensures that the retirement corpus is adjusted for the rising cost of living over time.

Existing Assets and Liabilities: We'll assume that Amit has no significant existing assets or liabilities that would directly impact his retirement planning.

Now, let's outline a retirement plan for Amit:

Determine Retirement Corpus:

To estimate the retirement corpus, we'll consider Amit's desired annual post-retirement income. Assuming he wishes to maintain a comfortable lifestyle, we'll consider 70% of his current income, adjusted for inflation. Additionally, we'll consider the number of years left until retirement and the expected inflation rate. Based on these factors, we can estimate the required retirement corpus.

Assess Monthly Savings Capacity:

Considering Amit's current income and expenses, we'll evaluate his monthly savings capacity. It is essential to strike a balance between saving for retirement and managing present financial obligations. We'll aim to allocate a reasonable portion of his income towards retirement savings while ensuring his current lifestyle is sustainable.

Investment Strategy:

To accumulate the retirement corpus, Amit should consider investing in a diversified portfolio that aligns with his risk tolerance and retirement timeframe. A combination of equity mutual funds, debt instruments, and other suitable investment vehicles can be selected to achieve his long-term financial goals. It's advisable to consult a financial advisor to determine the optimal asset allocation and investment strategy based on Amit's risk profile.

Systematic Investment Plan (SIP):

Amit can consider starting a Systematic Investment Plan (SIP) in mutual funds, which allows him to invest a fixed amount at regular intervals. SIPs offer the benefit of rupee-cost averaging and can help him accumulate wealth over time. The investment amount can be adjusted periodically based on his increasing income and changing circumstances.

Periodic Review and Adjustment:

It is essential for Amit to periodically review his retirement plan, taking into account changes in income, expenses, and investment performance. Adjustments can be made in the investment strategy and contribution amounts as needed to stay on track toward his retirement goal.

Risk Management:

Amit should also consider mitigating risks by securing appropriate life and health insurance coverage for himself and his family. This step ensures that unexpected events do not derail his retirement plan.

Professional Advice:

Amit should consult with a certified financial planner or investment advisor to develop a comprehensive retirement plan tailored to his specific financial situation and goals. An expert can provide personalized guidance, recommend suitable investment options, and help monitor the progress of the retirement plan.

Remember, this retirement plan is based on the assumptions provided. It's important for Amit to regularly assess and adapt the plan as his circumstances evolve. Regular monitoring and adjustments will help ensure he stays on track to retire comfortably by age 60.

Is retirement planning a part of investment planning?

Yes, retirement planning is a crucial component of overall investment planning. Retirement planning involves setting goals, estimating the required retirement corpus, and creating a strategy to accumulate sufficient funds to support one's desired lifestyle during retirement.

Investment planning, on the other hand, encompasses a broader scope and involves developing a strategy to grow and manage wealth over time. It includes various financial goals such as buying a house, saving for education, creating an emergency fund, and retirement planning.

Retirement planning is a subset of investment planning, specifically focusing on setting aside funds and investing them in appropriate vehicles to build a retirement corpus. It involves considerations such as determining the desired retirement age, estimating the post-retirement income needs, assessing risk tolerance, selecting suitable investment options, and periodically reviewing and adjusting the plan to stay on track.

By incorporating retirement planning into their investment strategy, individuals can ensure that they allocate sufficient resources and make appropriate investment choices to meet their retirement goals. It helps in providing financial security and a comfortable lifestyle during the post-employment phase of life.

Role of IRDA in Public Awareness

 

The Insurance Regulatory and Development Authority of India (IRDA) plays a crucial role in public awareness regarding the insurance sector, including life insurance. Here are some key roles and initiatives undertaken by IRDA to create public awareness:

Regulatory Framework: IRDA establishes and enforces regulations and guidelines for insurance companies to ensure fair practices, transparency, and consumer protection. These regulations often include provisions related to policyholders' rights, disclosure of information, claims settlement, and grievance redressal.

Consumer Education Initiatives: IRDA conducts various consumer education initiatives to promote awareness and understanding of insurance products and policyholders' rights. These initiatives include workshops, seminars, and campaigns targeting different segments of the population to educate them about the benefits of insurance and the importance of being informed policyholders.

Communication Channels: IRDA maintains effective communication channels to disseminate information to the public. This includes the official IRDA website, where individuals can access resources, FAQs, and information on insurance policies, regulations, and policyholders' rights. The website also provides a platform for lodging complaints and seeking grievance redressal.

Public Service Announcements (PSAs): IRDA collaborates with media outlets to release PSAs that raise awareness about the importance of insurance and policyholders' rights. These PSAs may be in the form of print advertisements, radio spots, or television commercials, conveying key messages to a wide audience.

Grievance Redressal Mechanisms: IRDA establishes and monitors grievance redressal mechanisms to address policyholders' complaints and ensure fair treatment. These mechanisms aim to resolve disputes between policyholders and insurance companies, providing a platform for individuals to seek assistance and get their issues resolved.

Regulatory Compliance and Monitoring: IRDA is responsible for monitoring insurance companies' compliance with regulations, ensuring they adhere to consumer protection guidelines and provide transparent and fair services to policyholders. Through regular inspections and audits, IRDA works to maintain a trustworthy and accountable insurance sector.

Collaborations and Partnerships: IRDA collaborates with industry stakeholders, including insurance companies, industry associations, and financial institutions, to enhance public awareness and understanding of insurance. These collaborations may involve joint awareness campaigns, seminars, and educational programs aimed at promoting financial literacy and educating individuals about insurance and their rights.

Through its regulatory oversight, consumer education initiatives, effective communication channels, grievance redressal mechanisms, and collaborations, IRDA plays a vital role in raising public awareness about the insurance sector, including life insurance. The aim is to empower individuals with knowledge, protect their interests, and foster a trustworthy and responsible insurance industry.

Concept of Marginal Costing

 

Concept of Marginal Costing

Introduction:

Marginal costing is a fundamental concept in managerial accounting that provides insights into cost behavior and decision-making. It focuses on segregating costs into fixed and variable components to understand the impact of changes in production levels and sales volumes on profitability. This study material aims to provide an overview of the concept of marginal costing, its key components, and its applications in decision-making.

Marginal Cost:

Marginal cost refers to the additional cost incurred to produce one more unit of a product or provide one more unit of service.

It includes variable costs, such as direct materials, direct labor, and variable overheads, that vary with the level of production or activity.

Marginal cost does not consider fixed costs, such as rent, depreciation, and salaries, as they remain unchanged regardless of the level of production.

 

Contribution Margin:

Contribution margin is the difference between sales revenue and variable costs.

It represents the amount available to cover fixed costs and contribute towards profit.

Contribution margin per unit is calculated as the difference between the selling price per unit and the variable cost per unit.

Key Concepts and Techniques in Marginal Costing:

 

Breakeven Analysis: Marginal costing is used to determine the breakeven point, which is the level of sales at which total revenue equals total costs, resulting in zero profit.

Cost-Volume-Profit (CVP) Analysis: CVP analysis helps in understanding the relationship between costs, volume, and profit. It analyzes the impact of changes in sales volume on profits.

Relevant Cost Analysis: Marginal costing assists in decision-making by considering only the costs that are relevant to a specific decision.

Decision-Making: Marginal costing helps in assessing the profitability of various alternatives, such as make or buy decisions, pricing decisions, and product mix decisions.

 

Advantages of Marginal Costing:

1. Simplified Analysis: Marginal costing simplifies cost analysis by separating costs into fixed and variable components.
2. Decision-Making Support: It provides a clear understanding of the cost behavior and assists in making informed decisions.
3. Flexibility: Marginal costing allows for flexibility in adjusting production levels and pricing decisions based on cost-volume-profit relationships.
4. Improved Profitability: By analyzing contribution margins, marginal costing helps identify the most profitable products or services.

Limitations of Marginal Costing:

• Ignores Fixed Costs: Marginal costing does not consider fixed costs, which may lead to incomplete cost analysis.
• Assumption of Constant Variable Cost per Unit: Marginal costing assumes that variable costs per unit remain constant throughout different levels of production or activity.
• Limited Applicability: Marginal costing is most suitable for short-term decision-making and may not provide accurate results for long-term planning.

 

Conclusion:

Marginal costing is a valuable tool for analyzing costs, profit determination, and decision-making in managerial accounting. By focusing on the relationship between costs, volume, and profits, it helps businesses understand their cost structures and make informed choices. Marginal costing provides insights into the financial implications of various decisions and assists in maximizing profitability. Understanding the concept of marginal costing is essential for managers and decision-makers in effectively managing costs and optimizing business performance.

Solved sums are available on the above topic at :

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