Costing Framework for Decision Making

Introduction

• Let us start our discussion with a costing framework suitable for decision making.
• The cost statement discussed so far is based on the principle of absorption costing.
• An alternative costing framework is marginal costing or variable costing.

Exercise Scenario

• You are a manager of a company producing different types of cookies.
• Your accountant has prepared the following statement for a new cookie launched in April:

• The product was well received in the market.
• Marketing Team suggested doubling the volume for May.
• Accountant suggested either:
  • Discontinue the product
  • Increase the price
• Marketing team is not happy about increasing the price within a month of launch.
• As a manager, you need to decide:
  • ❌ Discontinue the product
  • 🔁 Double the production volume

Absorption Costing (Full Costing)

• The accountant used absorption costing (also known as full costing).
• Under this method:
  • All costs are pooled together to compute cost of goods sold.
  • No separation between fixed and variable cost.
  • Total cost = ₹10 lakhs → distributed over units sold + unsold.
  • Cost of Goods Sold (COGS) = ₹9 lakhs.
  • Inventory Value (10,000 units) = ₹1 lakh.
• Conclusion by accountant: Product is not profitable, so it should be discontinued.

Marginal Costing (Variable Costing)

• Under marginal costing:
  • Fixed costs are not treated as product cost.
  • Treated as period cost instead.
  • Only variable cost is considered as product cost.
• Profit Statement (Marginal Costing):
  • Sales = ₹860,000
  • Variable Cost = ₹720,000
    • Contribution Margin = ₹140,000
  • Fixed Cost = ₹200,000
  • Net Loss = ₹60,000

Comparison of Cost per Unit

• Under full costing, part of the fixed cost moves from one period to another through closing stock.
• Under variable costing, closing stock includes only variable cost.
  • Fixed cost is fully charged in the period in which it is incurred.

Impact in Future Periods

• In the next period, when production increases:
  • Fixed cost per unit declines because:
    • Total fixed cost remains same, but is spread over more units.
  • Hence, closing stock value per unit also declines.