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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:
Particulars Amount
Total Production 100,000 packets
Units Sold 90,000 packets
Unsold Inventory 10,000 packets
Variable Cost ₹800,000
Fixed Cost ₹200,000
Revenue from Sales ₹860,000
  • 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

Method Cost per Unit Closing Stock Value (10,000 units)
Absorption Costing ₹10 ₹100,000
Variable Costing ₹8 ₹80,000
  • 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.
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