Total and Marginal expenses’ calculation and their connection with profit index

Izolda Chiladze Doctor of Economics

Our aim in this work is to show influence of calculation system on the profit indicator with the net total and marginal expenses.

According to the international standards requirements of accounting the direct costs of the materials, the direct labor costs and factory burden costs are included in prime cost of produced goods or services of enterprise. This last one represents indirect costs, because it is of common character and it appropriates to the separate kind of product”s prime cost by the distribution way. But non-enterprise indirect expenses (common administration and Marketing expenses) are not included in the prime cost of the products. Instead they are included in the profit – loss account and consequently they cannot be included in inventory estimation. Such cost account system is known as the prime cost calculation by total distribution of the costs, when the overhead costs are included in the prime cost of unit of product.
There is alternative system of the calculation, when only variable costs of the enterprise are included in the prime cost of the produced good. This system of calculation is known as product prime cost calculation by marginal expenses.
It is not eworthy that the volume of overhead expenses is not known till the end of the month, as they belong to costs of general character such as: amortization and insurance expenses of the enterprise; wages of the employees; salaries of the department managers of the enterprise etc. Integrated products are produced in an enterprise and sold several times during a month. Consequently, the calculation of product prime cost is necessary to be done before the end of a month. Therefore, it is necessary to plan the rate of overhead expenses inclusion in the prime cost of the finished product.
The rate of overhead expenses inclusion can be planned in GEL on the basis of machine/hours or labor/hours or by percentage of direct costs. Either some alternative base can be used, according to the management’s decision.
Assume that enterprise’s overhead expenses rate is defined as 5 GEL per machine/hour. Then during the month, as many machine/hour will be spent in the production period the additional 5 GEL will be included to the prime cost of finished production. It is obvious that at the end of the month, the factual volume of accumulated manufacturing overheads will be known. However, some discrepancy can be appeared between “Included” and actual overhead expenses. Existing discrepancy is not reflected on the prime cost of the product. Instead, it is included in the profit/loss account.
It is remarkable, that in some literature term “absorption rate” is used, instead of “inclusion rate” of overhead expenses (Kaplan, administration calculation, ACCA, translation from English, Tb, 2008, page 140-150). We do not agree with this definition. The finished products absorb not only indirect, but direct costs also. The “Inclusion rate” is used because the volume of actual overhead expenses is accumulated during the month and they become known only at the end of the month.
The calculation of product prime cost by full and marginal expenses is not considered as the calculation method, instead they are known as the principles of the calculation. Such approaches toward the calculation of prime cost are used according to the specific requirement of information consumer. Specifically, the prime cost rate is not necessary for the profit/loss declaration or for the making some decision inside the company.
As it is known, production expenses are divided into variable and constant expenses, according to the volume of the production. Direct costs are variable expenses, while manufacturing overheads include both of them. The systems of prime cost calculation are based on this method of classification of manufacturing overheads.
By total distribution of the expenses, according to the product prime cost calculation system, the variable and constant manufacturing overheads are both included in the prime cost of a unit of product.
As an example:
Planning data of one unit of product that should be manufactured are the following (GEL):
The selling price 20
The direct material expenses 6
Direct labor expense 4
Manufacturing overheads:
Variable 3
Constant 2
Prime cost by total distribution of the expenses 15
The level of the constant manufacturing overheads per product is established in terms of produced 1000 units a month, when the constant manufacturing overheads amount 2000 Gel.
Assume that 1500 units of product are produced in the current month and 1300 units are sold out. Actual overhead expenses amount 2600 GEL.

Profit/loss accounting with total distribution of the expenses will be as follows:
GEL GEL
Profit on sales (1300 units * 20 GEL) 26 000
Prime cost of sold products:
Initial remainder
Manufacturing (1500 units * 15 GEL) 22 500
The final remainder (200 units * 15 GEL) (3 000) (19 500)
————————— —————————
Profit on sales 6 500
Appropriated constant overhead expenses 3 000
(1500 pieces * 2 GEL)
Actual constant overhead expenses (2 600)
——————————————————————
Appropriate increase 400
——————————————————————————————
Profit 6 900
Included overhead expenses are calculated by multiplication of actual quantity of production and overhead expenses planned rate. In the discussed example, the manufacturing overheads are increased that increases the profit by the same amount. The odds of overhead expenses are created because included constant overhead expenses for the actual manufacturing of the product – per 1500 units as follows: 1500 units * 2 GEL = 3000 GEL.
However, as it is known, the constant expenses do not change in proportion with manufactured products. Because of this the profit must be adjusted by subtracting the sum that is caused by the manufacturing overheads inclusion. It is calculated by the subtraction of included and actual constant overhead expenses. Inclusion of overhead expenses increases the profit, while the lack of inclusion cuts the profit.
In this way, by total distribution of the expenses in the product prime cost calculation system, the manufacturing overheads will be included in the debit account of unfinished production. While constant manufacturing overheads inclusion discrepancy will be included in the debit of profit/loss account. The increase of inclusion is accounted in the debit of manufacturing overheads and in the profit/loss credit account. The inclusion shortage is accounted in the debit account of profit/loss and overhead expenses” credit account.
While calculating product prime cost by the marginal expenses, only variable costs are included in the prime cost of the product. Constant expenses are considered as the period expenses and are included in the profit/loss account. Consequently, constant manufacturing overheads are not included in the prime cost of the product.
As the constant manufacturing overheads are not included in the prime cost of the product, therefore the prime cost of the unit of production will be 13 GEL instead of 13, according to previous example.
Profit –loss accounting will be as follows:
GEL
Profit on sales (1300 units * 20) 26 000
Prime cost of sold products:
Initial remainder of the product
Enterprise (1500 units * 13 GEL) 19 500
The final remainder (200 units * 13 Gel) (2 600) (16 900)
——————— ———
Marginal profit 9 100
Constant manufacturing overheads (2 600)
———
Profit (loss) 6 500

The profit received according to the above calculation is 400 GEL less (6500 – 6900), than it was during the profit calculation of the total costing. This difference is caused by the first estimation, when 200 units of products prime cost of the finished production remained remainder was estimated by the 15 Gel and then by 13 Gel, so 200 pieces * 2 Gel =400 Gel.

Profit rates can be unified in an account: GEL
Profit with full consideration of the expenses 6 900
The final reserve with the total distribution (200 * 15 GEL) – 3000
The final reserve with the marginal costs (200 * 13 GEL) – 2600 (400)
————————————————
Profit with the marginal costing during the calculation 6 500
In this way, calculation system of products prime cost with the total and marginal costing influences the profit indicator. The difference between the profit indicators is caused by one reason – by the difference estimation of the unrealized products remainder prime cost. The difference of the included overhead expenses is not influencing it.
It is obvious that the calculation with the marginal costing cannot be used for financial reporting, because international accounting standards do not allow this, but inside the enterprise, during the decision making process, and while production planning it may be used successfully.
Now, we will bring the example to illustrate how the total distribution of prime cost calculation might give the false volume of profit.
For example, we will use the data of products unit price and its prime cost given in the preceding example. Assume that actual overhead expenses amount 1800 GEL in a month, while the production and realization indices are the following (see the table 1):
Prepared profit-loss accounting report according to each month, by the total distribution of manufacturing expenses on the base of shown data will be following (see the table 2).
According to the given data, variable cost per unit of product is 13 GEL by plan, while constant manufacturing overheads amount 2 GEL. Consequently, the total distribution of manufacturing overheads, the prime cost of the product is 15 GEL. Therefore, in teh calculations given in teh second table, the prime cost per unit of product is assessed as 15GEL that includes constant manufacturing overheads – 2 GEL. However, constant costs do not change in proportion with manufactured production. They remain unchanged. This means that no matter how many units of product will be manufactured, constant manufacturing overheads will remain 1800 GEL. By including 2 GEL of constant overhead expenses to each unit of the production, it is equalled to the variable expenses. Therefore, difference between included and actual constant overhead expenses is used to adjust the volume of profit. For example: The profit on sales amount 2000 GEL in first month. 800 GEL of constant manufacturing overheads have been included to the manufactured product (400 units * 2 GEL). While at the end of the month constant overhead expenses appeared to be 1800 GEL. Consequently the lack of inclusion was 100 GEL that decreases the profit by the same sum. The calculation for the next months will be the same.
If the unrealized products prime cost has grown at the end of the month by the result of separate months indicators counting, the profit grows before the compare period.
Now, we will show the profit calculation by means of marginal or variable expenses (See the table 2).
By analyzing indices of first and second tables, we can assume:
By the result of comparatively analyzes of the second and the third indicators we can make the conclusion:
· The profit indicators are equal by the both calculation system in I and IV months, as production and realization are coincided in both cases and the initial and final remainders do not change (see the table 1).
· In II and V months, profit is received if using full distribution of the expenses, while loss is observed if using calculation by marginal expenses;
· In the III months, final remainder of the product has decreased and the profit in the full distribution system is lower than in the calculations using marginal expenses;
· In V month, final remainder of finished production has increased and the profit during full distribution is higher that in the system of marginal expense calculation.
Therefore, the calculation using full distribution of the expenses shows higher profit rate, when the final remainder of unrealized production increases, than the calculation with marginal costs. Even when the volume of realized production remains unchanged. Moreover, in the second month, it seems that it is enough to sell 200 units of the product in order to gain 100 GEL profit. While in case of marginal expense calculation of the prime cost the results show 400 GEL loss. This is caused because in case of full distribution of the expenses, the 250 units of unrealized products are bearing big portion of the expenses. Therefore, the prime cost of sold production decreased and the profit increased. When the final remainder of finished production reduces, calculation with marginal expenses gain more profit.
Consequently there are the following principles: the calculation system of the products prime cost with the total distribution may show the profit and the calculation with the marginal expenses may show the loss. However, it will never be contrary that calculation with the marginal costing will not show loss and the calculation with full distribution will not show the profit. So this last shows the loss. Because of this principle, calculation system with the marginal expenses represents the trust way on the stage of taking decisions.
The preference arguments of the calculation with full distribution of prime costs are the following:
· The constant enterprise expenses arise by the result of enterprising and the enterprise process is not possible without them. And because of these the enterprise expenses may be included to the enterprise process and must be mentioned during the products estimation;
· Accounting with full distribution of the expenses, the calculation is relevant to proper principle of calculation so that the part of the manufacturing overheads is transmitted to the final reserve.
· It is necessary to include the constant overhead expenses in the prime cost of the products for the purpose of financial reporting. The products reserve prime cost contains the parts of included the constant expenses according to the calculation by the distributing total expenses.
· It is necessary to bring the constant expenses in the costing of products enterprise, during the analyzing of the products cost defining and profit. In spite of this the incomes will not be enough for hiding the expenses.
· The profit/loss analyze of the overhead expenses are useful for establishing not effectively used resources.
The opposed argument of the prime cost calculation with the distributing total expenses are:

· The size of constant expenses do not change during the changing of the enterprise scale, and because of this such costing would not belong to the manufacturing overheads and would not be mentioned during the reserve estimation;
· The increase of the profit is fixed when the size of realization do not change and there is no real profit.

Calculation with the variable expenses of the prime cost secures the enterprise by the more useful information for taking the decision. Division of the costing by the constant and variable expenses gives the necessary information for taking the decision. The prime cost calculation with the marginal costing have the following preferences:

· The calculation with the variable costing is free from the dealing out the constant costing subjectivity. The profit indicator on the unit may take us to the mistake for using the dealing out the total costing, because the increase of the constant invoice expenses on the products unit are planned on the base of planning size, if it will be used other kind of base, then the indicator of expenses and the products unit will be different in order of that the constant expenses did not change in wholeness.
· The profit in the net calculation system with the marginal costing is free from the influence of changing remainder of the unrealized products.
· The calculation with the variable expenses gives the means to avoid the capitalization of the constant marginal expenses in the unusual (un-standardized) reserve.

For example, the company may accumulate more reserve in that period when the demand on the products is cut down. By distributing the total expenses, the only parts of the constant marginal expenses, spending by the company during the period will be included in the manufacturing overheads, because the following overhead expenses will estimate the unrealized unnecessary reserve. As it is impossible to avoid the more reserve of goods, the recent period profit calculation will not be exact, because the constant overhead expenses are taken to the next calculation.
The managers may come to the calculation, that it is impossible to sell the reserves without essential cutting of the costs. According of this, the reserve will subordinate to the revaluation and it is necessary to write off the part of their costs in the following accounting period. The effect is that the profit volume of the following period will increase.
*The variable costing on the unit is put out during the calculation with prime cost marginal expenses and the constant expenses on the whole size. Then the enterprise costing is united in the system of total expenses and marginal costing.
The variable calculation with the variable costing is connected to the enterprise scale and it is the suitable method for taking the quickly decision than the calculation system with the distribution of the total costing.
The products prime cost calculation with the marginal costing may be used successfully by the purpose of real profit prove, when the enterprise management takes the decision about planning the products manufacturing and realization size.