Marginal Costing vs. Absorption Costing Revision Mr. BarryA-level Accounting Year 13

Learning Outcomes At the end of this session, you will be able to: Explain the differences between absorption costing and variable/marginal costing. Explain costs, contribution and break-even and calculate the breakeven point in units and revenue. (Marginal) Represent the break-even point on a chart (Marginal) Select and apply marginal costing techniques for decision making (Marginal) A-level Accounting Year 13Mr. Barry

Learning Outcomes Explain absorption costing to distinguish it from marginal costing (Absorption) Distinguish between cost centre and a cost unit (Absorption) Allocate, apportion and absorb overheads using absorption rate (Absorption) Apply the absorption rates to work out the full cost of a cost unit and work out the selling price of a product (Absorption) Mr. BarryA-level Accounting Year 13

Introduction In financial accounting stocks are valued at full production cost (including a share of fixed production overheads). This approach is known as absorption costing. An alternative approach, variable costing, is to value stock at variable production cost only. As well as valuing stocks differently, the format used to present the accounts is different in variable costing. A-level Accounting Year 13Mr. Barry

Marginal Costing Mr. BarryA-level Accounting Year 13

Marginal Costing Variable costs vary with levels of activity within the business Fixed Costs do not vary with levels of business activity Semi variable cannot be classified as either fixed or variable since they contain elements of each Mr. BarryA-level Accounting Year 13

Marginal costing Only variable costs are charged as a cost of sale Closing stocks valued at marginal (variable) production cost Fixed costs treated as a period cost & charged in full to the P&L account in the current period Contribution (or contribution towards covering fixed overheads) – difference between sales value and marginal (variable) cost Mr. BarryA-level Accounting Year 13

Marginal Cost Definition – The part of the cost of one unit of product (or service) which would be avoided if that unit were not produced, or which would increase if one extra unit were produced Marginal production cost per unit usually consists of – Direct materials – Direct labour – Variable production overheads Mr. BarryA-level Accounting Year 13

Observations Profit per unit varies at differing levels of sales because fixed o/head cost per unit changes with volume changes Contribution per unit is constant Profit = Total Contribution less Fixed Costs. Therefore if Total Contribution matches fixed costs, the breakeven point is reached (CVP analysis) Mr. BarryA-level Accounting Year 13

Important Marginal costing is an alternative method of costing to absorption costing. In marginal costing only variable costs are charged as a cost of sales and a contribution is calculated. Contribution = is of fundamental importance in marginal costing, and the term contribution is really short for contribution towards covering fixed overheads and making a profit. Sales – Variable costs = Contribution Mr. BarryA-level Accounting Year 13

Absorption & Variable Costing A-level Accounting Year 13 Mr. Barry

Absorption & Variable Costing Absorption costing: Product costs: – Fixed manufacturing – Variable manufacturing Period costs: – Non-manufacturing Variable costing: Product costs: – Variable manufacturing Period costs: – Fixed manufacturing – Non-manufacturing A-level Accounting Year 13 Mr. Barry

CONTRIBUTION – is the difference between selling price and variable costs Contribution should more properly be termed contribution towards fixed costs and profit, are once fixed costs are all covered contribution becomes profit. WORKED EXAMPLE 1 £ The selling price of a unit of BMX 100 Variable costs per unit -direct materials 27 Direct labour 32 Royalties 8 Fixed Costs 17 REQUIRED: Calculate the contribution made by the sale of one unit of BMX Mr. BarryA-level Accounting Year 13

ANSWER Contribution per unit = Selling price per unit - Variable cost per unit Contribution per unit = £100 - £67 (£27 + £32 + £8) Contribution per unit = £33 Mr. BarryA-level Accounting Year 13

WORKED EXAMPLE 2 Elia produces a single product. The information below relates to the production and sales of the product in October: Costs and Revenues per unit £ Sales revenue 70 Costs -direct materials 15 Direct labour12 Royalties 5 Fixed Costs20 Production and sales 1,000 units REQUIRED Prepare an income statement for October, showing the total contribution and profit. Mr. BarryA-level Accounting Year 13

ANSWERIncome Statement£ Sales 70,000 LESS Direct materials15,000 Direct labour12,000 Royalties 5,000 32,000 CONTRIBUTION 38,000 LESS FIXED costs 20,000 Profit 18,000 Mr. BarryA-level Accounting Year 13

THE USES OF MARGINAL COSTING MC is used in the following circumstances. When a business is: Costing ‘special’ or one off opportunities Deciding whether to make or buy the product Choosing between competing alternative actions Employing a penetration or destroyer pricing strategy Calculating the break even level of output Mr. BarryA-level Accounting Year 13

SPECIAL OR ONE OFF BUSINESS OPPORTUNITIES Worked Example The Annee manufacturing Company produces one product: ‘Annees’. The following information is available for a production level of 5,000 Annees: Costs and Revenues per unit £ Sales revenue 45 Costs -direct materials 12 Direct labour19 Royalties 1 Fixed Costs 8 There is spare capacity in the factory. A Malaysian retailer has indicated that he would be willing to purchase 200 Annees, but only if the price to her was £35 each. Required Advise the management of the Annee Co whether they should accept the order or not. Mr. BarryA-level Accounting Year 13

ANSWER The order should be accepted. The order will make a positive contribution of £600 (£3 per unit). WORKINGS Contribution = SP – MC per unit Contribution= £35 - £32 Contribution= £3 per annum NOTE The special order has no need to cover the fixed costs since they have already been absorbed into the selling price at the normal rate (£45). Mr. BarryA-level Accounting Year 13

Worked Example – Continued The Malaysian contract has no need to cover the fixed costs AGAIN. The contract is providing the manufacturer with an extra (marginal) contribution. We can check to see if the acceptance of the contract does make the business more profitable by preparing a marginal cost statement. Non acceptance of the order Accepting the order ££££ Sales 225,000 Sales 232,000 Direct Materials 60,000 Direct materials 62,400 Direct Labour 95,000 Direct Labour 98,800 Royalties 5, ,000 Royalties 5, ,400 CONTRIBUTION 65,000 CONTRIBUTION 65,600 Fixed Costs 40,000 Profit 25,000 Profit 25,600 Mr. BarryA-level Accounting Year 13

Question 1 The following information is given for G Singh, a manufacturer of IT cables: £ Direct materials4.50 per unit Direct Labour 7.70 per unit Fixed Costs1.80 per unit The IT cable sells to retailers at £30. Kibrit, a large dept store, wishes to purchase 3,000 cables at a price of £15 per service to include in its annual January sale. REQUIRED Advise G Singh whether he should accept Kibrits order. Mr. BarryA-level Accounting Year 13

MAKE or BUY DECISIONS WORKED EXAMPLE Adrian Dobrin produces T-Shirts for the fashion industry. The estimated costs and revenues for the next financial year are as follows: Costs and Revenues per unit, base on production and Sales of 140,000 T-shirts. £ Selling Price12 Direct materials 2 Direct Labour 3 Fixed costs 4 Total Production cost 9 Profit per T – Shirt 3 A manufacturer in India has indicated that the T-shirts could be supplied to Adrian at a total cost of only £7 each. Adrian has calculated that if existing selling price is maintained then profits will rise to £5 per item and total profits will rise to £700,000 next year – an increase in profits of £280,000. Required: Advise Adrian whether, on financial grounds, he should accept the offer from India Mr. BarryA-level Accounting Year 13

ANSWER Adrian should not accept the offer. If he did he would be worse off next year Than if he continued to manufacture the T-shirts himself. Profits would fall to only £140,000. Contribution if he CONTINUES to manufacture himself =£7 (Selling Price £12 – Marginal (variable costs) £5 (£2 + £3) Contribution if he PURCHASES from India=£5 (Selling Price £12 – Marginal (VC) £7) Make Vs Buy Make Buy £ £ Sales 1,680,000 Direct materials 280,000 Direct labour 420, ,000 Purchase Price 980,000 Contribution 980,000 Contribution 700,000 Less FIXED COSTS 560,000 Less Fixed Cost 560,000 PROFIT 420,000 Profit 240,000 Mr. BarryA-level Accounting Year 13

Fixed and Variable Costs Fixed Costs Fixed costs remain fixed over a range of output levels in the short-term Variable Costs Variable costs vary directly with changes in output levels For example: factory rent For example: materials and labour There are also ‘semi-variable costs’ which combine both a fixed and variable element eg a telephone bill which has fixed rental and variable call charges. Mr. BarryA-level Accounting Year 13

The Break-Even Point The formula for break-even in units of output is: fixed costs (£) contribution per unit (£) contribution per unit (£) = selling price per unit – variable costs per unit The break-even point is the output level (in units) at which the income from sales is just enough to cover all the costs, and the profit (or loss) is therefore zero. Mr. BarryA-level Accounting Year 13

Break-even point by calculation Jason Sports Limited manufactures golf clubs and is able to sell all that is produced. Fixed costs of running the business = £10,000 per month Selling price of each golf club = £30 each Variable costs (materials and direct labour) = £10 per unit What is the break-even point? £10,000 Using the formula, the break-even point in units of output is: = 500 units Fixed costs  Break-even point in units per month Selling price per unit less  variable costs per unit £30 - £10 Mr. BarryA-level Accounting Year 13

Break-even point by the graph method JASON SPORTS LIMITED: BREAK-EVEN GRAPH £5,000 £10,000 £15, costs and revenues units of output (per month) total costs sales revenue variable costs area of loss break-even point (500 units) where the total costs line crosses the sales revenue line. area of profit fixed costs £20,000 Mr. BarryA-level Accounting Year 13

Interpretation of break-even (selling price – variable costs) per unit x volume – fixed costs ( the level of output or activity) For example, for Jason Sports Ltd, the profit at 600 units = Profit/(loss) = (£30 - £10) x £10,000= £2,000= £12,000 - £10,000 The break-even graph can show not only the break-even point but also the profit or loss at any level of output/sales contained within the graph. To calculate profit or loss from the graph simply measure the gap between sales revenue and total costs at a chosen number of units, and read the money amounts off the vertical axis. Another way to calculate the profit or loss at any level of output/sales is the use the following formula: Mr. BarryA-level Accounting Year 13

The relationship between sales revenue, variable costs and fixed costs may not always remain constant because: The assumption that all output is sold may not be true. Limitations of break-even analysis The main limitations are: The presumption that there is only one product may not be correct. External factors (such as rate of inflation) are not considered. - sales prices may differ at different quantities sold (for example because of discounts). - variable costs may alter at different levels of output (for example due to bulk buying of materials). - fixed costs do not remain fixed at all levels of output (for example if extra premises are needed). Mr. BarryA-level Accounting Year 13

Margin of safety The margin of safety may be expressed: sales volume (units) – break-even point (units) In units In £ margin of safety in units x selling price (£) As a % margin of safety in units x 100 sales volume (units) eg Jason Sports Ltd at output of 700 units: 700 – 500 = 200 units eg Jason Sports Ltd at output of 700 units: 200 x £30 = £6,000 The margin of safety is the amount by which sales exceed the break- even point. The margin of safety is important to management as it shows the ‘cushion’ which current production/sales gives beyond the break- even point. Mr. BarryA-level Accounting Year 13

Target profit fixed costs (£) + target profit (£) contribution per unit (£) Number of units output It is also possible to calculate the output that needs to be sold in order to give a certain amount of profit (called the target profit). The formula for this is: = eg If Jason Sports Ltd requires a profit of £4,000 per month, the calculation is: £10,000 + £4000 cont£20 = 700 units with a sales value of £21, units at £30 each Mr. BarryA-level Accounting Year 13

Target profit (continued) The target profit of £4,000 can also be shown by means of a profit statement: sales revenue (700 units at £30 each) 21,000 less variable costs (700 units at £10 each) 7,000 equals contribution (to fixed costs and profit) 14,000 Jason Sports Limited £ less monthly fixed costs 10,000 equals target profit for month 4,000 Note that target profit can also be calculated by making use of the contribution sales ratio (see next two slides). Mr. BarryA-level Accounting Year 13

Contribution Sales Ratio The formula for contribution sales ratio is: contribution (£) selling price (£) The contribution sales (CS) ratio - also known as the profit volume (PV) ratio - expresses the amount of contribution in relation to the amount of the selling price. Referring to Jason Sports Ltd the CS ratio (per unit) is: = £20£ or 66.66% In break-even analysis, if fixed costs are known, then the CS ratio can be used to find the sales value at which the business breaks even, or the sales value to give a target amount of profit (see next slide). Mr. BarryA-level Accounting Year 13

Contribution Sales Ratio (continued) To find the sales value at which Jason Sports Ltd will break-even using the CS ratio: To find the sales value at which Jason Sports Ltd will achieve a target amount of profit (say £2,000) using the CS ratio: = As the selling price is £30 the units of output to achieve the £2,000 profit above is £18,000 / £30 = 600 units. £10, = £15,000 Fixed costs (£) CS ratio = fixed costs (£) + target profit c CS ratio £10,000 + £ = £18,000 Mr. BarryA-level Accounting Year 13

Before starting a new business: When to use break-even analysis In order to see the level of sales needed to cover costs or to make a particular level of profit. When making changes within the business: Break-even analysis will be used as part of the planning process to ensure the business remains profitable. To answer ‘what if?’ questions: Questions such as ‘what if sales fall by 15%?’ and ‘what if fixed costs increase by £1,000?’ can be answered. To evaluate alternative management viewpoints: For example assessing how automation may affect profit. Mr. BarryA-level Accounting Year 13

Limiting Factor 1.Calculate the contribution per unit (SP-VC) 2.Calculate the contribution per limiting factor, for example per labour hour (amount/price or units (Q)/£ per ___) 3.Rank the products in order of the product with the highest contribution per limiting factor 4.Devise a production schedule to maximise profits using the rank order Mr. BarryA-level Accounting Year 13

Question A company manufactured 3 products, X, Y and Z. The sales demand on the standard unit selling prices and costs for the next accounting period are estimated below: Calculate an optimum production plan when there is only 18,000 hours of direct labour available? Mr. BarryA-level Accounting Year 13 XYZ Maximum demand4,0005,5007,000 Selling price£28£22£30 Variable costs: Raw materials (£1 per kg) Direct Labour (£12 per hour)

Challenge 1.Calculate the contribution per unit (SP-VC) 2.Calculate the contribution per limiting factor, for example per labour hour 3.Rank the products 4.Devise production schedule Mr. BarryA-level Accounting Year 13

Absorption Costing Mr. BarryA-level Accounting Year 13

Overhead allocation : Recap Mr. BarryA-level Accounting Year 13 Product costs are built up using absorption costing by a process of allocation apportionment and absorption. Allocation: is the process by which whole cost items are charges direct to a cost unit or cost centre. Apportionment: follows on from overhead allocation. Identify all overhead costs as production department, admin or S&D overheads. The costs for heat, light and all costs that have been allocated to general overhead cost centres must be shared out between the other cost centres. Overhead costs should be shared out on a fair basis.

OverheadBasis Mr. BarryA-level Accounting Year 13

Service Cost Centre Mr. BarryA-level Accounting Year 13

How to calculate the amount of apportioned base for each department 1.Add up total available floor space or NBV 2.Divide each department allocation by the amount of base available Example: Mr. BarryA-level Accounting Year 13 CuttingFinishingMaintenanceCanteen Floor area50,00030,00015,0005,000 NBV150,000450,000

Calculation of the overhead absorption rate (OAR) 1.Distinguish between production departments 2.Decide on the correct bases to be used to apportion the overheads between departments 3.Draw up a schedule to apportion the overheads between all of the departments 4.Complete the schedule by apportioning the total of the overheads of each service departments to each of the production departments 5.Total up the overheads for each production department 6.Divide the total for each department by the correct basis and calculate the OAR for each production department Mr. BarryA-level Accounting Year 13

The absorption rate is calculated as : Budgeted overhead (£) Budgeted level of activity (machine hours/ labour hours) Many factories use a direct labour hour rate or machine hour rate in preference to a rate based on a % of direct materials cost, wages or prime cost. Mr. BarryA-level Accounting Year 13 Overhead absorption : Recap

Use of the overhead absorption rate (OAR) Calculate the full cost of a cost unit Mr. BarryA-level Accounting Year 13 £ Materials (metre x price per metre)x Labour (2 hours x price per hour)x Use overhead absorption rate for calculating cost of overheads (OAR x department overheads) x Full costx

Over & under absorption : Recap Mr. BarryA-level Accounting Year 13 The rate of overhead absorption is based on estimates and is quite likely that either one or both of the estimates will not agree with what actually occurred. Actual overheads will probably be either greater than or less than overhead absorbed into the cost of production. a)Over absorption means that the overheads charged to the cost of production are greater than the overheads actually incurred. b)Under absorption means that insufficient overheads have been included in the cost of production.  If actual overhead – absorbed overhead = Negative, then overheads are over absorbed.  If actual overhead – absorbed overhead = Positive, then the overheads are under absorbed.

Reasons for under / over  Actual overhead costs are different from budgeted overheads  The actual quantity level is different from the budgeted level of activity  Both actual overheads and actual activity level are different from budget Mr. BarryA-level Accounting Year 13

Inventory valuation and the effect on profit £ Selling price per bag Materials per bag11.00 Labour per bag16.00 Cutting dept overheads27.00 Finishing dept overheads29.75 Mr. BarryA-level Accounting Year 13 During the year ended 31 October 2013 the business produced 8,000 bags and sold 7,900 bags Inventory levels were: Fixed costs for the year were £454,000 Number of bags 1 November October