1 Absorption and marginal costing

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4 Introduction Before we allocate all manufacturing costs to products regardless of whether they are fixed or variable. This approach is known as absorption costing/full costing However, only variable costs are relevant to decision-making. This is known as marginal costing/variable costing

5 Definition Absorption costing Marginal costing

6 Absorption costing It is costing system which treats all manufacturing costs including both the fixed and variable costs as product costs

7 Marginal costing It is a costing system which treats only the variable manufacturing costs as product costs. The fixed manufacturing overheads are regarded as period cost

8 Cost Manufacturing costNon-manufacturing cost Direct Materials Direct Labour Overheads Finished goods Cost of goods sold Period cost Profit and loss account Absorption Costing Cost Manufacturing costNon-manufacturing cost Direct Materials Direct Labour Variable Overheads Finished goods Cost of goods sold Period cost Profit and loss account Marginal Costing Fixed overhead

9 Presentation of costs on income statement

10 Trading and profit ans loss account Absorption costingMarginal costing$ SalesXSalesX Less: Cost of goods soldXLess: Variable cost of Goods soldX Gross profitXProduct contribution marginX Less: ExpensesLess: variable non- manufacturing Selling expensesX expenses Admin. expensesX Variable selling expensesX Other expensesXX Variable admin. expensesX Other variable expensesX Total contribution expensesX Less: Expenses Fixed selling expensesX Fixed admin. expensesX Other fixed expensesX Net ProfitXNet ProfitX Variable and fixed manufacturing

11 Example

12 A company started its business in The following information Was available for January to March 2005 for the company that produced A single product: $ Selling price pre unit100 Direct materials per unit20 Direct Labour per unit10 Fixed factory overhead per month30000 Variable factory overhead per unit5 Fixed selling overheads1000 Variable selling overheads per unit4 Budgeted activity was expected to be 1000 units each month Production and sales for each month were as follows: JanFebMarch Unit sold Unit produced

13 Required: Prepare absorption and marginal costing statements for the three months

14 Absorption costing

15 JanuaryFebruaryMarch $$$ Sales Less: cost of good sold ($65) ($65) Adjustment for Over-/(under) Absorption of factory overhead9000(3000) Gross profit Less: Expenses Fixed selling overheads Variable selling overheads Net profit

16 Marginal costing

17 JanuaryFebruaryMarch $$$ Sales Less: Variable cost of good sold ($35) ($35) Product contribution margin Less: Variable selling overhead Total contribution margin Less: Fixed Expenses Fixed factory overhead Fixed selling overheads Net profit

18 Wk1: Standard fixed overhead rate = Budgeted total fixed factory overheads Budgeted number of units produced = $ units = $30 units Wk 2: Production cost per unit under absorption costing: $ Direct materials20 Direct labour10 Fixed factory overhead absorbed30 Variable factory overheads5 65 Back

19 Wk 3: (Under-)/Over-absorption of fixed factory overheads: JanuaryFebruaryMarch $$$ Fixed overhead Fixed overheads incurred (3000) 1000*$ *$30900*$30 Wk 4: Variable production cost per unit under marginal costing: $ Direct materials20 Direct labour10 Variable factory overhead5 35 No fixed factory overhead Back

20 Difference between absorption and marginal costing

21 Absorption costingMarginal costing Treatment for fixed manufacturing overheads Fixed manufacturing overheads are treated as product costing. It is believed that products cannot be produced without the resources provided by fixed manufacturing overheads Fixed manufacturing overhead are treated as period costs. It is believed that only the variable costs are relevant to decision- making. Fixed manufacturing overheads will be incurred regardless there is production or not

22 Absorption costingMarginal costing Value of closing stock High value of closing stock will be obtained as some factory overheads are included as product costs and carried forward as closing stock Lower value of closing stock that included the variable cost only

23 Absorption costingMarginal costing Reported profit If the production = Sales, AC profit = MC Profit If Production > Sales, AC profit > MC profit As some factory overhead will be deferred as product costs under the absorption costing If Production < Sales, AC profit < MC profit As the previously deferred factory overhead will be released and charged as cost of goods sold

24 Argument for absorption costing

25 Compliance with the generally accepted accounting principles Importance of fixed overheads for production Avoidance of fictitious profit or loss During the period of high sales, the production is small than the sales, a smaller number of fixed manufacturing overheads are charged and a higher net profit will be obtained under marginal costing Absorption costing is better in avoiding the fluctuation of profit being reported in marginal costing

26 Arguments for marginal costing

27 More relevance to decision-making Avoidance of profit manipulation Marginal costing can avoid profit manipulation by adjusting the stock level Consideration given to fixed cost In fact, marginal costing does not ignore fixed costs in setting the selling price. On the contrary, it provides useful information for break-even analysis that indicates whether fixed costs can be converted with the change in sales volume

28 Break-even analysis

29 Definition Breakeven analysis is also known as cost- volume profit analysis Breakeven analysis is the study of the relationship between selling prices, sales volumes, fixed costs, variable costs and profits at various levels of activity

30 Application Breakeven analysis can be used to determine a company’s breakeven point (BEP) Breakeven point is a level of activity at which the total revenue is equal to the total costs At this level, the company makes no profit

31 Assumption of breakeven point analysis Relevant range The relevant range is the range of an activity over which the fixed cost will remain fixed in total and the variable cost per unit will remain constant Fixed cost Total fixed cost are assumed to be constant in total Variable cost Total variable cost will increase with increasing number of units produced

32 Sales revenue The total revenue will increase with the increasing number of units produced

33 Total cost Variable cost Fixed cost Cost $ Sales (units) Sales revenue Total Cost/Revenue $ Sales (units) Total cost Profit BEP

34 Calculation method

35 Calculation method Breakeven point Target profit Margin of safety Changes in components of breakeven analysis

36 Breakeven point

37 Calculation method Contribution is defined as the excess of sales revenue over the variable costs The total contribution is equal to total fixed cost

38 Formula Breakeven point Fixed cost Contribution per unit Sales revenue at breakeven point = Breakeven point *selling price =

39 Alternative method: Sales revenue at breakeven point Contribution required to breakeven Contribution to sales ratio = Breakeven point in units Sales revenue at breakeven point Selling price = Contribution per unit Selling price per unit

40 Example Selling price per unit$12 Variable cost per unit$3 Fixed costs$45000 Required: Compute the breakeven point

41 Breakeven point in units = Fixed costs Contribution per unit = $45000 $12-$3 = 5000 units Sales revenue at breakeven point = $12 * 5000 = $60000

42 Alternative method Contribution to sales ratio $9 /$12 *100% = 75% Sales revenue at breakeven point = Contribution required to break even Contribution to sales ratio = $ % = $60000 Breakeven point in units = $60000/$12 = 5000 units

43 Target profit

44 Formula No. of units at target profit Fixed cost + Target profit Contribution per unit = Required sales revenue Fixed cost + Target profit Contribution to sales ratio =

45 Example Selling price per unit$12 Variable cost per unit$3 Fixed costs$45000 Target profit$18000 Required: Compute the sales volume required to achieve the target profit

46 No. of units at target profit Fixed cost + Target profit Contribution per unit = $ $18000 $12 - $3 = = 7000 units Required to sales revenue = $12 *7000 = $84000

47 Alternative method Required sales revenue Fixed cost + Target profit Contribution to sales ratio = $ $ % = = $84000 Units sold at target profit = $84000 /$12 = 7000 units

48 Margin of safety

49 Margin of safety Margin of safety is a measure of amount by which the sales may decrease before a company suffers a loss. This can be expressed as a number of units or a percentage of sales

50 Formula Margin of safety = Margin of safety Budget sales level *100% Margin of safety = Budget sales level – breakeven sales level

51 Sales revenue Total Cost/Revenue $ Sales (units) Total cost Profit BEP Margin of safety

52 Example The breakeven sales level is at 5000 units. The company sets the target profit at $18000 and the budget sales level at 7000 units Required: Calculate the margin of safety in units and express it as a percentage of the budgeted sales revenue

53 Margin of safety = Budget sales level – breakeven sales level = 7000 units – 5000 units = 2000 units Margin of safety = Margin of safety Budget sales level = = 28.6% *100 % The margin of safety indicates that the actual sales can fall by 2000 units or 28.6% from the budgeted level before losses are incurred.

54 Changes in components of breakeven point

55 Example Selling price per unit$12 Variable price per unit$3 Fixed costs$45000 Current profit$18000

56 If the selling prices is raised from $12 to $13, the minimum volume of sales required to maintain the current profit will be: Fixed cost + Target profit Contribution to sales ratio = $ $18000 $13 - $3 = 6300 units

57 If the fixed cost fall by $5000 but the variable costs rise to $4 per unit, the minimum volume of sales required to maintain the current profit will be: Fixed cost + Target profit Contribution to sales ratio = $ $18000 $12 - $4 = 7250 units

58 Limitation of breakeven point

59 Limitations of breakeven analysis Breakeven analysis assumes that fixed cost, variable costs and sales revenue behave in linear manner. However, some overhead costs may be stepped in nature. The straight sales revenue line and total cost line tent to curve beyond certain level of production

60 It is assumed that all production is sold. The breakeven chart does not take the changes in stock level into account Breakeven analysis can provide information for small and relatively simple companies that produce same product. It is not useful for the companies producing multiple products

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