1. Absorption and marginal costing

2. 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

3. Definition
Absorption costing
Marginal costing

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

5. 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

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

7. Presentation of costs on income statement

8. Trading and profit ans loss account
Absorption costing Marginal costing
$ $
Sales X Sales X
Less: Cost of goods sold X Less: Variable cost of
Goods sold X
Gross profit X Product contribution margin X
Less: Expenses Less: variable non- manufacturing
Selling expenses X expenses
Admin. expenses X Variable selling expenses X
Other expenses X X Variable admin. expenses X
Other variable expenses X
Total contribution expenses X
Less: Expenses
Fixed selling expenses X
Fixed admin. expenses X
Other fixed expenses X
Net Profit X Net Profit X
Variable and fixed manufacturing

9. Example

10. A company started its business in 2005. The following information
Was available for January to March 2005 for the company that produced
A single product: $
Selling price pre unit
Direct materials per unit
Direct Labour per unit
Fixed factory overhead per month
Variable factory overhead per unit 5
Fixed selling overheads
Variable selling overheads per unit 4
Budgeted activity was expected to be 1000 units each month
Production and sales for each month were as follows:
Jan Feb March
Unit sold
Unit produced

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

12. Absorption costing

13. January February March
$ $ $
Sales
Less: cost of good sold ($65)
Adjustment for Over-/(under)
Absorption of factory overhead (3000)
Gross profit
Less: Expenses
Fixed selling overheads
Variable selling overheads
Net profit

14. Marginal costing

15. January February March
$ $ $
Sales
Less: Variable cost of good
sold ($35)
Product contribution margin
Less: Variable selling overhead
Total contribution margin
Less: Fixed Expenses
Fixed factory overhead
Fixed selling overheads
Net profit

16. Wk1:
Standard fixed overhead rate
= Budgeted total fixed factory overheads
Budgeted number of units produced
= $30000
1000 units
= $30 units
Wk 2:
Production cost per unit under absorption costing: $
Direct materials
Direct labour
Fixed factory overhead absorbed 30
Variable factory overheads 5 65
Back

17. Wk 3:
(Under-)/Over-absorption of fixed factory overheads:
January February March
$ $ $
Fixed overhead
Fixed overheads incurred
(3000)
1000*$30
1300*$30
900*$30
No fixed factory overhead
Wk 4:
Variable production cost per unit under marginal costing: $
Direct materials
Direct labour
Variable factory overhead 5 35
Back

18. Difference between absorption and marginal costing

19. Absorption costing
Marginal 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

20. Absorption costing
Marginal 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

21. Absorption costing
Marginal 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

22. Argument for absorption costing

23. 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

24. Arguments for marginal costing

25. 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

26. Break-even analysis

27. 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

28. 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

29. 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

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

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

32. Calculation method

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

34. Breakeven point

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

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

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

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

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

40. Alternative method Contribution to sales ratio $9 /$12 *100% = 75%
Sales revenue at breakeven point
= Contribution required to break even
Contribution to sales ratio
= $45000
75%
= $60000
Breakeven point in units = $60000/$12 = 5000 units

41. Target profit

42. 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

43. 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

44. 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

45. Alternative method Required sales revenue Fixed cost + Target profit =
Contribution to sales ratio
$ $18000 =
75%
= $84000
Units sold at target profit = $84000 /$12 = 7000 units

46. Margin of safety

47. 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

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

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

50. 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

51. Margin of safety
= Budget sales level – breakeven sales level
= 7000 units – 5000 units
= 2000 units
Margin of safety
= Margin of safety
Budget sales level
= 2000
7000
= 28.6%
*100 %
*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.

52. Changes in components of breakeven point

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

54. 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

55. 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

56. Limitation of breakeven point

57. 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

58. It is assumed that all production is sold
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