1. 1 Absorption and marginal costing MOTI THIRUMALA RAJU

2. 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 MOTI THIRUMALA RAJU

3. 3 Definition Absorption costing Marginal costing MOTI THIRUMALA RAJU

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

5. 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 MOTI THIRUMALA RAJU

6. 6 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 MOTI THIRUMALA RAJU

7. 7 Presentation of costs on income statement MOTI THIRUMALA RAJU

8. 8 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 MOTI THIRUMALA RAJU

9. 9 Example MOTI THIRUMALA RAJU

10. 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 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 sold10008001100 Unit produced10001300900 MOTI THIRUMALA RAJU

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

12. 12 Absorption costing MOTI THIRUMALA RAJU

13. 13 JanuaryFebruaryMarch $$$ Sales 10000080000110000 Less: cost of good sold ($65)650005200071500($65) 2800038500 Adjustment for Over-/(under) Absorption of factory overhead9000(3000) Gross profit350003700035500 Less: Expenses Fixed selling overheads100010001000 Variable selling overheads 400032004400 Net profit300003280030100 MOTI THIRUMALA RAJU

14. 14 Marginal costing MOTI THIRUMALA RAJU

15. 15 JanuaryFebruaryMarch $$$ Sales 10000080000110000 Less: Variable cost of good sold ($35)3500028000385500($35) Product contribution margin650005200071500 Less: Variable selling overhead400032004400 Total contribution margin610004880067100 Less: Fixed Expenses Fixed factory overhead300003000030000 Fixed selling overheads100010001000 Net profit300003280030100 MOTI THIRUMALA RAJU

16. 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 materials20 Direct labour10 Fixed factory overhead absorbed30 Variable factory overheads5 65 Back MOTI THIRUMALA RAJU

17. 17 Wk 3: (Under-)/Over-absorption of fixed factory overheads: JanuaryFebruaryMarch $$$ Fixed overhead300003900027000 Fixed overheads incurred300003000030000 09000(3000) 1000*$30 1300*$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 MOTI THIRUMALA RAJU

18. 18 Difference between absorption and marginal costing MOTI THIRUMALA RAJU

19. 19 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 MOTI THIRUMALA RAJU

20. 20 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 MOTI THIRUMALA RAJU

21. 21 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 MOTI THIRUMALA RAJU

22. 22 Argument for absorption costing MOTI THIRUMALA RAJU

23. 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 MOTI THIRUMALA RAJU

24. 24 Arguments for marginal costing MOTI THIRUMALA RAJU

25. 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 MOTI THIRUMALA RAJU

26. 26 Break-even analysis MOTI THIRUMALA RAJU

27. 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 MOTI THIRUMALA RAJU

28. 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 MOTI THIRUMALA RAJU

29. 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 MOTI THIRUMALA RAJU

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

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

32. 32 Calculation method MOTI THIRUMALA RAJU

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

34. 34 Breakeven point MOTI THIRUMALA RAJU

35. 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 MOTI THIRUMALA RAJU

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

37. 37 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 MOTI THIRUMALA RAJU

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

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

40. 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 MOTI THIRUMALA RAJU

41. 41 Target profit MOTI THIRUMALA RAJU

42. 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 = MOTI THIRUMALA RAJU

43. 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 MOTI THIRUMALA RAJU

44. 44 No. of units at target profit Fixed cost + Target profit Contribution per unit = $45000 + $18000 $12 - $3 = = 7000 units Required to sales revenue = $12 *7000 = $84000 MOTI THIRUMALA RAJU

45. 45 Alternative method Required sales revenue Fixed cost + Target profit Contribution to sales ratio = $45000 + $18000 75% = = $84000 Units sold at target profit = $84000 /$12 = 7000 units MOTI THIRUMALA RAJU

46. 46 Margin of safety MOTI THIRUMALA RAJU

47. 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 MOTI THIRUMALA RAJU

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

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

50. 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 MOTI THIRUMALA RAJU

51. 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 % 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. MOTI THIRUMALA RAJU

52. 52 Changes in components of breakeven point MOTI THIRUMALA RAJU

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

54. 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 = $45000 + $18000 $13 - $3 = 6300 units MOTI THIRUMALA RAJU

55. 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 = $40000 + $18000 $12 - $4 = 7250 units MOTI THIRUMALA RAJU

56. 56 Limitation of breakeven point MOTI THIRUMALA RAJU

57. 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 MOTI THIRUMALA RAJU

58. 58 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 MOTI THIRUMALA RAJU