Absorption and marginal costing

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

Definition
 Absorption costing  Marginal costing

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

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

Absorption Costing Cost Manufacturing cost Direct Materials Direct Labour Overheads Non-manufacturing cost

Period cost Profit and loss account

Finished goods Marginal Costing

Cost of goods sold Cost

Manufacturing cost Direct Materials Direct Labour Variable Overheads

Non-manufacturing cost Fixed overhead

Period cost Profit and loss account 6

Finished goods

Cost of goods sold

Presentation of costs on income statement

Trading and profit ans loss account

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

Variable and fixed manufacturing

X X X X

Net Profit

X X X X

Example

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 100 Direct materials per unit 20 Direct Labour per unit 10 Fixed factory overhead per month 30000 Variable factory overhead per unit 5 Fixed selling overheads 1000 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 1000 800 1100 Unit produced 1000 1300 900

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

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Absorption costing

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January $ Sales 100000 Less: cost of good sold ($65) 65000 Adjustment for Over-/(under) Absorption of factory overhead Gross profit 35000 Less: Expenses Fixed selling overheads 1000 Variable selling overheads 4000 Net profit 30000

February $ 80000 52000 28000 9000 37000 1000 3200 32800

March $ 110000 71500 38500 (3000) 35500 1000 4400 30100

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Marginal costing

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Sales Less: Variable cost of good sold ($35) 35000 Product contribution margin 65000 Less: Variable selling overhead4000 Total contribution margin 61000 Less: Fixed Expenses Fixed factory overhead 30000 Fixed selling overheads 1000 Net profit 30000

January $ 100000

February $ 80000 28000 52000 3200 48800 30000 1000 32800

March $ 110000 385500 71500 4400 67100 30000 1000 30100

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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 Variable factory overheads Back $ 20 10 30 5 65 =

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Wk 3: (Under-)/Over-absorption of fixed factory overheads: January February March $ $ $ Fixed overhead 30000 39000 27000 Fixed overheads incurred 30000 30000 30000 0 9000 (3000) 1000*$30 1300*$30 900*$30

No fixed factory overhead Wk 4: Variable production cost per unit under marginal costing: $ Direct materials 20 Direct labour 10 Variable factory overhead 5 Back 35

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Difference between absorption and marginal costing

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Absorption costing Treatment for Fixed manufacturing fixed manufacturing overheads are treated as product overheads costing. It is believed that products cannot be produced without the resources provided by fixed manufacturing overheads

Marginal costing Fixed manufacturing overhead are treated as period costs. It is believed that only the variable costs are relevant to decisionmaking. Fixed manufacturing overheads will be incurred regardless there is production or not
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Value of closing stock

Absorption costing High value of closing stock will be obtained as some factory overheads are included as product costs and carried forward as closing stock

Marginal costing Lower value of closing stock that included the variable cost only

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Absorption costing Marginal costing Reported If the production = Sales, AC profit = MC Profit 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
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Argument for absorption costing

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 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

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Arguments for marginal costing

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 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

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Break-even analysis

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Definition
 Breakeven analysis is also known as costvolume 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

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Application
 Breakeven analysis can be used to determine a companys 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

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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

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

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Cost $

Total cost Variable cost Fixed cost

Sales (units) Total Cost/Revenue $

Sales revenue Profit Total cost

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BEP

Sales (units)

Calculation method

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

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Breakeven point

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

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

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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

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Example
 Selling price per unit  Variable cost per unit  Fixed costs Required:
 Compute the breakeven point

$12 $3 $45000

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Breakeven point in units =

Fixed costs Contribution per unit = $45000 $12-$3 = 5000 units

Sales revenue at breakeven point = $12 * 5000 = $60000

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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
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Target profit

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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

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Example
 Selling price per unit  Variable cost per unit  Fixed costs  Target profit Required: $12 $3 $45000 $18000

 Compute the sales volume required to achieve the target profit

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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

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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

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Margin of safety

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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

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

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Sales revenue
Total Cost/Revenue $

Profit

Total cost

BEP Margin of safety

Sales (units)

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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

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Margin of safety = Budget sales level breakeven sales level = 7000 units 5000 units = 2000 units Margin of safety = Margin of safety *100 % Budget sales level = 2000 *100 % 7000 = 28.6% 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.
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Changes in components of breakeven point

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

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 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
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 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
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Limitation of breakeven point

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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

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 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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