Absorption and marginal costing

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 thefixed and variable costs as product costs

5. Marginal costing • It is a costing system which treats only thevariable 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 Profit and loss account Cost of goods sold Marginal Costing Cost Manufacturing cost Non-manufacturing cost Variable Overheads Direct Materials Direct Labour Fixed overhead Period cost Finished goods Profit and loss account Cost of goods sold

7. Presentation of costs on income statement

8. Trading and profit ans loss account Absorption costingMarginal 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 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

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

12. Absorption costing

13. January February March $ $ $ Sales 100000 80000 110000 Less: cost of good sold ($65) 65000 52000 71500 28000 38500 Adjustment for Over-/(under) Absorption of factory overhead 9000 (3000) Gross profit 35000 37000 35500 Less: Expenses Fixed selling overheads 1000 1000 1000 Variableselling overheads 4000 3200 4400 Net profit 30000 32800 30100

14. Marginal costing

15. January February March $ $ $ Sales 100000 80000 110000 Less: Variable cost of good sold ($35) 35000 28000 385500 Product contribution margin 65000 52000 71500 Less: Variableselling overhead4000 3200 4400 Total contribution margin 61000 48800 67100 Less: Fixed Expenses Fixed factory overhead 30000 30000 30000 Fixedselling overheads 1000 1000 1000 Net profit 30000 32800 30100

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 20 Direct labour 10 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 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 35 Back

18. Difference between absorption and marginal costing

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

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 $45000 + $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 $45000 + $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 Margin of safety = Margin of safety Budget sales level *100%

49. Sales revenue 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