Absorption and marginal costing:

1 Absorption and marginal costing

Introduction:

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

Definition :

3 Definition Absorption costing Marginal costing

Absorption costing:

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

Marginal costing:

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

Slide 6:

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

Presentation of costs on income statement:

7 Presentation of costs on income statement

Slide 8:

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

Example:

9 Example

Slide 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 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

Slide 11:

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

Absorption costing:

12 Absorption costing

Slide 13:

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 Variable selling overheads 4000 3200 4400 Net profit 30000 32800 30100

Marginal costing:

14 Marginal costing

Slide 15:

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: Variable selling overhead4000 3200 4400 Total contribution margin 61000 48800 67100 Less: Fixed Expenses Fixed factory overhead 30000 30000 30000 Fixed selling overheads 1000 1000 1000 Net profit 30000 32800 30100

Slide 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 materials 20 Direct labour 10 Fixed factory overhead absorbed 30 Variable factory overheads 5 65 Back

Slide 17:

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

Difference between absorption and marginal costing:

18 Difference between absorption and marginal costing

Slide 19:

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

Slide 20:

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

Slide 21:

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

Argument for absorption costing:

22 Argument for absorption costing

Slide 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

Arguments for marginal costing:

24 Arguments for marginal costing

Slide 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

Break-even analysis:

26 Break-even analysis

Definition:

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

Application:

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

Assumption of breakeven point analysis:

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

Slide 30:

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

Slide 31:

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

Calculation method:

32 Calculation method

Calculation method:

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

Breakeven point:

34 Breakeven point

Calculation method:

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

Formula:

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

Slide 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

Example:

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

Slide 39:

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

Alternative method:

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

Target profit:

41 Target profit

Formula:

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 =

Example:

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

Slide 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

Alternative method:

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

Margin of safety:

46 Margin of safety

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

Formula:

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

Slide 49:

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

Example :

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

Slide 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 % * 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.

Changes in components of breakeven point:

52 Changes in components of breakeven point

Example:

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

Slide 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

Slide 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

Limitation of breakeven point:

56 Limitation of breakeven point

Limitations of breakeven analysis:

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

Slide 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