Absorption and marginal costing

1
ntroduction
a 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
a However, only variable costs are relevant
to decision-making. This is known as
marginal costing/variable costing

„
 efinition
a Absorption costing
a Marginal costing

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

˜
Marginal costing
a t is a costing system which treats only the
variable manufacturing costs as product
costs. The fixed manufacturing overheads
are regarded as period cost


 6
 


ost
Manufacturing cost Non-manufacturing cost

irect irect Overheads

Materials Labour Period cost

Finished goods ost of goods sold Profit and loss account


  


ost
Manufacturing cost Non-manufacturing cost

irect irect Variable Fixed

Materials Labour Overheads overhead Period cost

Finished goods ost of goods sold Profit and loss account

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Presentation of costs on income
statement

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 Trading and profit ans loss account
6
 


  


$ $
Sales X Sales X
Less: ost 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
Variable and fixed manufacturing Total contribution expenses X

Less: Expenses
Fixed selling expenses X
Fixed admin. expenses X
Other fixed expenses X
Net Profit X Net Profit X
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Example

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A company started its business in „00. The following information
Was available for January to March „00 for the company that produced
A single product:
$
Selling price pre unit 100
irect materials per unit „0
irect Labour per unit 10
Fixed factory overhead per month ÷0000
Variable factory overhead per unit 
Fixed selling overheads 1000
Variable selling overheads per unit ˜

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 h00 1100
Unit produced 1000 1÷00 Ä00
10
a Required:
a Prepare absorption and marginal costing
statements for the three months

11
Absorption costing

1„
 January February March
$ $ $
Sales 100000 h0000 110000
Less: cost of good sold ($r
r000 „000 ¢100
„h000 ÷h00
Adjustment for Over-/(under

Absorption of factory overhead Ä000 (÷000

Gross profit ÷000 ÷¢000 ÷00
Less: Expenses
Fixed selling overheads 1000 1000 1000
Variable selling overheads ˜000 ÷„00 ˜˜00
Net profit ÷0000 ÷„h00 ÷0100

1÷
Marginal costing

1˜
 January February March
$ $ $
Sales 100000 h0000 110000
Less: Variable cost of good
sold ($÷
÷000 „h000 ÷h00
Product contribution margin r000 „000 ¢100
Less: Variable selling overhead˜000 ÷„00 ˜˜00
Total contribution margin r1000 ˜hh00 r¢100
Less: Fixed Expenses
Fixed factory overhead ÷0000 ÷0000 ÷0000
Fixed selling overheads 1000 1000 1000
Net profit ÷0000 ÷„h00 ÷0100

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 ifference between absorption
and marginal costing

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Treatment for Fixed Fixed manufacturing

fixed manufacturing overhead are treated
manufacturing overheads are as period costs. t is
overheads treated as product believed that only the
costing. t is variable costs are
believed that relevant to decision-
products cannot be making.
produced without Fixed manufacturing
the resources overheads will be
provided by fixed incurred regardless
manufacturing there is production or
overheads not
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Value of High value of Lower value of

closing stock closing stock will be closing stock that
obtained as some included the variable
factory overheads cost only
are included as
product costs and
carried forward as
closing stock

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Reported f the production = Sales, A profit = M Profit

profit
f Production > Sales, A profit > M profit
As some factory overhead will be deferred as
product costs under the absorption costing

f Production < Sales, A profit < M profit

As the previously deferred factory overhead
will be released and charged as cost of goods
sold

„1
Argument for absorption costing

„„
a ompliance with the generally accepted
accounting principles
a mportance of fixed overheads for production
a Avoidance of fictitious profit or loss
a uring 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
a Absorption costing is better in avoiding the
fluctuation of profit being reported in marginal
costing
„÷
Arguments for marginal costing

„˜
a More relevance to decision-making
a Avoidance of profit manipulation
a Marginal costing can avoid profit manipulation by
adjusting the stock level
a onsideration given to fixed cost
a n 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

„r
 efinition
a Breakeven analysis is also known as cost-
volume profit analysis
a 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
a Breakeven analysis can be used to
determine a company¶s breakeven point
(BEP

a Breakeven point is a level of activity at
which the total revenue is equal to the total
costs
a At this level, the company makes no profit

„h
Assumption of breakeven point
analysis
a Relevant range
a 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
a Fixed cost
a Total fixed cost are assumed to be constant in total
a Variable cost
a Total variable cost will increase with increasing
number of units produced

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

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alculation method

÷„
 alculation method
a Breakeven point
a Target profit
a Margin of safety
a hanges in components of breakeven
analysis

÷÷
Breakeven point

÷˜
 alculation method
a ontribution is defined as the excess of
sales revenue over the variable costs

a The total contribution is equal to total fixed

cost

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Example
a Selling price per unit $1„
a Variable cost per unit $÷
a Fixed costs $˜000
Required:
a ompute the breakeven point

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 Alternative method
ontribution to sales ratio $Ä /$1„ *100% = ¢%
Sales revenue at breakeven point
= ontribution required to break even
ontribution to sales ratio
= $˜000
¢%
= $r0000
Breakeven point in units = $r0000/$1„ = 000 units

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Target profit

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 Formula
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Example
a Selling price per unit $1„
a Variable cost per unit $÷
a Fixed costs $˜000
a Target profit $1h000
Required:
a ompute the sales volume required to achieve
the target profit

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Alternative method
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Margin of safety

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Margin of safety
a Margin of safety is a measure of amount by
which the sales may decrease before a
company suffers a loss.
a This can be expressed as a number of units
or a percentage of sales

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Example
a The breakeven sales level is at 000 units.
The company sets the target profit at
$1h000 and the budget sales level at ¢000
units
Required:
alculate the margin of safety in units and
express it as a percentage of the budgeted
sales revenue

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 hanges in components of
breakeven point

„
Example
a Selling price per unit $1„
a Variable price per unit $÷
a Fixed costs $˜000
a urrent profit $1h000

÷
a f the selling prices is raised from $1„ to
$1÷, the minimum volume of sales required
to maintain the current profit will be:

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a f the fixed cost fall by $000 but the
variable costs rise to $˜ per unit, the
minimum volume of sales required to
maintain the current profit will be:

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Limitation of breakeven point

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Limitations of breakeven analysis
a 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

¢
a t is assumed that all production is sold.
The breakeven chart does not take the
changes in stock level into account
a Breakeven analysis can provide
information for small and relatively simple
companies that produce same product. t is
not useful for the companies producing
multiple products
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