Absorption and marginal costing

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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

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Definition
 Absorption costing
 Marginal costing

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

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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

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 Absorption Costing
Cost
Manufacturing cost Non-manufacturing cost

Direct Direct Overheads

Materials Labour Period cost

Finished goods Cost of goods sold Profit and loss account

Marginal Costing
Cost
Manufacturing cost Non-manufacturing cost

Direct Direct Variable Fixed

Materials Labour Overheads overhead Period cost

Finished goods Cost 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
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
Variable and fixed manufacturing
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 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 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

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Marginal costing

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 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

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

Wk 4: No fixed factory overhead

Variable production cost per unit under marginal costing:
$
Direct materials 20
Direct labour 10
Variable factory overhead 5
Back 35 17
Difference between absorption
and marginal costing

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 Absorption costing Marginal costing
Treatment for Fixed Fixed manufacturing
fixed manufacturing overhead are treated
manufacturing overheads are as period costs. It is
overheads treated as product believed that only the
costing. It 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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 Absorption costing Marginal costing
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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 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 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

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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

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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

BEP Sales (units) 31

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 $12
 Variable cost per unit $3
 Fixed costs $45000
Required:
 Compute the breakeven point

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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 $12
 Variable cost per unit $3
 Fixed costs $45000
 Target profit $18000
Required:
 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

Sales (units)
BEP
Margin of safety

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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 $12
 Variable price per unit $3
 Fixed costs $45000
 Current profit $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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