Absorption and marginal costing

IntroductionBefore we allocate all manufacturing costs to products regardless of whether they are fixed or variable. This approach is known as absorption costing/full costingHowever, only variable costs are relevant to decision-making. This is known as marginal costing/variable costing

Definition Absorption costingMarginal costing

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

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

CostManufacturing costNon-manufacturing costDirect MaterialsDirect LabourOverheadsFinished goodsCost of goods soldPeriod costProfit and loss accountAbsorption CostingCostManufacturing costNon-manufacturing costDirect MaterialsDirect LabourVariable OverheadsFinished goodsCost of goods soldPeriod costProfit and loss accountMarginal CostingFixedoverhead

Presentation of costs on income statement

Trading and profit ans loss accountAbsorption costingMarginal costing$$SalesXSalesXLess: Cost of goods soldXLess: Variable cost ofGoods soldXGross profitXProduct contribution marginX

Less: ExpensesLess: variable non- manufacturingSelling expensesX expensesAdmin. expensesX Variable selling expensesXOther expensesXX Variable admin. expensesX Other variable expensesXTotal contribution expensesX

Less: Expenses Fixed selling expensesX Fixed admin. expensesX Other fixed expensesXNet ProfitXNet ProfitXVariable and fixed manufacturing

Example

A company started its business in 2005. The following informationWas available for January to March 2005 for the company that producedA single product:$Selling price pre unit100Direct materials per unit20Direct Labour per unit10Fixed factory overhead per month30000Variable factory overhead per unit5Fixed selling overheads1000Variable selling overheads per unit4

Budgeted activity was expected to be 1000 units each monthProduction and sales for each month were as follows:JanFebMarchUnit sold10008001100Unit produced10001300900

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

Absorption costing

JanuaryFebruaryMarch$$$Sales 10000080000110000Less: cost of good sold ($65)6500052000715002800038500Adjustment for Over-/(under)Absorption of factory overhead9000(3000)Gross profit350003700035500Less: Expenses Fixed selling overheads100010001000 Variable selling overheads 400032004400Net profit300003280030100

Marginal costing

JanuaryFebruaryMarch$$$Sales 10000080000110000Less: Variable cost of goodsold ($35)3500028000385500Product contribution margin650005200071500Less: Variable selling overhead400032004400Total contribution margin610004880067100Less: Fixed Expenses Fixed factory overhead300003000030000 Fixed selling overheads100010001000Net profit300003280030100

Wk1:Standard fixed overhead rate = Budgeted total fixed factory overheads Budgeted number of units produced

= $30000 1000 units= $30 unitsWk 2:Production cost per unit under absorption costing:$Direct materials20Direct labour10Fixed factory overhead absorbed30Variable factory overheads565Back

Wk 3:(Under-)/Over-absorption of fixed factory overheads:JanuaryFebruaryMarch$$$Fixed overhead300003900027000Fixed overheads incurred30000300003000009000(3000)1000*$301300*$30900*$30Wk 4:Variable production cost per unit under marginal costing:$Direct materials20Direct labour10Variable factory overhead535No fixed factory overheadBack

Difference between absorption and marginal costing

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

Absorption costingMarginal costingValue of closing stockHigh 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

Absorption costingMarginal costingReported profitIf the production = Sales, AC profit = MC Profit

If Production > Sales, AC profit > MC profitAs some factory overhead will be deferred as product costs under the absorption costing

If Production < Sales, AC profit < MC profitAs the previously deferred factory overhead will be released and charged as cost of goods sold

Argument for absorption costing

Compliance with the generally accepted accounting principlesImportance of fixed overheads for productionAvoidance of fictitious profit or lossDuring 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 costingAbsorption costing is better in avoiding the fluctuation of profit being reported in marginal costing

Arguments for marginal costing

More relevance to decision-makingAvoidance of profit manipulationMarginal costing can avoid profit manipulation by adjusting the stock levelConsideration given to fixed costIn 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

DefinitionBreakeven analysis is also known as cost-volume profit analysisBreakeven analysis is the study of the relationship between selling prices, sales volumes, fixed costs, variable costs and profits at various levels of activity

ApplicationBreakeven 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 costsAt this level, the company makes no profit

Assumption of breakeven point analysisRelevant rangeThe 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 constantFixed costTotal fixed cost are assumed to be constant in totalVariable costTotal variable cost will increase with increasing number of units produced

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

Total costVariable costFixed costCost $Sales (units)Sales revenueTotal Cost/Revenue $Sales (units)Total costProfitBEP

Calculation method

Calculation methodBreakeven pointTarget profitMargin of safetyChanges in components of breakeven analysis

Breakeven point

Calculation methodContribution is defined as the excess of sales revenue over the variable costs

The total contribution is equal to total fixed cost

FormulaBreakeven point Fixed costContribution per unitSales revenue at breakeven point

= Breakeven point *selling price=

Alternative method:Sales revenue at breakeven point Contribution required to breakevenContribution to sales ratio=Breakeven point in unitsSales revenue at breakeven pointSelling price=Contribution per unitSelling price per unit

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

Breakeven point in units = Fixed costsContribution per unit = $45000 $12-$3 = 5000 units

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

Alternative methodContribution to sales ratio $9 /$12 *100% = 75%Sales revenue at breakeven point= Contribution required to break evenContribution to sales ratio= $45000 75%= $60000Breakeven point in units = $60000/$12 = 5000 units

Target profit

FormulaNo. of units at target profit Fixed cost + Target profitContribution per unit=Required sales revenueFixed cost + Target profitContribution to sales ratio=

ExampleSelling price per unit$12Variable cost per unit$3Fixed costs$45000Target profit$18000Required:Compute the sales volume required to achieve the target profit

No. of units at target profit Fixed cost + Target profitContribution per unit=$45000 + $18000$12 - $3== 7000 unitsRequired to sales revenue = $12 *7000 = $84000

Alternative methodRequired sales revenueFixed cost + Target profitContribution to sales ratio=$45000 + $1800075%== $84000Units sold at target profit = $84000 /$12 = 7000 units

Margin of safety

Margin of safetyMargin 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

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

Sales revenueTotal Cost/Revenue $Sales (units)Total costProfitBEPMargin of safety

Example The breakeven sales level is at 5000 units. The company sets the target profit at $18000 and the budget sales level at 7000 unitsRequired:Calculate the margin of safety in units and express it as a percentage of the budgeted sales revenue

Margin of safety= Budget sales level breakeven sales level= 7000 units 5000 units= 2000 unitsMargin 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 by2000 units or 28.6% from the budgeted level before losses areincurred.

Changes in components of breakeven point

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

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 profitContribution to sales ratio=$45000 + $18000$13 - $3= 6300 units

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 profitContribution to sales ratio=$40000 + $18000$12 - $4= 7250 units

Limitation of breakeven point

Limitations of breakeven analysisBreakeven 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

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