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Absorption and marginal costing

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Presentation on theme: "Absorption and marginal costing"— Presentation transcript:

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 the fixed and variable costs as product costs

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

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

7 Presentation of costs on income statement

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

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 Direct materials per unit Direct Labour per unit Fixed factory overhead per month Variable factory overhead per unit 5 Fixed selling overheads 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 Unit produced

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

12 Absorption costing

13 January February March
$ $ $ Sales Less: cost of good sold ($65) Adjustment for Over-/(under) Absorption of factory overhead (3000) Gross profit Less: Expenses Fixed selling overheads Variable selling overheads Net profit

14 Marginal costing

15 January February March
$ $ $ Sales Less: Variable cost of good sold ($35) Product contribution margin Less: Variable selling overhead Total contribution margin Less: Fixed Expenses Fixed factory overhead Fixed selling overheads Net profit

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 Direct labour 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 Fixed overheads incurred (3000) 1000*$30 1300*$30 900*$30 No fixed factory overhead Wk 4: Variable production cost per unit under marginal costing: $ Direct materials Direct labour Variable factory overhead 5 35 Back

18 Difference between absorption and marginal costing

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

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

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

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

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 $ $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 $ $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
*100%

49 Sales revenue Profit Total cost BEP Margin of safety
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

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.

52 Changes in components of breakeven point

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

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 $ $18000 = $13 - $3 = 6300 units

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 $ $18000 = $12 - $4 = 7250 units

56 Limitation of breakeven point

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

58 It is assumed that all production is sold
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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