Absorption and marginal costing

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

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

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

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

Presentation of costs on income statement

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

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

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

Absorption costing

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

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

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

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

Difference between absorption and marginal costing

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

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

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

Break-even analysis

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 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 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

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

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

Calculation method

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

Breakeven point

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

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

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

Target profit

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 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

Margin of safety

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

Sales revenue Profit Total cost BEP Margin of safety Total Cost/Revenue $ Profit Total cost Sales (units) BEP Margin 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 units Required: Calculate the margin of safety in units and express it as a percentage of the budgeted sales revenue

Changes in components of breakeven point

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

Limitation of breakeven point

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

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

Finnie & Fogg Limited produces suit-bags which each sell for Rs,42. 50 Finnie & Fogg Limited produces suit-bags which each sell for Rs,42.50. The variable costs of manufacture include direct materials of Rs,9 and direct labour of Rs,11. In July 20X6 the company has budgeted to sell 850 suit-bags. Fixed overheads for the month are expected to total Rs,14 250. Calculate the company’s: (a) budgeted contribution for July 20X6 (b) budgeted net profit for July 20X6.

Exercise ABC Limited manufactures Cricket Balls . The selling price of a Cricket Balls is Rs,5.50. Variable costs per Cricket Balls comprise Rs,1.38 of direct materials and Rs,0.98 of direct labour. The company’s finance director estimates that fixed costs for 20X9 will be Rs,588 530. Net profits in 20X8 were Rs,52 000 based on sales of 200 000 Cricket Balls. The directors are aiming for a net profit of Rs,72 000 in 20X9.  calculate the company’s break-even point in units (to the nearest whole unit)  calculate the percentage increase in sales required in 20X9 that is necessary in order to hit the directors’ target profit (to one decimal place).

Yasoda Limited manufactures a range of industrial machines, each of which uses a quantity of a rare metal, "B". The metal is mined commercially in only one country of the world, Pamania, although small deposits of it have been found elsewhere from time to time. The directors of Yasoda have just been informed that rebel insurgents have started a civil war in Pamania. The war may last for a long time, and it seems likely that supplies of "B" will be cut off completely. The company’s engineers have been working on the prototype of a new machine which will not require the use of "B"; however, testing has only just commenced, and the new machine will not be ready for commercial production for at least another year.  The company currently has 100kg of "B" in stock; it was purchased for Rs,420 per kg. The production director thinks it likely that a further 90kg of "B" can be sourced through her contacts, although the price will be very much higher than previously: around Rs,800 per kg. The sales director thinks that there is some scope for increasing selling prices to pass on at least part of the increased cost to customers. However, he has forecast only modest increases so as not to affect potential demand.

Cost and selling price information for each of the three machine types that the company produces are as follows:   Type A Type B Type C Selling price (new price per Rs,6 000 Rs,5 500 Rs,4 500 sales director’s forecasts) Velanium usage per machine 2.5kg 3kg 2.8kg Other raw materials costs Rs,1 500 Rs,1 400 Rs,880 Variable cost of labour Rs,1 750 Rs,1 310 Rs,960 Demand per year 35 30 40 Required:

calculate the contribution per unit of limiting factor for each of the three machine types advise the directors on the optimal production plan for the next year