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

4. 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

5. 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

6. Presentation of costs on income statement

7. 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

8. Example

9. 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

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

11. Absorption costing

12. 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

13. Marginal costing

14. 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

15. 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

16. 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

17. Difference between absorption and marginal costing

18. 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

19. 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

20. 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

21. Break-even analysis

22. 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

23. 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

24. 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

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

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

27. Calculation method

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

29. Breakeven point

30. Calculation method
Contribution is defined as the excess of sales revenue over the variable costs
The total contribution is equal to total fixed cost

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

32. 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

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

34. Target profit

35. 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

36. 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

37. Margin of safety

38. 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

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

40. Sales revenue Profit Total cost BEP Margin of safety
Total Cost/Revenue $
Profit
Total cost
Sales (units)
BEP
Margin of safety

41. 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

42. Changes in components of breakeven point

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

44. Limitation of breakeven point

45. 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

46. 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

47. Finnie & Fogg Limited produces suit-bags which each sell for Rs,42. 50
Finnie & Fogg Limited produces suit-bags which each sell for Rs, 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,
Calculate the company’s:
(a) budgeted contribution for July 20X6
(b) budgeted net profit for July 20X6.

48. 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, Net profits in 20X8 were Rs, based on sales of Cricket Balls. The directors are aiming for a net profit of Rs, 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).

49. 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.

50. 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:

51. 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