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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 Marginal costing
It is costing system which treats all manufacturing costs including both the fixed and variable costs as product costs
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 Direct Materials Direct Labour Overheads Non-manufacturing cost Period cost Profit and loss account Finished goods Cost of goods sold Marginal Costing Cost Manufacturing cost Direct Materials Direct Labour Non-manufacturing cost Fixed overhead Variable Overheads Period cost Finished goods Cost of goods sold Profit and loss account 6 .
Presentation of costs on income statement 7 .
manufacturing expenses Variable selling expenses Variable admin.Trading and profit ans loss account Absorption costing Sales Less: Cost of goods sold $ X X Marginal costing Sales Less: Variable cost of Goods sold Product contribution margin Less: variable non. expenses Other fixed expenses Net Profit $ X X X Gross profit Less: Expenses Selling expenses X Admin. expenses X Other expenses X X X Variable and fixed manufacturing X X X X Net Profit X X X X X 8 . expenses Other variable expenses Total contribution expenses Less: Expenses Fixed selling expenses Fixed admin.
Example 9 .
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 10 .A company started its business in 2005.
Required: Prepare absorption and marginal costing statements for the three months 11 .
Absorption costing 12 .
January $ Sales 100000 Less: cost of good sold ($65) 65000 Adjustment for Over-/(under) Absorption of factory overhead Gross profit 35000 Less: Expenses Fixed selling overheads 1000 Variable selling overheads 4000 Net profit 30000 February $ 80000 52000 28000 March $ 110000 71500 38500 9000 37000 1000 3200 32800 (3000) 35500 1000 4400 30100 13 .
Marginal costing 14 .
Sales Less: Variable cost of good sold ($35) 35000 Product contribution margin 65000 Less: Variable selling overhead4000 Total contribution margin 61000 Less: Fixed Expenses Fixed factory overhead 30000 Fixed selling overheads 1000 Net profit 30000 January $ 100000 February $ 80000 28000 52000 3200 48800 30000 1000 32800 March $ 110000 385500 71500 4400 67100 30000 1000 30100 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 Variable factory overheads Back $ 20 10 30 5 65 16 .
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 Back 35 17 .
Difference between absorption and marginal costing 18 .
Fixed manufacturing overheads will be incurred regardless there is production or not 19 . It is believed that products cannot be produced without the resources provided by fixed manufacturing overheads Marginal costing Fixed manufacturing overhead are treated as period costs. It is believed that only the variable costs are relevant to decisionmaking.Absorption costing Treatment for Fixed fixed manufacturing manufacturing overheads are overheads treated as product costing.
Value of closing stock Absorption costing High value of closing stock will be obtained as some factory overheads are included as product costs and carried forward as closing stock Marginal costing Lower value of closing stock that included the variable cost only 20 .
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 profit If Production > Sales. AC profit < MC profit As the previously deferred factory overhead will be released and charged as cost of goods sold 21 .Absorption costing Marginal costing Reported If the production = Sales.
Argument for absorption costing 22 .
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. 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 23 . the production is small than the sales.
Arguments for marginal costing 24 .
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 25 Consideration given to fixed cost . More relevance to decision-making Avoidance of profit manipulation Marginal costing can avoid profit manipulation by adjusting the stock level In fact. marginal costing does not ignore fixed costs in setting the selling price.
Break-even analysis 26 .
Definition Breakeven analysis is also known as costvolume profit analysis Breakeven analysis is the study of the relationship between selling prices. fixed costs. sales volumes. variable costs and profits at various levels of activity 27 .
the company makes no profit 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.
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 Total fixed cost are assumed to be constant in total Fixed cost Variable cost Total variable cost will increase with increasing number of units produced 29 .
Sales revenue The total revenue will increase with the increasing number of units produced 30 .
Cost $ Total cost Variable cost Fixed cost Sales (units) Total Cost/Revenue $ Sales revenue Profit Total cost BEP Sales (units) 31 .
Calculation method 32 .
Calculation method Breakeven point Target profit Margin of safety Changes in components of breakeven analysis 33 .
Breakeven point 34 .
Calculation method Contribution is defined as the excess of sales revenue over the variable costs The total contribution is equal to total fixed cost 35 .
Formula Breakeven point Fixed cost = Contribution per unit Sales revenue at breakeven point = Breakeven point *selling price 36 .
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 37 .
Example Selling price per unit Variable cost per unit Fixed costs Required: $12 $3 $45000 Compute the breakeven point 38 .
Breakeven point in units = Fixed costs Contribution per unit = $45000 $12-$3 = 5000 units Sales revenue at breakeven point = $12 * 5000 = $60000 39 .
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 40 .
Target profit 41 .
of units at target profit Fixed cost + Target profit = Contribution per unit Required sales revenue Fixed cost + Target profit = Contribution to sales ratio 42 .Formula No.
Example Selling price per unit Variable cost per unit Fixed costs Target profit Required: $12 $3 $45000 $18000 Compute the sales volume required to achieve the target profit 43 .
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 44 .No.
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 45 .
Margin of safety 46 .
This can be expressed as a number of units or a percentage of sales 47 .Margin of safety Margin of safety is a measure of amount by which the sales may decrease before a company suffers a loss.
Formula Margin of safety = Budget sales level – breakeven sales level Margin of safety = Margin of safety *100% Budget sales level 48 .
Total Cost/Revenue $ Sales revenue Profit Total cost BEP Margin of safety Sales (units) 49 .
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 50 .
51 .6% from the budgeted level before losses are incurred.6% The margin of safety indicates that the actual sales can fall by 2000 units or 28.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.
Changes in components of breakeven point 52 .
Example Selling price per unit Variable price per unit Fixed costs Current profit $12 $3 $45000 $18000 53 .
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 54 = . If the selling prices is raised from $12 to $13.
$4 = 7250 units 55 . the minimum volume of sales required to maintain the current profit will be: Fixed cost + Target profit Contribution to sales ratio = $40000 + $18000 $12 . If the fixed cost fall by $5000 but the variable costs rise to $4 per unit.
Limitation of breakeven point 56 .
However.Limitations of breakeven analysis Breakeven analysis assumes that fixed cost. The straight sales revenue line and total cost line tent to curve beyond certain level of production 57 . variable costs and sales revenue behave in linear manner. some overhead costs may be stepped in nature.
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 58 .