Absorption and marginal costing

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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
4

Definition

Absorption costing
Marginal 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
Direct
Materials

Direct
Labour

Non-manufacturing cost

Overheads

Finished goods

Cost of goods sold

Marginal Costing

Direct
Labour

Finished goods

Profit and loss account

Cost

Manufacturing cost
Direct
Materials

Period cost

Non-manufacturing cost

Variable
Overheads

Fixed
overhead

Cost of goods sold

Period cost
Profit and loss account
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Presentation of costs on income

statement

Trading and profit ans loss account

Absorption costing
Sales
Less: Cost of goods sold
Gross profit
Less: Expenses
Selling expenses X
Admin. expenses X
Other expenses X

Marginal costing
$
X
X
X

Variable and fixed manufacturing

Net Profit

Sales
Less: Variable cost of
Goods sold
Product contribution margin

$
X
X
X

Less: variable non- manufacturing

expenses
Variable selling expenses
Variable admin. expenses
Other variable expenses
Total contribution expenses

X
X
X
X

Less: Expenses
Fixed selling expenses
Fixed admin. expenses
Other fixed expenses
Net Profit

X
X
X
X

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Example

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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
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Required:

Prepare absorption and marginal costing

statements for the three months

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Absorption costing

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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

(3000)
35500

1000
3200
32800

1000
4400
30100

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Marginal costing

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January
$
100000

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

February
$
80000

March
$
110000

28000
52000
3200
48800

385500
71500
4400
67100

30000
1000
32800

30000
1000
30100

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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
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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

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Difference between absorption

and marginal costing

20

Absorption costing
Treatment for Fixed
fixed
manufacturing
manufacturing overheads are
overheads
treated as product
costing. 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.
Fixed manufacturing
overheads will be
incurred regardless
there is production or
not
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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

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Absorption costing
Marginal costing
Reported If the production = Sales, AC profit = MC Profit
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
23

Argument for absorption costing

24

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

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Arguments for marginal costing

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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
27

Break-even analysis

28

Definition

Breakeven analysis is also known as costvolume 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

29

Application

Breakeven 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
costs
At this level, the company makes no profit
30

Assumption of breakeven point

analysis

Relevant range

Fixed cost

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

Variable cost

Total variable cost will increase with increasing

number of units produced
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Sales revenue

The total revenue will increase with the

increasing number of units produced

32

Cost $

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

Sales revenue
Profit
Total cost

BEP

Sales (units)

33

Calculation method

34

Calculation method

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

35

Breakeven point

36

Calculation method

Contribution is defined as the excess of

sales revenue over the variable costs

The total contribution is equal to total fixed

cost

37

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

38

Alternative method:
Sales revenue at breakeven point
Contribution required to breakeven
=
Contribution to sales ratio Contribution per unit
Breakeven point in units
Sales revenue at breakeven point
=
Selling price

Selling price per unit

39

Example
Selling price per unit
Variable cost per unit
Fixed costs
Required:

$12
$3
$45000

Compute the breakeven point

40

Breakeven point in units =

Fixed costs
Contribution per unit
= $45000
$12-$3
= 5000 units

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

41

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
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Target profit

43

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

44

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
45

No. 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

46

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

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Margin of safety

48

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

49

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

50

Sales revenue

Total Cost/Revenue $

Profit

BEP

Total cost

Sales (units)

Margin of safety

51

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

52

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
= 28.6%
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.
53

Changes in components of
breakeven point

54

Example

Selling price per unit

Variable price per unit
Fixed costs
Current profit

$12
$3
$45000
$18000

55

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

$45000 + $18000
$13 - $3

= 6300 units
56

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
= $40000 + $18000
$12 - $4
= 7250 units
57

Limitation of breakeven point

58

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
59

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
60

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