ABSORPTION AND

MARGINAL COSTING
COMPILED BY; MUHAMMAD ISRAR UL HAQ 1
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

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DEFINITION
Absorption costing
Marginal costing

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

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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

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 Absorption Costing
Cost
Manufacturing cost Non-manufacturing cost

Direct Direct Overheads

Materials Labour Period cost

Finished goods Cost of goods sold Profit and loss account

Marginal Costing
Cost
Manufacturing cost Non-manufacturing cost

Direct Direct Variable Fixed

Materials Labour Overheads overhead Period cost

Finished goods Cost of goods sold Profit and loss account

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PRESENTATION OF
COSTS ON INCOME
STATEMENT
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 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
Variable and fixed manufacturing
Less: Expenses
Fixed selling expenses X
Fixed admin. expenses X
Other fixed expenses X
Net Profit X Net Profit X
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EXAMPLE
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A company started its business in 2016. The following information
Was available for January to March 2016 for the company that produced
A single product:
Rs.
Selling price per unit 100
Direct materials per unit 20
Direct Labor 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 February March
Rs. Rs. Rs.
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

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MARGINAL COSTING
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 January February March
Rs. Rs. Rs.
Sales 100000 80000 110000
Less: Variable cost of good
sold (35) 35000 28000 38500
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

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 Wk1:
Standard fixed overhead rate
= Budgeted total fixed factory overheads
Budgeted number of units produced

= Rs.30000
1000 units
= Rs.30 per units
Wk 2:
Production cost per unit under absorption costing:
Rs.
Direct materials 20
Direct labour 10
Fixed factory overhead absorbed 30
Variable factory overheads 5
65
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Wk 3:
(Under-)/Over-absorption of fixed factory overheads:
January February March
Rs. Rs. Rs.
Fixed overhead 30000 39000 27000
Fixed overheads incurred 30000 30000 30000
0 9000 (3000)
1000*$30 1300*$30 900*$30

Wk 4: No fixed factory overhead

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
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 Absorption costing Marginal costing
Treatment for Fixed Fixed manufacturing
fixed manufacturing overhead are treated
manufacturing overheads are as period costs. It is
overheads treated as product believed that only the
costing. It is variable costs are
believed that relevant to decision-
products cannot be making.
produced without Fixed manufacturing
the resources overheads will be
provided by fixed incurred regardless
manufacturing there is production or
overheads not
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 Absorption costing Marginal costing
Value of High value of Lower value of
closing stock closing stock will be closing stock that
obtained as some included the variable
factory overheads cost only
are included as
product costs and
carried forward as
closing stock

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ARGUMENT FOR
ABSORPTION
COSTING
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ARGUE
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

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BREAK-EVEN
ANALYSIS
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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

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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

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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

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

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 Cost $

Total cost

Variable cost

Fixed cost

Sales (units)
Total Cost/Revenue $

Sales revenue
Profit
Total cost

BEP Sales (units)

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

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BREAKEVEN POINT
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CALCULATION METHOD
Contribution is defined as the excess of sales revenue over the
variable costs

The total contribution is equal to total fixed cost

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FORMULA
Breakeven point
Fixed cost
=
Contribution per unit

Sales revenue at breakeven point

= Breakeven point *selling price

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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

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

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

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

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 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
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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

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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

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 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

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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
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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

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FORMULA
Margin of safety
= Budget sales level – breakeven sales level

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

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 Sales revenue
Total Cost/Revenue $

Profit
Total cost

Sales (units)
BEP
Margin of safety

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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

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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.
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 CHANGES IN
COMPONENTS OF
BREAKEVEN POINT
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EXAMPLE
Selling price per unit $12
Variable price per unit $3
Fixed costs $45000
Current profit $18000

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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

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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
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 LIMITATION OF
BREAKEVEN POINT
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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

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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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