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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

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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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CostManufacturing cost Non-manufacturing cost

Direct Materials

Direct Labour

Overheads

Finished goods Cost of goods sold

Period cost

Profit and loss account

Absorption Costing

CostManufacturing cost Non-manufacturing cost

Direct Materials

Direct Labour

Variable Overheads

Finished goods Cost of goods sold

Period cost

Profit and loss account

Marginal Costing

Fixedoverhead

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Presentation of costs on income statement

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Trading and profit ans loss accountAbsorption costing Marginal costing

$ $Sales X Sales XLess: Cost of goods sold X Less: Variable cost of

Goods sold XGross profit X Product contribution margin X

Less: Expenses Less: variable non- manufacturingSelling expenses X expensesAdmin. expenses X Variable selling expenses XOther expenses X X Variable admin. expenses X

Other variable expenses XTotal 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

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Example

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A company started its business in 2005. The following informationWas available for January to March 2005 for the company that producedA single product:

$Selling price pre unit 100Direct materials per unit 20Direct Labour per unit 10Fixed factory overhead per month 30000Variable factory overhead per unit 5Fixed selling overheads 1000Variable selling overheads per unit 4

Budgeted activity was expected to be 1000 units each monthProduction and sales for each month were as follows:

Jan Feb MarchUnit sold 1000 800 1100Unit 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$ $ $

Sales 100000 80000 110000Less: cost of good sold ($65) 65000 52000 71500

28000 38500Adjustment for Over-/(under)Absorption of factory overhead 9000 (3000)Gross profit 35000 37000 35500Less: Expenses Fixed selling overheads 1000 1000 1000 Variable selling overheads 4000 3200 4400Net profit 30000 32800 30100

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Marginal costing

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January February March$ $ $

Sales 100000 80000 110000Less: Variable cost of good

sold ($35) 35000 28000 385500Product contribution margin 65000 52000 71500Less: Variable selling overhead4000 3200 4400Total contribution margin 61000 48800 67100Less: Fixed Expenses Fixed factory overhead 30000 30000 30000 Fixed selling overheads 1000 1000 1000Net profit 30000 32800 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 20Direct labour 10Fixed factory overhead absorbed 30Variable factory overheads 5

65Back

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Wk 3:(Under-)/Over-absorption of fixed factory overheads:

January February March$ $ $

Fixed overhead 30000 39000 27000Fixed overheads incurred 30000 30000 30000

0 9000 (3000)1000*$30 1300*$30 900*$30

Wk 4:Variable production cost per unit under marginal costing:

$Direct materials 20Direct labour 10Variable factory overhead 5

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No fixed factory overhead

Back

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Difference between absorption and marginal costing

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Absorption costing Marginal costingTreatment 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

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Absorption costing Marginal costingValue 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

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Absorption costing Marginal costingReported profit

If the production = Sales, AC profit = MC Profit

If Production > Sales, AC profit > MC profitAs some factory overhead will be deferred as product costs under the absorption costing

If Production < Sales, AC profit < MC profitAs the previously deferred factory overhead will be released and charged as cost of goods sold

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Argument for absorption costing

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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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Total cost

Variable cost

Fixed cost

Cost $

Sales (units)

Sales revenue

Total Cost/Revenue $

Sales (units)

Total costProfit

BEP

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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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FormulaBreakeven 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=

Breakeven point in unitsSales revenue at breakeven point

Selling price=

Contribution per unitSelling price per unit

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Example Selling price per unit $12 Variable cost per unit $3 Fixed costs $45000Required:

Compute the breakeven point

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Breakeven point in units = Fixed costsContribution per unit

= $45000 $12-$3

= 5000 units

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

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Alternative methodContribution to sales ratio $9 /$12 *100% = 75%Sales revenue at breakeven point= Contribution required to break even

Contribution to sales ratio= $45000 75%= $60000Breakeven point in units = $60000/$12 = 5000 units

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Target profit

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FormulaNo. of units at target profit

Fixed cost + Target profit

Contribution per unit=

Required sales revenueFixed 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 $18000Required:

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 methodRequired 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= Margin of safety Budget sales level

*100%

Margin of safety= Budget sales level – breakeven sales level

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Sales revenueTotal Cost/Revenue $

Sales (units)

Total costProfit

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 Budget sales level= 2000 7000= 28.6%

*100 %

*100 %

The margin of safety indicates that the actual sales can fall by2000 units or 28.6% from the budgeted level before losses areincurred.

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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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