This document discusses absorption costing and marginal costing. Absorption costing treats all manufacturing costs, including fixed costs, as product costs. Marginal costing treats only variable manufacturing costs as product costs and regards fixed costs as period costs. Absorption costing results in a higher value of closing stock and reported profit compared to marginal costing. While absorption costing complies with accounting principles, marginal costing is more relevant for decision making as it considers only costs that change with changes in activity. Breakeven analysis examines the relationship between sales, costs and profits using contribution and is useful but has limitations as it assumes costs change linearly.

1. Absorption and marginal costing
1

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
2

3. Definition
 Absorption costing
 Marginal costing
3

4. Absorption costing
 It is costing system which treats all
manufacturing costs including both the fixed
and variable costs as product costs
4

5. 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

6. 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
6

7. Presentation of costs on income
statement
7

8. 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 8

9. Example
9

10. A company started its business in 2005. The following information
Was available for January to March 2005 for the company that pro
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

11.  Required:
 Prepare absorption and marginal costing
statements for the three months
11

12. Absorption costing
12

13. January February March
$ $ $
Sales 100000 80000 110000
Less: cost of good sold ($65) 65000 52000 71
28000 38500
Adjustment for Over-/(under)
Absorption of factory overhead 9000 (3000)
Gross profit 35000 37000 35500
Less: Expenses
Fixed selling overheads 1000 1000 10
Variable selling overheads 4000 3200 44
Net profit 30000 32800 30100
13

14. Marginal costing
14

15. January February March
$ $ $
Sales 100000 80000 110000
Less: Variable cost of good
sold ($35) 35000 28000 385500
Product contribution margin 65000 52000 71
Less: Variable selling overhead4000 3200 44
Total contribution margin 61000 48800 67100
Less: Fixed Expenses
Fixed factory overhead 30000 30000 30
Fixed selling overheads 1000 1000 10
Net profit 30000 32800 30100
15

16. 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 20
Direct labour 10
Fixed factory overhead absorbed 30
Variable factory overheads 5
65
Back 16

17. Wk 3:
(Under-)/Over-absorption of fixed factory overheads
January February March
$ $ $
Fixed overhead 30000 39000 27000
Fixed overheads incurred 30000 30000 300
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
17

18. Difference between absorption
and marginal costing
18

19. 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
19

20. 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
20

21. 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
21

22. Argument for absorption costing
22

23.  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
23

24. Arguments for marginal costing
24

25.  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
25

26. Break-even analysis
26

27. 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
27

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, the company makes no profit
28

29. 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
29

30.  Sales revenue
 The total revenue will increase with the increasing
number of units produced
30

31. Cost $
Total cost
Variable cost
Fixed cost
Sales (units)
Total Cost/Revenue $
Sales revenue
Profit
Total cost
31
BEP Sales (units)

32. Calculation method
32

33. Calculation method
 Breakeven point
 Target profit
 Margin of safety
 Changes in components of breakeven analysis
33

34. Breakeven point
34

35. 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

36. Formula
Breakeven point
Fixed cost
=
Contribution per unit
Sales revenue at breakeven point
= Breakeven point *selling price
36

37. 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

38. Example
 Selling price per unit $12
 Variable cost per unit $3
 Fixed costs $45000
Required:
 Compute the breakeven point
38

39. Breakeven point in units = Fixed costs
Contribution per unit
= $45000
$12-$3
= 5000 units
Sales revenue at breakeven point = $12 * 5000 = $60000
39

40. 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

41. Target profit
41

42. 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
42

43. 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
43

44. 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
44

45. 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

46. Margin of safety
46

47. 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
47

48. Formula
Margin of safety
= Budget sales level – breakeven sales level
Margin of safety
= Margin of safety *100%
Budget sales level
48

49. Sales revenue
Total Cost/Revenue $
Profit
Total cost
Sales (units)
BEP
Margin of safety
49

50. 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. 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
2000 units or 28.6% from the budgeted level before losses
incurred.
51

52. Changes in components of
breakeven point
52

53. Example
 Selling price per unit $12
 Variable price per unit $3
 Fixed costs $45000
 Current profit $18000
53

54.  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
54

55.  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
55

56. Limitation of breakeven point
56

57. 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
57

58.  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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