Absorption and marginal costing made easy

1. Absorption and marginal costing

6. Cost Manufacturing cost Non-manufacturing cost Direct Materials Direct Labour Overheads Finished goods Cost of goods sold Period cost Profit and loss account Absorption Costing Cost Manufacturing cost Non-manufacturing cost Direct Materials Direct Labour Variable Overheads Finished goods Cost of goods sold Period cost Profit and loss account Marginal Costing Fixed overhead

7. Presentation of costs on income statement

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 Less: Expenses Fixed selling expenses X Fixed admin. expenses X Other fixed expenses X Net Profit X Net Profit X Variable and fixed manufacturing

9. Example

10. 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

12. Absorption costing

13. January February March $ $ $ 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

14. Marginal costing

15. January February March $ $ $ Sales 100000 80000 110000 Less: Variable cost of good sold ($35) 35000 28000 385500 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

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

17. 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 Wk 4: Variable production cost per unit under marginal costing: $ Direct materials 20 Direct labour 10 Variable factory overhead 5 35 No fixed factory overhead Back

18. Difference between absorption and marginal costing

19. 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 Fixed manufacturing overheads are treated as product costing . It is believed that products cannot be produced without the resources provided by fixed manufacturing overheads Treatment for fixed manufacturing overheads Marginal costing Absorption costing

20. Lower value of closing stock that included the variable cost only High value of closing stock will be obtained as some factory overheads are included as product costs and carried forward as closing stock Value of closing stock Marginal costing Absorption costing

21. If the production = Sales, AC profit = MC 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 Reported profit Marginal costing Absorption costing

22. Argument for absorption costing

24. Arguments for marginal costing

26. Break-even analysis

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

32. Calculation method

34. Breakeven point

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

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

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

41. Target profit

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 =

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

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

46. Margin of safety

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

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

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

52. Changes in components of breakeven point

56. Limitation of breakeven point