Absorption and marginal costing

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Absorption and marginal costing

  1. 1. Absorption and marginal costing 1
  2. 2. JOIN KHALID AZIZ FRESH CLASSES FOR ICAP MODULE D…COST ACCOUNTING REGISTER YOUR SELF NOW COMPLETION OF SYLLABUS WITH ACCENTUATE ON BASIC CONCEPTS. 2
  3. 3. JOIN KHALID AZIZ FRESH CLASSES FOR ICAP MODULE B…FINANCIAL ACCOUNTING REGISTER YOUR SELF NOW. COMPLETION OF SYLLABUS WITH ACCENTUATE ON BASIC CONCEPTS. 3
  4. 4. 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
  5. 5. Definition Absorption costing Marginal costing 5
  6. 6. Absorption costing It is costing system which treats all manufacturing costs including both the fixed and variable costs as product costs 6
  7. 7. 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 7
  8. 8. Absorption Costing Cost Manufacturing cost Non-manufacturing costDirect Direct OverheadsMaterials Labour Period cost Finished goods Cost of goods sold Profit and loss account Marginal Costing Cost Manufacturing cost Non-manufacturing costDirect Direct Variable FixedMaterials Labour Overheads overhead Period cost Finished goods Cost of goods sold Profit and loss account 8
  9. 9. Presentation of costs on incomestatement 9
  10. 10. Trading and profit ans loss account Absorption costing Marginal costing $ $Sales X Sales XLess: Cost of goods sold X Less: Variable cost of Goods sold XGross profit X Product contribution margin XLess: 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 XVariable and fixed manufacturing Less: Expenses Fixed selling expenses X Fixed admin. expenses X Other fixed expenses XNet Profit X Net Profit X 10
  11. 11. Example 11
  12. 12. 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 4Budgeted 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 12
  13. 13.  Required:  Prepare absorption and marginal costing statements for the three months 13
  14. 14. Absorption costing 14
  15. 15. 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 15
  16. 16. Marginal costing 16
  17. 17. 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 17
  18. 18. Wk1:Standard fixed overhead rate= Budgeted total fixed factory overheads Budgeted number of units produced= $30000 1000 units= $30 unitsWk 2:Production cost per unit under absorption costing: $Direct materials 20Direct labour 10Fixed factory overhead absorbed 30Variable factory overheads 5 65Back 18
  19. 19. 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*$30Wk 4: No fixed factory overheadVariable production cost per unit under marginal costing: $Direct materials 20Direct labour 10Variable factory overhead 5Back 35 19
  20. 20. Difference between absorptionand marginal costing 20
  21. 21. Absorption costing Marginal costingTreatment for Fixed Fixed manufacturingfixed manufacturing overhead are treatedmanufacturing overheads are as period costs. It isoverheads 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 21
  22. 22. Absorption costing Marginal costingValue of High value of Lower value ofclosing 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 22
  23. 23. Absorption costing Marginal costingReported If the production = Sales, AC profit = MC Profitprofit 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
  24. 24. Argument for absorption costing 24
  25. 25.  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 25
  26. 26. Arguments for marginal costing 26
  27. 27.  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
  28. 28. Break-even analysis 28
  29. 29. 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 29
  30. 30. 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 30
  31. 31. Assumption of breakeven pointanalysis 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 31
  32. 32.  Sales revenue  The total revenue will increase with the increasing number of units produced 32
  33. 33. Cost $ Total cost Variable cost Fixed cost Sales (units)Total Cost/Revenue $ Sales revenue Profit Total cost BEP Sales (units) 33
  34. 34. Calculation method 34
  35. 35. Calculation method Breakeven point Target profit Margin of safety Changes in components of breakeven analysis 35
  36. 36. Breakeven point 36
  37. 37. 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
  38. 38. FormulaBreakeven point Fixed cost= Contribution per unitSales revenue at breakeven point= Breakeven point *selling price 38
  39. 39. 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 39
  40. 40. Example Selling price per unit $12 Variable cost per unit $3 Fixed costs $45000Required:  Compute the breakeven point 40
  41. 41. Breakeven point in units = Fixed costs Contribution per unit = $45000 $12-$3 = 5000 unitsSales revenue at breakeven point = $12 * 5000 = $60000 41
  42. 42. 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 42
  43. 43. Target profit 43
  44. 44. FormulaNo. of units at target profit Fixed cost + Target profit= Contribution per unitRequired sales revenue Fixed cost + Target profit= Contribution to sales ratio 44
  45. 45. 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 45
  46. 46. No. of units at target profit Fixed cost + Target profit = Contribution per unit $45000 + $18000 = $12 - $3 = 7000 unitsRequired to sales revenue = $12 *7000 = $84000 46
  47. 47. Alternative methodRequired sales revenue Fixed cost + Target profit= Contribution to sales ratio $45000 + $18000= 75%= $84000Units sold at target profit = $84000 /$12 = 7000 units 47
  48. 48. Margin of safety 48
  49. 49. 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
  50. 50. Formula Margin of safety = Budget sales level – breakeven sales levelMargin of safety= Margin of safety *100% Budget sales level 50
  51. 51. Sales revenueTotal Cost/Revenue $ Profit Total cost Sales (units) BEP Margin of safety 51
  52. 52. Example The breakeven sales level is at 5000 units. The company sets the target profit at $18000 and the budget sales level at 7000 unitsRequired: Calculate the margin of safety in units and express it as a percentage of the budgeted sales revenue 52
  53. 53. Margin of safety= Budget sales level – breakeven sales level= 7000 units – 5000 units= 2000 unitsMargin 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 by2000 units or 28.6% from the budgeted level before losses areincurred. 53
  54. 54. Changes in components ofbreakeven point 54
  55. 55. Example Selling price per unit $12 Variable price per unit $3 Fixed costs $45000 Current profit $18000 55
  56. 56.  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
  57. 57.  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
  58. 58. Limitation of breakeven point 58
  59. 59. 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
  60. 60.  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
  61. 61. JOIN KHALID AZIZ ECONOMICS OF ICMAP, ICAP, MA-ECONOMICS, B.COM. FINANCIAL ACCOUNTING OF ICMAP STAGE 1,3,4 ICAP MODULE B, B.COM, BBA, MBA & PIPFA. COST ACCOUNTING OF ICMAP STAGE 2,3 ICAP MODULE D, BBA, MBA & PIPFA. CONTACT: 0322-3385752 0312-2302870 R-1173,ALNOOR SOCIETY, BLOCK 19,F.B.AREA, KARACHI, PAKISTAN 61

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