Absorption and marginal costing

CHARLES SURESH DAVID

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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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Break-even analysis

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Breakeven point

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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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Presentation of costs on income
statement

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Difference between absorption
and marginal costing

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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) 16

Calculation method
 Contribution is defined as the excess of
sales revenue over the variable costs

 The total contribution is equal to total fixed

cost at BEP.

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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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Example
 Selling price per unit Rs.12
 Variable cost per unit Rs. 3
 Fixed costs Rs. 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 = Rs.60000

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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
=
P/V Ratio

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Example
 Selling price per unit Rs.12
 Variable cost per unit Rs.3
 Fixed costs Rs.45000
 Target profit Rs.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 = Rs.12 *7000

= Rs. 84000

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Alternative method
Required sales revenue
Fixed cost + Target profit
=
P/V 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 as a percentage of sales:

= 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
Rs.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 Rs.12
 Variable price per unit Rs.3
 Fixed costs Rs.45000
 Current profit Rs.18000

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 If the selling prices is raised from Rs.12 to Rs.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 Rs.5000 but the
variable costs rise to Rs.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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A company started its business in 2015. The following information
Was available for January to March 2015 for the company that produced
A single product:
Rs.
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
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 January February March
SALES(a) 100000 80000 110000
Less: Variable cost (b) 39000 31200 42900
Total contribution margin(a)-(b)=(c) 61000 48800 67100
Less: Fixed Factory Expenses 30000 30000 30000
Fixed Selling Overheads 1000 1000 1000
Total Fixed Expenses (d) 31000 31000 31000
NET PROFIT (c)- (d) 30000 17800 36100

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