Absorption And Marginal Costing - Weebly

INTRODUCTIONBefore we allocate all manufacturing costs toproducts regardless of whether they are fixed orvariable. This approach is known as absorptioncosting/full costing However, only variable costs are relevant todecision-making. This is known as marginalcosting/variable costing ABSORPTIONAND MARGINALCOSTING12DEFINITION ABSORPTION COSTINGAbsorption costingMarginal costing It is costing system which treats all manufacturingcosts including both the fixed and variable costs asproduct costs34Absorption CostingCostManufacturing costMARGINAL COSTING It is a costing system which treats only the variablemanufacturing costs as product costs. The fixedmanufacturing overheads are regarded as periodcostDirectMaterialsDirectLabourFinished goodsNon-manufacturing costOverheadsPeriod costCost of goods soldProfit and loss accountMarginal CostingCostManufacturing costDirectMaterialsDirectLabourNon-manufacturing costVariableOverheadsFixedoverhead5Period cost6Finished goodsCost of goods soldProfit and loss account1

Trading and profit ans loss accountAbsorption costingSalesLess: Cost of goods soldGross profitXLess: ExpensesSelling expenses XAdmin. expenses XOther expenses XPRESENTATIONMarginal costing XXXOF COSTS ON INCOMEVariable and fixed manufacturingSTATEMENT7Net ProfitX XSalesLess: Variable cost ofGoods soldProduct contribution marginXXLess: variable non- manufacturingexpensesVariable selling expensesVariable admin. expensesOther variable expensesTotal contribution expensesXXXXLess: ExpensesFixed selling expensesFixed admin. expensesOther fixed expensesNet ProfitXXXX8A 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 unit100Direct materials per unit20Direct Labour per unit10Fixed factory overhead per month30000Variable factory overhead per unit5Fixed selling overheads1000Variable selling overheads per unit4EXAMPLEBudgeted activity was expected to be 1000 units each monthProduction and sales for each month were as follows:JanFebMarchUnit sold10008001100 10Unit produced100013009009 Wk1:Standard fixed overhead rate Budgeted total fixed factory overheadsBudgeted number of units producedRequired: Prepare absorption and marginal costing statements forthe three months 300001000 units 30 unitsWk 2:Production cost per unit under absorption costing:11Direct materialsDirect labourFixed factory overhead absorbedVariable factory overheadsBack 2010305 12652

Wk 3:(Under-)/Over-absorption of fixed factory overheads:JanuaryFebruaryMarch Fixed overhead300003900027000Fixed overheads incurred 30000300003000009000(3000)1000* 301300* 30900* 30No fixed factory overheadWk 4:Variable production cost per unit under marginal costing: Direct materials20Direct labour10Variable factory overhead5Back35January Sales100000Less: cost of good sold ( 65) 65000Adjustment for Over-/(under)Absorption of factory overheadGross profit35000Less: ExpensesFixed selling overheads 1000Variable selling overheads 4000Net profit30000ABSORPTIONCOSTING1413February 800005200028000March 000440030100MARGINALCOSTING1615January 100000SalesLess: Variable cost of goodsold ( 35)35000Product contribution margin 65000Less: Variable selling overhead4000Total contribution margin61000Less: Fixed ExpensesFixed factory overhead 30000Fixed selling overheads 1000Net profit30000February 80000March 10003280030000100030100DIFFERENCEBETWEEN ABSORPTIONAND MARGINAL COSTING18173

Treatment forfixedmanufacturingoverheadsAbsorption costingFixedmanufacturingoverheads aretreated as productcosting. It isbelieved thatproducts cannot beproduced withoutthe resourcesprovided by fixedmanufacturingoverheadsMarginal costingFixed manufacturingoverhead are treatedas period costs. It isbelieved that only thevariable costs arerelevant to decisionmaking.Fixed manufacturingoverheads will beincurred regardlessthere is production or19notValue ofclosing stockAbsorption costingHigh value ofclosing stock will beobtained as somefactory overheadsare included asproduct costs andcarried forward asclosing stockMarginal costingLower value ofclosing stock thatincluded the variablecost only20Absorption costingMarginal costingReported If the production Sales, AC profit MC ProfitprofitIf Production Sales, AC profit MC profitAs some factory overhead will be deferred asproduct costs under the absorption costingIf Production Sales, AC profit MC profitAs the previously deferred factory overheadwill be released and charged as cost of goodssoldARGUMENTFOR ABSORPTIONCOSTING2221 Compliancewith the generally acceptedaccounting principles Importance of fixed overheads forproduction Avoidance of fictitious profit or loss During the period of high sales, the production issmall than the sales, a smaller number of fixedmanufacturing overheads are charged and ahigher net profit will be obtained under marginalcostingAbsorption costing is better in avoiding thefluctuation of profit being reported in marginalcostingARGUMENTSFOR MARGINALCOSTING24234

Morerelevance to decision-makingof profit manipulation Avoidance Marginal costing can avoid profit manipulation byadjusting the stock level Consideration given to fixed costIn fact, marginal costing does not ignore fixedcosts in setting the selling price. On the contrary,it provides useful information for break-evenanalysis that indicates whether fixed costs canbe converted with the change in sales volumeMARGINOF SAFETY2625MARGIN OF SAFETYFORMULAMargin of safety is a measure of amount by whichthe sales may decrease before a company suffers aloss. This can be expressed as a number of units or apercentage of sales Margin of safety Budget sales level – breakeven sales levelMargin of safety Margin of safety *100%Budget sales level27EXAMPLESales revenueTotal Cost/Revenue 28The breakeven sales level is at 5000 units. Thecompany sets the target profit at 18000 and thebudget sales level at 7000 unitsRequired:Calculate the margin of safety in units and expressit as a percentage of the budgeted sales revenue ProfitBEPTotal costSales (units)Margin of safety29305

Margin of safety Budget sales level – breakeven sales level 7000 units – 5000 units 2000 unitsACTIVITY-BASED COSTINGMargin 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 are31incurred.COSTING PRODUCTS.TRADITIONAL COSTING METHODS. Directmaterials and directlabor costs are easy to trace Overhead cannot be tracedeasily and must be assignedwith estimates SpreadsTRADITIONAL COSTING METHODS.NEED FOR A NEW SYSTEMA single or plantwide ratecalled a predeterminedoverhead rate is used: Amount of direct labor usedin many industries hasdecreased JobOrder Direct LaborCosts Process Cost MachineHoursoverhead cost overentire customer base Each order “appears” to costthe same Orders with high profitmargins subsidize orderswith low profit margins Total overhead fromdepreciation on equipment,utilities, repairs, maintenancehas increased6

ACTIVITY-BASED COSTING (ABC)An overhead cost allocationsystem that allocates overheadto multiple activity cost poolsand assigns the activity costpools to products or servicesby means of cost drivers thatrepresent the activities used.ACTIVITYAny event, action, transaction, orwork sequence that causes acost to be incurred in producinga product or providing aservice.Illustration 4-2ACTIVITY COST POOLACTIVITIES AND RELATED COST DRIVERSThe overhead costallocated to a distinct typeof activity or relatedactivities.Illustration 4-3COST DRIVERAny factor or activity that has adirect cause-effect relationshipwith the resources consumed.In ABC cost drivers are used toassign activity cost pools toproducts or services.7

ACTIVITY-BASED COSTING (ABC)Calculate unit cost Identify activities Identify cost driver Compute overhead rate Assign overhead costs Assume that a company makes widgetsManagement decides to install an ABC systemGeneral LedgerManagement decides that all overhead costs onlyhave three cost drivers—sometimes called activities(obviously a simplification of the real world) ALL OVERHEAD COSTS ARE THEN ALLOCATED TO ONEOF THE ACTIVITY COST POOLS.OVERHEAD COST DRIVERS AREDETERMINED: LET’S WORK AN EXAMPLE . . .Direct labor hoursMachine hoursNumber of purchase ordersPayroll taxesMachine maintenanceDirect Labor 1,000 500Purchasing Dept.labor 4,000Fringe benefits 2,000Purchasing Dept.Supplies 250Equipmentdepreciation 750Electricity 1,250Unemploymentinsurance 1,500Machine Hours# of Purchase OrdersWhich overhead costs do youthink are driven by direct laborhours?ALL OVERHEAD COSTS ARE THEN ALLOCATED TO ONEOF THE ACTIVITY COST POOLS.Direct LaborGeneral LedgerPayroll taxesMachine maintenance 1,000 500Purchasing Dept.labor 4,000Fringe benefits 2,000 1,0002,0001,500 4,500Machine HoursPurchasing Dept.Supplies 250Equipmentdepreciation 750Electricity 1,250Unemploymentinsurance 1,500Overhead driver by direct laborhours# of Purchase OrdersALL OVERHEAD COSTS ARE THEN ALLOCATED TO ONEOF THE ACTIVITY COST POOLS.Direct LaborGeneral LedgerPayroll taxesMachine maintenance 1,000 500Purchasing Dept.labor 4,000Fringe benefits 2,000 1,0002,0001,500 4,500Machine HoursPurchasing Dept.Supplies 250Equipmentdepreciation 750Electricity 1,250Unemploymentinsurance 1,500 5007501,250 2,500# of Purchase OrdersWhich overhead costs aredriven by machine hours?8

ALL OVERHEAD COSTS ARE THEN ALLOCATED TO ONEOF THE ACTIVITY COST POOLS.General LedgerPayroll taxesDirect Labor 1,000Machine maintenance 1,0002,0001,500 4,500 500Purchasing Dept.labor 4,000Fringe benefits 2,000Purchasing Dept.Supplies 250Equipmentdepreciation 750Electricity 1,250Unemploymentinsurance 1,500Machine HoursDirect LaborAgain the formulas is:Costs in Activity CostPool/Base rate 1,0002,0001,500 4,500Assume the following bases:Machine HoursDirect labor hours 1,000Machine hours 250Purchase orders 100 5007501,250 2,500# of Purchase Orders 4,000250 4,250And finally, which overheadcosts are driven by # ofpurchase orders?AN OVERHEAD RATE IS THEN CALCULATED FOR EACHCOST POOL: 5007501,250 2,500# of Purchase OrdersThe ABC rates are: 4,500/1,000 4.50 per direct 4,000labor hour250 2,500/250 10 per machine hour 4,250 4,250/100 42.50 per purchase orderOVERHEAD COSTS ARE THEN ALLOCATED TO EACHPRODUCT ACCORDING TO HOW MUCH OF EACH BASETHE PRODUCT USES.The ABC rates are:NOW LET’S ALLOCATE OVERHEADA: 4,500/1,000 4.50 per direct laborhour 2,500/250 10 per machine hourBase ADirect labor hours 4,250/100 42.50 per purchase orderLets assume the company makes two products, Widget A andWidget B:Let’s also assume that each product uses the following quantityof overhead cost drivers:BaseDirect labor hoursMachine hoursPurchase ordersWidget A40010050Widget B60015050Total1,000250100Notice thatall base unitsareaccountedfor.Let’s do the same thing for the other two rates, to get the total amountof overhead applied to Widget A:Base400 100 50 WIDGETRateAllocated4.50 1,800.00Just like we learned in Accounting 2020, we multiplythe base used by the rate.In this case, 400 hours used to make Widget A ismultiplied by the rate of 4.50. This gives total overheadapplied for this activity cost pool of 1,800 toWidget A.NOW LET’S ALLOCATE OVERHEAD TO W IDGETB:CONTINUING THE CALCULATION:Widget ADirect labor hoursMachine hoursPurchase ordersTotal400 TORate4.50 10.00 42.50 Allocated1,800.001,000.002,125.004,925.00Let’s do the same thing for the other two rates, to get the total amountof overhead applied.Widget BDirect labor hoursMachine hoursPurchase ordersTotalBase60015050Rate 4.50 10.00 42.50Allocated 2,700.00 1,500.00 2,125.00 6,325.00The original overhead to be applied was 4,500 of direct labordriven overhead 2,500 of machine hour driven overhead 4,250 ofpurchase order driven overhead 11,250 total overhead to apply.The actual overhead allocated was 4,925 for Widget A 6,350 11,250 overhead applied.9