CHAPTER 8

Absorption and marginal costing

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 Presentation of costs on income statement
known as marginal costing/variable
costing
Definition
◼ Absorption costing
◼ Marginal costing
Absorption costing
◼ It is costing system which treats all
manufacturing costs including both
the fixed and variable costs as
product costs Example
Marginal costing or Variable 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

◼ Required:
◼ Prepare absorption and
marginal costing statements
for the three months
Absorption costing

Difference between absorption and

Marginal costing marginal costing
Argument for absorption costing Break-even analysis
◼ Compliance with the generally
Definition
accepted accounting principles
◼ Breakeven analysis is also known as
◼ Importance of fixed overheads for
cost-volume profit analysis
production
◼ Breakeven analysis is the study of
◼ Avoidance of fictitious profit or loss the relationship between selling
prices, sales volumes, fixed costs,
• During the period of high variable costs and profits at various
sales, the production is small levels of activity
than the sales, a smaller Application
number of fixed ◼ Breakeven analysis can be used to
manufacturing overheads are determine a company’s breakeven
charged and a higher net point (BEP)
profit will be obtained under ◼ Breakeven point is a level of activity
marginal costing at which the total revenue is equal
to the total costs
• Absorption costing is better
◼ At this level, the company makes no
in avoiding the fluctuation of
profit
profit being reported in Assumption of breakeven point analysis
marginal costing ◼ Relevant range
Arguments for marginal costing ◼ The relevant range is the
◼ More relevance to decision-making range of an activity over
◼ Avoidance of profit manipulation which the fixed cost will
remain fixed in total and the
• Marginal costing can avoid profit variable cost per unit will
manipulation by adjusting the remain constant
stock level
◼ Fixed cost
◼ Consideration given to fixed cost
◼ Total fixed cost are assumed
• In fact, marginal costing does not to be constant in total
ignore fixed costs in setting the
selling price. On the contrary, it ◼ Variable cost
provides useful information for ◼ Total variable cost will
break-even analysis that increase with increasing
indicates whether fixed costs can number of units produced
be converted with the change in
sales volume ◼ Sales revenue
◼ The total revenue will
increase with the increasing
number of units produced
Calculation method
◼ Breakeven point
◼ Target profit
◼ Margin of safety
◼ Changes in components of
breakeven analysis
Breakeven point
Calculation method
◼ Contribution is defined as the excess
of sales revenue over the variable
costs
◼ The total contribution is equal to
total fixed cost
Target profit 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
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

Limitation of breakeven point

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
Changes in components of breakeven point production
◼ 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