UNIT 2:

MARGINAL AND ABSORPTION COSTING

Unit Objectives
By the end of this Presentation, you should be able to:
1. explain marginal costing and absorption costing
2. explain the difference between marginal costing and absorption costing;
3. prepare profit statements based on absorption costing and marginal costing,
4. reconcile the difference in profit under absorption costing and marginal
costing,
5. State the advantages and disadvantages of absorption and marginal costing
for a manufacturing business.
6. explain such terms as breakeven point, contribution and margin of safety,
7. explain the assumptions underlying break-even analysis,
8. apply cost volume-profit analysis to single products and multiple products,
9. Draw and interpret a breakeven chart from information supplied; and
ABSORPTION COSTING AND MARGINAL COSTING

Meaning of Absorption Costing and Marginal Costing

Absorption costing is the technique under which total cost (that is fixed
cost and variable cost) is charged as production cost. It is also known as
full costing.
Marginal costing is a costing approach where the product cost is made
up of variable production costs and fixed costs are considered as period
costs and are thus charged directly to profit and loss account for the
period.

The following formulae enable us to quickly grasp most of the issues to

be discussed in the remaining sessions of this presentation.
Total Cost = Total Fixed cost +Total Variable Cost
Contribution = Sales - Variable Cost (that is marginal cost)
Profit = Contribution - Fixed Cost
Features of Marginal Costing
Features which are essential part of a system of marginal costing are as
follows:
(a) The marginal (variable) costs are regarded as the costs of products.
(b) Stocks of finished goods and work in progress are valued on the basis of
marginal costs.
(c) Prices are based on marginal costs plus the contribution.
(d) A special form of profit and loss account or statement is employed
(marginal profit and loss account)
(e) Profit is calculated by deducting marginal costs from sales revenue to
arrive at the contribution after which fixed overheads are deducted to
determine profit.
(f) The relative profitability of departments or products is usually based on a
study of the contributions made available by each department or product.
(g) Fixed costs are treated as period costs and are charged to profit and loss
account for the period in which they are incurred.
dvantages of Absorption and Marginal Costing
Absorption Costing Marginal Costing
It includes an element of fixed Contribution per unit is constant
overheads in inventory values unlike profit per unit which
varies with changes in sales
volume
Analyzing under/over absorption There is no under or over
of overhead is a useful exercise in absorption of overheads (and
controlling costs of an hence no adjustment is required
organization in the income statement)
Is small organizations, absorbing Fixed costs are a period cost and
overheads into the costs of are charged in full to the period
products is the best way of under consideration.
estimating job costs and products
on jobs.
It is useful in the decision-
making process
 Income Statement under Absorption Costing and Marginal
Costing
We noted under session 1 that absorption costing uses full cost of manufacture
to value inventory while, marginal costing uses direct material cost, direct
labour cost and variable manufacturing overhead to value inventory. The
concepts that we need to take note are product cost and period cost .
gure 2.Income Statement Absorption Costing
¢
Sales xxx
Less cost of goods sold
Cost of goods manufactured/produced xx
Add opening stock of finished goods xx
xx
Less closing stock xx

Gross Profit xx
Less selling and administration costs xx
Net Profit xx

Note that cost of goods produced consists of direct material, direct labour
cost, variable production overhead and fixed production overhead.
Opening stock is valued at previous period’s production cost
Closing stock is valued at production cost of current period
Marginal Costing Income Statement

Sales xxx
Less cost of goods sold:
Opening stock xx
Add variable cost of production xx
xxx

Less closing stock xx

Cost of goods sold xx
Variable admin., selling overhead xx
Total variable cost xxx
xxx

Contribution
Less fixed production, admin. and selling overhead xxx
Net Profit xxx
Opening stock is valued at variable cost of production of the previous
period.
Variable cost of production consist of direct material cost, direct labour
cost and variable production overhead.
Closing stock is valued at current variable cost of production
 Practical Example
Let us use the following information about ABC Company Ltd to illustrate the preparation of
marginal and absorption income statements.

Variable cost per unit: GHȼ

Direct material 2
Direct labour 4
Variable manufacturing overhead 1
Variable selling and administration expenses 3

Fixed cost per year:

Fixed manufacturing overhead 30,000
Fixed selling and administration expenses 10,000
Number of units produced each year is 6,000

Unit in beginning stock 0

Unit sold 5,000
Selling price per unit 20

Required
Prepare income statement for ABC Limited using absorption costing and Marginal costing.
Reconciling Profits Reported Under the Different Methods

Comparative Income effect of Absorption and Marginal

Costing of Profit Reporting
Relation between Relation between
Production and Effect on Stock Absorption and
Sale for the Period Marginal Costing
Production equal No change in stock Absorption costing
sales equal marginal
costing profit.
Production is greater Stock increases Absorption costing
than sales profit, will be greater
than marginal costing
profit
The production is Stock decreases Absorption costing
less than sales profit will be less
than marginal costing
Illustrative Question 2
Based on the principles we have discussed, let us use another example to illustrate the preparation of
income statements under absorption and marginal costing techniques.

Saacat Company manufactures and sells a single product. The following costs were incurred during the
company’s first year of operation.
Variable cost per unit: GHc
Direct Material 6
Direct Labour 9
Variable manufacturing overhead 3
Variable selling and administration expenses 4

Fixed costs per year:

Fixed manufacturing overhead300,000
Fixed selling and administration expenses 190,000
During the year the company produced 25,000 units sold 20,000 units
The selling price of the company’s product was $50 per unit.
Required:
1. Assume that, the company uses the absorption method:
(a)Compute the unit product cost
(b) Prepare an income statement for the year

2. Assume that, the company uses the variable costing method

(a)Compute the unit product cost
(b) Prepare an income statement for the year
 BREAK-EVEN ANALYSIS: MEANING, ASSUMPTIONS, AND USES

Break-even Analysis Defined

Break-even analysis is the term given to the study of inter-relationship
between cost, volume and profit at various levels of activity. It involves the
application of marginal costing techniques and it is sometimes called Cost-
Volume-Profit (C.V.P). Analysis which is often used in budget planning by
marketing managers as well as the accountants.
• Corporate decisions such as:
– number of units to produce in order to meet demand,
– make a certain level of sales,
– target a level of profit (given a particular tax bracket),
– the level of sales that will enable the organization to cover just its cost
or
– the price at which units produced should be sold
are among the most important decisions.
 Assumptions Underlying Break-even Analysis

The break-even analysis is based on the following assumptions:

(a) All costs can be segregated into fixed and variable elements/components
(b) Total Fixed cost will remain constant and Total variable cost will vary
proportionately with activity.
(c) The only factor affecting cost and revenue is volume that is price is fixed
as well as cost.
(d) Over the activity range being considered, cost and revenue behave in a
linear fashion
(e) That technology, production methods and efficiency remain unchanged
(f) That the analysis relates to one product only or to constant product mix
(g) There are no stock level changes or that stock are valued at marginal cost
only
(h) There is no change in the general price level.
Uses of Break-even Analysis
(a) It helps in determining the selling price which
will give the desired profit
(b) It helps in determining the costs and revenues
at different levels of outputs
(c) It helps in determining the quantity of goods
to produce to break-even
(d) It can be used to examine the effect of change
in selling price or of price differentiation in different
markets
(e) It can be used to examine the impact on
changes in fixed and variable costs on profits.
 BREAK-EVEN CHART – GRAPHICAL
APPROACH
Traditional Break-Even Chart
The break-even point can be determined graphically. The break-even chart is prepared showing on
the horizontal axis the sales (in units or value) and on the vertical axis values for sales revenue and
cost.

The fixed cost line is drawn parallel to the horizontal axis at a point on the vertical axis denoting
the total fixed cost. The total cost line which starts at the point where the fixed cost line meets the
vertical axis, and ends at the point which represents on the horizontal axis the anticipated sales in
units and on the vertical axis the sum of the total variable cost of those units plus the total fixed
cost.

The total revenue line is drawn from the point of origin in a linear form to the point representing
revenue on the vertical axis and the anticipated sales level in the horizontal axis.

The break-even point is the intersection of the sales line and total cost line.

By projecting the lines horizontally and vertically from this point to the appropriate axis it is
possible to read of the BEP in sales value and sales units.
 Break-even chart
Cost and revenue ¢ Million
Total
12
revenue
10 Total cost
8

4 Fixed cost

2
0
20 40 60 80 100 120

Scale Units (‘000)

Illustration Question
Let us use the question below to systematically
explain the construction of a traditional break-
even chart and the determination of break-even
sales value and units of output.
The budgeted output for a factory is 120,000
units. The fixed overhead amounts to
¢4,000,000 and variable cost are ¢50 per unit.
The average selling price is ¢100 per unit.
Present this information on a traditional break-
even chart.
Step 1
(a) Determine the total cost as follows: fixed cost + [variable cost
unit x total output]
From our example it will be ¢4,000,000 + [¢50 x 120,00] =
¢10,000,000
(b) Determine the total revenue as selling price per unit x total
output.
From the example this will be ¢100 x 120,000 = ¢12,000,000
Step 2
The next step involves drawing the axes on suitable graph paper,
inserting the costs and sales values and then drafting the fixed
cost line at the appropriate point on the chart. From our example,
the fixed costs amount to: ¢4,000,000. the fixed cost line is
drawn parallel to x-axis, starting from 4,000,000 on the y-axis.
Step 3
Draw the total cost line. The total cost line is drawn starting
from the point on the Y-axis which represents fixed cost. For
example, from our question, total cost is ¢10,000,000 a total cost
line is drawn from ¢4,000,000 the fixed cost point on Y-axis, to
¢10,000,000 cost point on the right side of the Y-axis.
Note that the distance between the total cost line and fixed cost
line represent variable cost.
Step 4
The total revenue line is drawn commencing at zero and finishing
at the point of maximum sales. From the question, total revenue
is ¢12,000,000.
From the completed break-even chart other important facts such
as profit, loss and margin of safety can be shown.
Below the break-even point the business will be making loss
since total revenue will be less than total cost. On the other
hand, a point above the break-even point represents profit, since
total revenue exceeds total cost. At the break-even point there is
no profit nor loss since total revenue equals total cost.
The margin to safety represents the difference between
sales at a given activity and sales at the break-even point.
From our example, the margin of safety is ¢4,000,000,
that is ¢12,000,000 - ¢8,000,000. The margin of safety
can be expressed as a percentage of sales. In the
example, under discussion it will be 331/3%, that is
[¢4,000,000 ¢12,000,000] x 100. The greater the margin
of safety the more advantageous it is for the business.
 Profit Volume Graph
We explained under session 3, that the break-even analysis is also
called cost-volume-profit analysis. The reason being that, it is an
analysis of how profits change as costs change in response to
changes in production or sales volume. The analysis can also be
depicted by a profit-volume chart/graph.
Profit-volume charts exhibit the relationship between profit and
sales volume. The traditional break-even charts suffer from one
limitation. Profit cannot be read directly from the chart. It can
only be deduced by deducting the total cost reading from the total
revenue reading. A profit graph overcome this by plotting the
profit directly against activity
The construction of the profit graph involves drawing the sales
curve/line and the profit curve/line.
Step 1 Draw the horizontal and vertical axis.
Step 2 The negative range of the vertical axis should be
equal to the fixed cost (that is the loss) and the positive
range equal to profit (that is total revenue-total cost).
From the example, fixed cost is ¢4000,000 and profit is
¢4,000,000 [that is ¢12,000,000 - ¢8,000,000]
Step 3: The horizontal axis represents the sales.
Step4:The break-even point is determined by joining the
profit line to the fixed cost line intersects the sales line
in the break-even point. Figure 4.5 illustrates the profit-
volume chart.
Profit-Volume Chart

Profit
(¢’million)

2 4 6 8 10 12 Sales
(¢’million)
-2
B.E.P.
-4

-6
Loss/ FC
(¢’million)
 BREAK-EVEN ANALYSIS - CONTRIBUTION
APPROACH
Break-Even Point – Equation Approach
The break-even point is the level of activity where total cost equal total revenue. Thus, at this
level of activity no profit or loss is made.

As we noted either session 4, the break-even point can be calculated in sales units and sales.
(1) Break-even point in units =

(2) Break-even point in sales value (a)

or
(b)

You can also find the break-even in sales value by simply multiplying the break-even in units by
the selling price per unit.
•

(3) Contribution-Sales Ratio =

•

The contribution to sales ratio is also called contribution margin ratio.

Let us illustrate the computation of break-even point using the equation above.
Illustration Question
Nkwa Enterprise makes a single product with a sales price of GHȼ 100 and
marginal cost of GHȼ60 fixed costs are GHȼ69,000 per annum.
Calculate
(a) Number of units to break-even
(b) Sales value at break-even
(c) Contribution to sales ratio
(d)What number of units will need to be sold to achieve a profit of
GHȼ20,000 per annum
(e)What level of sales will achieve a profit of GHȼ20,000
(f)If the tax rate is 40%, how many units will be needed to be sold to make a
profit after tax of GHȼ 20,000
(g)Because of increasing cost, the marginal cost is expected to rise to GHȼ63
per unit and fixed cost to GHȼ70,000 per annum. If the selling price cannot
be increased, what would be the number of units required to maintain a profit
of GHȼ20,000 per annum?
 Margin of Safety

It shows the measure by which total sales exceeds the break-even

point. Margin of safety is a measure by which the budgeted
volume of sales is compared with the volume of sales required to
break even. It is the difference in units between the budgeted
sales volume and break even point.
It is sometimes expressed as a percentage of the budget sales
volume. Thus

Example
Maame Enterprise makes and sells a product which has a variable
cost of $30.00 and which sells for $400.00. Budgeted fixed cost
are $70,000 and budgeted sales are 8,000 units. What is the BEP
and the Margin of Safety?
 COST-VOLUME PRODUCT ANALYSIS FOR
MULTI-PRODUCTS
Step by Step Approach
The computation of break-even point for multiple products is not as straight forward as that
of a single product. A number of computations are required. Let us examine some of
them.
1. Computation of contribution per unit for each product.
The analysis begins with determining the contribution by each product. Remember that
contribution per unit can be calculated as selling price per unit – variable cost per unit.

It must be noted that the contribution per unit can also be referred to as contribution
margin. The use of contribution margin is particularly useful where the total sales and total
variable cost are given rather than selling price per unit and variable cost per unit.

2. Calculation of Contribution to sales ratio

The next step involves calculation of contribution to sales ratio (or contribution
margin ratio) for each product.
3. Calculation of percentage to sales
The sales by each product should be expressed as a percentage of the total sales by the firm
for each period. Sales of Individual Products x 100
Total Sales of the firm
4. Computation of the Weighted Average Contribution Margin
Ratio
The denominator for the formula for calculating the break-even
point for multi-products is the weighted average contribution
margin ratio. It is calculated as follows:
C1P1 + C2 P2 + C3 P4 + ‘’’ Cn Pn
That is multiplying each products contribution margin ratio by
its percentage to sales and summing up. In the formula, C
represents contribution margin ratio of each product and P is the
percentage of each product’s sales to total sales.

5. The Break-even point

The break-even point can be calculated using the formula:
6 . Allocation of the Break-even sales to the individual products
The percentage of each products sales to total sales is
used to share the break-even sales to the products
7. Break-even units of each product.
The results obtained under step 6 for each products is
divided by its selling price in order to determine the
break-even sales in units.
8. Checking the Results
The computations are checked for their correctness by
multiplying each products sales in units by its
contribution per unit. The computations can also be
checked by multiplying the contribution margin ratios
of each product by the BEP for each product. In either
case, this should sum up to the fixed cost.
Let us use the question on Glory Ltd to illustrate the step by step approach

Glory Ltd. produces three products Alpha, Beta and Delta. The
following are the results for one year:

Product Sales Variable Cost

GH¢ GH¢
Alpha 50,000 20,000
Beta 30,000 18,000
Delta 20,000 25,000
Total 100,000 63,000

Fixed overhead 22,200

 Illustration
Product SP/u VC/u Units sold
A 20 14 10,000
B 40 8 10,000
C 4 4.2 50,000
D 10 7 20,000

FIXED COST = 240,000