Download Marginal Costing vs. Absorption Costing Revision

Marginal Costing vs. Absorption
Costing
Revision
Mr. Barry
A-level Accounting Year 13
Learning Outcomes
At the end of this session, you will be able to:
• Explain the differences between absorption costing and
variable/marginal costing.
• Explain costs, contribution and break-even and calculate
the breakeven point in units and revenue. (Marginal)
• Represent the break-even point on a chart (Marginal)
• Select and apply marginal costing techniques for decision
making (Marginal)
Mr. Barry
A-level Accounting Year 13
Learning Outcomes
• Explain absorption costing to distinguish it from
marginal costing (Absorption)
• Distinguish between cost centre and a cost unit
(Absorption)
• Allocate, apportion and absorb overheads using
absorption rate (Absorption)
• Apply the absorption rates to work out the full cost of a
cost unit and work out the selling price of a product
(Absorption)
Mr. Barry
A-level Accounting Year 13
Introduction
• In financial accounting stocks are valued at full
production cost (including a share of fixed
production overheads). This approach is known
as absorption costing.
• An alternative approach, variable costing, is to
value stock at variable production cost only.
• As well as valuing stocks differently, the format
used to present the accounts is different in
variable costing.
Mr. Barry
A-level Accounting Year 13
Marginal Costing
Mr. Barry
A-level Accounting Year 13
Marginal Costing
Variable costs vary with levels of activity within
the business
Fixed Costs do not vary with levels of business
activity
Semi variable cannot be classified as either fixed
or variable since they contain elements of each
Mr. Barry
A-level Accounting Year 13
Marginal costing
• Only variable costs are charged as a cost of sale
• Closing stocks valued at marginal (variable)
production cost
• Fixed costs treated as a period cost & charged in
full to the P&L account in the current period
• Contribution (or contribution towards covering
fixed overheads) – difference between sales value
and marginal (variable) cost
Mr. Barry
A-level Accounting Year 13
Marginal Cost
• Definition – The part of the cost of one unit of
product (or service) which would be avoided if that
unit were not produced, or which would increase if
one extra unit were produced
• Marginal production cost per unit usually consists of
– Direct materials
– Direct labour
– Variable production overheads
Mr. Barry
A-level Accounting Year 13
Observations
• Profit per unit varies at differing levels of sales
because fixed o/head cost per unit changes
with volume changes
• Contribution per unit is constant
• Profit = Total Contribution less Fixed Costs.
Therefore if Total Contribution matches fixed
costs, the breakeven point is reached (CVP
analysis)
Mr. Barry
A-level Accounting Year 13
Important
• Marginal costing is an alternative method of
costing to absorption costing. In marginal costing
only variable costs are charged as a cost of sales
and a contribution is calculated.
• Contribution = is of fundamental importance in
marginal costing, and the term contribution is
really short for contribution towards covering
fixed overheads and making a profit.
• Sales – Variable costs = Contribution
Mr. Barry
A-level Accounting Year 13
Absorption & Variable Costing
Mr. Barry
A-level Accounting Year 13
Absorption & Variable Costing
• Absorption costing:
• Variable costing:
• Product costs:
• Product costs:
– Fixed manufacturing
– Variable manufacturing
• Period costs:
– Non-manufacturing
Mr. Barry
– Variable manufacturing
• Period costs:
– Fixed manufacturing
– Non-manufacturing
A-level Accounting Year 13
CONTRIBUTION – is the difference between selling price and
variable costs
Contribution should more properly be termed contribution
towards fixed costs and profit, are once fixed costs are all
covered contribution becomes profit.
WORKED EXAMPLE 1
£
The selling price of a unit of BMX
100
Variable costs per unit direct materials
27
Direct labour
32
Royalties
8
Fixed Costs
17
REQUIRED: Calculate the contribution made by the sale
of one unit of BMX
Mr. Barry
A-level Accounting Year 13
ANSWER
Contribution per unit =
Selling price per unit - Variable cost per
unit
Contribution per unit =
£100 - £67 (£27 + £32 + £8)
Contribution per unit = £33
Mr. Barry
A-level Accounting Year 13
WORKED EXAMPLE 2
Elia produces a single product. The information below
relates to the production and sales of the product in
October:
Costs and Revenues per unit
£
Sales revenue
70
Costs - direct materials
15
Direct labour
12
Royalties
5
Fixed Costs
20
Production and sales 1,000 units
REQUIRED Prepare an income statement for October,
showing the total contribution and profit.
Mr. Barry
A-level Accounting Year 13
ANSWER
Sales
LESS
Direct materials
Direct labour
Royalties
CONTRIBUTION
LESS FIXED costs
Profit
Mr. Barry
Income Statement
£
15,000
12,000
5,000
A-level Accounting Year 13
£
70,000
32,000
38,000
20,000
18,000
THE USES OF MARGINAL COSTING
MC is used in the following circumstances.
When a business is:
• Costing ‘special’ or one off opportunities
• Deciding whether to make or buy the product
• Choosing between competing alternative
actions
• Employing a penetration or destroyer pricing
strategy
• Calculating the break even level of output
Mr. Barry
A-level Accounting Year 13
SPECIAL OR ONE OFF BUSINESS OPPORTUNITIES
Worked Example
The Annee manufacturing Company produces one product:
‘Annees’. The following information is available for a production level of
5,000 Annees:
Costs and Revenues per unit
£
Sales revenue
45
Costs direct materials
12
Direct labour
19
Royalties
1
Fixed Costs
8
There is spare capacity in the factory. A Malaysian retailer has
indicated that he would be willing to purchase 200 Annees, but only if
the price to her was £35 each.
Required
Advise the management of the Annee Co whether they should accept
the order or not.
Mr. Barry
A-level Accounting Year 13
ANSWER
The order should be accepted. The order will
make a positive contribution of £600 (£3 per unit).
WORKINGS
Contribution
= SP – MC per unit
Contribution
= £35 - £32
Contribution
= £3 per annum
NOTE
The special order has no need to cover the fixed
costs since they have already been absorbed into
the selling price at the normal rate (£45).
Mr. Barry
A-level Accounting Year 13
Worked Example – Continued
The Malaysian contract has no need to cover the fixed costs AGAIN.
The contract is providing the manufacturer with an extra (marginal)
contribution.
We can check to see if the acceptance of the contract does make the
business more profitable by preparing a marginal cost statement.
Non acceptance of the order
£
£
Sales
225,000
Direct Materials 60,000
Direct Labour
95,000
Royalties
5,000
160,000
Accepting the order
£
Sales
Direct materials
Direct Labour
Royalties
62,400
98,800
5,200
£
232,000
166,400
CONTRIBUTION
65,000
CONTRIBUTION
65,600
Fixed Costs
40,000
Fixed Costs
40,000
Profit
25,000
Profit
25,600
Mr. Barry
A-level Accounting Year 13
Question 1
The following information is given for G
Singh, a manufacturer of IT cables:
Direct materials
Direct Labour
Fixed Costs
£
4.50 per unit
7.70 per unit
1.80 per unit
The IT cable sells to retailers at £30. Kibrit, a large dept
store, wishes to purchase 3,000 cables at a price of £15
per service to include in its annual January sale.
REQUIRED
Advise G Singh whether he should accept Kibrits order.
Mr. Barry
A-level Accounting Year 13
MAKE or BUY DECISIONS
WORKED EXAMPLE
Adrian Dobrin produces T-Shirts for the fashion industry. The estimated costs
and revenues for the next financial year are as follows:
Costs and Revenues per unit, base on production and Sales of 140,000 T-shirts.
£
Selling Price
12
Direct materials
2
Direct Labour
3
Fixed costs
4
Total Production cost
9
Profit per T – Shirt
3
A manufacturer in India has indicated that the T-shirts could be supplied to Adrian at
a total cost of only £7 each.
Adrian has calculated that if existing selling price is maintained then profits will rise to
£5 per item and total profits will rise to £700,000 next year – an increase in profits of
£280,000.
Required:
Advise Adrian whether, on financial grounds, he should accept the offer from India
Mr. Barry
A-level Accounting Year 13
ANSWER
Adrian should not accept the offer. If he did he would be worse off next year
Than if he continued to manufacture the T-shirts himself. Profits would
fall to only £140,000.
Contribution if he CONTINUES to manufacture himself =
£7
(Selling Price £12 – Marginal (variable costs)
£5 (£2 + £3)
Contribution if he PURCHASES from India =
£5
(Selling Price £12 – Marginal (VC) £7)
Make Vs Buy
Make
£
Sales
Direct materials 280,000
Direct labour
420,000
Contribution
Less FIXED COSTS
PROFIT
1,680,000 Sales
Mr. Barry
A-level Accounting Year 13
700,000
980,000
560,000
420,000
Buy
£
1,680,000
Purchase Price
Contribution
Less Fixed Cost
Profit
980,000
700,000
560,000
240,000
Fixed and Variable Costs
Fixed Costs
Variable Costs
Fixed costs remain fixed
over a range of output
levels in the short-term
For example: factory rent
Variable costs vary
directly with changes in
output levels
For example: materials and
labour
There are also ‘semi-variable costs’ which combine both a fixed and variable element eg
a telephone bill which has fixed rental and variable call charges.
Mr. Barry
A-level Accounting Year 13
The Break-Even Point
• The break-even point is the output level (in units) at which the income
from sales is just enough to cover all the costs, and the profit (or loss)
is therefore zero.
• The formula for break-even in units of output is:
fixed costs (£)
contribution per unit (£)
contribution per unit (£) =
selling price per unit – variable costs per unit
Mr. Barry
A-level Accounting Year 13
Break-even point by calculation
Jason Sports Limited manufactures golf clubs and is able to sell all
that is produced.
Fixed costs of running the business = £10,000 per month
Selling price of each golf club = £30 each
Variable costs (materials and direct labour) = £10 per unit
What is the break-even point?
• Using the formula, the break-even point in units of output is:
Fixed costs
4
Selling price per unit less 4
variable costs per unit
Mr. Barry
£10,000
=
£30 - £10
A-level Accounting Year 13
500 units
Break-even point in
units per month
Break-even point by the graph method
JASON SPORTS LIMITED: BREAK-EVEN GRAPH
sales
revenue
break-even point (500
units) where the total
costs line crosses the sales
revenue line.
£20,000
total costs
£15,000
variable
costs
costs and
revenues
£10,000
fixed costs
£5,000
0
100
200
300
400
500
units of output (per month)
Mr. Barry
A-level Accounting Year 13
600
700
Interpretation of break-even
• The break-even graph can show not only the break-even point but
also the profit or loss at any level of output/sales contained within
the graph.
• To calculate profit or loss from the graph simply measure the
gap
between sales revenue and total costs at a chosen number of units, and
read the money amounts off the vertical axis.
• Another way to calculate the profit or loss at any level of output/sales
is the use the following formula:
(the level of output or activity)
Profit/(loss) =
(selling price – variable costs) per unit x volume – fixed costs
For example, for Jason Sports Ltd, the profit at 600 units =
(£30 - £10) x 600 - £10,000
Mr. Barry
= £12,000 - £10,000
A-level Accounting Year 13
= £2,000
Limitations of break-even analysis
The main limitations are:
• The relationship between sales revenue, variable costs and fixed
costs may not always remain constant because:
- sales prices may differ at different quantities sold
example because of discounts).
(for
- variable costs may alter at different levels of output (for
example due to bulk buying of materials).
- fixed costs do not remain fixed at all levels of output (for
example if extra premises are needed).
• The assumption that all output is sold may not be true.
• The presumption that there is only one product may not be correct.
• External factors (such as rate of inflation) are not considered.
Mr. Barry
A-level Accounting Year 13
Margin of safety
• The margin of safety is the amount by which sales exceed the breakeven point.
• The margin of safety is important to management as it shows the
‘cushion’ which current production/sales gives beyond the breakeven point.
• The margin of safety may be expressed:
In units
sales volume (units) – break-even point (units)
eg Jason Sports Ltd at output of 700 units: 700 – 500 = 200 units
In £
margin of safety in units x selling price (£)
eg Jason Sports Ltd at output of 700 units: 200 x £30 = £6,000
As a %
Mr. Barry
margin of safety in units x 100 sales
volume (units)
A-level Accounting Year 13
Target profit
• It is also possible to calculate the output that needs to be sold in
order to give a certain amount of profit (called the target profit).
• The formula for this is:
Number of units output
=
fixed costs (£) + target profit (£)
contribution per unit (£)
eg If Jason Sports Ltd requires a profit of £4,000 per month, the
calculation is:
£10,000 + £4000
cont£20
=
700 units with a sales value of
£21,000
700 units at £30 each
Mr. Barry
A-level Accounting Year 13
Target profit (continued)
• The target profit of £4,000 can also be shown by means of a profit
statement:
Jason Sports Limited
£
sales revenue (700 units at £30 each)
21,000
less variable costs (700 units at £10 each)
7,000
equals contribution (to fixed costs and profit) 14,000
less monthly fixed costs
10,000
equals target profit for month
4,000
Note that target profit can also be calculated by making use of the contribution sales
ratio (see next two slides).
Mr. Barry
A-level Accounting Year 13
Contribution Sales Ratio
• The contribution sales (CS) ratio - also known as the profit volume (PV)
ratio - expresses the amount of contribution in relation to the amount
of the selling price.
• The formula for contribution sales ratio is:
contribution (£)
selling price (£)
• Referring to Jason Sports Ltd the CS ratio (per unit) is:
£20£
30
=
0.6666 or 66.66%
In break-even analysis, if fixed costs are known, then the CS ratio can be used to find
the sales value at which the business breaks even, or the sales value to give a target
amount of profit (see next slide).
Mr. Barry
A-level Accounting Year 13
Contribution Sales Ratio (continued)
• To find the sales value at which Jason Sports Ltd will break-even using
the CS ratio:
Fixed costs (£)
CS ratio
=
£10,000
0.6666
=
£15,000
• To find the sales value at which Jason Sports Ltd will achieve a target
amount of profit (say £2,000) using the CS ratio:
fixed costs (£) + target profit c
CS ratio
=
£10,000 + £2000
0.6666
=
£18,000
As the selling price is £30 the units of output to achieve the £2,000 profit above is
£18,000 / £30 = 600 units.
Mr. Barry
A-level Accounting Year 13
When to use break-even analysis
• Before starting a new business:
In order to see the level of sales needed to cover costs or to
make a particular level of profit.
• When making changes within the business:
Break-even analysis will be used as part of the planning process
to ensure the business remains profitable.
• To answer ‘what if?’ questions:
Questions such as ‘what if sales fall by 15%?’ and ‘what if fixed
costs increase by £1,000?’ can be answered.
• To evaluate alternative management viewpoints:
For example assessing how automation may affect profit.
Mr. Barry
A-level Accounting Year 13
Limiting Factor
1. Calculate the contribution per unit (SP-VC)
2. Calculate the contribution per limiting factor,
for example per labour hour (amount/price
or units (Q)/£ per ___)
3. Rank the products in order of the product
with the highest contribution per limiting
factor
4. Devise a production schedule to maximise
profits using the rank order
Mr. Barry
A-level Accounting Year 13
Question
• A company manufactured 3 products, X, Y and
Z. The sales demand on the standard unit
selling prices and costs for the next accounting
period are estimated below:
X
Y
Z
4,000
5,500
7,000
Selling price
£28
£22
£30
Variable costs:
Raw materials (£1 per kg)
Direct Labour (£12 per hour)
5
12
4
9
6
18
Maximum demand
• Calculate an optimum production plan when
there is only 8,125 hours of direct labour
available?
Mr. Barry
A-level Accounting Year 13
Challenge
1. Calculate the contribution per unit (SP-VC)
2. Calculate the contribution per limiting factor,
for example per labour hour
3. Rank the products
4. Devise production schedule
Mr. Barry
A-level Accounting Year 13
Step 1. Calculate C.P.U.
X
Y
Z
Selling price
£28
£22
£30
Variable costs
RM
DL
(5)
(12)
(4)
(9)
(6)
(18)
11
9
6
C.P.U.
Mr. Barry
A-level Accounting Year 13
Step 2 Calculate contribution per
limiting factor
X
Y
Z
Selling price
£28
£22
£30
Variable costs
RM
DL
(5)
(12)
(4)
(9)
(6)
(18)
11
9
6
£12/£12 per
hour
£9/£12 per
hour
£18/£12
per hour
1 hour
0.75 hour
1.5 hour
11 C.P.U/ 1
hour
11 C.P.L.F
9 C.P.U/ 0.75
hour
12 C.P.L.F
6 C.P.U/ 1.5
hour
4 C.P.L.F
C.P.U.
Limiting factor
Contribution
per limiting
factor
Mr. Barry
A-level Accounting Year 13
Step 3. Rank the products
Ranking
Mr. Barry
2
1
A-level Accounting Year 13
3
Step 4. Production schedule
Demand
Hours
Unit produced
X
4000
4000
4000
Y
5500
4125
5500
Z
7000
0
0
8125
Mr. Barry
A-level Accounting Year 13
Absorption Costing
Mr. Barry
A-level Accounting Year 13
Overhead allocation : Recap
• Product costs are built up using absorption costing by a
process of allocation apportionment and absorption.
• Allocation: is the process by which whole cost items are
charges direct to a cost unit or cost centre.
• Apportionment: follows on from overhead allocation.
Identify all overhead costs as production department,
admin or S&D overheads. The costs for heat, light and all
costs that have been allocated to general overhead cost
centres must be shared out between the other cost centres.
• Overhead costs should be shared out on a fair basis.
Mr. Barry
A-level Accounting Year 13
Overhead
Mr. Barry
A-level Accounting Year 13
Basis
Service Cost Centre
Mr. Barry
A-level Accounting Year 13
How to calculate the amount of
apportioned base for each department
1. Add up total available floor space or NBV
2. Divide each department allocation by the
amount of base available
Example:
Mr. Barry
Cutting
Finishing
Maintenance Canteen
Floor area
50,000
30,000
15,000
NBV
150,000
450,000
A-level Accounting Year 13
5,000
Calculation of the overhead absorption
rate (OAR)
1. Distinguish between production departments
2. Decide on the correct bases to be used to apportion the
overheads between departments
3. Draw up a schedule to apportion the overheads between
all of the departments
4. Complete the schedule by apportioning the total of the
overheads of each service departments to each of the
production departments
5. Total up the overheads for each production department
6. Divide the total for each department by the correct basis
and calculate the OAR for each production department
Mr. Barry
A-level Accounting Year 13
Overhead absorption : Recap
• The absorption rate is calculated as :
Budgeted overhead (£)
Budgeted level of activity (machine hours/ labour
hours)
• Many factories use a direct labour hour rate or
machine hour rate in preference to a rate based on a
% of direct materials cost, wages or prime cost.
Mr. Barry
A-level Accounting Year 13
Use of the overhead absorption rate
(OAR)
Calculate the full cost of a cost unit
£
Mr. Barry
Materials (metre x price per metre)
x
Labour (2 hours x price per hour)
x
Use overhead absorption rate for calculating cost
of overheads (OAR x department overheads)
x
Full cost
x
A-level Accounting Year 13
Over & under absorption : Recap
•
The rate of overhead absorption is based on estimates and is quite likely
that either one or both of the estimates will not agree with what actually
occurred. Actual overheads will probably be either greater than or less
than overhead absorbed into the cost of production.
a)
Over absorption means that the overheads charged to the cost of
production are greater than the overheads actually incurred.
Under absorption means that insufficient overheads have been included
in the cost of production.
b)


Mr. Barry
If actual overhead – absorbed overhead = Negative, then overheads are
over absorbed.
If actual overhead – absorbed overhead = Positive, then the overheads
are under absorbed.
A-level Accounting Year 13
Reasons for under / over
Actual overhead costs are different from
budgeted overheads
The actual quantity level is different from the
budgeted level of activity
Both actual overheads and actual activity level
are different from budget
Mr. Barry
A-level Accounting Year 13
Inventory valuation and the effect on
profit
£
Selling price per bag
100.50
Materials per bag
11.00
Labour per bag
16.00
Cutting dept overheads
27.00
Finishing dept overheads
29.75
During the year ended 31 October 2013 the business produced 8,000 bags
and sold 7,900 bags
Number of bags
Inventory levels were:
1 November 2012
800
31 October 2013
900
Fixed costs for the year were £454,000
Mr. Barry
A-level Accounting Year 13