Absorption costing is a costing system which treats all costs of production as product costs, regardless weather they are

variable or fixed. The cost of a unit of product under absorption costing method consists of direct materials, direct labor and both variable and fixed overhead. Absorption costing allocates a portion of fixed manufacturing overhead cost to each unit of product, along with the variable manufacturing cost. Because absorption costing includes all costs of production as product costs, it is frequently referred to as full costing method.

Variable, Direct or Marginal Costing:

Definition and explanation:
Variable costing is a costing system under which those costs of production that vary with output are treated as product costs. This would usually include direct materials, direct laborand variable portion of manufacturing overhead. Fixed manufacturing cost is not treated as aproduct costs under variable costing. Rather, fixed manufacturing cost is treated as a period cost and, like selling and administrative expenses, it is charged off in its entirety against revenue each period. Consequently the cost of a unit of product in inventory or cost of goods sold under this method does not contain any fixed overhead cost. Variable costing is some time referred to as direct costing or marginal costing. To complete this summary comparison of absorption and variable costing, we need to consider briefly the handling of selling andadministrative expenses. These expenses are never treated as product costs, regardless of the costing method in use. Thus under either absorption or variable costing, both variable and fixed selling and administrative expenses are always treated as period costs and deducted from revenues as incurred. A small company that produces a single product has the following cost structure. Number of units produced Variable costs per unit: Direct materials Direct labor Variable manufacturing overhead Variable selling and Administrative expenses Fixed costs per year: Fixed manufacturing overhead Fixed selling and administrative expenses Rs.30,000 Rs.10,000 Rs.2 Rs.4 Rs.1 Rs.3 6,000

Required:

1. 2.

Compute the unit product cost under absorption costing method. Compute the unit product cost under variable / marginal costing method. Unit product Cost Absorption Costing Method

Direct materials Direct labor Variable manufacturing overhead

Rs.2 Rs.4 Rs.1 --------

Total variable production cost Fixed manufacturing overhead

Rs.7 Rs.5 --------

Unit product cost

Rs.12 ===== Unit product Cost Variable Costing Method

Direct materials Direct labor Variable manufacturing overhead

Rs.2 Rs.4 Rs.1 --------

Unit product cost

Rs.7 =====

(The Rs.30,000 fixed manufacturing overhead will be charged off in total against income as a period expense along with selling and administrative expenses).

Under the absorption costing, notice that all production costs, variable and fixed, are included when determining the unit product cost. Thus if the company sells a unit of product and absorption costing is being used, then Rs.12 (consisting of Rs.7 variable cost and Rs.5 fixed cost) will be deducted on the income statement as cost of goods sold. Similarly, any unsold units will be carried as inventory on the balance sheet at Rs.12 each. Under variable costing, notice that all variable costs of production are included in product costs. Thus if the company sells a unit of product, only Rs.7 will be deducted as cost of goods sold, and unsold units will be carried in the balance sheet inventory account at only Rs.7.

Cost volume profit analysis (CVP analysis) is one of the most powerful tools that managers have at their command. It helps them understand the interrelationship between cost, volume, and profit in an organization by focusing on interactions among the following five elements:

1. 2. 3. 4. 5.

Prices of products Volume or level of activity Per unit variable cost Total fixed cost Mix of product sold

Because cost-volume-profit (CVP) analysis helps managers understand the interrelationships among cost, volume, and profit it is a vital tool in many business decisions. These decisions include, for example, what products to manufacture or sell, what pricing policy to follow, what marketing strategy to employ, and what type of productive facilities to acquire.

Contribution Margin and Basics of Cost Volume Profit (CVP) Analysis:

Contribution Margin:
Contribution margin is the amount remaining from sales revenue after variable expenseshave been deducted. Thus it is the amount available to cover fixed expenses and then to provide profits for the period. Contribution margin is first used to cover the fixed expenses and then whatever remains go towards profits. If the contribution margin is not sufficient to cover the fixed expenses, then a loss occurs for the period. This concept is explained in the following equations: Sales revenue Variable cost* = Contribution Margin *Both Manufacturing and Non Manufacturing Contribution margin Fixed cost* = Net operating Income or Loss *Both Manufacturing and Non Manufacturing

Example: Assume that Masers A. Q Asem Private Ltd. has been able to sell only one unit of product during the period. If company does not sell any more units during the period, the company's contribution margin income statement will appear as follows: Masers A. Q. Asem Private Ltd Contribution margin Income Statement For the month of------------Total Sales (1 Unit only) Rs.250 Less Variable expenses 150 --------Contribution margin 100 Less fixed expenses 35,000 --------Net operating loss Rs.(34,900) ======

Per Unit Rs.250 150 --------100 ======

For each additional unit that the company is able to sell during the period, Rs.100 more in contribution margin will become available to help cover the fixed expenses. If a second unit is sold, for example, then the total contribution margin will increase by Rs.100 (to a total of Rs.200) and the company's loss will decrease by Rs.100, to Rs.34800. If enough units can be sold to generate Rs.35,000 in contribution margin, then all of the fixed costs will be

covered and the company will have managed to at least break even for the month-that is to show neither profit nor loss but just cover all of its costs. To reach the break even point, the company will have to sell 350 units in a period, since each unit sold contribute Rs.100 in the contribution margin. This is shown as follows by the contribution margin format income statement. Masers A. Q. Asem Private Ltd Contribution Margin Income Statement For the month of------------Total Per Unit Sales (350 Units) Rs.87,500 Rs.250 Less variable expenses 52,500 150 ----------------Contribution margin 35,000 Rs.100 Less fixed expenses 35,000 ====== ---------Net operating profit Rs.0 ======

Note that the break even is the level of sales at which profit is ZERO. Once the break even point has been reached, net income will increase by unit contribution margin by each additional unit sold. For example, if 351 units are sold during the period then we can expect that the net income for the month will be Rs.100, since the company will have sold 1 unit more than the number needed to break even. This is explained by the following contribution margin income statement.

Masers A. Q. Asem Private Ltd

Contribution Margin Income Statement For the month of------------Total Sales (351 Units) Rs.87,750 Less Variable expenses 52,500 ---------Contribution margin 35,100 Less fixed expenses 35,000 ---------Net operating loss Rs.100 ======

Per Unit Rs.250 150 ---------100 ======

If 352 units are sold then we can expect that net operating income for the period will be Rs.200 and so forth. To know what the profit will be at various levels of activity, therefore, managerdo not need to prepare a whole series of income statements. To estimate the profit at any point above the break even point, the manager can simply take the number of units to be sold above the breakeven and multiply that number by the unit contribution margin. The result represents the anticipated profit for the period. Or to estimate the effect of a planned increase in sale on profits, the manager can simply multiply the increase in units sold by theunit contribution margin. The result will be expressed as increase in profits. To illustrate it suppose company is currently selling 400 units and plans to sell 425 units in near future, the anticipated impact on profits can be calculated as follows: Increased number of units to be sold Contribution margin per unit Increase in the net operating income 25 100 2,500 ======

To summarize these examples, if there were no sales, the company's loss would equal to its fixed expenses. Each unit that is sold reduces the loss by the amount of the unit contribution margin. Once the break even point has been reached, each additional unit sold increases the company's profit by the amount of the unit contribution margin.

Contribution Margin Ratio:

The contribution margin as a percentage of total sales is referred to as contribution margin ratio (CM Ratio).

Formula of CM Ratio:
Formula or equation of CM ratio is as follows: [CM Ratio = Contribution Margin / Sales]

This ratio is extensively used in cost-volume profit calculations.

Break Even point:

Break even point is the level of sales at which profit is zero. According to this definition, atbreak even point sales are equal to fixed cost plus variable cost. This concept is further explained by the the following equation: [Break even sales = fixed cost + variable cost] The break even point can be calculated using either the equation method or contribution margin method. These two methods are equivalent.

Equation Method:
The equation method centers on the contribution approach to the income statement. The format of this statement can be expressed in equation form as follows: Profit = (Sales Variable expenses) Fixed expenses Rearranging this equation slightly yields the following equation, which is widely used in cost volume profit (CVP) analysis: Sales = Variable expenses + Fixed expenses + Profit example we can use the following data to calculate break even point. Sales price per unit = Rs.250 variable cost per unit = Rs.150 Total fixed expenses = Rs.35,000

Calculate break even point