2.1 Absorption Costing & Marginal Costing

Question 1

Absorption costing is a method of / and aim is

Answer 1

• Is a method of attributing production overheads to each unit
• The aim is to determine the full production cost per unit
• This helps to make pricing policy decisions and value inventory

Question 2

Product costs

Answer 2

• Are charged to the individual product and matched against the sales revenue they generate in the period in which they are sold
• Includes direct materials, direct labour, direct expenses and production overheads (both variable and fixed)
• Included in valuation of inventory (with absorption costing focus on production costs only)

Question 3

Period costs

Answer 3

• Are charged in full to the SOPL in period in which they are incurred
• Non production overheads ie. administrative costs, selling & distribution costs and finance costs
• Are not included in valuation of inventory (but would be included when determining a selling price)

Question 4

The treatment of fixed production overheads with absorption vs marginal costing

Answer 4

• Absorption: They are considered product costs, and included in full production cost per unit
• Marginal: Are considered period costs and not included in full production cost of a product but are charged to the SOPL

Question 5

Overhead absorption procedure

Answer 5

Step 1: Allocation and apportionment
Step 2: Reapportionment
Step 3: Absorption

Question 6

Step 1: Allocation and apportionment

Answer 6

Select appropriate cost centres
- Some will be production cost centres (directly involved in production)
- And others will be service cost centres (provide support services)

Split overhead costs between them
- Overhead allocation - Where an overhead relates entirely to one cost centre it can be wholly attributed to that single cost centre
- Overhead apportionment - Where an overhead relates to more than one cost centre it is shared on a fair and suitable basis

Question 7

Step 2: Reapportionment (secondary apportionment)

Answer 7

• The next step is to apportion the service cost centres total costs to the production cost centres that make use of them
• This is done because the aim is to have all the production overheads identified with a production cost centre so that we can calculate the full production cost of the units from each production cost centre

Question 8

Step 3: Absorption

Answer 8

• All production overheads will be absorbed into units of production, using a suitable basis
• The objective is to use a measure that reflects the nature of the work in the department
• Normal practice is to use a predetermined absorption rate (based on budgeted costs and volume) so that a price can be determined beforehand and variations can be smoothed

Question 9

Step 3: Absorption - common absorption bases:

Answer 9

• Units produced - simplest, but only valid if all cost units produced in the period are identical (single product)
• Direct labour hour rate - most appropriate in labour intensive cost centre, this is becoming less common with automation
• Machine hour rate - more common now, appropriate in cost centres where machine activity is predominant

(Another less common method is to use a percentage rate, where absorption rate is calculated as a percentage of the cost - direct material cost, direct labour cost or prime cost)

Question 10

Step 3: Absorption - Overhead Absorption Rate (OAR)

Answer 10

OAR = Total budgeted overhead cost (allocated and apportioned) / Budgeted quantity of absorption base (eg: total direct machine hours)

• This is used when all products produced in factory use same type of labour or machines
• Results in an absorption rate that can be charged to all products based on number of machine hrs used

Question 11

The problem with using predetermined overhead absorption rates is that

Answer 11

• The actual figures are likely to be different from the estimates used in the calculations
• The org will have to determine if it has absorbed too much or too little overhead into the products at the end of the period (over or under absorption)
• The amount of the overhead could be more or less than was budgeted
• The quantity of the absorption bases could have been more or less than was budgeted

Question 12

Over or under absorption can be calculated as follows:

Answer 12

Overhead absorbed (budgeted OAR x actual level of activity)

Less: Actual overhead

= Over / (under) absorbed overhead

Question 13

Advantages of absorption costing

Answer 13

• Fixed production overhead costs can be a large proportion of the total production costs, if not absorbed then this large portion would not be included in measurement of product costs
• It follows the matching (accruals) concept by carrying forward a portion of the fixed production overhead cost in the inventory valuation to be matched against the sales value when the items are sold
• It is necessary to include fixed production overheads in inventory values for FS (IAS2)
• Analysis of under-/over-absorbed fixed production overhead may be useful for identifying inefficient utilisation of production resources
• In the longer term all costs are variable and it is appropriate to try to identify fixed production overheads costs with the products that cause them (used for reason for ABC)

Question 14

Disadvantages of absorption costing

Answer 14

• The apportionment and absorption of fixed production overhead costs is arbitrary and relies on a subjective choice between cost centres
• Profits vary with changes in production volume (ie. inventory levels) - by increasing output, more fixed production overheads are absorbed into production costs, and if the extra output is not sold these are carried forward in closing inventory value

Question 15

Marginal costing is a

Answer 15

• Costing method which charges products with variable costs alone
• The marginal cost is the extra cost arising as a result of producing one more unit, or the cost saved as a result of producing one less unit
• It is the principal costing technique used in decision making because it allows managements attention to be focused on changes which result from decision under consideration

Question 16

The marginal cost comprises

Answer 16

• Direct material
• Direct labour
• Variable overheads

Question 17

Marginal costing and fixed production overheads

Answer 17

• None are included in inventory valuation as they will not increase as a result of making one additional unit
• They are treated as period costs and written off in total against the contribution of the period

Question 18

The contribution concept is at the heart of marginal costing and it is calculated as:

Answer 18

Contribution per unit = Unit selling price - All unit variable costs

Total contribution = Contribution per unit x Sales volume

Profit = Total contribution - Fixed costs

Question 19

Advantages of marginal costing

Answer 19

• It is a simpler costing system because there is not requirement to apportion and absorb overhead costs
• It reflects the behaviour of costs in relation to activity - when sales increase, cos rises only by additional variable costs (makes it more relevant for short run decision making based on changes to activity)
• It avoids the disadvantages of absorption costing

Question 20

Disadvantages of marginal costing

Answer 20

• When fixed costs are high relative to variable costs, and when production overheads are high relative to direct costs, the marginal cost of production and sales is only a small proportion of total costs. It might therefore provide inadequate info about costs and product profitability over the longer term
• It could be argued that the treatment of direct labour costs as a variable cost item is unrealistic (when direct labour employees are paid a fixed wage or salary their cost is fixed not variable)