Chapter 2 Flashcards
What is the main objective of “costing”?
Establishing the cost per unit of the products made by a business.
What is absorption costing?
Absorption costing lists direct costs (totaling our prime cost), variable production overheads and fixed production overheads.
What affect does absorption costing have on inventory valuation?
Under absorption costing we value inventory at the full production cost per unit meaning that an element of the periods fixed costs are included in the inventory value.
How is absorption costing done? Where do each of the different costs on the cost card come from?
Direct costs, such as direct materials and direct labour, go straight onto the card. For our indirect costs, it is more complicated. For costs that are costs of production but cannot be directly attributed to a single unit of production, i.e. factory rent and supervisor salary costs in a factory that has both production and servicing cost centres such as machining, finishing, stores and maintenance, the aforementioned indirect cost needs to be ALLOCATED between these four cost centres. Then it needs to be REAPPORTIONED to to the production cost centres and finally ABSORBED on a suitable basis, depending on certain factors.
What does the term allocation mean?
Allocation is the allocation of costs between each of the service cost centres and production cost centres. In short, how much of the costs that the business incur be allocated to a given cost centre. For example, if we pay £100,000 a year for our factory rent and our 4 departments use up floor space at a 4:3:2:1 ratio, then £40,000 is allocated to our machining store, £30,000 to our finishing store, and so on.
What does the term reapportion mean?
“To reapportion” means reapportionment of the costs allocated to a service cost centre to other cost centres; this could be other service cost centres or production cost centres. For example, if our maintenance department spends 90% of its time fixing machines in the machining department and only 10% of its time fixing sanders in the finishing department, we allocate the maintenance departments allocated costs between our machining and finishing departments in a 90:10 ratio.
What does the term absorption mean?
This is the process of determining how we absorb the costs of machining and finishing in our products. If we only have one type of product, we can absorb the costs equally over all of our products. If the production overhead is £50,000 and we make 5,000 units, our overhead absorption rate is £10 per unit and we put that on our cost card. If our manufacturing process is very machine intensive, that would mean that a major cost area for the business would be the amount of time its machines spend on each unit. Therefore it would be sensible to apportion the production overhead on a machine hour basis. I.e. If we make 2 different kinds of products, one that takes 1 machine hour to produce and another that takes 2 machine hours to produce, the second machine will absorb twice the cost of the first.
What is the end goal of the absorption costing process?
To calculate our Overhead Absorption Rate (OAR)
Which of the following include both the variable and fixed production costs in the calculation of the cost of sales - absorption costing, marginal costing
Absorption costing
How do you calculate contribution?
Selling price less variable costs
How is inventory valued under marginal costing?
At the variable cost per unit
What causes the difference between profit under absorption costing and marginal costing?
The movement of inventory levels from a high level to a lower level will cause absorption costing profit to be lower than marginal costing profit, because under absorption costing inventory has an element of fixed overhead that has been absorbed. When inventory levels decrease, the fixed overhead absorbed in the opening inventory is “released” so you have more cost in your P&L, so less profit under absorption costing. Conversely, when inventory levels are rising, fixed overhead absorbed into the inventory is “stored” in the closing inventory so under absorption costing profit is higher.
Another way of explaining it is that under absorption costing, opening and closing stock have a higher value. So if we have more stock at the end then that less cost that has been put into the P&L, So absorption costing profit is higher.
What are the advantages of marginal costing?
1) Its simpler - you don’t have to worry about under or over absorption in your P&L.
2) Suitable for short term decision making - if there is positive contribution, the activity should in theory be undertaken
3) Treats fixed costs as they behave - they are period costs rather than product costs
4) Profit is influenced by sales and not by production
What are the disadvantages of marginal costing?
1) It does not comply with IFRS 2 so cannot be used in year end financial statements
2) Fixed costs are still incurred by the business - so long term, they shouldnt be ignored
3) All costs have to be split between fixed and variable elements
