Chapter 6 - Marginal, Absorption And Activity Based Costing Flashcards
Marginal costing
Marginal cost is the cost of producing one extra unit of output.
To help with short term decisions costs are classified by their behaviour as either variable costs or fixed costs. Such a classification of costs is used in marginal costing to work out how much it costs to produce each extra unit of output.
Marginal cost is concerned with variable product costs - direct material, direct labour, direct expenses and variable production overheads which increase as output increases.
Knowing the marginal cost of a unit enables managers to focus on contribution provided by each unit.
Absorption costing
Absorption costing absorbs the costs of the business amongst the cost units.
The absorption cost of a unit of output is made up of the following costs:
Direct materials, direct labour, direct expenses, production overheads ( fixed and variable)
Marginal and absorption costing compared
Marginal costing - recognises that period costs vary with time rather than activity and identifies the variable production cost of one extra unit.
Absorption costing - This technique absorbs all product costs into each unit of output through use of an overhead absorption rate. Therefore the more units that are produced, the cheaper the cost will be per unit because the overheads are spread over a greater number of units.
Marginal and absorption costing: profit comparisons
Under marginal costing closing inventory is valued at variable production by contrast absorption cost includes a share of fixed production costs in the closing inventory valuation.
However for financial statements absorption costing must be used for inventory valuation purposes in order to comply with IAS 2. Closing inventory’s is based on the product costs of direct materials, direct labour, direct expenses and production overheads. Non production overheads are not included in either costing method as they are period costs which are charged to the statement of profit or loss.
Activity based costing
Activity based costing charges overheads to production on the bases of activities.
ABC indentifies what causes overheads to be incurred rather than charging total overheads for a particular period. Instead of using overhead recovery methods based around labour hours or machine hours ABC uses cost drivers linked to the way in which a business is conducted.
Cost drivers are activities which cause costs to be incurred.
By identifying cost drives the cost per unit of a product can be calculated based on its use of activities.
The use of cost pools
Cost pools are groups of overheads costs that are incited by the same activity.
When using activity based costing it is advisable to group together those overhead costs which are attributed to the same activity in a cost pool.
The first step is to group together in a cost pool the overhead costs which are incurred by the same activity. E.g purchasing costs in production.
The second step is to identify the factor which influences the costs - the cost driver. E.g cost of placing an order for purchase of goods
The third step is to charge the rate of each cost to production based on the use of activity.
Advantages of using abc
Cost information is more accurate because cost drivers are used to indentify the activity which causes costs to be incurred
It is now objective because it is able to identify the overhead costs relating to different products rather than the overheads of the whole business
Gives management a good understanding of why costs are incurred and how they will be altered by changes in production
