Costing Flashcards
What is absorption costing
- All production overheads are absorbed into products.
- Any unsold inventory is measured at total production cost.
- When production is equal to sales, the profits reported by both methods are the same. There is no transfer of fixed production overhead either into or out of the period because opening inventory is the same as closing inventory.
- When production exceeds sales, the profit reported by the absorption costing method is greater than that reported by the marginal costing method. This is due to the transfer of part of the fixed production overhead to the following period through the closing inventory as the inventory level increases.
- When production is less than sales, the profit reported by the absorption costing method is less than that reported by the marginal costing method. This is due to additional fixed production overhead brought into the period through opening inventory as the closing inventory level decreases.
What are the pros and cons of Absorption costing
Pros
* Consistent with financial reporting as per IAS 2
* Consistent of internal and external reporting
* Long term recovery of fixed costs
Cons
* Absorption costing can rely on arbitrary allocations of fixed production overheads to unit costs, which could be misleading to short-term decision making.
* unsold inventory includes a portion of the fixed production overheads. If this inventory remains unsold beyond the expected time frame, the selling price may have to be reduced to incentivise the sale. This could result in the fixed production overheads not being fully recovered by the selling price, resulting in a much lower profit for the period in which the inventory is ultimately sold.
What is Marginal costing
- Only variable costs are included in the full product cost. Any revenue generated after the sale less product costs is called contribution which will then be used to cover the fixed production costs.
- Treats overheads as a period cost
