Costing including marginal and absorption costing Flashcards
Methods of costing (2)
- Direct costing = Direct cost tracing only assigns direct manufacturing costs, not fixed manufacturing costs, to products or services
- Overhead absorption costing = involves allocating production overheads to
cost objects:- Plant wide / Blanket Overhead Absorption Rate – OAR based on machine hours and labour hours – different overhead allocation to the 2 jobs. - 2 – stage allocation process for both traditional absorption costing systems and Activity Based Costing systems
Under or Over Absorption of overheads in absorption costing
What is the issue? (3)
- The OAR is based on budgeted overheads and budgeted activity e.g. number of labour hours.
- At the end of the period, we know what the actual activity was and apply the OAR to the actual activity.
- The difference between the absorbed overheads and the actual overheads is a period cost adjustment in the financial accounts. The period may be a month, quarter, or year for example.
OAR Issues: Budgeted Overheads
There are problems in using actual overheads:
There is a delay in finding product costs, so essential information for decision making is not available until the end of the accounting period
- Monthly profit calculations
- Inventory valuation
- Basis for setting prices
- If this is done monthly, then fluctuations in OAR will occur
Seasonality – changes in activity, customers want to know the price
- Need to use an estimated normal product cost based on average long-run activity rather than an actual product cost
- Establish a budgeted overhead rate based on annual estimated overhead expenditure and activity
Under and over recovery of
overheads
It is very unlikely that the actual overheads and / or production levels are the same as the budgeted overheads and production levels used to calculate the OAR
Therefore, overheads will be under or over recovered
- Under or over recovery of overhead due to the activity level being different to the budgeted activity level is called a ______ ___________ __________ ____________
- Under or over recovery of overhead due to the actual fixed overhead expenditure being different to the budget is called a _______ __________ _______________ __________
- Financial accounting regulations require that under or over recovery of overheads is treated as a ______ _____ ____________
It is very unlikely that the actual overheads and / or production levels are the same as the budgeted overheads and production levels used to calculate the OAR
Therefore, overheads will be under or over recovered
- Under or over recovery of overhead due to the activity level being different to the budgeted activity level is called a FIXED OVERHEAD VOLUME VARIANCE
- Under or over recovery of overhead due to the actual fixed overhead expenditure being different to the budget is called a FIXED OVERHEAD EXPENDITURE VARIANCE
- Financial accounting regulations require that under or over recovery of overheads is treated as a period cost adjustment
Non-Manufacturing overheads
Financial accounting regulations specify that only ____________ ________ should be allocated to products.
Non-manufacturing costs should be assigned to products for __________-_________ (particularly cost-plus pricing).
Some non-manufacturing costs may be a ________ _____, of the product
Examples: (3)
Generally, aim to select an allocation base/_____ ______ that corresponds to the ___________ of non-manufacturing overhead
For many non-manufacturing overheads, it may be hard to determine an appropriate basis for allocation. A widely used approach is to allocate based on the product’s production costs
Financial accounting regulations specify that only manufacturing overheads should be allocated to products.
Non-manufacturing costs should be assigned to products for decision-making (particularly cost-plus pricing).
Some non-manufacturing costs may be a direct cost, of the product
Examples:
- Delivery costs,
- Sales commission,
- Travel costs
Generally, aim to select an allocation base/cost driver that corresponds to the causation of non-manufacturing overhead
For many non-manufacturing overheads, it may be hard to determine an appropriate basis for allocation. A widely used approach is to allocate based on the product’s production costs
Aims of costing
One of the main aims of costing is to establish the cost of one cost unit of work, whatever the work is.
Examples of a cost unit could be:
- Manufacturing: per item made
- Chemical business: kilogram of chemical
- Transport company: passenger mile
- Nursing home: resident day
- University: student
Methods of costing – job costing
- Job costing is used where each job can be separately identified from other jobs and costs are charged to that specific job.
- All direct costs are easy to identify, and the overheads are added on a predetermined basis, such as labour hours or machine hours.
- The overheads are allocated on a predetermined OAR basis.
Methods of costing – continuous work – Process Costing
- Used where masses of similar products or services are produced in a flow process.
- In the manufacturing industry, this could be making food. In this case, process costing is the method used.
- In this situation, the total costs of the process for a given period of time are collected together and averaged per unit of output for that period.
Marginal and absorption costing
These two costing systems are often used in cost accounting, but for different purposes:
Marginal (variable) costing – ?
Absorption costing – ?
The use of each system is dependent on the informational needs of the business:
- ‘can we afford to sell 1,000 units of our product at a discount of 20%?’ – this is _________ costing
- ‘what profit have we made this year?’ – __________ costing
Marginal and absorption costing
These two costing systems are often used in cost accounting, but for different purposes:
- Marginal (variable) costing – helps with short-term decision making.
- Absorption costing – is used to calculate inventory valuations and profit calculations.
The use of each system is dependent on the informational needs of the business:
- ‘can we afford to sell 1,000 units of our product at a discount of 20%?’ – this is marginal costing
- ‘what profit have we made this year?’ – absorption costing
Marginal costing (Variable Costing)
What is marginal costing?
What are costs classified by and what is the effect of this?
What is the marginal cost of a unit usually but not always?
What does knowing this cost allow?
The contribution is:…?
Marginal costing is effectively the cost of producing one extra unit of output.
Cost are classified by their behaviour (variable, fixed) so that it is easy to work out the cost of producing one extra unit.
The marginal cost of a unit is usually (but not always) the total of the variable costs of producing a unit of output.
Knowing this cost allows managers to consider the contribution to the business by each unit.
The contribution is: selling price less variable cost.
Marginal costing (4,2) vs Absorption costing (3,2)
Marginal costing
Variable costs:
- Variable direct materials
- Variable direct labour
- Variable direct expenses
- Variable overheads
Fixed costs:
- Fixed direct expenses
- Fixed overheads
Absorption costing
Direct costs:
- Direct materials
- Direct labour
- Direct expenses
Indirect costs:
- Variable overheads
- Fixed overheads
Marginal costing vs Absorption costing
Main use?
How does it work?
Main focus?
Usefulness?
Limitations?
Marginal costing
Main use?
- To help with short term decision
making
How does it work?
- Costs are classified as either variable or fixed
- Contribution towards fixed costs
is calculated as selling price less
variable costs
Main focus?
- Marginal cost
- Contribution
Usefulness?
- Concept of contribution is easy to understand
- Useful for short term decision
making
Limitations?
- Costs must be identified as either fixed or variable
- All overheads must be recovered, or a loss will be made
- Not acceptable under IAS 2
Inventories
Absorption costing
Main use?
- To calculate profit
- To calculate inventory
How does it work?
- Overheads are charged to output through an overhead absorption rate, often based
on labour hours or machine hours
Main focus?
- All production overheads charged to output
- Calculating profit
- Calculating inventory valuation
Usefulness?
- Acceptable under IAS 2
- Appropriate for traditional industries where overheads are charged to output based on direct labour or machine hours
Limitations?
- Not as useful for short term decision making
Marginal costing – Contribution
- Once the contribution per unit has been established, the total contribution for the period can be established.
- The fixed costs are then ___________ , to arrive at the _________ for the period.
- Once the contribution per unit has been established, the total contribution for the period can be established.
- The fixed costs are then deducted, to arrive at the profit for the period.
Advantages to a marginal costing statement (4,5)
- Contribution per unit is clearly identified
- Effect on changes to costs easily identified
- Effect on changes to selling price easily identified
- Helps with short-term decision making such as:
- Break even analysis - Margin of safety - Target profit - Contribution sales ratio - Limiting factors
Absorption costing
This method answers the question … ‘What does it cost to make one unit of output?’
The absorption cost of a unit of output is made up of:
This method answers the question … ‘What does it cost to make one unit of output?’
- Direct materials
- Direct labour
- Direct expenses
- Production overheads (variable and fixed)
- Absorption cost
