Marginal costing and absorption costing Flashcards
Cost Accounting
What is accurate cost information important for?
- ______ ______________ still use the ______ ______________ for __________ ___________ and __________ ___________ ___________ which has led to the advent of better methods of ______ ______________ such as ____
What can happen if the information is too simplistic?
- Accurate cost information is important for decision making
- Many companies still use the same information for external reporting and internal decision making which has led to the advent of better methods of cost allocation such as ABC
Decision mistakes can be made if the information is too simplistic. For example, the use of blanket overhead rates
Cost Accounting - Example
A company manufactures TV screens and PC screens and works out the unit cost by including materials, labour costs and an element of overhead costs.
The majority of the overhead includes supervisor salaries, utility costs and plant insurance.
The company uses labour hours to allocate the overhead to the products.
The cost information for the TV screens is as follows:
- Materials £300,000
- Labour costs £ 100,000 (40,000 hours)
- Total production overheads are £80,000 and are allocated on the basis of total labour hours which are (40000 for TV and 10000 for the PC screens.) i.e. £1.60 per hour or £64000 is allocated to the TV screens.
- The total costs for the TV screens is £464,000.
- The total number of TV screens produced is 10,000 units.
However the management accountant is not happy with this unit cost as he says that the TV screens are bearing too much of the overhead cost.
Out of the £80,000 overhead costs the £65,000 is for utility costs and the PC screens use more electricity due to an additional finishing process required.
Meters are installed and it is discovered that the PC screens use approximately 90% of utility costs.
Recalculate the unit cost for TV screens using this information.
What can be concluded from this?
- The original cost is £46.40 per TV screen
- Total overhead is £80,000 and can be split into utility costs of £65000 and £15000 other production overhead
- 10% of the utility costs should be assigned to TV screens i.e. £6,500 and the allocation of the other production overheads will continue to be based on Direct labour hours (DLH)
Therefore, £12000 will be allocated for other production overhead. The total overhead allocated will be £ 18,500.
Unit cost for one TV screen will now be £41.85
Conclusion, TV screens are bearing more overhead than they should, this may result in incorrect decisions with regard to pricing etc.
Old unit cost £46.40 (per TV screen)
New unit cost (per TV screen) £41.85
Difference of £4.55 per unit
Allocating Costs in a Traditional Costing System – Absorption Costing
What is it - CIMA definition
How are product costs built up?
- a method of costing that, in addition to direct costs, assigns all or a proportion of, production overhead costs to cost units by means of one or a number of overhead absorption rates.
product costs are built up using absorption costing by a process of allocation, apportionment and absorption
Absorption Costing – Traditional Reasons
Stock Valuation: It ensures that inventory reflects full production costs, aligning with accounting standards; for balance sheet & c.o.s
Pricing Decisions: It helps set prices by factoring in all costs, including fixed overheads.
Product Profitability: It assesses true profitability, aiding informed business decisions.
Allocating Costs in a Traditional Costing System
4 steps?
2 systems
- Assign all manufacturing overhead to production and service cost centres
- Reallocate the costs assigned to service cost centres to production cost centres
- Compute separate overhead rates for each production cost centre (overhead absorption rates)
- Assign cost centre overheads to products or other chosen cost objects
Two Basic systems of costing:
-
Job order costing
- used where many different products are produced each period.
- For example a special order of handmade furniture, an order of a particular printed material.
- These products are usually made in small batches. Each batch is called a job. - Process costing
- used where manufacturing involves making a single homogeneous product such as bricks, drinks, etc for long periods of time.
How is process costing different to job costing?
- A single product is produced on a continuous basis and each unit is identical
- Costs are accumulated by department rather than by job
- The department production report is the important information rather than the job cost sheet used in job costing
- Unit costs are computed also by department rather than by job
How are they similar?
- The allocation of cost in the job order system and process costing system is similar in that costs of materials and labour and overheads are added to determine unit costs.
- Overheads are normally charged on a predetermined basis. For example the company might charge overheads to production based on labour hours. The company cannot wait until the end of the year to determine the full overhead costs so it must estimate now (accounts needed for decision making).
Traditionally use full absorption costing
Predetermined Overhead Rates (3 effects)
Avoids fluctuating unit prices throughout the year but…
- results in differences in what is actually absorbed into cost of production, if levels of activity are very different then bigger differences
- Stocks of finished goods will carry in them overhead costs from prior periods
Arguments For Absorption Costing (3)
- It considers the importance of all costs in producing a product/service
- It is consistent with external reporting purposes
- Requires less recording effort compared with say Activity Based Costing
Arguments Against Absorption Costing (5)
- Very old system – over 100 years old. Manufacturing systems then labour intensive
- Today, using machines, e.g. MG motor company in Nanjing, China uses robots (high levels of depreciation and maintenance less labour costs)
- Absorption costing rates are crude method in today’s highly technological environment and more suited for less complex manufacturing environments
- Determining basis of apportionments is very arbitrary and will have a direct impact on other decisions such as price setting
- Wrong decisions may be made by managers as they assume all costs in the unit price must be recovered without considering relevant costs and sunk costs
Marginal Costing
What is it?
…valued at…?
How are fixed cost treated?
What is an important performance measure?
How is that calculated?
How can that be expressed?
What is that often linked to?
- Is an alternative method of costing to absorption costing. In marginal costing, only variable costs are charged as a cost of sale and a contribution is calculated which is sales revenue minus the variable cost of sales.
- Closing stocks of work in progress or finished goods are valued at marginal (variable) production cost.
- Fixed costs are treated as a period cost, and are charged in full to the profit and loss account of the part of the accounting period in which they are incurred.
Contribution
In marginal costing the variable costs are matched against the sales value for the period to highlight an important performance measure ; contribution
contribution = sales value - variable costs
contribution may be expressed in absolute terms or contribution per unit
- Contribution is often linked to a key or limiting factor to give a sum required to cover fixed overhead and profit
e.g. contribution per machine hour, per direct labour hour or per kilo of scarce raw material
CIMA
Use of marginal costing
- To provide information for short term planning and decision making
- In routine cost accounting:
- cost calculation
- stock valuation
Arguments for marginal costing
- easy to understand
- no apportionments, which are frequently arbitrary
- no over/under absorption of overhead
- fixed costs are incurred on a time basis (not related to activity) therefore it is logical to write them off in the period as incurred
- accounts prepared using marginal costing closely resemble the actual cash flow situation
a - Marginal Costing
.
b - Absorption Costing
c - Differences in profit levels (5 points)
- In period 1, production equals sales and there are no stock movements so that profits are the same with both systems.
- When production exceed sales (periods 2 and 4) absorption costing reports the greater profits because fixed costs are deferred in the stock valuations.
- For example, in period 2 stocks increase by 100 units thus resulting in fixed costs of £1,200 (100*£12) being deferred as an expense with the absorption costing system.
- Therefore, absorption costing profits exceed marginal costing profits by £1,200.
- When sales exceed production the opposite situation occurs and marginal costing reports the higher profits.
Arguments in Favour of Absorption Costing (4) and arguments in favour of Marginal Costing (8)
Absorption Costing
- It is “fair’ to share fxed production costs between units of production as such costs are incurred in order to make output
- Closing inventories valued in accordance with IAS 2 principles
- Where building up Inventory is necessary [eg fireworks manufacture] fixed costs should be included ininventory valuations in order to prevent a series of losses (eg in periods before bonfire night) from occurring
- It is easier to determine the profitabillty of several products by charging a share of fixed overheads to them [rather than working out if the total contribution from several products will cover fixed costs)
Marginal Costing
- Simple to operate
- Absorption costing encourages management to produce goods
in order to absorb allocated overheads Instead of meeting market demands - No apportionments of fixed costs
- Fixed costs = period costs unchanged at all output volumes
- Under/over absorption of overheads is avoided
- Closing inventory realistically valued at variable production cost per unit
- Size of contribution provides management with useful information about expected profits
- It is a great aid to decision making (unlike absorption costing)
