Absorption costing and variable

costing revenues for decision making

(Week 3)

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 Lecture outline
• Variable (marginal) and full costing
compared
• Over/Under absorption of overheads
• Income reporting under Marginal and
Absorption costing
• Reconciliation of differences in profits
• Relevant costing
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Variable and full costing compared
Variable (marginal) costing:
Under variable costing, all fixed manufacturing costs
are excluded from inventoriable costs (only
manufacturing variable costs are included).
Only variable manufacturing costs are included in the
costing of inventory. Fixed manufacturing costs are
charged directly to the Income Statement as period
costs.

Full (absorption) costing:

Under full costing, all variable manufacturing and
fixed manufacturing costs are included as
inventoriable costs.

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 Marginal Costing

Under Marginal costing variable costs are

charged to cost units and fixed costs of
the period are written off in full against
the total contribution.

Opening and closing inventory are valued

at marginal (variable) cost.
 Marginal Costing
In support of marginal costing it is argued that:

Modern thinking is that most costs are variable in

a very long term and understand what they vary
with.

Management attention is concentrated on the more

controllable measure of contribution. It is often
argued by proponents of marginal costing that
apportionment of fixed production overhead to
individual units is carried out on a purely arbitrary
basis. This is not very useful for decision-making
and can mislead.
 Marginal Cost:

• Marginal cost is the aggregate of

variable costs, i.e. prime cost plus
variable overhead (manufacturing and
non-manufacturing).

• Marginal costing system is based on the

system of classification of costs into
fixed and variable.
 Absorption costing

Production-Volume Variance
• If budgeted period volume > actual volume
– Too little fixed cost has been absorbed
• If budgeted period volume < actual volume
– Too much fixed cost has been absorbed
Production Volume Variance (PVV) tells
whether actual production was above or
below predicted/budgeted volume
BUT: PVV does not inform us about
efficiency of production process.

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 Aldwych Enterprise
Marginal V Full costing
Units
Opening inventory 825
Closing inventory 1,800
Increase in inventory level 975
£
Full costing profit 60,150
Marginal costing profit 50,400
Difference in profit 9,750

Fixed OAR = £9,750/£975 = £10 per unit

 Undesirable effects of full costing
Encourages operational inefficiencies
– Full costing enables a manager to increase
operating profit in a specific period by increasing
the production schedule. (Real Activities earnings
management)
– Even if there is ZERO customer demand for the
additional production as fixed manufacturing costs
would otherwise have been written off as period
costs. So classifying potentially period cost to
closing inventory if there is ZERO demand.
Undesirable stock building (high closing inventory
i.e. high absorption of fixed costs in the closing
inventory)
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 Alleviating undesirable effects
Again Technology
to the rescue
Change internal accounting system into more integrated systems
– Materials Requirement Planning (MRP) – (For production planning and inventory
control)
– Enterprise Resource Planning (ERP) – (Automating mostly on real time basis
from several back office operations e.g. accounting , procurement, production
to front office operations such as marketing , sales etc)
– For JIT management e.g Toyota concept of "kanban," now is developed into using
software increasing productivity. Also called Supermarket method where materials are
“pulled” in right quantity and at the right time by sending a signal (historically through
cards to the preceding process)

Revise performance evaluation of managers i.e. not necessarily entirely focused on the
bottom line profit.
Think of an example of
supply chain issues !
Redesign operating systems
– Reduce waste
– Acquire resources only when needed (do not let stocks pile up)
Move towards “Just-in-Time” management (Although number of risks, notably those associated with 42
your
supply chain )
 Does it matter which method to
choose?
– International Accounting Standard 2 (IAS 2) does not allow
Marginal costing for external reporting purposes.

– In the long term the total reported profit will be the same
whichever method is used. This is because all of the costs
incurred will eventually be charged against sales; timing of the
sales that causes the profit differences from period to period.

– Absorption costing can smooth out profit by carrying forward

the fixed production overheads through high levels of
production than needed (Real Earnings Management tool –
AND even income smoothing tool).

– Marginal costing has a strong case in its favour as in the long

run almost all costs are variable and therefore relevant for user
of financial statements.
 Limitations of Marginal Costing
It is difficult to classify exactly the
expenses into fixed and variable category.
Most of the expenses are neither totally
variable nor wholly fixed..
Sales staff may mistake marginal cost for
total cost and sell at a low price; which
will result in loss or low profits.
Some assumptions regarding the
behaviour of various costs may not be
necessarily true in a realistic situation. For
example, the assumption that fixed cost will
remain static throughout is not correct.
 Differential cost / Incremental cost
Differential cost (incremental cost) is the
change in the cost due to change in activity
from one level to another.
(It is the cost of being deprived of the next best
option)

For example, if the cost of one alternative is

£3,000 per year and the cost of another
alternative is £5,000 per year. The difference of
£2,000 would be differential cost.
 Opportunity Cost
‘The value of the benefit sacrificed when
one course of action is chosen, in
preference to an alternative. The
opportunity cost is represented by the
forgone potential benefit from the best
rejected course of action.’
CIMA Terminology

E.g. return expected from an

investment other than the present one.
 Opportunity Cost
– Never recorded in formal accounting records since they do
not generate cash outlays.
– Examples:
− Opportunity cost of going on holidays instead of doing a summer job
= foregone pay
− Opportunity cost of investing in new business property instead of
investing in Dow Jones Index and forgone in the property market in
the UK.

• You may have had short term gains with some lucky
speculative trading but if you had invested in S&P500 index
(500 largest companies including NASDAQ and NYSE) for the
entire year you would have had the opportunity cost for not
having invested in perhaps property market in the UK that
rose about 2.76% in average. S&P500 fell over 6% in 2018
(So there would have been a huge opportunity cost)
(As a side note: In history Dow Jones has swung 1,000 points in a
single session 8 times - of that 5 such swings were in 2018)
 Sunk cost (Past costs)
It is expenditure that has been incurred
and cannot be recovered even if a decision
is abandoned
– Actual costs incurred in the past
– Cannot be changed by any decision now or
in the future (also called past costs)
– Shown in financial accounts as asset
(capitalised) or expense
 Relevant costs
• Those costs that will be affected by a
decision may be referred to as relevant
costs, while others are non-relevant and
should be ignored in the analysis.
 Non-relevant costs
Non-relevant costs will remain unaltered
regardless of a decision.

Some examples are:

• Sunk or past costs
• Total Fixed overheads that will not increase
or decrease
• Expenditure that will be incurred in the
future, but as a result of decisions taken in
the past that cannot now be changed.
 Further non-relevant costs
• Sunk cost – Past cost
• Absorbed fixed costs
• Future expense for which an irreversible
decision was taken in the past
• Mere book entries such as depreciation
charge; which do not necessarily depict
true loss in value of an asset due to the
decision.
 Cost classification for
decision making purposes
Costs that vary with the Costs that are the same
decision irrespective of which
under consideration decision is made

Relevant Irrelevant
costs costs
The cost of Costs that were
being Opportunity Sunk costs incurred as a
deprived costs (Past costs) result of a
of the next past decision
best option
Those that Future Future Those that
vary with outlay costs outlay costs do not vary
the decision with the
decision