:0

IFP ACCOUNTING
AND FINANCE

ABSORPTION COSTING & MARGINAL

COSTING
Prepared by:
Jed Clarke
 WE REVIEWED COSTS ALREADY
:1 Business managers need to know and understand costs to make a wide range of important decisions.

Fixed Costs – costs that do not change with output.

Variable costs – costs that change directly due to output.

Direct Costs – costs that can be directly attributed to a cost centre.

Indirect costs – costs that cannot be traced to a cost centre.

Some of these decisions relate to the business as a whole, other decisions relate to part of the activities of a business.
These are often referred to as cost centres or profit centres.

Today we are going to look at how indirect costs like factory rent and other overheads are allocated to a cost object.

Jed Clarke
 What is a cost centre?
:2 Cost centres are typical business units that incur costs but only indirectly
contribute to revenue generation.

• For example, a company may consider their legal

department, accounting department, research and development,
advertising, marketing, and customer service a cost centre.

• The managers in charge of these departments can control and contain

costs – and they are evaluated on their ability to do this.

• But there is not much they can do to directly impact the

company’s revenues.

Jed Clarke
 What is a profit centre?
:3 A profit centre is a business unit or department within an organization that generates
revenues and profits or losses.

Both costs and revenues are allocated to this centre, so that profit can be calculated.

Management closely monitors the results of profit centres, since these entities are the
key drivers of results.

Management typically uses profit centre results to decide whether to allocate additional
funding to them, and also whether to shut down low-performing units.

The manager of a profit centre usually has the authority to make decisions regarding
how to earn revenue and which expenses to incur.

Jed Clarke
 WHAT IS A COST OBJECT?
:4 Anything which costs can be assigned to:

• The cost of a product or service

• a car used by the business

• or a job being completed by a building company

• Can even be split into individual departments of a business

Jed Clarke
 OVERHEADS
:5 Overheads refers to an ongoing expense of operating a business.

Overheads are the expenditure which cannot be conveniently traced to or identified with any particular cost unit.

Unlike operating expenses such as raw material and labour.

Examples include:

• Rent

• Admin

• Utilities

• Insurance

• Repairs and maintenance

• Sales and Marketing

In short, an overhead is any expense incurred to support the business while not being directly related to a specific product or service

Jed Clarke
 Different costing methods
:6 Decisions relating to products and profit-centres can be made using a variety of
costing methods.

The ones we cover in this syllabus are:

1. Absorption costing
2. & Marginal (aka Variable/Contribution) costing

Jed Clarke
 ABSORPTION COSTING FOR INVENTORY
:7 This week we are going to calculate the profit and value of inventory of a
manufacturing business using marginal costing and absorption costing.

So, what is absorption costing?

Absorption costing is a costing system that is used in valuing inventory.

It not only includes the cost of materials and labour, but also both variable and
fixed manufacturing overhead costs.

Absorption costing is also referred to as full costing.

Jed Clarke
 ABSORPTION COSTING
:8 Under the absorption method of costing (aka “full costing”), the following costs go into the product:

• Direct material (DM)

• Direct labour (DL)

• Variable manufacturing overhead (VMOH)

• Fixed manufacturing overhead (FMOH)

The costs below are considered period costs and do not go into the cost of a product. They are, instead, expensed in
the period occurred:

Variable selling and administrative

Fixed selling and administrative

Jed Clarke
:9

Jed Clarke
 EXAMPLE

:10
Example of Absorption Costing

Company A is a manufacturer and seller of a single product. In 2016, the company reported the following costs:

Variable costs per unit: Fixed costs:

Direct materials cost: $25 Fixed manufacturing overhead of $300,000

Direct labor cost: $20 Fixed selling and administrative of $200,000

Variable manufacturing overhead cost: $10

Variable selling and administrative cost: $5

Over the year, the company sold 50,000 units and produced 60,000 units, with a unit selling price of $100 per unit.

Jed Clarke
 ABSORPTION COSTING EXAMPLE
:11 Using the absorption method of costing, the unit product cost is calculated as follows:

Direct materials + Direct labor + Variable overhead + Fixed manufacturing overhead

allocated

= $25 + $20 + $10 + $300,000 / 60,000 units = $60 unit product cost under absorption costing

Remember that selling and administrative costs (fixed and variable) are considered period
costs and are expensed in the period occurred.

Those costs are not included in the product costs.

Jed Clarke
 ADVANTAGES OF ABSORPTION COSTING

:12• Its main advantage is that it is GAAP compliant.

• It is required in preparing reports for financial statements and stock
valuation purposes.
• In addition, absorption costing takes into account all costs of
production, such as fixed costs of operation, factory rent, and cost
of utilities in the factory.
• It includes direct costs such as direct materials or direct labour and
indirect costs such as plant manager’s salary or property taxes.
• It can be useful in determining an appropriate selling price for
products.
Jed Clarke
 DISADVANTAGES OF ABSORPTION
COSTING
:13
• Absorption costing includes allocating fixed manufacturing overheads to
the product cost, so it is not always useful for product decision-making.
• Therefore, variable costing is used instead to help management to make
product decisions.
• Absorption costing is sometimes used as an accounting trick to
temporarily increase a company’s profitability by moving fixed
manufacturing overhead costs from the income statement to the balance
sheet.
• This is because all fixed costs are not subtracted from revenue unless the
products are sold.
• By allocating fixed costs into the cost of producing a product, the costs
can be hidden from a company’s income statement in inventory.

Jed Clarke
:14

Jed Clarke
 Contribution Costing (Marginal
Costing)
:15 This method is different to absorption costing as it avoids allocation of overheads to cost or profit
centres.

Contribution – Revenue for the centre – direct costs.

The profit for the business as a whole is the total of contributions for each individual centre, minus the
indirect costs.

Jed Clarke
 MARGINAL COSTING VS ABSORPTION
COSTING
:16 Marginal costing is a method where the variable costs are considered as the
product cost, and the fixed costs are considered as the costs of the period.

Absorption costing, on the other hand, is a method that considers both fixed
costs and variable costs as product costs.

For absorption costing, profit is usually higher because of the inclusion of fixed
costs as production costs.

Jed Clarke
 MARGINAL COSTING CALCULATION

:17

Jed Clarke
 MARGINAL COSTING EXAMPLE

:18

Jed Clarke
 MARGINAL COST PER BIKE
:19

Remember, MC is only
concerned with
variable costs.

FC’s are treated as

expenses later.
Jed Clarke
 CONTRIBUTION PER BIKE
:20

Jed Clarke
 MARGINAL COSTING STATEMENT

:21
Where does total
contribution come
from?

Contribution per
unit 80 x number of
sales 100 = 8000

Fixed costs are

deducted from our
contribution to get
us to our profit for
the week.

Jed Clarke
 ABSORPTION COSTING

:22
Absorption costing absorbs the costs of the business amongst the cost units.

It essentially answers the question, ‘What does it cost to make one unit of output?’

Jed Clarke
 ABSORPTION COSTING EXAMPLE
:23

Jed Clarke
 ABSORPTION COSTING EXAMPLE
:24

Jed Clarke
 Absorption Costing Example
:25

Jed Clarke
 If all bikes were sold...
:26 Income statement
Marginal Costing Absorption Costing

Sales 20,000 20,000

Less COGS 12,000 14,000
Gross Profit 8,000 6,000
Less Expenses:
Production Overheads 2,000 -
Total Profit 6,000 6,000

But what if only 50 were sold?

Jed Clarke
 If only 50 were sold...
:27 Income statement
Marginal Costing Absorption Costing

If a company used the Sales 10,000 10,000

absorption costing
method when Less COGS 6,000 7,000
publishing their Gross Profit 4,000 3,000
financial accounts:
Less Expenses:
• They would look
more profitable Production Overheads 2,000 -
• And their assets Total Profit 2,000 3,000
would be higher
Marginal Costing Absorption Costing
Because they only SOFP
expense for the
overheads when they Current Assets
are sold Closing Inventory (at cost) 6,000 7,000

Jed Clarke
 GENERAL OVERVIEW
:28 Banks may restrict loan amounts given to customers based on a current ratio. The current
ratio takes closing inventory into account as an asset.

Current Ratio = Current Assets

Current Liabilities

Using absorption costing – they are able to achieve a higher current ratio

However, using marginal costing - when closing inventory is also valued lower, the company
can reduce taxable amounts.

Jed Clarke
 COSTS ARE TREATED DIFFERENTLY
:29

Jed Clarke 29
 COMPARISON

:30

30
Jed Clarke
 COMPARISON (CONTINUED)
:31

Jed Clarke 31
 COMPARISON (CONTINUED)
:32

Jed Clarke 32