CERTIFICATE LEVEL

Subject Fundamentals of Management Accounting (BA2)

Hashan Bellanthuda
Lecturer ACMA, CGMA, ACCA Affiliate

Module Tutorial 02 – Absorption and Marginal Costing

Code BA2/HB/02
 Cost Accounting Systems (CAS)

Study Session 02: Absorption and Marginal costing

Topic 01 - CAS:

What? Why? and How?

Topic 02 - Traditional Cost Accounting Methods

1. Absorption Costing
2. Marginal Costing
Study
Session
02
Topic 03 - Profit Calculation:

Absorption and Marginal Costing

Topic 04 - Profit Reconciliation

Absorption to Marginal Costing

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Cost Accounting Systems
• The “cost of a product” can be categorized as “direct costs” and “indirect costs” based on
cost classification.

• Direct cost comprises of direct material, direct labour, direct expenses and any other
direct cost item

• Indirect costs/ overheads comprise of other production overheads or non-production

overheads (E.g. Salary of the security guard of a manufacturing organization)

❖ “We need to see what methods/techniques are available for us to relate the cost (both
direct and indirect) of the organization and finally calculate the profit or loss for the
period by selling these products.”

❖ These methods/techniques are known as Cost Accounting Systems.

What is a Cost Accounting System?

• In relating direct costs there are number of methods available (i.e. Job, Batch, Contract,
and Service costing, which will be covered in later chapters), such methods are somewhat
simple comparatively.

• But relating indirect costs / overheads (OHs) to end products or services is seen as more
difficult due to their nature.

• Methods available to attribute Overheads (O/H) are known as O/H Cost Accounting
Systems.

There are 2 main O/H Cost Accounting Systems available.

1) Traditional O/H Cost Accounting Systems

2) Modern O/H Cost Accounting Systems

Traditional O/H Cost Accounting Systems

From a traditional perspective, there are 2 main cost accounting systems available to relate
O/Hs.

✓ Absorption Costing

✓ Marginal Costing

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Absorption Costing

• The following steps are considered in attributing cost under absorption costing;
o Identification of costs and cost centers
o Allocation
o Apportionment
o Re – apportionment
▪ Reciprocal servicing
• Repeated distribution method
• Equation/ algebraic method

Step 1: Allocation of production overhead to production and service cost centres (these
relate to overheads directly identifiable for each cost centre)
E.g. 2 production supervisors work in department A and 3 supervisors work in department
B. Each supervisor is paid a salary of $40,000. Allocated cost for department A would
therefore be $80,000 and department B would be $120,000

Step 2: Apportionment of production overhead to production and service cost centres based
on an apportionment basis (these relate to overheads that are commonly incurred not
directly traceable for each cost centre).
E.g. The rent for the building amounts to $100,000. Since it is a common cost, it has to be
split among department A and department B using a suitable basis (such as floor area).

Step 3: Reapportionment of overhead collected in service cost centres (from step 1 and 2)
to production cost centres (since production units pass only through production cost
centres and not service cost centres) either using the repeated distribution method or the
equation / algebraic method.
E.g. Assume that the product passes through department A and department B only. The cost
of the cleaning department has to be re-apportioned to department A and department B.
Refer the writing book

Step 4: Absorption of overheads from production cost centres into cost units using a
predetermined overhead absorption rate (OAR)

o Calculation of OAR
▪ Per unit
▪ Per labour hour
▪ Per machine hour
▪ % of direct labour
▪ % of direct material cost
▪ % of prime cost

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Some questions will specify how the OAR should be calculated. If it is not specified, use
labour hours or machine hours. If both are given, use the higher of the two.

• Under absorption costing, the full cost of production is considered in arriving at the
Gross Profit (i.e. all direct and indirect production costs are deducted from sales to arrive
at gross profit).

• Then we deduct the “Non –production overheads” from the gross profit to arrive at the
net profit.

✓ Sales - Full cost of production = Gross Profit / Loss

✓ Gross Profit / loss – Non-Production overheads = Net Profit / Loss

• Full cost of production includes the following items.

Direct Materials
Variable Costs Direct Labour
Direct Expenses
Variable Production overhead Full production costs
+ Fixed Production overhead

Profit Statement (Absorption Costing)

• If absorption costing profit calculation is used by the organization, the following three
points will be taken into consideration;

✓ End products (production and stock) are valued at full production cost.
(DM+DL+VPOH+FPOH)

✓ Fixed OH’s are related using OAR which is a predetermined rate, thus giving rise
to under/over absorption.

✓ Absorption costing does not handle non production costs, so the only option
available is to take it as an end period cost.

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Profit Statement – Absorption Costing

Sales XXX
(-) Full production Cost of Sales
Opening Inventory XXX
+ Total production cost XXX
(-) Closing Inventory (XXX) (XXX)
Over / (under) absorption XX/ (XX)
Gross Profit / Loss XX/ (XX)
(-) non- production Overheads (XX)
NET Profit / Loss XX/ (XX)

Over / Under absorption

Refer the writing book

Marginal Costing
• Under marginal costing, costs are categorized under fixed and variable cost

• Initially the organization would arrive at contribution by deducting the marginal cost
(total variable cost) from sales revenue for the time period.

✓ Sales revenue – Marginal Cost (Variable Cost) = Contribution

• Then, fixed cost for the time period is taken as a whole and deducted from contribution to
arrive at the profit or loss for the period.

✓ Contribution – Fixed Cost = Profit / Loss

• Marginal Cost is the addition of all variable costs, which includes

Direct Material
Direct Labour Prime Cost
Direct Expenses All Variable costs
Variable production overheads (Direct & Indirect)
Variable administration overheads
Variable selling overheads

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Profit Statement (marginal costing)

If marginal costing profit calculation is used by the organization, the following three points
will be taken into consideration;

• Units (production and stocks) are valued at variable production cost

(DM+DL+VPOH)

• With marginal costing, the concern is about segregating cost into variable and fixed,
even the non-production cost is now divided into two parts where the variable non
production part is separately taken to calculate the contribution.

• All fixed costs are taken as end period costs.

Profit Statement – Marginal Costing

Sales Revenue XXX
( - )Marginal Cost of Sales
Opening Inventory XXX
+ Variable production cost XXX
( -) Closing Inventory (XX)
XXX
Variable Administration cost XXX
Variable Selling Cost XXX (XXX)
CONTRIBUTION XXX

(-) Fixed Cost

Fixed Production overheads XXX
Fixed non-production overheads XXX (XXX)

PROFIT /(LOSS) XX /(XX)

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 • NOTE
In these two methods, the only difference is how they treat “Fixed production overheads”

Marginal Costing Absorption Costing

Fixed Production Overheads Period cost Product Cost
(Total is charged for the (It is charged per Product)
period)

• “Non-production overheads are treated as period costs in both methods”

Valuation of Inventory

• Under Marginal Costing inventory is valued at their marginal cost and under
Absorption costing inventory is valued at the full cost of production.

Marginal Absorption
Inventory valued at “Variable cost of production” “Full cost of production”

DM+DL+DE+VPOH DM+DL+DE+ VPOH + FPOH

• Since inventory is valued at different prices, this will result in a difference in profit /
loss for the period, under Marginal and Absorption costing.

Profit reconciliation
Absorption and Marginal costing gave us two different profits, however by recognizing what
made the difference we can reconcile them using the format below

Profit Reconciliation Statement.

Marginal costing based profit xx

Increase/decrease in stocks x FPOAR xx/ (xx)

Absorption costing based profit xx

Refer the writing book

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Modern O/H Cost Accounting Systems
The only modern system that is covered in BA2 is activity-based costing (ABC).

Activity-based costing (ABC) is a more recent development in cost analysis. It is based on the
idea that to use a single absorption base of either labour or machine hours does not accurately
reflect the cause of the overhead costs being incurred.

Using an ABC approach, overhead costs are accumulated initially in activity cost pools. These
might include, for example, order placing or material handling. Costs would then be collected
and analysed for each activity cost pool and a cost driver would be identified for each activity.
Cost drivers are the factors which cause the cost of an activity to increase.

Using estimates of the costs attributed to each activity cost pool and the number of cost drivers
associated with it, a cost driver rate is calculated. This is similar in principle to the calculation
of absorption rates.

For example, if the total cost of the activity of setting up a machine is $5,000 for a period and
the number of machine set-ups for the period is 250, the cost per set-up is $20 ($5,000/250).
Each product that requires the use of this machine is regarded as having incurred $20 of
overhead cost each time the machine is set up for the product.

This analysis of overhead costs into activities, and their absorption using a variety of cost
drivers, is believed to produce more accurate product costs. The ABC technique can also be
applied to non-production costs as well as to the determination of the costs of services provided.

Pricing strategies based on cost

• Some organisations set their selling price based on the cost of producing the product or
providing the service. Often referred to as 'cost-plus pricing', this involves adding a mark-
up to the total cost of the product or service in order to arrive at the selling price

• If an organisation does use cost as the basis for pricing it has to decide whether to employ
a standard mark-up or whether to vary the mark-up according to the market conditions,
type of customer, etc.

This mark up may be influenced by factors such as:

• The amount that customers are willing to pay. For example, the product may have a high
perceived value (if, say, it is in short supply) which would therefore encourage the
organisation to use a higher mark up.
• The level of competition that the product will experience. If the product has many close
competitors and substitutes then the organisation may be forced to use a lower mark up.
• The organisation's objectives. For example, when first trying to break into a market and gain
market awareness and market share an organisation might use a lower mark up percentage.
• Alternatively, the profit mark-up may be fixed so that the company makes a specific return on
capital based on a particular capacity utilisation.

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• Under different circumstances there may be different interpretations of what gets included
in the 'cost' element of cost plus pricing. In some circumstances full cost may be used
(including absorbed overheads), in other circumstances it might be more appropriate to
use marginal cost.

Full cost plus pricing

✓ Using this method, the selling price for the product is determined as:

Selling price = Full cost per unit × (1 + mark up percentage)

✓ So that, for example, if the full cost was $40 and the organisation was using a 15% mark
up percentage then the selling price would be set at $46 (i.e. $40 × 1.15).

✓ Full cost can be interpreted in different ways. It will always include the full production
cost, including all absorbed overheads. But some organisations may also interpret it to
include sales, distribution and administration costs.
(Note: typically, the more costs that are included in the full cost then the lower that the mark
up percentage used is likely to be).

Marginal cost-plus pricing

✓ Using this method, the selling price for the product is determined as:

Selling price = Marginal cost per unit × (1 + mark up percentage)

✓ To the accountant, marginal cost is the same as variable cost. In setting the selling price
using this method a larger mark-up percentage is added because both fixed costs and
profit must be covered.

✓ It is a particularly useful method when determining a minimum acceptable selling price

(for example, for a one-off product order) and this is examined in more detail in a later
chapter.

Benefits and problems when using marginal cost pricing

Some of the reasons for using marginal cost in preference to full cost are as follows:

(1) It is just as accurate as total cost-plus pricing. A larger mark-up percentage is added because
both fixed costs and profit must be covered, but the uncertainty over the fixed costs per unit
remains in both pricing methods.
(2) Knowledge of marginal cost gives management the option of pricing below total cost when
times are bad, in order to fill capacity.

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(3) It is particularly useful in pricing specific one-off contracts because it recognises relevant costs
and opportunity costs as well as sunk costs.
(4) It also recognises the existence of scarce or limiting resources. Where these are used by
competing products and services it must be reflected in the selling price if profit is to be
maximized

The main criticisms of marginal cost pricing are:

(1) Like any cost based pricing method, it ignores other factors such as levels of competition,
customer attitudes etc.
(2) The mark-up becomes even more arbitrary than that used in full cost plus as now it must also
include a subjective element which allows for the selling price to cover fixed costs. For this
reason, many accountants argue that marginal cost plus pricing should only be used for
marginal (short-term or one-off) decisions.

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Theory Focus Questions (TFQ’s)

1) The information given below relates to a four-week accounting period of WHW. WHW
has three production cost centres (Machining, Assembly and Finishing) and one service
cost centre (Stores).

(a) Calculate the total overheads for each cost centre. Then, reapportion the cost of the
service cost centre and calculate the OAR for each production cost centre.

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Item Basis of Machining Assembly Finishing Stores Total
apportionment

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(b) One of the products use 3.5kg of Material A and 4.5kg of Material B which costs $4.8/kg
and $1.9/kg respectively. The product takes 3 machine hours and 1.5 labour hours in the
machining department, and five direct labour hours in each of the assembly and finishing
departments. Calculate to 2 d.p. the total cost per unit of this product.

2) Rainbow Ltd manufactures and sells calculators. Each product passes through two manufacturing
processes production process 1 and production process 2. And the company has only one service
centre.
Estimated annual overhead costs are:

$
Building rent 800,000
Machine expenses 400,000
Machinery depreciation 600,000
Staff supervision 1,200,000
Staff welfare 400,000
3,400,000

Additional information:

Departments
Production 1 Production 2 Service
Floor space ( sq.m) 140 50 10
Machine hours 100 100 -
Number of employees 20 16 4
Labour hours 20,000 10,000 -

Direct cost

For 1 calculator ($)

Direct material cost per unit 560
Direct labour cost per unit 340
Direct other cost per unit 50% of direct
materials

Service department overhead cost is re-apportioned to production departments 1 and 2 of

70% and 30% respectively.

Required:
1. Prepare the Overhead Analysis Sheet showing clearly the basis of
apportionment.
2. Re- apportionment of service department total overheads among the
production departments.
3. Calculate OAR based on the budgeted labour hours of each department.
4. Calculate the cost per calculator if the following hours are taken to produce a
calculator
a. Production department 1 -3 labour hours and
b. Production department 2 -2 labour hours

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3) A company produces and sells one product only which sells for $50 per unit. There was
no stock at the end of May and other information is as follows;

Standard cost per unit:

• Direct material $18

• Direct wages $4
• Variable production overheads $3

Budgeted and actual costs per month ($)

• Fixed production overheads 99,000

• Fixed selling expenses 14,000
• Fixed administration expenses 26,000
• Variable selling expenses 10% of sales value

Budgeted capacity is 11,000 units per month

Number units produced and sold (actual)

June July
Sales units 12,800 11,000
Production units 14,000 10.200

Required;

I. Prepare profit statements for each of the monthly periods, using the following
methods of costing
a. Absorption costing
b. Marginal costing
II. Prepare a reconciliation statement

4)

Keats plc commenced business on 1 March making one product only, the standard cost of
which is as follows:

$
Direct labour 5
Direct material 8
Variable production overhead 2
Fixed production overhead 5
––
Standard production cost 20
––

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The fixed production overhead figure has been calculated on the basis of a budgeted normal
output of 36,000 units per annum.

You are to assume that actual fixed overheads were as expected and that all the budgeted
fixed expenses are incurred evenly over the year. March and April are to be taken as equal
period months.

Selling, distribution and administration expenses are:

Fixed $120,000 per annum

Variable 15% of the sales value

The selling price per unit is $35 and the numbers of units produced and sold were:

March April
(units) (units)
Production 2,000 3,200
Sales 1,500 3,000
Required:

(a) prepare profit statements for each of the months of March and April using:
(i) absorption costing, and
(ii) marginal costing
(b) Prepare a reconciliation of the profit or loss figures given in your answers to (a)(i) and (a)(ii)
accompanied by a brief explanation.

5) A company has two production and two service departments (stores and maintenance).
The Following information about activity in the recent costing period is available.

Production departments Stores Maintenance

Department department
A B
Overhead costs $10,030 $8,970 $10,000 $8,000

Cost of material
$30,000 $50,000 - $20,000
requisitions

Maintenance
8,000 1,000 1,000 -
hours needed

Recognition is made of the fact that the stores and maintenance department do work for
each other. Service department costs are apportioned as follows.

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 Dept A Dept B Stores Maintenance
Stores (100%) 30% 50% - 20%
Maintenance 80% 10% 10% -
(100%)

Reapportion the service department costs using the repeated distribution method of
apportionment and the algebraic approach.

6)

7)

Mars Co has now reapportioned the service centre costs to its two production departments
resulting in total overheads of $176,203 and $85,797 for the mixing and stirring departments
respectively (as calculated in Question 6).

The mixing department is labor-intensive and the stirring department is machine-intensive.

During the year the following data has been collected on the work done to produce the
company's range of products.

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8)

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Exam Focus Questions (EFQ’s)

Question 01
E plc operates a marginal costing system. For the forthcoming year, variable costs are
budgeted to be 60% of sales value and fixed costs are budgeted to be 10% of sales value.
If E plc increases its selling prices by 10%, but if fixed costs, variable costs per unit and sales
volume remain unchanged, identify the effect on E plc's contribution:
A a decrease of 2%
B an increase of 5%
C an increase of 10%
D an increase of 25%

Question 02
When comparing the profits reported under marginal and absorption costing during a period
when the level of stocks increased, identify which of the following statements would be true:
A absorption costing profits will be higher and closing stock valuations lower than those under
marginal costing
B absorption costing profits will be higher and closing stock valuations higher than those under
marginal costing
C marginal costing profits will be higher and closing stock valuations lower than those under
absorption costing
D marginal costing profits will be lower and closing stock valuations higher than those under
absorption costing

Question 03
Exe Limited makes a single product whose total cost per unit is budgeted to be $45. This
includes fixed cost of $8 per unit based on a volume of 10,000 units per period. In a period,
sales volume was 9,000 units, and production volume was 11,500 units. The actual profit for
the same period, calculated using absorption costing, was $42,000.
If the profit statement were prepared using marginal costing, identify the profit for the period
A $10,000
B $22,000
C $50,000
D $62,000

Question 04
If inventory levels have increased during the period, identify which of the following options
would be correct for the profit calculated using marginal costing when compared with that
calculated using absorption costing:
A. Higher
B. Lower
C. Equal
D. Impossible to answer without further information

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Question 05
Identify which of the following statements would be true: fixed production overheads will
always be under-absorbed when:

A. actual output is lower than budgeted output

B. actual overheads incurred are lower than budgeted overheads
C. overheads absorbed are lower than those budgeted
D. overheads absorbed are lower than those incurred

Question 06

Question 07
The process of cost apportionment is carried out so that:
A Costs may be controlled
B Cost units gather overheads as they pass through cost centres
C Whole items of cost can be charged to cost centres
D Common costs are shared among cost centres

Question 08

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Question 09
A company absorbs overheads on machine hours that were budgeted at 11,250 with overheads
of $258,750. The actual results were 10,980 hours with overheads of $254,692.
Overheads were:
A Under absorbed by $2,152
B Over absorbed by $4,058
C Under absorbed by $4,058
D Over absorbed by $2,152

Question 10
A company absorbs overheads on the basis of machine hours.
In a period, actual machine hours were 22,435, actual overheads were $496,500 and there
was over absorption of $64,375.
What was the budgeted overhead absorption rate per machine hour (to the nearest $)? $

Question 11
A company uses the repeated distribution method to reapportion service department costs. The
use of this method suggests:
A The company's overhead rates are based on estimates of cost and activity levels, rather
than actual amounts.
B There are more service departments than production cost centres.
C The company wishes to avoid under or over absorption of overheads in its production cost
D The service departments carry out work for each other.

Question 12
Based on the data below, what is the amount of the overhead under/over-absorbed?
Budgeted overheads $493,200
Budgeted machine hours 10,960
Actual machine hours 10,493
Actual overheads $514,157

A $20,957 under absorbed

B $21,015 over absorbed
C $21,015 under absorbed
D $41,972 under absorbed

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Question 13
Factory overheads can be absorbed by which of the following methods?
1 Direct labour hours
2 Machine hours
3 As a % of prime
4 $x per unit
A 1,2,3or4
B 1 and 2 only
C 1, 2 or 3 only
D 2, 3 or 4 only

Question 14
Department L production overheads are absorbed using a direct labour hour rate. Budgeted
production overheads for the department were $480,000, and the actual labour hours were
100,000. Actual production overheads amounted to $516,000.

Based on the above data, and assuming that the production overheads were over absorbed by
$24,000, what was the overhead absorption rate per labour hour?
A $4.80
B $4.92
C $5.16
D $5.40
Question 15

Question 16
ABC absorbs fixed production overheads in one of its departments on the basis of machine hours.
There were 100,000 budgeted machine hours for the forthcoming period. The fixed production
overhead absorption rate was $2.50 per machine hour. During the period, the following actual
results were recorded:
Machine hours 110,000
Fixed production overheads $300,000
Which of the following statements is correct?
A Overhead was $25,000 over-absorbed
B Overhead was $25,000 under-absorbed
C Overhead was $50,000 over-absorbed
D No under or over absorption occurred

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Question 17
Which of the following would be the most appropriate basis for apportioning machinery
insurance costs to cost centres within a factory?
A The number of machines in each cost centre
B The floor area occupied by the machinery in each cost centre
C The value of the machinery in each cost centre
D The operating hours of the machinery in each cost centre

The following information relates to questions 18, 19 and 20

Question 18
What is the most appropriate production overhead absorption rate for department 1?
A 40% of direct material cost
B 200% of direct labour cost
C $10 per direct labour hour
D $0.60 per machine hour

Question 19
What is the most appropriate production overhead absorption rate for department 2?
A 50% of direct material cost
B 18% of direct labour cost
C $0.72 per direct labour hour
D $60 per machine hour

Question 20
In quarter 2, department 2 decided to use an absorption rate based on the number of units.
Department 2 over absorbed fixed production overheads for quarter 2 by $6,000. The fixed
production overhead absorption rate was $8 per unit and is based on the normal level of
activity of 5,000 units. Actual production was 4,500 units.
What was the actual fixed production overheads incurred for the period?
A $30,000
B $36,000
C $40,000
D $42,000

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