Chapter 3 Costing

• Costing
• Absorption costing
• Marginal costing
• Absorption costing vs marginal costing

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Costing 1

Cost accounting
 A management information system which analyses past, present and future data
 To provide a bank of data for the management accountant to use

Costing
 The process of determining the cost of products, services or activities
 Methods include absorption costing and marginal costing

Overview of costs
 Direct costs – materials, labour, expenses – charged as part of production cost
 Production overheads absorbed into production cost
 Non-production overheads charged directly to statement of profit or loss (income statement)

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Absorption costing 1

What is absorption costing?

 Absorption costing is a method of sharing out overheads incurred amongst units produced

Three steps:
 Allocation
 Apportionment
 Absorption – leads to under- or over-absorbed overhead

Practical reasons for using absorption costing

 Inventory valuation
 Pricing decisions
 Establishing profitability of products
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Absorption costing 2

Over- or under-absorbed overhead occurs when overheads do not equal overheads

absorbed.

 Over-absorption means that overheads charged to the cost of production or sales are
greater than the overheads actually incurred.
 Under-absorption means that insufficient overheads have been included in the cost of
production or sales.
Under or over absorption

Actual overhead X

Less overhead absorbed (X)

Under or (Over) Absorption X

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Absorption costing 3

OAR = Budgeted overhead

Budgeted activity

Consider which activity should be chosen:

 Units
 Labour hours
 Machine hours

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Absorption costing 4

Advantages and disadvantages of absorption costing

Advantages
 It recognizes that selling prices must cover all costs.
 It complies with standards on accounting for inventory.

Disadvantages
 Profits can be manipulated by simply changing production levels.
 It assumes that overheads are volume related.

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Question: Absorption costing

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Question: Absorption costing (cont’d)

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Answer: Absorption costing

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Marginal costing 1

Principles of marginal costing

A principle whereby variable production costs only are charged to cost units and
the fixed costs attributable to the relevant period are written off in full against the
contribution for the period.
Inventory is valued at the variable cost of production.

Charge variable production costs only to each unit

Appropriate for decision making

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Marginal costing 2

Contribution towards fixed costs is represented by:

(a) Selling price per unit less all variable costs per unit (whether production, admin or
selling etc)
(b) Fixed costs + profit

Advantages of marginal costing

(c) Most appropriate for decision making as it highlights contribution
(d) Fixed costs are treated in accordance with their nature, ie as period costs
(e) Profit depends on sales and efficiency not on production levels
(f) Slightly simpler variance analysis

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Marginal costing 3

Disadvantages of marginal costing

(a) There is a danger that products will be sold on an ongoing basis at a marginal
contribution which fails to cover fixed costs
(b) Does not comply with IAS 2, so year-end adjustments are needed for the preparation of
published accounts
(c) Requires analysis of mixed costs between fixed and variable
(d) Seasonal variations in a year can cause unnecessary profit variances

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Marginal costing 4

Effect of inventory valuation on profit

a) Production = sales (so inventory is constant)
AC profit = MC profit
(b) Production < sales (so inventory is falling)
AC profit < MC profit
(c) Production > sales (so inventory is climbing)
AC profit > MC profit

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Question: Marginal costing
There is no opening inventory in Year 1.

Selling price per unit $10

Variable costs per unit
Direct materials $2
Direct labour $3
Production overhead $1
Selling and distribution $1
Fixed costs
Production: budgeted $8,000
actual $8,500 Each year
Selling and distribution (budgeted and actual) $2,000
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Question: Marginal costing (cont’d)
Activity levels: Year 1 Year 2
Units Units
Budgeted production 4,000 4,000
Actual sales 4,200 4,000
Actual production 4,400 3,800

Required
Complete the statement of profit or loss under marginal costing principles for both years.

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Answer: Marginal costing

Marginal costing

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Marginal costing 5

Reconciliation of profit
 Change in inventory × OAR
 Inventory
 Increase
 Absorption profit is
 More

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Question: Reconciliation of profit

Required
Reconcile the profit figures calculated in:
(a) Absorption costing
(b) Marginal costing

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Answer: Reconciliation of profit
Year 1 Year 2
AC Profit 2,500 1,100
Add fixed overhead in opening inventory – 400
Less fixed overhead in closing inventory* 400 –
MC profit 2,100 1,500
*200  $2

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Absorption costing v marginal costing 1

Arguments in favour of absorption costing (AC)

 When sales fluctuate because of seasonality of demand but production is

constant, AC avoids large fluctuations in profit.
 Marginal costing fails to recognise the importance of working to full
capacity.
 Marginal costing does not recognise the effects on pricing decisions if cost
plus method of pricing is used.
 Prices based on marginal cost (minimum prices) do not guarantee that
contribution will cover fixed costs.

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Absorption costing v marginal costing 2

Arguments in favour of absorption costing (AC) (cont’d)

 In the long run all costs are variable, and absorption costing recognises these
long-run variable costs.
 It is consistent with the requirements of accounting standards

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Absorption costing v marginal costing 3

Arguments in favour of marginal costing

 It shows how cash flows/profits are affected by changes in sales

volumes as contribution varies in direct proportion to units sold.
 By using absorption costing and setting a production level greater
than sales demand, profits can be manipulated.
 Separating fixed and variable costs is vital for decision-making.
 For short-run decisions in which fixed costs do not change:
• The decision rule is to choose the alternative which maximises
contribution, fixed costs being irrelevant

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