Absorption and marginal costing

Chapter 8

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MARGINAL + FIXED OVERHEAD = ABSORPTION
COSTING COSTING

STANDARD
COST

IMPACT ON
INVENTORY
AND PROFIT

COMPARISON OF
METHODS

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 Reminder
Relation to cost Direct costs: Indirect costs:
object ‘Costs that are ‘The cost of
Changes in the unambiguously capacity that
related level of linked to the provides services to
activity production of a more than one
particular output.’ product.’

Variable costs: Materials, labour Power costs for

‘Costs that vary running machines
proportionately (power consumed
with the level of an by each machine is
activity.’ unknown), handling
materials, cost of
setting up machines

Fixed costs: Machine or labour Personnel costs,

‘Costs that tend to that is dedicated to communication
remain constant the production of systems,
despite changes in one product. depreciation on
the level of an PPE, amortisation
activity.’ on intangibles
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 Question

Which costs should be

charched to costs
units?
Fix costs
! only direct costs can be
accurately assigned to cost
Cost object
objects

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Costing systems

Direct costing Absorption

system costing system
(marginal or
variable
costing system Traditional
costing systems
(absorption)

Activity-based-
costing (ABC)
systems

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Marginal Costing
Only variable production costs are charged to cost units.
Fixed costs are expensed (period costs)
Marginal cost of Production
 Increase in cost of inputs for 1 additional unit of output.
 Sum of all direct production costs per unit + variable
production overhead per unit
 Unit contribution = Unit selling price – marginal cost
of sale per unit
 Total contribution = Total revenue – marginal cost of sales

For decision-making purposes profit per unit is misleading!

Always use contribution

Inventory valuation
 At variable production cost per unit
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Absorption Costing
Principle
 All production costs should be charged to (i.e. “absorbed into”)
cost units
 Inventory is valued at total production cost
(i.e. full absorption cost) per unit (Session 7)

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 PL - Absorption Costing
$
Sales revenue X
Opening inventory (at absorption cost) X
Variable production costs X i.e. absorption
Fixed production overhead X cost of
Closing inventory (at absorption cost) (X) production
––
Cost of goods sold (at absorption cost) (X)
––
Gross profit X
Variable non-production overhead (X)
Fixed non-production overhead (X)
––
Net profit X
––
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PL – Marginal Costing

$
Sales revenue X
Opening inventory (at marginal cost) X
Marginal (variable) production costs X
Closing inventory (at marginal cost) (X)
––
Cost of goods sold (at marginal cost) (X)
Variable non-production overheads (X)
––
Contribution X
Fixed production overheads (X)
Fixed non-production overheads (X)
––
Net profit X
––
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 Cost application

Marginal Absorption
Only the variable cost is The variable cost and
applied to inventory fixed overhead is applied
to inventory

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 Profit measurement

Marginal Absorption
Contribution margin The gross margin
(which excludes applied (which includes applied
overhead) overhead)

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 Overhead costs

Marginal Absorption
To be expensed in the Are applied to products
period (COGS and closing
(P&L) inventory)
(P&L and BS)

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Classification of overheads

Marginal Absorption
Fixed, variable Administration,
Production, non- production, distribution
production and selling overheads

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 Ease of operation

Marginal Absorption
Yes No

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IFRS, GAAP compliance /
Reporting

Marginal Absorption
No Yes
Internal reporting External reporting

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Classification of overheads

Marginal Absorption
Fixed, variable Administration,
Production, non- production, distribution
production and selling overheads

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 Impact on profit

Marginal Absorption
Increase in stock >> low Increase in stock >> high
profit profit
Decrease in stock >> high Decrease in stock >> low
profit profit

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 International use of costing
methods,%

Canada Australia Japan Sweden UK Germany

Direct costing
system (marginal or
48 33 31 42 52 70
variable costing
system

Traditional costing
52 67 69 58 48 30
systems (absorption)

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Profit Reconciliation
$
MC profit X
Add: Fixed overhead in closing inventory X
Less: Fixed overhead in opening inventory (X)
–––
AC profit X

Effect on profit of changing inventory levels

Inventory values: AC > MC (always!) due to inclusion of fixed
production costs

Inventory levels Effect on profit

Closing = opening  AC = MC
Closing < opening  AC < MC
Closing > opening  AC > MC
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Illustration - MC
Melody Co Ltd., which
manufactures receivers
BUDGET per month

Sales – 20,000 receivers 400 000

Manufacturing costs of goods sold

Variable costs 240 000

Fixed overhead 60 000
Gross Profit 100 000
Selling and distribution costs 20 000
(fixed)
Net profit 80 000
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 Melody Co Ltd., which
Illustration - MC manufactures receivers
Data: first two trading
periods

Period 1 Period 2
Sales 18 000 21 000
Production 24 000 18 000

Show marginal costing

Selling price (per unit) 20

VC per unit 12
Stock 6 000 3 000

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 Illustration - MC
Period 1 If sales increases
by 100
Sales – 18,000 receivers 360 000 Revenue increases 2000
by
Variable costs – 24,000 receivers 288 000 VC increases by 1200
Closing inventory - 6,000 receivers
(72 000)

Contribution 144 000

Fixed overhead 60 000 Contribution increases 800
by

Selling and distribution costs 20 000 Fixed costs 0

(fixed)
Net profit 64 000 Profit increases by 800
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Budget 80 000 Fall 16 000 (-

2000*8)
Illustration - AC
Melody Co Ltd., which
manufactures receivers
BUDGET per month

Sales – 20,000 receivers 400 000

Manufacturing costs of goods sold

Variable costs 240 000

Fixed overhead 60 000
Gross Profit 100 000
Selling and distribution costs 20 000
(fixed)
Net profit 80 000

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Illustration - AC Melody Co Ltd., which
manufactures receivers
Data: first two trading
periods

Period 1 Period 2
Sales 18 000 21 000
Production 24 000 18 000

Show absorption costing

Selling price (per unit) 20

Absorption rate 3
VC
12
Stock 6 000 3 000
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 Illustration
Period 1 COGS:
Sales – 18,000 receivers 360 000 Opening inventory 0
COGS (at absorption rate) 258 000 Variable costs 288 000
24,000 receivers *12
Gross profit 102 000 Fixed production 72 000
overhead 24,000
Selling and distribution costs 20 000 receivers *3
(fixed)

Net profit 82 000 Over absorbed Fixed Cost (12 000)

(2000)

Closing inventory (90 000)

COGS 258 000
Budget 80 000 Increase 2 000 25
Illustration Absorption!
Case 2
X plc produces one product – desks. Each desk is budgeted to
require 4 kg of wood at $3 per kg, 4 hours of labour at $2 per
hour, and variable production overheads of $5 per unit. Fixed
production overheads are budgeted at $20,000 per month and
average production is estimated to be 10,000 units per month.
The selling price is fixed at $35 per unit. There is also a variable
selling cost of $1 per unit and fixed selling cost of $2,000 per
month. During the first two months X plc had the following
levels of activity:
January February
Production 11,000 units 9,500 units
Sales 9,000 units 11,500 units

(a) Prepare a cost card using absorption costing

(b) Set out Profit Statements for the months of January and
February.
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JOB, BATCH AND SERVICE
COSTING
Session 9

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1 Job Costing

A specific order costing method which attributes costs

to individual jobs
When used
 Customers’ special requirements for jobs of relatively
short duration
 A wide range of “unique” products/jobs requiring
different amounts of resource inputs
 Suited to industries producing specialised or tailored
outputs e.g.
 accounting/legal services
 service engineering/garage repairs

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2 Batch (“Operation”) Costing

A specific order costing method which attributes costs to batches of

products
When used
 Similar articles manufactured in batches (for sale/use)
 Articles may also have individual characteristics
 Where variations of a single design require a sequence of standardised
operations (e.g. footwear, clothing, furniture)
Product cost
 Sum of average costs of operations
(may be ascertained by process costing techniques)
+
 Specific costs (if any) of unique operations

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3 Service Costing

Cost accounting for specific services or functions (e.g.

service centres)
When used
 To ascertain cost of providing a unit of service (e.g.
telephone networks)
 In both private (e.g. hotel) and public (e.g. hospital)
sectors
 Both for resale (e.g. legal advice) and
internal services (e.g. staff training)

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