Chapter Content Absorption Costing Traditional Costing Marginal Costing Pricing Absorption costing Absorption costing is a method of costing in which the cost of a product is built up as the sum of direct costs and a ID: 1028592
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1. 2ChapterTraditional Costing
2. Chapter ContentAbsorption CostingTraditional CostingMarginal CostingPricing
3. Absorption costingAbsorption costing is a method of costing in which the cost of a product is built up as the sum of direct costs and a fair share of production overhead costA fully absorbed cost is used to value inventory and as a basis for pricingOverheads are absorbed across all units using a single cost driver (usually machine or labour hours).Results in a ‘FULL’ product cost per unitIs an acceptable inventory valuation method as per IAS 2Suitable costing system for mass produced, homogeneous products - where overheads are largely volume driven.
4. Standard cost card-Absorption costing $Direct materials x Direct labour x Variable overheads x Fixed production overheads x Absorption cost per unit x OAR
5. Overhead Absorption Rate (OAR)Fixed production overheads are absorbed into units using the OAR.The OAR is calculated using budgeted figures; OAR = Budgeted Fixed Production Overheads Budgeted level of activityThe activity could be based on labour hours, machine hours or sometimes number of units.The choice of activity will depend on whether the operation is labour intensive or machine intensive.Once the OAR has been ascertained, absorption occurs as soon as a unit is made. Every unit will absorb the same amount in respect of production overheads
6. Over/under-absorptionBecause the OAR is based on budgeted figures it is highly likely that the overhead absorbed during a period may be different from the actual overhead incurredAn over-absorption will occur when the absorbed overhead is more than the actual overhead incurred.Under-absorption is when the absorbed overhead is less than the actual overhead incurred.An over-absorption has the effect of understating profits and therefore it is added back to Gross profit in the statement of profit or lossUnder-absorptions overstate profits and they are therefore subtracted fro gross profit
7. Example: under-absorptionIdentify which of the following statements would be true: fixed production overheads will always be under-absorbed when:A actual output is lower than budgeted outputB actual overheads incurred are lower than budgeted overheadsC overheads absorbed are lower than those budgetedD overheads absorbed are lower than those incurred
8. Example..A company uses a standard absorption costing system. The fixedoverhead absorption rate is based on labour hours.Extracts from the company’s records for last year were as follows: Budget ActualFixed production overhead $450,000 $475,000Output 50,000 units 60,000 unitsLabour hours 900,000 930,000The ______ (choose between 'over' and 'under') absorbedfixedproduction overheads for the year were $______ (fill in the value).
9. Proforma of Income Statement
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11. In a month when actual production was 2,400 units and exceeded salesby 180 units, what is the profit reported under absorption costing?
12. Marginal CostingInventories and production are valued at the variable production costs per unit.Fixed cosys are treated as a period cost and subtracted in full in the income statementStandard cost card $Direct materials x Direct labour x Variable overheads x Marginal cost x Contribution is emphasised.
13. ContributionContribution = Sales Less Variable CostsDirect MaterialsDirect LabourVariable Overheads
14. Proforma of Income Statement
15. In a month when actual production was 2,400 units and exceeded salesby 180 units, what is the profit reported under marginal costing?
16. Reconciliation of profitsThe only difference between the two approaches is the value of inventories. Absorption costing values inventory at a higher value as it includes the fixed production overhead in the standard cost card. Therefore:increased closing inventory increases current period’s profit compared with marginal costing because more fixed cost is deferred to the next period as opening stock.decreased inventory decreases current period’s profit compared with marginal costing because more fixed cost is released in the current period.
17. Differences in profitIf Opening Stock > Closing Stock then MC Profit > AC ProfitIf Opening Stock < Closing Stock then MC Profit < AC ProfitIf Opening Stock = Closing Stock then MC Profit = AC ProfitDifference in profit = (opening – closing stock) x FOAR
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19. Solution.. OAR = $5000/1000 = $5/unit profit per unit = 50 – 15 – 10 – 5 – 5 = $15 total profit = 1000 x 15 = $15,000b. contribution/unit = 50 – 15 – 10 - 5 = $20 total contribution = $20 x 1000 = $20,000 profit = $20,000 - $5000 = $15,000As expected, if opening stock = closing stock, the profits for the period will be the same
20. Example..A company produces a single product called the Genie. Budgeted output for August is 30,000 units. Budgeted fixed production costs for the month were $150,000. Opening stock was 6000 units and closing stock was 4200 units. Profit reported under marginal costing was $165,000. What would be the profit reported using absorption costing?
21. Pricing using absorption costingAdd a mark up to total budgeted factory costKey advantagesensures all production costs are coveredcan be used to justify price risesKey disadvantagesignores customers and competitorsdoesn’t reflect the incremental cost of new orders
22. Pricing using marginal costingAdd a mark up to the variable production costKey advantagesuseful for incremental ordersavoids arbitrary overhead allocationsKey disadvantagesignores customers and competitorsdoesn’t cover all costs in the long run
23. Mark-up and marginA margin is a % on salesA mark-up is a % on costE.g….If a baker’s margin is 20%, what is her mark-up?