Marginal costing and Absorption costing
Marginal costing statement: Absorption Costing:
Revenue x Revenue x
Less variable costs (x) Less total cost ( x)
= Contribution x Proft x
Less fixed costs (x)
= Profit x
Absorption cost is when costs are absorbed/included in the cost of each unit. The usual methods for absorbing overheads are by using 'labour hours' or 'machine hours'.
If a business only makes one product then you just need to take the fixed overhead cost and divide it by the number of units made. The ovrehead is to be shared equally between all units made.
Labour hours: Overhead absorption rate= fixed overheadd/ total labour hours.
Example: Fixed overhead for 2 products is £90,000. It takes 600 hours to make product A, and 300 hours to make product B. ( 900 hours in total)
£90,000 / 900 hours = £100 per labour hour.
Product A will absorb in total: 600 hours x £100 = £60,000 of overhead
Product B will absorb in total: 300 hours x £100 = £30,000 of overhead. they equal the £90,000
Machine hours: Fixed overhead / total machine hours
Example: rent of £10,000 is absorbed by 2 products; small and large tables. Small tables take 225 machine hours in one month to make, 525 machine hours for large ones
£10,000 / (225+525) = £13.333 Per machine hour
Small tables = 225 x £13.333 = £3000
Large tables = 525 x £13.333 = £7000 they equal th £10,000
Activity based costing (ABC)
Example: A business makes armchairs and office chairs. Production overheads are incurred as it takes time to set up machinery to make each batch of products. In one week there are 40 armchairs made in 5 batches of 8 and 100 office chairs made in 20 batched of 5. Each batch requires one set up (£56) and a quality inspection (£84)
Total number of batches = 25
Total Set up costs = 1400 - 25 x 56
Total inspection costs = 2100 - 25 x 84
Total cost = 3500
40 armchairs and 100 office chairs = 140 products.
3500 / 140 = 25
40 armchairs = (5x56) £280 + (5x84) £420 of cost = £700 £700/40 = £17.50 per chair
100 office chairs = (20x56) 1120+ (20x84) 1680 = 2800/100 = £28 per chair
ABC is regarded as producing more accurate product costs: The way costs are shared between the products is based on how/why the costs arise rather than on a basis such as labour hours used in absorption costing. More accurate costs = more helpful in business decisions.
Why can ABC not be useful?
- If overhead costs are incurred because of machine/ labour hours, absorption costing would be the better option to use.
- If fixed overheads are low compared to direct costs, it might not be worth the effort in sharing them out accurately. It wont really change product cost.
- If the business is only making one product, it's easier to share the overheads between the units
- Total overheads don't effect the profit either way
ABC advantages and disadvantages
- Cost of one unit is more accurate
- Objective - rules set up that are used to allocate overhead costs based on how they are incurred
- Good information provided to managers about how costs arise so they have more control
- If overhead costs are high, more accurate costs avoid managers being mislead about costs
- Acceptable for inventory valuation under IAS2
- Complicated to set up
- Time consuming to set up
- Because it is complicated, mistakes may occur
- It might be confusing to understand
- Choosing cost drivers can be difficult/impossible
- Regular reviews must be done to check that cost drivers are still relevent.
Cost driver - an activity that results in an overhead cost being incurred e.g machine hours, machine hours, set ups and deliveries.
A Cost pool is a group of overhead costs that are incurred by the same activity. A cost pool collects all the costs together e.g machine maintenance.
Example: costs cost pool cost driver cost per machine hours
engineers time £480 £600 400 hours 600/400 = £1.50
Spare parts £120 £1.50 x 1/10= 0.15p
Cost centre = A section of a business where costs are collected e.g production department, administration department, canteen, cleaning and maintenace.