- The simplest method of calculating costs.
- Businesses work out the direct costs of making a product, and then add on a proportion of the indirect costs (overheads).
- Indirect costs can be divided equally between all products, or shared out according to how much revenue each product makes, etc.
- E.g. if a business makes five different products, then the simplest way to allocate indirect costs is to allocate 20% of the indirect costs to each product.
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- A bit like full costing, because it adds a proportion of the indirect costs onto the direct cost of each product.
- The main difference is that in absorption costing, each product is allocated a different percentage of each individual indirect cost (heating and lighting, rent, etc.) rather than a percentage of total indirect costs.
- E.g. canteen costs might be divided up according to the percentage of staff working on each product, rent might be shared out according to how much floor space each product requires, etc.
- Absorption costing is more accurate than full costing but it takes longer.
- It can also lead to conflict as managers argue over how they're going to allocate the overheads.
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- A.K.A. Marginal Costing.
- The difference between the direct cost per unit and the selling price of each unit makes a contribution towards paying for the indirect costs.
- In contribution costing, once there is enough contribution to cover the overheads (indirect costs), all contribution is profit. The finance department works out how many sales the business needs to make to cover the overheads and start making profit. This figure is called the break-even output.
- Contribution = Selling price per unit - Direct costs per unit
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- Standard costs (sometimes called average costs) are what a business expects each unit they produce to cost them.
- They're a bit like budgets, but budgets relate to departments and standard costs relate to products.
- Businesses predict how much each unit will cost to make. They work out the average cost of the raw materials for one product, and add the hourly wage cost multiplied by the number of hours they expect it will take to produce each unit. They also add an estimate of the indirect costs involved in producing each unit - this is the total indirect cost, divided by the number of products they expect to produce.
- In reality, some workers might take longer to produce one unit than others, and some raw materials might be wasted. Predictions might turn out to be wrong if wages or the cost of materials increase unexpectedly.
- Variance is the difference between the standard cost and the actual cost. This can be favourable (costs are less than planned so there's more profit) or adverse (costs are more than planned).
- Standard costing is usually used by businesses that produce a large number of the same item, and where the work involved in production takes the same amount of time for each unit (e.g. sticking labels on tins of beans in a factory). It's not suitable for businesses that make one-off products (e.g. made-to-measure wedding dresses).
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