CIMA - C1 Fundamentals of Management Accounting
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3: Overhead costs – absorption costing⏐ Part A Cost determination and behaviour
TRUE FALSE
It is generally accepted that a time-based method should be used wherever
possible (for example labour rate hours or machine rate hours).
Direct materials price percentage is not usually considered to be a suitable
method because there is no reason why a higher material cost should lead
to a cost unit incurring more overhead production overhead cost.
10 H Co bases its overhead absorption rate on labour hours. The following information is available for 20X9.
Budgeted overheads $600,000
Actual overheads $660,000
Budgeted labour hours 120,000
Actual labour hours 110,000
Calculate the over- or under-absorption of overheads for 20X9.
A $60,000 over-absorbed B $60,000 under-absorbed
C $110,000 over-absorbed D $110,000 under-absorbed
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Part A Cost determination and behaviour ⏐ 3: Overhead costs – absorption costing
81
Answers to Quick Quiz
1 False. It is the process whereby whole cost items are charged direct to a cost unit or cost centre.
2 (a) (3)
(b) (4)
(c) (2)
(d) (3)
3
Department Involved in production (9)
Finished goods warehouse
Canteen
Machining department
9
Offices
Assembly department
9
4 A = 2
B = 4
C = 1
D = 5
E = 3
5 Repeated distribution method
6 B
7 True
8 Traditional costing systems tend to allocate
too great
a proportion of overheads to high volume products and
too small
a proportion of overheads to low volume products.
9 True. It is generally the case that overheads increase with time therefore a time-based approach is considered most
sensible.
True. This method is not particularly logical.
10 D OAR =
hours labour Budgeted
overheads Budgeted
=
120,000
$600,000
= $5 per labour hour
Overheads absorbed = 110,000 hours x $5
= $550,000
Overheads absorbed – actual overheads = $550,000 – $660,000
= $110,000
∴
overheads were under-absorbed by $110,000.
Now try the questions below from the Exam Question Bank
Question numbers Page
11
−
15
353
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3: Overhead costs – absorption costing⏐ Part A Cost determination and behaviour
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Topic list Learning outcomes Syllabus references Ability required
1 Marginal cost A(ix) A(5) Application
2 Marginal costing A(ix) A(5) Application
3 Pricing decisions A(x) A(5) Comprehension
Marginal costing and
pricing decisions
Introduction
In Chapter 3 we saw how product costs are absorbed into the cost of units of output using
absorption costing.
This chapter describes marginal costing, an alternative method of dealing with overheads.
Whereas absorption costing recognises fixed costs (usually fixed production costs) as part of
the cost of a unit of output and hence classifies them as product costs, marginal costing
treats all fixed costs as period costs. (Remember we covered product costs and period costs
in Chapter 1.)
This chapter then goes on to cover how unit costs (whether full product costs derived using
absorption costing, or marginal costs) can be used as the basis for setting prices.
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4: Marginal costing and pricing decisions ⏐ Part A Cost determination and behaviour
1 Marginal cost
Whereas fully absorbed product costs include fixed overhead, the marginal cost of a product usually consists of variable
costs only.
1.1 Marginal cost
Marginal cost is 'part of the cost of one unit of product or service that would be avoided if the unit were not produced,
or that would increase if one extra unit were produced'. CIMA Official Terminology
The marginal production cost per unit of an item usually consists of the following.
• Direct materials
• Direct labour
• Variable production overheads
1.2 Contribution
Contribution is an important measure in marginal costing, and it is calculated as the difference between sales value and
marginal or variable cost.
Contribution is '(sales value – variable cost of sales)'. CIMA Official Terminology
The term 'contribution' is really short for 'contribution towards covering fixed overheads and making a profit'.
Question
Contribution
A particular electrical good is sold for $1,009.99. The direct material cost per unit is $320, the direct labour cost per unit
is $192 and the variable production overhead cost per unit is $132. Fixed overheads per annum are $100,000 and the
budgeted production level is 1,000 units.
The contribution per unit of the electrical good is $
.
Answer
The contribution per unit is $
365.99
Workings
$
$
Selling price per unit
1009.99
Marginal cost per unit
Direct material
320
Direct labour
192
Variable production overhead
132
644.00
Contribution per unit
365.99
We do not include absorbed fixed overheads in the calculation of marginal cost per unit and contribution per unit.
FAST FORWARD
FAST FORWARD
Key term
Key term
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Part A Cost determination and behaviour ⏐ 4: Marginal costing and pricing decisions
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2 Marginal costing
Marginal costing is an alternative method of costing to absorption costing. In marginal costing, only variable costs are
charged as a cost of sale and a contribution is calculated. Closing inventories of work in progress or finished goods are
valued at marginal (variable) production cost. Fixed costs are treated as a period cost, and are charged in full against
profit in the accounting period in which they are incurred.
Marginal (or variable) costing 'assigns only variable costs to cost units while fixed costs are written off as period
costs'. CIMA Official Terminology
Fixed costs are a period charge and are the same for any volume of sales and production (within the relevant range).
So if an extra unit is sold the following happens.
•
Revenue will increase by the sales value of the item sold.
•
Costs will increase by the variable cost per unit.
•
Profit will increase by the difference between sales value per unit and variable cost per unit
(contribution).
Therefore only variable costs are charged to the cost of sales.
Fixed costs are deducted from total contribution (the difference between sales revenue and the cost of sales) to derive
profit for the period.
When a unit of product is made, the extra costs incurred in its manufacture are the variable production costs. Fixed costs
are unaffected – no extra fixed costs are incurred when output is increased. The valuation of units of output and hence
closing inventory is therefore at variable production cost because these are the only costs properly attributable to the
product.
Before explaining marginal costing principles any further, it will be helpful to look at a numerical example.
2.1 Example: marginal costing
Water Co makes a product, the Splash, which has a variable production cost of $6 per unit and a sales price of $10 per
unit. At the beginning of September 20X0, there were no opening inventories and production during the month was
20,000 units. Fixed costs for the month were $45,000 (production, administration, sales and distribution). There were no
variable marketing costs.
Required
Calculate at each of the following sales levels, the total contribution and total profit for September 20X0 and the
contribution per unit and the profit/loss per unit, using marginal costing principles.
(a) 10,000 Splashes
(b) 15,000 Splashes
(c) 20,000 Splashes
FA
S
T F
O
RWAR
D
Key term
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4: Marginal costing and pricing decisions ⏐ Part A Cost determination and behaviour
Solution
The first stage in the profit calculation must be to identify the variable costs, and then the contribution. Fixed costs are
deducted from the total contribution to derive the profit. All closing inventories are valued at marginal production cost
($6 per unit).
10,000 Splashes
15,000 Splashes
20,000 Splashes
$
$
$
$
$
$
Sales (at $10)
100,000
150,000
200,000
Opening inventory
0
0
0
Variable production cost
120,000
120,000
120,000
120,000
120,000
120,000
Less value of closing
inventory (at marginal cost)
60,000
30,000
–
Variable cost of sales
60,000
90,000
120,000
Contribution
40,000
60,000
80,000
Less fixed costs
45,000
45,000
45,000
Profit/(loss)
(5,000
)
15,000
35,000
Profit/(loss) per unit
$(0.50)
$1
$1.75
Contribution per unit
$4
$4
$4
The conclusions which may be drawn from this example are as follows.
(a) The profit per unit varies at differing levels of sales, because the average fixed overhead cost per unit
changes with the volume of output and sales.
(b) The contribution per unit is constant at all levels of output and sales. Total contribution, which is the
contribution per unit multiplied by the number of units sold, increases in direct proportion to the volume
of sales.
(c) Since the contribution per unit does not change, the most effective way of calculating the expected profit
at any level of output and sales would be as follows.
(i) First calculate the total contribution.
(ii) Then deduct fixed costs as a period charge in order to find the profit.
(d) In our example the expected profit from the sale of 17,000 Splashes would be as follows.
$
Total contribution (17,000 × $4) 68,000
Less fixed costs
45,000
Profit
23,000
2.2 Profits, losses and breakeven point
(a) If total contribution exceeds fixed costs, a profit is made.
(b) If total contribution exactly equals fixed costs, no profit and no loss is made and breakeven point is
reached.
(c) If total contribution is less than fixed costs, there will be a loss.
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Part A Cost determination and behaviour ⏐ 4: Marginal costing and pricing decisions
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Question
Marginal costing principles
PC company makes two products, the Loo and the Wash. Information relating to each of these products for April 20X1 is
as follows.
Loo
Wash
Opening inventory
nil
nil
Production (units)
15,000
6,000
Sales (units)
10,000
5,000
$
$
Sales price per unit
20
30
Unit costs
Direct materials
8
14
Direct labour
4
2
Variable production
overhead
2
1
Variable sales overhead
2
3
Fixed costs for the month
$
Production costs
40,000
Administration costs
15,000
Sales and distribution costs
25,000
Using the approach set out in the answer to the example in Section 2.1 above, the marginal costing profit for April 20X1
is $
.
Answer
The profit is $
10,000
Workings
$
Contribution from Loos (unit contribution = $20 – $16 = $4 × 10,000)
40,000
Contribution from Washes (unit contribution = $30 – $20 = $10 × 5,000)
50,000
Total contribution
90,000
Fixed costs for the period
80,000
Profit
10,000
2.3 Inventory valuation using absorption costing and marginal costing
Marginal costing is significantly different from absorption costing. It is an alternative method of accounting for costs
and profit, which rejects the principles of absorbing fixed overheads into unit costs.
(a) In marginal costing
(i) Closing inventories are valued at marginal production cost.
(ii) Fixed costs are charged in full against the profit of the period in which they are incurred.
(b) In absorption costing
(i) Closing inventories are valued at full production cost, and include a share of fixed production costs.
(ii) This means that the cost of sales in a period will include some fixed overhead incurred in a
previous period (in opening inventory values) and will exclude some fixed overhead incurred in the
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4: Marginal costing and pricing decisions ⏐ Part A Cost determination and behaviour
current period but carried forward in closing inventory values as a charge to a subsequent
accounting period.
With this in mind work through the following example.
2.4 Example: marginal and absorption costing
TLF Company manufactures a single product, the Claud. The following figures relate to the Claud for a one-year period.
Activity level 50% 100%
Sales and productions (units) 400 800
$ $
Sales 8,000 16,000
Production costs: variable 3,200 6,400
fixed 1,600 1,600
Sales and distribution costs:
variable 1,600 3,200
fixed 2,400 2,400
The normal level of activity for the year is 800 units. Fixed costs are incurred evenly throughout the year, and actual fixed
costs are the same as budgeted.
There were no inventories of Claud at the beginning of the year.
In the first quarter, 220 units were produced and 160 units sold.
Required
(a) Calculate the fixed production costs absorbed by Clauds in the first quarter if absorption costing is used.
(b) Calculate the under/over recovery of overheads during the quarter.
(c) Calculate the profit using absorption costing.
(d) Calculate the profit using marginal costing.
Solution
(a)
activity) of level (normal output Budgeted
costsproduction fixed Budgeted
=
units800
$1,600
Absorption rate = $2 per unit produced.
During the quarter, the fixed production overhead absorbed was 220 units × $2 = $440.
(b)
$
Actual fixed production overhead
400 (1/4 of $1,600)
Absorbed fixed production overhead
440
Over absorption of overhead
40
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Part A Cost determination and behaviour ⏐ 4: Marginal costing and pricing decisions
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(c) Profit for the quarter, absorption costing
$
$
Sales (160 × $20)
3,200
Production costs
Variable (220 × $8)
1,760
Fixed (absorbed overhead (220 × $2))
440
Total (220 × $10)
2,200
Less closing inventories (60 × $10)
600
Production cost of sales
1,600
Adjustment for over-absorbed overhead
40
Total production costs
1,560
Gross profit
1,640
Less: sales and distribution costs
variable (160 × $4)
640
fixed (1/4 of $2,400)
600
1,240
Net profit
400
(d) Profit for the quarter, marginal costing
$
$
Sales
3,200
Variable production costs
1,760
Less closing inventories (60 × $8)
480
Variable production cost of sales
1,280
Variable sales and distribution costs
640
Total variable costs of sales
1,920
Total contribution
1,280
Less:
Fixed production costs incurred
400
Fixed sales and distribution costs
600
1,000
Net profit
280
Now have a go at the following questions to assess whether or not you can use both absorption costing and marginal
costing.
Question
Calculating profits
Suppose that a company makes and sells a single product. At the beginning of period 1, there are no opening inventories
of the product, for which the variable production cost is $4 and the sales price $6 per unit. Fixed costs are $2,000 per
period, of which $1,500 are fixed production costs.
Period 1 Period 2
Sales 1,200 units 1,800 units
Production 1,500 units 1,500 units
(a) Assuming normal output is 1,500 units per period, the absorption costing profit in each period and in total would
be:
(i) Period 1 $
(ii) Period 2 $
(iii) Total $
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