Traditional Costing Methods

1 Introduction

The collective term traditional costing methods refers to absorption costing and marginal costing. Both answer the same question — what does one unit cost? — and they give different answers, because they treat fixed production overhead differently.

You need to understand both in order to compare and contrast them, and from there to weigh them against modern alternatives such as activity based costing (chapter 4). You also need the marginal-costing idea of contribution, which links to a great deal of the rest of P1: limiting factor analysis (chapter 5), variance reconciliations (chapters 9 and 10) and cost-volume-profit analysis (chapter 15).

This chapter carries syllabus outcome P1A3a — cost accumulation, allocation, apportionment and absorption — and the topics marginal costing and absorption costing. Sections 3 and 4 are the mechanics; sections 5 to 8 are the comparison.

One recording covers this chapter. It answers Example 1, compares absorption and marginal costing and their strengths and weaknesses, and works Example 4 as the two full profit statements that Answer 4 sets out under “Why it works”. Three points before you play it.

Example numbers: it says “exercise one” and “exercise 2”; the second is Example 4 in these notes.

Check the figures against Answer 4: the fixed overhead absorption rate is $30 a unit, the profit is $660,000 under absorption costing and $615,000 under marginal costing, and the difference is 1,500 × $30 = $45,000.

Coverage: it does not teach section 3 — allocation, apportionment, the absorption rate and over- and under-absorption — and leaves it for later. Section 3 is examinable; read it in full.

YouTube video

2 Why a cost per unit is needed

The purpose of a cost per unit

Why does an organisation need to obtain a cost per unit?

The purpose of a cost per unit

The four rationales for costing set out in chapter 1, applied to a unit of output:

To value inventory in the statement of financial position, and so to measure the cost of sales for the period.
To determine a selling price. If a desk costs $20 to make, the price has to exceed $20 — although what competitors charge is a separate and equally important question.
To plan and to budget — how much wood to buy next year depends on what one unit consumes.
To make decisions: whether to accept an order, make or buy, continue or discontinue.
To measure the effect of a management decision on cost — a change of supplier, a process change, a cost-saving scheme.
To measure performance, through key ratios and through variance analysis (chapters 9 and 10), which compares what a unit should have cost with what it did cost.

Note that the first two need a full cost and the fourth needs only the costs that change. That is chapter 1's point about different costs for different purposes, and it is the whole reason both methods in this chapter exist.

3 Cost accumulation, allocation, apportionment and absorption

Direct costs are traced to the unit that incurs them. Production overheads cannot be, by definition, so getting them into a unit cost takes four steps. The syllabus names all four.

The four steps

Accumulation — gathering costs together and recording them against the part of the organisation that incurs them.

Allocation — charging a whole overhead to the single cost centre that caused it, where it belongs entirely to that one centre.

Apportionment — dividing an overhead that is shared between two or more cost centres across them, on a basis that reflects how each uses it.

Absorption — charging the overheads collected in a production cost centre onto the units passing through it, at a rate per hour or per unit.

A cost centre is a part of the organisation — a department, a machine, a process — to which costs are charged. Production cost centres make the output. Service cost centres — stores, maintenance, the canteen — exist to support the production centres and no unit of output passes through them, so their costs must be reapportioned onto the production centres before anything can be absorbed.

3.1 Allocation and apportionment

The test for allocation is whether the whole of the cost belongs to one cost centre. The wages of the machining department's own supervisor are allocated to machining. The rent of a building that houses three departments is not — it is apportioned.

An apportionment basis should reflect what causes each centre to consume the cost. There is no rule; these are the usual choices:

Overhead	Usual basis of apportionment
Rent, rates, heating, lighting, building insurance	Floor area occupied
Depreciation and insurance of machinery	Cost or carrying amount of machinery
Canteen, personnel, welfare, supervision	Number of employees
Power	Machine hours, or metered consumption
Stores and materials handling	Number of requisitions, or value of materials issued

Apportionment is arbitrary, and knowing that is examinable.

Floor area is a reasonable way of sharing rent, but a department does not cause rent by occupying space — the rent would be the same if it occupied none. The share is a convention, not a cause. That is the objection activity based costing exists to answer (chapter 4), and it is why an absorption cost is a poor basis for a decision (chapter 14).

3.2 Absorption and the overhead absorption rate

Once every overhead sits in a production cost centre, it is absorbed onto the units passing through that centre at a predetermined rate:

Overhead absorption rate = Budgeted overhead for the cost centre ÷ Budgeted activity for the cost centre

The activity chosen should be the one that best measures what passes through the centre:

Machine hours in a machine-intensive centre, where output and overhead both follow machine running time.
Direct labour hours in a labour-intensive centre.
Units of output, but only where the centre makes one product, or products so alike that a unit is a fair measure.

Different cost centres may use different bases, and normally should. Using one plant-wide rate for the whole factory is the simplification the legacy method is usually criticised for, and it is exactly what chapter 4's Example 1 part (a) does before ABC is applied to it.

Why the rate is predetermined

The rate is set before the period begins, from budgeted overhead and budgeted activity, because a cost per unit is needed while the period is running — to quote prices, value inventory monthly and control costs. Waiting until the actual figures are known would make it useless.

The consequence is that the overhead absorbed during the period will almost never equal the overhead actually incurred. The difference is dealt with in section 3.4.

Allocation, apportionment and absorption

A factory has two production cost centres, Machining and Assembly, and one service cost centre, Stores. Budgeted overheads for the period are:

	$
Indirect wages — Machining	30,000
Indirect wages — Assembly	20,000
Indirect wages — Stores	10,000
Factory rent	40,000
Machinery insurance	12,000
	112,000

The following budgeted information is available:

	Machining	Assembly	Stores
Floor area (m²)	4,000	3,000	1,000
Machinery at cost ($000)	500	100	—
Stores requisitions	3,000	1,000	—
Machine hours	25,000	5,000	—
Direct labour hours	3,000	25,000	—

Machining is machine-intensive and Assembly is labour-intensive.

Required:

Allocate and apportion the budgeted overheads between the three cost centres, and reapportion the Stores overhead to the two production cost centres.
Calculate an appropriate overhead absorption rate for each production cost centre.
Calculate the overhead absorbed by one unit of Product X, which takes 2 machine hours in Machining and 2 direct labour hours in Assembly.

Allocation, apportionment and absorption

(1) Allocation, apportionment and reapportionment

Overhead	Basis	Total $	Machining $	Assembly $	Stores $
Indirect wages	Allocated	60,000	30,000	20,000	10,000
Factory rent	Floor area 4 : 3 : 1	40,000	20,000	15,000	5,000
Machinery insurance	Machinery cost 5 : 1 : —	12,000	10,000	2,000	—
		112,000	60,000	37,000	15,000
Reapportion Stores	Requisitions 3 : 1	—	11,250	3,750	(15,000)
Total overhead		112,000	71,250	40,750	—

Workings.

Rent: floor area totals 8,000 m². Machining 4,000/8,000 × $40,000 = $20,000; Assembly 3,000/8,000 × $40,000 = $15,000; Stores 1,000/8,000 × $40,000 = $5,000.
Machinery insurance: machinery cost totals $600,000. Machining 500/600 × $12,000 = $10,000; Assembly 100/600 × $12,000 = $2,000. Stores has no machinery, so it takes none.
Stores reapportionment: 4,000 requisitions in total. Machining 3,000/4,000 × $15,000 = $11,250; Assembly 1,000/4,000 × $15,000 = $3,750.

Check: $71,250 + $40,750 = $112,000, the total budgeted overhead. Every apportionment must cast back to the total, and checking that it does is the fastest way to catch an error.

(2) The absorption rates

	Machining	Assembly
Total overhead	$71,250	$40,750
Basis	25,000 machine hours	25,000 labour hours
Absorption rate	$2.85 per machine hour	$1.63 per labour hour

Machining absorbs on machine hours because it is machine-intensive; Assembly absorbs on labour hours because it is labour-intensive. Using labour hours in Machining would charge $71,250 over 3,000 hours — $23.75 an hour — and would load the overhead onto whichever product happened to need a person standing beside the machine.

(3) Overhead absorbed by one unit of Product X

Machining 2 hrs × $2.85	5.70
Assembly 2 hrs × $1.63	3.26
Overhead absorbed per unit	8.96

Adding the direct materials and direct labour of Product X to that $8.96 gives its full production cost — the cost card of chapter 2 §5, completed.

3.3 Absorption costing in one line

Full production cost = Direct materials + Direct labour + Direct expenses + Absorbed production overhead

3.4 Over- and under-absorption

Because the rate is predetermined, the overhead absorbed into production during the period will differ from the overhead actually incurred. The difference is written off to profit for the period; it is not carried in inventory.

Over-absorption — more was absorbed than incurred. Costs have been overstated, so the adjustment increases profit.
Under-absorption — less was absorbed than incurred. Costs have been understated, so the adjustment reduces profit.

There are only two things that can cause it, and separating them is what chapter 9's fixed production overhead variances do:

Cause	Measured as
Actual overhead differed from budgeted overhead	Actual overhead − budgeted overhead (the expenditure difference)
Actual activity differed from budgeted activity	(Actual activity − budgeted activity) × the absorption rate (the volume difference)

Over- and under-absorption

Continuing Example 2. The Machining cost centre budgeted overhead of $71,250 and 25,000 machine hours, giving an absorption rate of $2.85 per machine hour.

In the period, Machining actually worked 24,000 machine hours and actually incurred overhead of $70,000.

Required:

Calculate the over- or under-absorption of overhead.
Analyse it between its two causes.
State how it is treated in the profit statement.

Over- and under-absorption

(1) The over- or under-absorption

Overhead absorbed (24,000 hrs × $2.85)	68,400
Overhead incurred	70,000
Under-absorbed	1,600

Less was absorbed than was incurred, so the period's costs have been understated by $1,600.

(2) The two causes

	$
Expenditure: actual $70,000 against budget $71,250	1,250	Favourable — less was spent than planned
Volume: (24,000 − 25,000) hrs × $2.85	(2,850)	Adverse — the hours to absorb the overhead over were not worked
Net under-absorption	(1,600)

The volume effect dominates, and that is the usual pattern: an absorption rate is only right at the activity level it was set for, which is the objection chapter 2 §4.2 raises against any “fixed cost per unit”.

(3) Treatment

The $1,600 is charged as an additional expense in the period's profit statement. It is not added to the value of inventory: inventory is measured at the standard absorbed cost, and the under-absorption is a period cost. Over-absorption is credited in the same way.

Chapter 9 re-derives exactly these two figures as the fixed production overhead expenditure variance and the fixed production overhead volume variance. They are the same arithmetic under another name.

4 Features of absorption costing

A share of production overhead is included in the product cost, so the result is a full production cost per unit.
It is the acceptable method of inventory valuation in the financial statements, under IAS 2.
Overheads are allocated, apportioned and then absorbed, in the sequence set out in section 3.
It suits mass-produced, homogeneous products where overhead is largely driven by volume.
Fixed production overhead is treated as a product cost — it attaches to the unit and stays in inventory until the unit is sold.

4.1 Strengths and weaknesses of absorption costing

Strengths	Weaknesses
It is required for inventory valuation in the financial statements, so the organisation does not have to keep two different values for the same inventory.	The absorption rate depends on an assumed level of activity. If actual activity differs, overhead is over- or under-absorbed (section 3.4) and the unit cost was never right.
A price set on a full cost recovers the fixed overheads. A price set on a marginal cost does not, and in the long run every cost has to be recovered.	Apportionment bases are conventions, not causes. A share of factory rent is not a cost the unit caused, so a full cost can be precise and still misleading.
Fixed production overhead is a real cost of making the product. Leaving it out understates what production costs.	Reported profit rises when production exceeds sales, so it can be increased by making units nobody has ordered — the mechanism chapter 1 §8 treats as an ethics question.
Where production and sales are seasonal, matching production cost to the period of sale avoids reporting a loss in every month that builds inventory.	It is the wrong basis for a short-term decision, because it charges the unit with costs that will not change if the decision goes the other way (chapter 14).

5 Features of marginal costing

Only variable costs are included in the product cost.
Fixed overheads are treated as period costs — charged in full against the profit of the period in which they arise, and never carried in inventory.
The focus is on contribution, which is not distorted by how overhead has been apportioned or by how many units were produced.
It is most useful for internal, short-term decision-making, and for any question in which the level of activity changes.

Contribution

Contribution = selling price − variable cost. It is what each unit contributes towards covering the fixed costs and, once those are covered, towards profit.

It is the single most reused idea in P1. Chapter 5 ranks products by contribution per unit of the scarce resource; chapter 8 maximises total contribution under constraints; chapters 9 and 10 reconcile budgeted to actual contribution; chapter 15 divides fixed costs by contribution to find the break-even point.

5.1 Strengths and weaknesses of marginal costing

Strengths	Weaknesses
Contribution per unit is constant, so the effect of a change in activity can be computed in one line. This is what makes CVP, limiting factor analysis and relevant costing workable.	It is not acceptable for inventory valuation in the financial statements, so a separate absorption-based value has to be produced for external reporting.
Profit moves with sales, not with production, so it cannot be flattered by building inventory.	Inventory is measured below the cost of making the goods, which understates the asset and brings all the fixed cost into the current period.
No arbitrary apportionment of fixed overhead is needed, so no part of the unit cost is a convention.	A price set on marginal cost alone recovers nothing towards the fixed overheads. Used for anything but a one-off order with spare capacity, it destroys profit.
It is simpler, and the fixed cost is shown as one figure where management can see and control it.	The split between fixed and variable is itself an estimate and rests on the linear assumption within a relevant range (chapter 2 §4.3).

6 The two profit statements compared

The two methods lay a profit statement out differently, and the difference is not presentational — it is where the fixed production overhead sits.

Absorption costing	Marginal costing
Revenue	Revenue
Less cost of sales at FULL production cost (opening inventory + production − closing inventory)	Less variable cost of sales at MARGINAL cost (opening inventory + production − closing inventory)
Less any under-absorption / plus any over-absorption	= CONTRIBUTION
= Gross profit	Less fixed production overhead INCURRED, in full
Less non-production costs	Less non-production costs
= Profit	= Profit

Inventory is valued at the full production cost in the first and at the marginal cost in the second. Everything else follows from that.

7 Reconciling the two profits

Absorption and marginal costing report different profits in the short term, because inventory either does or does not carry a charge for fixed overhead.

When production in the period is not equal to sales — that is, when inventory rises or falls — the two profits differ. When production equals sales, they are the same.

Absorption profit − Marginal profit = Change in inventory units × Fixed overhead absorption rate

SIAM

When Stocks Increase, Absorption profit is More.

And the other way round: when inventory falls, marginal costing gives the higher profit, because the fixed overhead carried forward in last period's inventory is released into this period's cost of sales under absorption costing.

Reconciling absorption and marginal profit

Sales in the period were 12,000 units.

Production volume was 13,500 units.

Selling price $150 per unit.

Variable costs $65 per unit.

Fixed production costs $30 per unit.

The company uses a marginal costing system.

Required: calculate the difference in reported profit if absorption costing were used instead.

Reconciling absorption and marginal profit

The short answer, which is all the question asks for

Production (13,500) exceeds sales (12,000), so inventory has increased by 1,500 units. By SIAM, absorption costing reports the higher profit. The adjustment is the change in inventory multiplied by the fixed overhead absorption rate:

(13,500 − 12,000) × $30 = $45,000

Absorption costing profit is $45,000 higher than the marginal costing profit reported for the period.

The selling price and the variable cost are not needed for this. They are there as distracters — and note that “fixed production cost per unit” is simply another name for the fixed overhead absorption rate.

Why it works — the two full statements

Assuming no opening inventory, and that the $30 rate was set on the level of output actually achieved, so that there is no over- or under-absorption:

Absorption costing	$	$
Revenue 12,000 × $150		1,800,000
Cost of production 13,500 × $95	1,282,500
Less closing inventory 1,500 × $95	(142,500)
Cost of sales		(1,140,000)
Profit		660,000

Marginal costing	$	$
Revenue 12,000 × $150		1,800,000
Variable cost of production 13,500 × $65	877,500
Less closing inventory 1,500 × $65	(97,500)
Variable cost of sales		(780,000)
Contribution		1,020,000
Fixed production overhead 13,500 × $30		(405,000)
Profit		615,000

$660,000 − $615,000 = $45,000, which is the same answer by a much longer route. The whole of the difference is the fixed overhead sitting inside the closing inventory: 1,500 units are valued at $95 rather than $65, and 1,500 × $30 = $45,000.

Do not work the full statements in the exam if only the difference is asked for. They are here because seeing the two side by side is the only way to be sure why the rule works.

One assumption worth naming. The question gives a fixed production cost per unit and no total, so the fixed overhead for the period is taken as 13,500 × $30 = $405,000. If output had differed from the level the $30 rate was set on, there would be an over- or under-absorption (section 3.4) and the absorption profit would change — but the $45,000 difference between the two profits would not.

8 Which method, and when

The question being asked	Method	Because
What is the closing inventory worth in the financial statements?	Absorption	A full production cost is required (IAS 2)
What profit did we make, for external reporting?	Absorption	It follows from the inventory valuation
Should we accept this order at this price?	Marginal	Only the costs that change are relevant; fixed overhead does not
Which product should we make first when a material is short?	Marginal	Contribution per unit of the scarce resource ranks them (chapter 5)
How many units must we sell to break even?	Marginal	Fixed costs ÷ contribution per unit (chapter 15)
What long-run list price recovers all our costs?	Absorption	Everything has to be recovered eventually

Neither method is more correct than the other. They answer different questions, which is chapter 1's point about the rationales for costing made concrete. What is always wrong is using a full absorption cost to take a short-term decision, and using a marginal cost to set a long-run price.

9 Test your knowledge

Two quick checks before you move on: work through the flashcards to fix this chapter’s key terms and definitions, then sit the objective questions for exam-style practice. Both mark themselves and explain the answers as you go.

Answer the questions one at a time. Your progress is saved so you can leave and come back.

Open chapter practice