Accounting for Overheads – Marginal Costing and Total Absorption Costing

1 Introduction

This is a key chapter as it looks at two approaches to calculating profits: marginal costing and total absorption costing. Marginal costing accounts for only variable costs in the cost of production. Total absorption cost tries to take all production costs into account.

Different profits are likely to be calculated under each method.

2 Profit statements and their preparation in absorption and marginal costing formats

Some definitions:

Marginal cost (MC):   the additional cost caused when one more unit is made. Marginal cost will be the sum of all variable costs per unit.

Total absorption cost (TAC):   the total cost of manufacturing a unit. This is the sum of the marginal cost and a fair share of the fixed production costs.

Fixed overhead absorption rate:   budgeted fixed production costs divided by budgeted output in units.

Profit per unit:   selling price per unit less total absorption cost per unit ie less marginal costs and all fixed production costs.

Contribution per unit:   selling price per unit less marginal cost per unit

Here is a cost card showing selling price and costs per unit:

Note:

Total absorption cost per unit = $65 ($40 marginal cost + $25 fixed cost per unit)

Let us say that in a month, 1000 units were made and 900 of those were sold. This means that there must be 100 items left in inventory. The profit can be calculated in two ways.

Marginal cost (MC) approach

Note:

1.   Under marginal costing closing inventory is valued at its marginal cost

2.   All fixed costs are deducted as a lump sum, sometimes referred to as a period cost.

Total absorption cost (TAC) approach

Note:

1.   Under TAC closing inventory is valued at its total absorption cost

Fixed costs are accounted for in the total absorption cost of sales.

Commentary on the two methods of calculating profits

You will see that the two profits are different, with TAC profits of $31,500 and MC profits of 29,000, i.e. TAC profits are $2,500 greater.

This difference can be reconciled to the difference in closing inventory valuation. In TAC, the closing inventory of $6,500 contains some fixed costs ($6,500 = 100 x ($40 + $25)). These will be accounted for in the next period when those items are sold. In the MC approach all fixed costs are deducted in the period.

The reconciliation

Set the reconciliation out properly and you will get the mark every time. The only difference between the two profits is the fixed production overhead sitting inside the change in inventory.

The rule behind it is short. If inventory increases, absorption profit is the higher, because fixed overhead has been carried forward into next period instead of charged this period. If inventory falls, marginal profit is the higher. If inventory does not change, the two profits are identical.

Note the difference here is $2,500 — the 100 units left in inventory at the $25 fixed overhead per unit.

Both methods are correct. It’s simply if inventories are valued differently then profits will be different.

Commentary on the two methods of calculating the cost of production

Marginal cost: each unit causes $40 additional costs and when sold will generate $100 additional revenue. The contribution of $60 means that each unit makes the company $60 richer. It would even be worthwhile making for $40 MC and selling as low as $41 as that would generate a small contribution. Marginal cost is therefore good for decision making.

However, because MC does not take into account all production costs, it can be argued that the cost of production and the value of inventory is understated.

Total absorption cost: each unit costs $65 to produce, but each unit does not cause an extra $65 as fixed costs are fixed. Despite a TAC of $65 it would still be worth selling units at $50, so TAC can be bad for decision making.

However, all production costs are taken into account and arguably TAC is better for inventory valuation.

Either methods can be used in internal cost accounting, but for external reporting in the financial statements TAC has to be used for inventory valuation.

3 Cost allocation and cost apportionment

Marginal costs are relatively easy to account for because the cost caused by each additional unit can be measured. However, fixed costs do not increase with each extra unit made. The best that can be done to take these production costs into account is to spread them, as fairly as possible into the cost per unit.

The simplest way to work out an absorption rate is to calculate:

Typically as units are produced they pass through a number of departments such as component manufacturing, assembly, finishing and testing. The first challenge is to calculate the fixed production costs relating to each production department.

There are two general ways in which costs can be traced to or identified with production departments:

Cost allocation:   where the whole of a cost can be traced to a single department.

Cost apportionment:   where a cost has to be divided over several departments.

Cost allocation occurs when it is obvious that all of the cost relates to a single department. For example, assembly might take place in a building which receives a separate rent invoice; all of the rent would be allocated to assembly.

Cost apportionment would have to be carried out if a rent invoice were received for the whole business, so relating to all manufacturing departments. Apportionments (dividing-up the total cost) are done on a common sense basis. For example:

Heating costs   apportioned on the basis of floor area

Insurance of machines   apportioned on the basis of machine value

Rent   apportioned on the basis of floor area

Canteen costs   apportioned on the basis of the number of people employed.

Once the amounts are apportioned the cost in each department will be:

4 Secondary apportionment

The canteen is a production-related cost because it is used to provide meals to the workforce. It is known as a service department. However, units being produced spend time only in the preparation and assembly departments. Therefore, to account for canteen costs they must be re-apportioned into the preparation and assembly departments (secondary apportionment).

This will be done on the basis of the number of employees in each of those departments ie 8:6

5 Absorption rates

The costs now have to be traced into (or charged) to items being produced. If there is only one type of item being produced then the costs per item would simply be the total costs spread over the items. This would be known as a fixed overhead absorption rate per unit.

However, often a mix of items is produced, and the normal approach is to charge overheads on the basis of the amount of time that the items spend in each department. It is assumed that there is a correlation between spending time in a department and benefitting from what goes on there.

The time can be estimated using:

• Labour hours:   this will give a fixed overhead absorption rate per labour hour
  

• Machine hours:   this will give a fixed overhead absorption rate per machine hour
  

• Assume the following;
  

Machine hours basis

Budgeted machine hours in the preparation department

  10,000 x 2 + 6,000 x 3 = 38,000

Budgeted machine hours in the assembly department

  10,000 x 1 + 6,000 x 1 = 16,000

Fixed overhead absorption rate per machine hour in the preparation department

  = 61,494 [the apportioned costs]/38,000 = $1.62/hour

Fixed overhead absorption rate per machine hour in the assembly department

  = 40,906 [the apportioned costs]/16,000 = $2.56/hour

Fixed overheads charged to Product A:

  Preparation 2 x 1.62 + Assembly 1 x 2.56 = $5.80

Fixed overheads charged to Product B

  Preparation 3 x 1.62 + Assembly 1 x 2.56 = $7.42

6 More on service department costs: reciprocal services

It can happen that one service department provides services for another service department as well as for production departments. For example, the factory canteen will provide meals to maintenance department staff as well as to production department workers. Also, the maintenance department might spend some time servicing and repairing machinery in the canteen.

There are a number of ways of dealing with these reciprocal service costs, but you need to know only two for this syllabus:

Direct apportionment:   this approach completely ignores inter-service department costs transfers. Because inter-service relationships are usually relatively minor and there are some arbitrary choices to make on initial apportionment (heating could be apportioned on floor area, volume of buildings or the number of radiators), this rough and ready approach is almost certainly good enough.

Step down method:   this approach starts with one service department and apportions its costs to production departments and other service departments. Another service department is then reapportioned to production departments and remaining service departments: no costs will ever be apportioned back into a service centre once it has been cleared out of costs.

7 More on the process of cost absorption for indirect costs

The illustrations above showed how:

1.   Fixed overheads are allocated or apportioned into production departments

2.   An overhead absorption rate is calculated (usually per labour hour or per machine hour)

3.   Overheads will be charged back to production using the same basis as used to work out the absorption rate.

It is important to understand that overhead absorption rates are calculated in advance on the basis of budgeted costs and budgeted output because a rate is needed from the very start of the period and only budgeted amounts will be known then.

The predetermined absorption rate is then never adjusted retrospectively.

Actual and pre-determined rates compared

In principle you could wait until the end of the period, take the fixed overheads that were actually incurred and the output that was actually produced, and divide one by the other. That is an actual absorption rate, and its merit is accuracy: every unit carries its true share of the cost, and no over or under absorption can ever arise.

The trouble is timing and volatility. The rate is not available until the period is over, so the business cannot cost a job, quote a price or value work in progress during the period — which is exactly when it needs to. And because fixed overheads stay much the same while output moves about, the rate lurches from month to month: a quiet month makes every unit look expensive and a busy month makes the same unit look cheap, though nothing about the product has changed.

A pre-determined rate, calculated in advance from the budget, is available on day one and stays constant all year, so costs and quotations are comparable across the period. The price of that is that it will almost never be exactly right, and an over or under absorption has to be dealt with at the end of the period. In practice almost every business accepts that trade-off and uses a pre-determined rate.

This will usually mean that the actual fixed costs are not properly accounted for and that a final adjustment is needed in respect of:

• Under-absorption   where not enough fixed costs have been accounted for.
  

• Over-absorption   where too many fixed costs have been accounted for.
  

The double entry

Production overheads pass through a production overhead control account. Overheads actually incurred are debited to it as they are paid or accrued; overheads absorbed into production are credited out of it into work in progress at the pre-determined rate. Whatever is left on the account at the end of the period is the over or under absorption, and it is transferred to the statement of profit or loss.

An under absorption is a debit in the statement of profit or loss — a further cost, because not enough overhead was charged to production. An over absorption is a credit, because too much was charged.

Why the absorption went wrong

A single figure of $14,000 does not tell management anything they can act on, so split it into its two causes.

Read that way the report is useful. Output was better than planned and helped by $6,000; the whole of the problem is that overheads cost $20,000 more than they were budgeted to, and that is the figure to go and investigate.

8 Non-production overheads

Administration, selling and distribution costs are never absorbed into the value of inventory — accounting standards do not permit it. But a business still needs to know the full cost of a unit when it is setting a price, because a price that covers only production cost will not keep the head office open.

There is no single right way to attribute them, so a simple, defensible basis is chosen. The three you should know are a percentage of production cost, a percentage of sales value, and a rate per unit sold. Distribution costs are often attributed on a different basis again, such as weight or delivery distance, because that is what actually drives them.

The same $150,000 recovered as a percentage of a budgeted sales value of $750,000 would give a rate of 20% of selling price instead, and a different answer per unit. That is worth remembering: the total recovered is the same, but which products look profitable depends on the basis you pick, so choose the one that best reflects what causes the cost.