Cost accounting Overheads

Learning objectives Calculate under-/over-absorption Understand the principles of overhead apportionment and absorption and common bases used Calculate under-/over-absorption Explain what is meant by Variable (Marginal) Costing and Contribution Understand the differences between Variable (Marginal) and Absorption Costing Calculate stock valuations using Variable or Absorption Costing

Learning objective 1 Understand the principles of overhead apportionment and absorption and common bases used

Cost Centre A production or service location, function, activity or item of equipment for which costs are accumulated.

Cost Allocation To assign a whole item of cost, or of revenue, to a single cost unit, centre, account or time period

Overhead apportionment is defined as: To spread revenues or costs over two or more cost units, centres, accounts or time periods. This may also be referred to as ‘indirect allocation’. CIMA Official Terminology

Overhead absorption This is the process by which overheads are included in the total cost of a product. “The charging of overheads to cost units by means of rates separately calculated for each cost centre, in most cases the rates are pre-determined.” (CIMA)

Bases of absorption Direct labour hour Direct labour cost Direct materials Machine hours Prime cost Cost unit OAR = Overhead for period Absorption base

Calculate under-/over-absorption Learning objective 2 Calculate under-/over-absorption

Predetermined absorption rates Predetermined OAR for cost centre = Budgeted total overheads for cost centre Budgeted total no. of units of absorption base Reason: actual overheads and actual number of base units not known until end of period. Therefore, overheads are absorbed - into actual production - at predetermined OAR - throughout accounting period

Under or Over Absorption If,  Overheads absorbed > actual overheads = over absorption  Overheads absorbed < actual overheads = under absorption

Under or Over Absorption Note: it is actual costs and overheads which determine final profit. Therefore, Actual DM + Actual DL + absorbed overheads = Calculated production cost +(-) under-absorbed/over-absorbed overhead = Total production cost

Non-production overheads Overhead Absorption base(s) Selling and marketing Sales value or Production cost Research and development Production cost or Conversion cost or Added value Distribution Production cost or Sales value Administration Production cost or Conversion cost or Added value Added value = sales value – cost of bought out materials and services

Explain what is meant by Variable (Marginal) Costing and Contribution Learning objective 3 Explain what is meant by Variable (Marginal) Costing and Contribution

Marginal Costing ‘A cost accounting method which assigns only variable costs to cost units while fixed costs are written off as period costs’ (Terminology.) Variable costing is another name of marginal costing. The marginal cost of a product –“ is its variable cost”. This is normally taken to be; direct labour, direct material, direct expenses and the variable part of overheads.

Contribution Contribution is the difference between the sales and the marginal cost of sales. It contributes towards fixed expenses and profit. Contribution margin = Sales - Variable Expenses Revenue (per product) - Variable Costs (per product) = Contribution (per product) Total Contribution - Total Fixed Costs = Total Profit or (Total Loss)

Uses of Variable Costing As a basis of providing information to management for planning and decision making Routine cost accounting system for the calculation of costs and valuation of stocks

Example 1 In a period, 20,000 units of Z were produced and sold. Costs and revenues were: $ Sales 100,000 Production costs: Variable 35,000 Fixed 15,000 Admin & Selling overheads: Fixed 25,000 Prepare operating statements based on both Absorption and Variable Costing.

Solution Operating Statement Absorption Costing Approach $ Sales 100,000 Less Production Cost of Sales 50,000 = Gross Profit 50,000 Less Admin. + selling overheads 25,000 = Net profit 25,000

Solution Operating Statement Variable Costing Approach $ Sales 100,000 Less Variable cost 35,000 = Contribution 65,000 Less Fixed costs production 15,000 Admin. S&D 25,000 40,000 = Net profit 25,000

Solution Operating Statement Absorption Costing Approach $ $ $ $ Sales (18,000 x $5 90,000 Less Production Cost of Sales 50,000 - Closing stock (2,000 x $2.50) 5,000 45,000 = Gross Profit 45,000 Less Admin. + selling overheads 25,000 = Net profit 20,000

Understand the differences between Variable and Absorption Costing Learning objective 4 Understand the differences between Variable and Absorption Costing

Differences Variable costing only takes into account variable costs (including variable overheads) Variable costing treats fixed factory overheads as period costs Absorption costing absorbs both fixed and variable factory overheads into the total cost of production Closing stock figure excludes fixed overheads under variable costing but includes them under absorption costing Operating statements under the absorption approach do not distinguish between fixed and variable elements

Use Absorption costing is the basis of all financial accounting statements Variable costing is simple to operate for routine cost accounting

Learning objective 5 Calculate stock valuations using Marginal or Absorption Costing

Stocks and Variable Costing Where you have opening and closing stock figures, the operating statements will produce different net profits This is because absorption and marginal costing differ in their valuation of stock

Example 2 Use same data as in Example 1, except that only 18,000 of the 20,000 units produced were sold, 2000 units being carried forward as stock to the next period. The operating statements will be as follows:

Solution Operating Statement Absorption Costing Approach $ $ Sales (18,000 x $5 90,000 Less Production Cost of Sales 50,000 - Closing stock (2,000 x $2.50) 5,000 45,000 = Gross Profit 45,000 Less Admin. + selling overheads 25,000 = Net profit 20,000

Solution Operating Statement Variable Costing Approach $ $ Sales 90,000 Less Variable cost 35,000 - Closing stock (2,000 x $1.75) 3,500 31,500 = Contribution 58,500 Less Fixed costs production 15,000 Admin. S&D 25,000 40,000 = Net profit 18,500

Workings Absorption Costing average production cost (including fixed costs) = $50,000 20,000 = $2.50 Variable Costing variable costs only = $35,000 = $1.75

Overheads and Marginal/ Absorption Costing End of session 5