1. Cost accounting
Overheads

2. 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

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

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

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

6. 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

7. 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)

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

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

10. 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

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

12. 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

13. 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

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

15. 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.

16. 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)

17. 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

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

19. 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

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

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

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

23. 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

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

25. Learning objective 5
Calculate stock valuations using Marginal or Absorption Costing

26. 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

27. 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:

28. 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

29. 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

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

31. Overheads and Marginal/ Absorption Costing
End of session 5