In cost allocation 2, we will be discussing two conventional costing systems; variable

costing and absorption costing. Also we will be discussing the allocation of the joint
product cost using various methods.

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Before we continue with the discussion, we’ll quickly recap on the major points that
we discussed in unit 3. In unit 3, we discussed some of the basic principles of cost
allocation. Direct costs are traced to the cost traced to the cost object, while indirect
MOH costs are allocated to the cost object using some appropriate allocation base.
We also discussed two conventional rates to allocate MOH; that is the plantwide rate
and the departmental rates. We also discussed the allocation of support department
costs to other support and production departments based on their consumption
proportion using the direct, step-down and reciprocal methods.

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Variable and absorption costing are two traditional costing system, which assumes
that cost is driven by the changes in volume of production. Joint product costs that
are allocated to the different joint products is not useful for making decisions such as
deciding to sell at the split-off point or to process further. Joint costs however is
useful for calculating the cost of the joint product, which will eventually be recorded
as COGS when the product is sold.

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After studying this unit, you should be able to achieve the following LOs. These LOs
are also provided in the study organizer so please take sometime to go over them
while studying the unit and when you have completed the unit, revisit these LOs
again to see if you can be able to do what is being required by these LOs.

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As can be seen, the cost per unit under variable costing is lower than the cost per unit
under the absorption cost per unit because absorption costing includes one extra cost
as a product cost. That is the FMOH cost. Therefore, the major difference in
calculating the product cost under the variable and absorption costing system is the
treatment of the FMOH cost. Under variable costing, FMOH is a period cost, which
means that the full cost will be expensed as soon as it is incurred in a particular
period. Under absorption costing system however, FMOH is part of a product cost.
Therefore, this cost is only expensed when a product is sold. So in case where some
of the products are unsold, part of the FMOH cost in these unsold products will be
carried forward into the future as inventoriable cost. These costs will be expensed in
the future when these products are sold. Therefore, in summary, the major difference
between the variable costing and the absorption costing is the timing of expensing
the FMOH cost.

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In calculating profit under the two costing system, the variable costing system follows
a contribution margin method. That is under variable costing, the costs are
differentiated between variable and fixed; whether the costs are manufacturing or
non-manufacturing. In other words, all the variable costs; whether manufacturing or
non-manufacturing are deducted first to calculate the contribution margin, then all
the fixed costs, whether manufacturing or non-manufacturing are deducted from the
contribution margin to calculate the net profit.

Under absorption costing, profit is calculated using the gross margin method. Hence,
the costs are differentiated between manufacturing and non-manufacturing cost;
whether they are variable or fixed. So in calculating the gross margin, all the
manufacturing costs, whether fixed or variable are deducted from the sales. After
calculating the gross margin, all the non-manufacturing costs, whether variable or
fixed are deducted from the gross margin to calculate the net profit.

COGS can be calculated as:

= Opening inventory + current productions – ending inventory
OR
= Pre-determined FMOH unit cost* x Units Sold.

*Pre-determined FMOH unit cost = Budgeted FMOH ÷ Units produced

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The difference in product costs implies differences in profits. From our earlier
discussion, we establish the fact that the timing of expensing the FMOH is the major
difference between the two costing systems.
Therefore, in reconciling the difference in profit, there are three scenarios to
consider.
1.When units produced is equal to unit sold. In this case, since all the products are
sold, the total FMOH cost that is inventoried under absorption costing will be
expensed. Under variable all the FMOH incurred to produce the product will also be
expensed in the same period. Profit will be the same.
2.When units produced is more than units sold. In this case the variable costing will
expense the full amount of FMOH, while under absorption, only the portion of FMOH
that is related to the units sold will be expensed. Since the FMOH cost expensed
under absorption is less than the FMOH cost expensed under variable, absorption
profit will be greater than variable profit.
3.When units produced are less than units sold. This situation is only possible due to
the carrying forward of unsold units from the previous period to the future period. So
if more units are sold, the portion of FMOH expensed under absorption will be more
than under variable, resulting in a higher profit under variable.

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Longer Method:
In the first part of the reconciliation is the difference in the COGS, starting with the COGS
under absorption. In the second part of the reconciliation is the difference in profit; starting
with the profit under variable.
COGS – Absorption
Less COGS – Variable
Diff in COGS
Less FMOH expensed under variable
TOTAL DIFFERENCE
Profit – Variable
Less Profit – Absorption
TOTAL DIFFERENCE
Shorter Method:

Diff. in FMOH Change in Predetermined

Expensed under = inventory x FMOH rate per
Absorption & (in units) unit
Variable costing

The change in inventory in units is the change between the units produced and units sold. If
production units is equal to sales unit then the change will be zero; if production unit is
greater than the sales unit, then there will be an increase; and if production unit is less than
sales unit, there will be a decrease. The predetermined FMOH rate is calculated using the
formula discussed in unit 3; that is budgeted FMOH cost ÷ budgeted qty. of the cost driver.

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Joint costs are all the manufacturing costs of producing a joint product , which is two
or more products that are produced simultaneously in one production process.

Examples of joint products in:

• Oil refining industry are – petroleum, LPG, and kerosene
•Chicken processing industry – drumsticks, wings, breasts
•Timber processing industry – timber, wood chips

As per the introduction, the total joint product cost is only useful for calculating
inventory cost, which will be included in the COGS when the goods are sold. It is not
used for deciding whether to sell the joint product at the split-off point or process
further. Only the incremental revenues and costs are useful for deciding whether to
sell the joint product at the split-off point or to process it further.

When producing joint products, the existence of by-products is sometimes inevitable.

These are joint products that has little value compared to the major joint products. In
allocating joint product costs to the main joint products, the common practice is to
subtract its net realisable value from the cost of the joint process. Then the remaining
joint process cost is allocated to the major joint products. An alternative method is to
value the by-product at its sales value at the split-off point and deduct from total
production cost of the main joint products.

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There are four methods of allocating joint product cost using proportions.
1.Physical units method – uses some physical characteristic (e.g. weight) to allocate
joint cost.

2. Relative sales value method – uses the relative sales value of the final product (that
is sales value of units produced) at the split-off point to allocate joint cost.

3. Constant gross margin method – allocates joint cost so that the gross margin of
each product is identical.

4. Net realisable value method – allocates joint cost using the net realisable value of
the final product (that is the units produced not sold)

All the methods of allocating joint production process are arbitrary therefore there is
no one correct way . The choice of method depends on managers and the cost and
benefit analysis.

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In unit 4 we discussed that the major difference between the variable and absorption
costing system is the timing of expensing the FMOH. That is, both systems will
expense the same amount of FMOH cost, but in different time frames. Under variable
costing the FMOH is a period cost therefore it is expensed in full as it is incurred,
while under absorption costing, the FMOH is only expensed when goods are sold. The
unsold goods carried forward the FMOH cost that will be expensed in the future
period when the goods will be sold.

Joint product costs are irrelevant for deciding whether to sell the joint product at a
split-off point or to process it further. It is only used for costing the inventory, which
will be transferred to the COGS when the inventory is sold.

There are various methods of allocating joint product costs. However, not one
method is superior over the others. They are all arbitrary methods.

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