ACC 222 TOPIC 5 Alternative Costing Methods

MZUMBE UNIVERSITY
SCHOOL OF BUSINESS
ACC 222: COSTINGGEMENT TOPIC 5
ACCOUNTING II
ALTERNATIVE PRODUCT
DR. ERASMUS F. KIPESHA
COSTING METHODS
PhD. (Fin Mgt),MBA(Finance),BAF, CPA(T)
Email: elkipesha@mzumbe.ac.tz
Mobile:+255713833337
Introduction
The cost of manufacturing product can be
Introduction
classified on the basis of behavior or function. Recall:
Basing on behavior costs can be divided into • Product costs are the costs of obtaining the
variable and fixed costs and asset inventory (stock), they are not charged
Basing on function we have production cost, to income statement until inventory item is
administration costs, distribution costs etc. sold.
Variable costs are the costs which increase or
decrease due to the changes in volume of • Period costs are the costs which are written
activities while fixed costs are not affected by the off through the profit and loss account in the
changes in volume of activities. period in which they occur.
3 4
Dr. Erasmus Kipesha, Mzumbe University- elkipesha@mzumbe.ac.tz Dr. Erasmus Kipesha, Mzumbe University- elkipesha@mzumbe.ac.tz
Introduction Absorption costing

• It is costing system which treats all
They are two alternative ways for product manufacturing costs including both the fixed
costing depending on the basis of cost and variable costs as product costs
classification namely,
1. Absorption costing
2. Marginal costing
5 6
1
Marginal costing Absorption Costing
• It is a costing system which treats only the  Is a product costing method in which all manufacturing
costs (Fixed + Variable) are allocated to products
variable manufacturing costs as product costs.
The fixed manufacturing overheads are
regarded as period cost  Costs are classified on the basis of function.
 Both variable and fixed manufacturing costs are

allocated to units of output and other costs such as
administration cost, selling and distribution costs are
written off in profit and loss account as period costs.
7 8
Absorption costing Advantage of Absorption Costing

The fixed overhead costs are assigned to
products using the appropriate fixed overhead I. It conforms to the matching accounting
absorption rate. principles that is revenue should be matched
with the costs incurred to earn it.
The application of overhead absorption rate
result into over or under absorption of II. It recognize the cost units benefit from both
overhead hence it should be taken into account fixed and variable costs
when preparing income statement. III. It is used for external reporting
Overhead absorption rates = Actual/ budgeted manufacturing overhead cost IV. It does not understate the importance of
Budgeted activity level fixed costs.
9 10
Disadvantages of Absorption Costing Absorption: Income Statement Format

I. Full costing/absorption costing lead to misleading INCOME STATEMENT
Tshs Tshs
conclusion about dropping the product, pricing Sales XXX
decision or shutdown decision since product can be Less cost of good sold
Opening stock XXX
seen unprofitable but in reality it makes higher Add production XXX
Cost goods available XXX
contribution towards recovering fixed costs. Less closing stock XXX
Cost of goods sold XXX
II. It is not possible to determine the effect of Under/over absorption XXX
profitability of each product Gross profit XXX
Less expenses
III. The same data can provide different conclusion due Administrative cost XXX
Advertising XXX
to different denominator used in the computation of Selling and distribution XXX
pre determined overhead rate XXX
Net profit XXX
11 12
2
Absorption Statement Marginal Costing Method
Over absorption means that the overhead Is a product costing method whereby only
charged to production are greater than the variable costs of manufacturing are charged to
actual overhead incurred and this means that units of output and the fixed costs attributable
we need to reduce the cost that have been to the reporting period are written off fully
charged to the P&L a/c. against the contribution for that period.
Under absorption means that insufficient Costs are categorized on the basis of cost
overheads have been charged to production behavior (variable and fixed costs) and the
and this means that the cost of sale figure will attributable fixed costs are allocated to the
have to be increased. particular department.
13 14
Features of Marginal Costing Assumption of Marginal Costing

All element of cost can be divided into fixed and
i. It separates cost into variable and fixed cost at variable costs.
every stage until the product is sold.
The selling price per unit remains unchanged at all
ii. Fixed costs are treated as period cost and levels of activities.
charged to profit and loss account during the Variable cost per unit is constant irrespective of
period in which they are incurred. Fixed costs levels of output and fluctuates directly in
are not carried forward to the next year income. proportion to changes in the volume of output.
iii. It uses contribution approach in which variable Fixed costs remain unchanged or constant for the
costs are deducted from sales to obtain entire volume of production.
contribution margin which is used to cover fixed Volume of production is the only factor which
costs and contributes to profit. influences the costs.
15 16
Marginal costing: Income Statement

Advantages of Marginal Costing Format
Used in decision making such as CVP analysis INCOME STATEMENT
Tshs Tshs
and flexible budget Sales
Less variable production cost of sales
XXX
Is a simple inventory valuation method Opening stock

Add production
XXX
XXX
XXX
Reduce the need for accounting for over or Less closing stock XXX
Variable production cost of sales XXX
under absorption Add other variable costs XXX
Total variable costs XXX
Contribution margin XXX
Less fixed costs
Fixed manufacturing cost XXX
Other fixed costs XXX
XXX
Net profit XXX
17 18
3
Absorption Vs Marginal Costing Overview of Absorption and
The conceptual point of difference between
Variable Costing
marginal and absorption costing is the treatment
Absorption Variable
of fixed manufacturing overheads. Costing Costing
Under absorption costing all production costs Direct Materials
fixed and variable are allotted to cost units hence Direct Labor
Product
all manufacturing cost become product cost. Product Costs
Costs Variable Manufacturing Overhead
While in marginal costing only variable
Fixed Manufacturing Overhead
production cost are charged to cost unit and
Period
fixed cost attributable to relevant period are Period Variable Selling and Administrative Expenses
Costs
written off in full against the contribution for that Costs Fixed Selling and Administrative Expenses
period
19 20
Absorption Vs Marginal Costing

Cost element Absorption Costing Variable Costing Note: Manufacturing Cost Flows
Manufacturing cost
-Variable cost Product cost Product cost Balance Sheet Income
-Fixed cost Product cost Period cost Costs Inventories Statement
Material Purchases Raw Materials Expenses
Non Manufacturing cost
-Variable cost Period cost Period cost Direct Labor
-Fixed cost Period cost Period cost
Work in
Variable Process
Cost classification Basing on function Basing on cost behavior Manufacturing
Overhead
Acceptance for use Accepted for balance sheet Not accepted for balance
Cost of
and valuation for final sheet and final accounts Fixed Finished
accounts preparation Goods
Manufacturing Goods
Overhead Sold
Relevance for decision Not relevant Useful for decision making
making
Selling and Fixed Mfr’g OH
Uses Used for external reporting Used for internal reporting
Administrative Period Costs Selling and
Dr. Erasmus Kipesha, Mzumbe University- elkipesha@mzumbe.ac.tz
21
Administrative
22
Effect of Stock Movement Profit Reconciliation

The conceptual difference between absorption
a) When Production =Sales costing and marginal costing lies in the treatment
Both variable costing and marginal costing will of fixed production overheads
show the same profit To explain the difference in profit shown by the
b) When Production >Sales two approaches consider the fixed overheads
Absorption profit will be grater than Marginal absorbed under absorption method and written
costing profit off in full under Marginal costing
Reconciliation format
c) When Production <Sales
Profit per Absorption costing xxxx
Marginal costing will be higher than Absorption Stock movement xxxx
Fixed overhead absorption rate xx
costing profit Xxxx
Profit per marginal costing xxxx
23 24
4
A company started its business in 2005. The following information
Was available for January to March 2005 for the company that produced
A single product:
Tshs
Selling price pre unit 100
Direct materials per unit 20
Direct Labour per unit 10
Example Fixed factory overhead per month 30000
Variable factory overhead per unit 5
Fixed selling overheads 1000
Variable selling overheads per unit 4
Budgeted activity was expected to be 1000 units each month
Production and sales for each month were as follows:
Jan Feb March
Unit sold 1000 800 1100
Unit produced 1000 1300 900
Prepare Income statements under both Marginal and absorption
26
Wk1: Wk 3:
Standard fixed overhead rate (Under-)/Over-absorption of fixed factory overheads:
= Budgeted total fixed factory overheads January February March
Budgeted number of units produced Tshs Tshs Tshs
Fixed overhead 30000 39000 27000
= Tshs 30000 Fixed overheads incurred 30000 30000 30000
1000 units 0 9000 (3000)
= Tshs 30 units 1000*30 1300*30 900*30
Wk 2:
Production cost per unit under absorption costing:
Wk 4: No fixed factory overhead
Tshs
Direct materials 20 Variable production cost per unit under marginal costing:
Direct labour 10 Tshs
Fixed factory overhead absorbed 30 Direct materials 20
Variable factory overheads 5 Direct labour 10
65 Variable factory overhead 5
27
35 28
Absorption Costing Marginal Costing

January February March January February March
Tshs Tshs Tshs Tshs Tshs Tshs
Sales 100000 80000 110000 Sales 100000 80000 110000
Less: cost of good sold (65) 65000 52000 71500 Less: Variable cost of good
35000 28000 38500 sold (35) 35000 28000 385500
Adjustment for Over-/(under) Product contribution margin 65000 52000 71500
Absorption of factory overhead 0 9000 (3000) Less: Variable selling overhead4000 3200 4400
Gross profit 35000 37000 35500 Total contribution margin 61000 48800 67100
Less: Expenses Less: Fixed Expenses
Fixed selling overheads 1000 1000 1000 Fixed factory overhead 30000 30000 30000
Variable selling overheads 4000 3200 4400 Fixed selling overheads 1000 1000 1000
Net profit 30000 32800 30100 Net profit 30000 17800 36100
29 30
5
Stock Movements Profit Reconciliation
. .
Jan Feb March
Opening Stock 0 0 500
Profit per Absorption 30000 32800 30100
Add: Production 1000 1300 900 OvH movement 0 15000 -6000
Total good available 1000 1300 1400 Profit per Margin 30000 17800 36100
Less Sales 1000 800 1100
Closing Stock 0 500 300
Less opening stock 0 0 500
Stock movement 0 500 (200)
OvH movement 0 15000 (6000)
31 32
End of Chapter 5

ACC 222 TOPIC 5 Alternative Costing Methods

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MZUMBE UNIVERSITY

Introduction Absorption costing

 Both variable and fixed manufacturing costs are

Absorption costing Advantage of Absorption Costing

Disadvantages of Absorption Costing Absorption: Income Statement Format

Features of Marginal Costing Assumption of Marginal Costing

Marginal costing: Income Statement

Is a simple inventory valuation method Opening stock

Absorption Vs Marginal Costing

Effect of Stock Movement Profit Reconciliation

Absorption Costing Marginal Costing

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