CHAPTER 8: MARGINAL & ABSORPTION COSTING

1. CHAPTER OBJECTIVES
Explain the importance of, and apply, the concept of contribution.[S]
Demonstrate and discuss the effect of absorption and marginal costing on
inventory valuation and profit determination.[S]
Calculate profit or loss under absorption and marginal costing.[S]
Reconcile the profits or losses calculated under absorption and marginal
costing.[S]
Describe the advantages and disadvantages of absorption and marginal
costing.[K]

2. CONTENTS
In this chapter, marginal costing and absorption costing are defined and compared
with each other. In general terms, these two are costing methods that are used to
value inventory and cost of goods sold.

The basic difference between the two methods lies in the way we treat fixed
production overheads. Under marginal costing, fixed production overheads are
treated as period costs. Meanwhile, under absorption costing, fixed production
overheads are allocated into the cost of making each unit of output.
Marginal costing is usually applied in making short-term decisions such as one-off
contracts.

2.1 Marginal Costing and contribution

The word “marginal" in marginal costing comes from Latin margo, which means
"edge, brink, border, margin". This etymology highlights the incremental nature of
marginal costing.

The marginal cost of production is the incremental costs required to produce an

extra unit, which equals the total variable cost of the unit. This includes direct
materials, direct labour, direct expenses and variable production overheads.

For inventory valuation, it is important to distinguish the marginal cost of production

and the marginal cost of sale. The marginal cost of sale is the incremental costs
required to produce and sell an extra unit, which equals the marginal cost of
production plus variable selling and distributing cost.

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 The contribution is the sales revenue after marginal/variable product costs have
been paid.

Key formula
Selling price less variable cost = contribution.
The contribution information has a major advantage over profit information in the
decision-making process, that is, from contribution information we can calculate the
potential changes in profit or loss with a change in sales.

EXAMPLE 1
OZONE is a manufacturer supplying Thermometer for hospitals. Given below is the
information about this single product:
$
Sales price 160
Direct materials 60
Direct labour 35
Prime cost 95
Variable production overheads 25
Fixed production overheads 10
Total cost 130

Based on a budgeted normal output of 6,000 units, it has been estimated that fixed
costs would be $60,000. Predicted costs and revenues generated in scenarios of
different sales volumes are as below.
Previous month Current month
Sales of 2,000 Sales of 2,500
thermometers thermometers
$ $
Sales revenue 320,000 400,000
Direct materials 120,000 150,000
Direct labour 70,000 87,500
Prime cost 190,000 235,500
Variable production overheads 50,000 62,500
Marginal cost of production 240,000 300,000
CONTRIBUTION 80,000 100,000
Fixed production overheads 60,000 60,000
Total profit 20,000 40,000
Contribution per unit 40 40
Profit per unit 10 16

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 From the above information, it can be seen that there is an increase in the profit per
unit from $10 when 2000 units are sold to $16 when 2,500 units are sold. This is
due to the increase in all the variable costs (direct materials, direct labour, direct
expenses and variable overheads), while fixed costs are kept stable at $60,000.

Accordingly, we can see that the figure of profit per unit is not particularly insightful
in this case, since it is directly influenced by the number of units being sold. As a
result, the concept of contribution is introduced and widely adopted by management
accountants.

When the number of units produced and the number of units sold changes, profit
per unit changes, while contribution remains constant.

Key formulas
Total contribution = Contribution per unit × Sales volume.
Profit = Total contribution – Fixed overheads.

2.2 Absorption costing

In absorption costing, all production cost should be absorbed into cost units.
Accordingly, the total cost of a unit includes two elements: variable cost per unit
and the proportion of overhead costs that are absorbed into each unit.
Variable cost per unit can be calculated at the start of the period. With overhead
costs, we use the term predetermined overhead absorption rate, which equals
budgeted overhead divided by budgeted activity.

2.3 Standard cost under Marginal Costing (“MC”) and Absorption

Costing (“AC”)

Key terms
Standard cost is the estimated amount of the costs that typically incur in the
process of producing a unit of product.

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 2.3.1 Standard cost under MC

Direct material xx
Direct labour xx
Direct overhead xx
Total variable production cost per unit xx

As a result, the Statement of Profit and Loss (“SOPL”) under MC will be

Sales xx
Less Cost of sales
Opening inventory (*) xx
Variable cost of production xx
Less: Closing inventory (*) xx
xx
Less: variable selling cost, admin cost… xx
Contribution xx
Less: Fixed cost (**) xx
Profit/Loss xx

(*) - valued at marginal cost per unit

(**) - Total fixed cost = fixed production overheads + fixed non-production
overheads

2.3.1 Standard cost under MC

Direct material xx
Direct labour xx
Direct overhead xx
Fixed production overhead xx
Total production cost per unit xx

As a result, the SOPL under AC will be

Sales xx
Less Cost of sales
Opening inventory (*) xx
Variable cost of production xx
Fixed overhead absorbed xx
Less: Closing inventory (*) xx
xx
(under)/over absorption xx
Gross profit
Less: non-production cost xx
Profit/Loss xx

(*) - valued at marginal cost per unit

(**) - Total fixed cost = fixed production overheads + fixed non-production
overheads

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 EXAMPLE 2
HAGL started as a manufacturing business on 1 Jan 2021, with a single product
being made. The cost card of this product is written below:
$
Sales price 15
Direct materials 2
Direct labour 4
Variable production overheads 1
Fixed production overheads 3
Standard cost 5

Based on a monthly budgeted normal output of 12,000 units, it has been calculated
that the fixed production overhead incurred in January was $36,000.

Selling and administrative expenses are as below:

Fixed $3,000 per month
Variable 10% of the sales value
The number of units produced and sold in Jan 2021 was:
- Production 10,000 units
- Sales 9,000 units
The management accounting has been asked to prepare the absorption costing
and marginal costing income statements for Jan 2021.

Solution:
Absorption costing statement of profit or loss – Jan 2021
$ $
Sales revenue 135,000
Less: cost of sales
Opening inventory
Variable cost of production (10,000 x $7) 70,000
Fixed overhead absorbed (10,000 x $3) 30,000
Less closing inventory (1,000 x $10) (10,000) (90,000)
Under absorption (6,000)
Gross profit 39,000
Less: Selling and administration expenses
- Fixed cost 3,000
- Variable cost (10% of sales value) 13,500 (16,500)
Profit 22,500

Marginal costing statement of profit or loss – Jan 2021

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 $ $
Sales revenue 135,000
Less: cost of sales
Opening inventory
Variable cost of production (10,000 x $7) 70,000
Less closing inventory (1,000 x $7) (7,000) (63,000)
Other variable costs (13,500)
Gross profit 58,500
Less: Fixed cost
- Fixed production cost 36,000
- Fixed selling and administration cost 3,000 (39,000)
Profit 19,500

2.4 Profit under MC and AC

As we can see from the previous section, the standard cost per unit calculated
using marginal costing would always be lower than the one calculated using
absorption costing. The inventory value is sometimes different under each method.
But what is the implication of these differences on the difference between profit
calculations using the two methods?

An interesting point to note when explaining this is the way fixed production costs
are treated under each method. Under marginal costing, we treat fixed production
costs as period costs, which are expensed (as cost of goods sold) immediately as
they are incurred. Under absorption costing, fixed production costs are absorbed
into unit production cost at a predetermined overhead absorption rate. These costs
are expensed later when the units are sold. This point helps explain why the
difference in inventory value leads to the difference in profits under different
valuation methods, which is discussed below.

▪ When there is no change in inventory level: All produced products in the

period were sold, therefore all the fixed overheads are expensed, regardless
of the valuation method. As a result, both methods give the same profit.

▪ When there is an increase in inventory levels: The number of products

produced is bigger than the number of products sold. As a result, under
absorption costing, an amount of fixed overheads are not expensed at the
same period and thus carried forward to the next accounting period.
Meanwhile, under marginal costing, all fixed overheads are expensed in the

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 period. Therefore, absorption costing gives the lower cost of goods sold and
higher profit.

▪ When there is a decrease in inventory levels: The number of products

produced is smaller than the number of products sold. As a result, under
absorption costing, an extra amount of fixed overheads are expensed as
costs of goods sold in the same period. Meanwhile, under marginal costing,
only the predetermined amount of fixed overheads are expensed in the
period. Therefore, absorption costing gives a higher cost of goods sold and
lower profit.

EXAMPLE 3
Closing inventory at the end of Jan 2021 shows the difference between the level of
outputs and the level of sales, i.e. 1,000 units (10,000 – 9,000)
According to example 2, the profit for Jan 2021 would be:
Under absorption costing: $22,500
Under marginal costing: $19,500

Difference in profits = $3,000

It can be interpreted that this difference is caused by the fixed overhead held in
inventory, i.e. 1,000 units of inventory ‘holding’ $3 fixed overhead per unit

(or 1,000 × $3 = $3,000 which is the difference between the profit in the profit
statements under the different costing methods for Jan 2021 mentioned above).

In an examinable question, the information of the profit under either marginal or

absorption costing might be provided, and you would be required to estimate the
alternative profit.

There is a quicker approach to profit reconciliation:

Absorption costing profit 22,500

(Opening inventory – Closing inventory) × OAR (0–1,000) × 3 –3,000
Marginal costing profit 19,500

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 EXAMPLE 4
MINH NGUYEN has been launching a product called Lizzy for 1 year. Below are
the recorded accounting information relating to Lizzy
Sales volume 40,000
$
Selling price per unit 10.00
Variable cost per unit
Production 5.50
Selling and administration 1.10
Fixed costs per unit
Production overhead 1.20
The fixed production overhead cost was based on a budget of $60,000.
There are no difference between budgeted and actual fixed production overheads
and production volume. MINH NGUYEN adopts absorption costing
If MINH NGUYEN used marginal rather than absorption costing
The profit will be higher/lower at $_____?

Solution:
If MINH NGUYEN uses marginal rather than absorption costing, the profit will be
$12,000 lower.
Budgeted production = budgeted fixed production overhead / fixed overhead
absorption rate = $60,000/$1.20 = 50,000 units
Opening inventory = 0 (just finished first year of trading)
Closing inventory = opening inventory + production – sales
= 0 + 50,000 – 40,000 = 10,000
Difference between marginal costing and absorption costing =
Change in inventory × fixed overhead absorption rate =
(0 – 10,000) × $1.20 = $12,000
Inventory is increasing therefore marginal profit will be lower

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 2.5 Compare Marginal costing and Absorption costing
Marginal costing
Fixed costs are treated as period
cost and are charged in full to the
period under consideration.
The valuation of closing inventory is
not in compliance with IAS 2.
There is no under or over
absorption of overheads (and
therefore there is no requirement for
adjustment in the statement of profit
or loss).
Marginal costing is more useful in
the decision-making process. Its
contribution information provides
more insights for planning costs and
other tactical decisions.
The method is simple and easy to
use.
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Absorption costing
Fixed costs are absorbed into the cost of
products at a predetermined rate and
expensed when the units are sold. In small
organisations, this is the best way of
estimating job costs and profits on jobs.
Absorption costing includes an element of
fixed
production overheads in inventory values (in
compliance with IAS 2).
Analysing under/over absorption of overheads
is a useful cost controlling practice in an
organisation.
Absorption costing is not as useful in the
decision-making process, especially the short-
term one, because the fixed costs do not
change in the short term.
Instead, absorption costing is more useful for
financial accounting purposes, for routine profit
reporting application.
The method is more complex, requires
advanced skills.
Absorption costing is useful in circumstances
where it is difficult to classify all costs as fixed
or variable, or when variable costs only
contribute a low proportion in total costs.
107
 CHAPTER SUMMARY
- The marginal cost of production is the incremental costs required to produce
an extra unit, which equals the total variable cost of the unit
- The contribution is the sales revenue after marginal/variable product costs
have been paid.
- Selling price less variable cost = contribution.
- The contribution information has a major advantage over profit information in
the decision-making process, that is, from contribution information we can
calculate the potential changes in profit or loss with a change in sales..
- In absorption costing, all production cost should be absorbed into cost units.
Accordingly, the total cost of a unit includes two elements: variable cost per
unit and the proportion of overhead costs that are absorbed into each unit.
- Under marginal costing, we treat fixed production costs as period costs, which
are expensed (as cost of goods sold) immediately as they are incurred. Under
absorption costing, fixed production costs are absorbed into unit production
cost at a predetermined overhead absorption rate. These costs are expensed
later when the units are sold
• When there is no change in inventory level, both methods give the same
profit.
• Different methods would give differ profit if there is any change in the level
of inventories in the period.
- Absorption costing is not as useful in the decision-making process as marginal
costing, especially the short-term one, because the fixed costs do not change
in the short term. Instead, absorption costing is more useful for financial
accounting purposes, for routine profit reporting application

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PRACTICE QUESTION

1. The overhead absorption rate for product Y is $2 per direct labour hour. Required
direct labour hours per unit is 5 hours/ unit. Beginning Inventory of product Y was 200
units and closing inventory was 500 units.
Required: Determine the difference between the profit for the month under absorption
costing and under marginal costing?
A The marginal costing profit would be $3000 less.
B The marginal costing profit would be $3000 greater.
C The marginal costing profit would be $600 greater.
D The marginal costing profit would be $600 greater

2. ZING Co manufactures a single product. The fixed production overheads for the
period are budgeted to be$50,000. The budgeted output for the period amounts to
10000 units. Opening inventory at the start of the period equals 8500 units, closing
inventory at the end of the period equals 6300 units.
ZING Co adopts marginal costing, in which the profit was $500,000.
Required: Calculated the profit for the period under absorption costing:
A $925,000
B $675,000
C $920,000
D $680,000

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ANSWER
1. The correct answer is: The marginal costing profit would be $3000 less
Difference in profit = change in inventory level x fixed overhead per unit
= (200 – 500) × ($2 x 5)
= $3000
The absorption costing profit will be greater because inventories have increased

2.
The correct answer is: $680,000
Units
Opening inventory 8500
Closing inventory 6300
Decrease 2200 × ($50,000/10,000) = $11,000 lower
Profit under absorption costing = $500,000 – $11,000 = $489,000

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 CHAPTER 9: JOB, BATCH, SERVICE AND PROCESS
COSTING

1. CHAPTER OBJECTIVES
Job and batch costing:
▪ Describe the characteristics of job and batch costing.[K]
▪ Describe the situations where the use of job or batch costing would be
appropriate.[K]
▪ Prepare cost records and accounts in job and batch costing situations.[S]
▪ Establish job and batch costs from given information.[S]
Process costing
▪ Describe the characteristics of process costing.[K]
▪ Describe the situations where the use of process costing would be
appropriate.[S]
▪ Explain the concepts of normal and abnormal losses and abnormal gains.[K]
▪ Calculate the cost per unit of process outputs.[S]
▪ Prepare process accounts involving normal and abnormal losses and
abnormal gains.[S]
▪ Calculate and explain the concept of equivalent units.[S]
▪ Apportion process costs between work remaining in-process and transfers
out of a process using the weighted average and FIFO methods.[S]
▪ Prepare process accounts in situations where work remains incomplete.[S]
▪ Prepare process accounts where losses and gains are identified at different
stages of the process.[S]
▪ Distinguish between by-products and joint products.[K]
▪ Value by-products and joint products at the point of separation.[S]
▪ Prepare process accounts in situations where by-products and/or joint
products occur.[S] (Situations involving work-in-process and losses in the
same process are excluded).
Service/operation costing
▪ Identify situations where the use of service/operation costing is
appropriate.[K]
Illustrate suitable unit cost measures that may be used in different
service/operation situations.[S]
▪ Carry out service cost analysis in simple service industry situations.[S]

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2. CONTENTS

2.1. Job and batch costing

2.1.1 Job costing

Job costing is a costing method used to determine the cost of specific jobs, which
are performed according to the customer's order. Accordingly, each job has its
unique price and unique requirements in terms of different amounts and types of
labour (e.g. skilled and unskilled); materials; overheads).
Job costing is appropriate and likely to be used in custom-made industries for the
production of specialized outputs. For example, custom-designed furniture, party
invitations, auditing services, maintenance and repair services and any
goods/services produced one at a time/in small quantity and that is unique to each
need.
Like any other costing method, the objectives of job costing is to identify, assign
and accurately record relevant costs to complete each distinctive order.
▪ Each distinctive order is given a unique job code.
▪ When the total cost is determined, the good/service provider would add a
certain amount of profit to the total cost to form the selling price.
Cost records
Until the job is complete, all costs arising are recorded on a job card (or job cost
sheet).
Direct costs:
▪ Direct materials (from goods received notes (GRNs)/ suppliers' invoices,
from stores requisitions);
▪ Direct labour (wages from timesheets);
▪ Direct expenses from invoices.
Indirect cost:
▪ manufacturing overhead (predetermined)
Abnormal costs: costs arise due to a change in the production process, usually
when re-working is needed.
Treatments:
▪ Charged to a job (if the change come from the customer’ side e.g. customer
changed their requirements);
▪ Written off (e.g. company policy stated abnormal costs to be written off to a
specific account).

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 EXAMPLE 1
Product Sao Ta's unit cost is $240. A selling price is set based on a margin of 20%.
What is the selling price?

Solution
Margin = Selling price – unit cost
Margin = 20% selling price, then the unit cost = 100% - 20% = 80% selling price
Therefore selling price = $240 ÷ 80% = $300

EXAMPLE 2
Product MH's unit cost is $240. The mark-up is 20%.
What is the selling price?

Solution
Profit per unit = 20% unit cost, the selling price = 120% unit cost
Therefore selling price = $240 × 120% = $288

2.1.2 Batch costing

Batch costing is also a form of specific order costing, however, there are a few
differences:
Basis for Job costing Batch costing
comparison
Definition Job costing, a specific costing Batch costing, a specific
method, used when the costing method, used when the
good/service is produced per good/service is produced in
specific requirements. batches or mass-produced
following specific requirements.

Production The product is produced as per The product is produced in

quantity customer specification. batches or at a large scale
(mass production).
Product identity Product has a unique identity, Even when mass-produced,
as each job is different from products can keep their identity
others. intact, as they are produced in
the continuum.
Cost unit The cost unit in job costing is The cost unit in batch costing is
Executed Job. the Batch of goods produced.

Cost The cost is ascertained on the The cost is ascertained for the
ascertainment completion of each job. whole batch and then the unit
cost is determined.

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 2.2. Process costing

Key terms
Process costing is a costing system that assigns all production costs to
processes or departments and averages them across all units produced.
(Management Accounting Information for Creating and Managing Value by
Langfield Smith).

Process costing is used for businesses with a sequence of repetitive production

processes.

2.2.1 Equivalent unit

If units, completed at a certain degree (work in process inventories), exist at the
beginning or the end of the accounting period, they need to be converted into
equivalent units (“EU”) for the convenience of measuring costs. In other words,
work in process inventories can be expressed as a part of the completed inventory.

For example, if there are 100 30% finished units at the end of the period, for the
convenience of the accounting process, the aforementioned items can be recorded
as 30 fully completed units. Therefore, the 100 in-process units are equivalent to 30
fully completed units or 30 EUs.

The main assumption of process costing is that material costs incurred at the
beginning of the process. Labour costs and overheads are incurred throughout the
production process. (Labour costs and overheads are also known as conversion
costs.)

The 4 major steps when dealing with process costing

Step 1: Analyse the physical flow of units
Step 2: Calculate the equivalent units (for direct material, Labour and
overheads).
Step 3: Calculate the unit costs (the cost per equivalent unit for direct material,
Labour and overheads).

Step 4: Analyse the total amount of costs (to determine and remove work in
process and/or transfer that amount to the following production department or
finished goods).

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 EXAMPLE 3
The following information is recorded at company A for Process 1:
Period costs $2,400
Input: 300 units
Output: 200 fully completed units and 100 units only 40% complete
There were no process losses.
Required:
Produce the process account

Solution:

Physical units Degree of completion Equivalent units

Fully completed units 200 100% 200

Work in progress 100 40% 40

Total 300 240

Therefore, cost per EU = $2,400/240 units = $10 per equivalent unit

Process 1 account

Units $ Units $

Input 300 2,400 Transfer to the 200 2,000

following process

Work in progress 100 400

300 2,400 300 2,400

2.2.2 Different degrees of completion

For most processes, the material is fully provided at the beginning of the process,
so the amount to be added for these inputs to become finished goods are labour
and overheads, which means that if there are to be WIPs at the end of the period,
these costs, labour and overheads, are to be allocated over the equivalent units.
The material cost should be allocated overall units, but conversion costs should be
allocated over the EUs.
Note: Conversion costs = labour costs +overheads costs

EXAMPLE 4
The following information is recorded at company T for Process no.1:

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 Material costs: 200 units at $6 per unit. Labour costs: $1,800. Overheads costs:
$2,400
Output:
150 fully completed units, transferred to Process 2.
50 three-fifth complete for direct labour, one-fifth complete for overheads, but
fully complete for materials.
There were no process losses.
Required: Produce the process account.

Solution:

Physical Material Labour Overheads

units
% EU % EU % EU

Fully worked units 150 100% 150 100% 150 100% 150

Work in progress 50 100% 50 60% 30 20% 10

Total 200 200 180 160

Costs incurred $1,200 $1,800 $2,400

Cost per EU $6 $10 $15

Cost per finished product = $6 + $10 + $15 = $31

Cost of 150 finished products = $31 × 150 = $4,650
Cost of closing work in progress:
- Material: $6 × 50 = $300
- Labour: $10 × 30 = $300
- Overheads: $15 × 10 = $150
Total: $750

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 Process 1 account

Units $ Units $

Input 200 1,200 Transfer to next 150 4,650

process

Labour and 4,200 Work in progress 50 750

overhead

200 5,400 200 5,400

2.2.3 Opening work in progress

The 2 primary accounting methodologies to record the inventory used in process
costing: Weighted average and FIFO (First in first out).
a. Weighted average method:
In the weighted average method, no distinction is made between units in the
process at the start of a period and those added during the period.
Step 1:
Opening WIP (physical unit) + Physical units started - Physical units completed
and transferred out = Closing WIP (physical unit)
Step 2: Calculate Equivalent units
Equivalent units completed and transferred out + Equivalent units in closing work
in progress = Total Equivalent units
Step 3: Calculate cost per Equivalent Unit
Calculate cost per EU for direct material, added material and conversion costs
Note that under the Weighted average method, total costs include the cost of
opening WIP (which are finished in this period). That is because when
calculating EU, we have included the opening WIP into the calculation
Step 4: Calculate cost of finished goods and cost of WIP

EXAMPLE 5
Details of process 1 in PAN Co for Jan 20X1 are as follows:
- Opening WIP: 400 units, with degree of completion as:
+ Materials: 100% with the value of $1,800
+ Conversions: 30% with the value of $780
- Units input for the period: 1,400 units

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 - Closing WIP 300 units, with degree of completion as:
+ Materials: 100%
+ Conversions: 40%
- Costs incurred in the period:
+ Material costs: $6,300
+ Conversion costs: $5,700
There were no process losses.
Required: Using the weighted average method, prepare the process account for
Jan 20X1.

Solution:
Step 1: Opening WIP (physical unit) + Physical units started - Physical units
completed and transferred out = Closing WIP (physical unit)
=> Physical units completed and transferred out = Opening WIP + Physical units
started - Closing WIP = 400 + 1,400 – 300 = 1,500

Step 2 & 3: Calculate EU and cost per EU

Physical Material Conversion

units
% EU % EU

Finished goods (transferred to 1,500 100% 1,500 100% 1,500

Process 2)

Closing WIP 300 100% 300 40% 120

Total 200 1,800 1,620

Costs $8,100 $6,480

- Opening WIP $1,800 $780

- Costs incurred in the period $6,300 $5,700

Cost per EU $4.5 $4

Step 4: Calculate cost of finished goods and cost of WIP

- Finished goods: ($4.5 + $4) × 1,500 = $12,750
- Closing WIP:
+ Material: $4.5 × 300 = $1,350
+ Conversion: $4 × 120 = $480
Value of closing WIP = $1,830

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 Process 1 account

Units $ Units $

Opening WIP 400 2,580 Transfer to the 1,500 12,750

following process

Input 1,400 6,300 Work in progress 300 1,830

Labour and 5,700

overheads

1,800 14,580 1,800 14,580

b. FIFO:
The FIFO method assumes that the existing units in the process (WIP) at the
beginning of the period need to be completed first before any production process
for new units begins.

Step 1:
Opening WIP (physical unit) + Physical units started - Physical units completed and
transferred out = Closing WIP (physical unit)
Step 2: Calculate Equivalent units
1. Equivalent units needed to complete opening WIP
2. Newly introduced and completed and transferred out
3. Equivalent units in closing work in progress
(1) + (2) + (3) = Total Equivalent units
Step 3: Calculate cost per Equivalent Units
Calculate cost per EU for direct material, added material and conversion costs
Note that under the FIFO method, only use costs incurred in the period. That is
because when calculating EU, we have included the opening WIP in the calculation
Step 4: Calculate cost of finished goods and cost of WIP

EXAMPLE 6
Details of process 1 in PAN Co for Jan 20X2 are as follows:
- Opening WIP: 400 units, with degree of completion as:
+ Materials: 100% with the value of $1,800
+ Conversion: 30% with the value of $780

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 - Units input for the period: 1,400 units
- Closing WIP 300 units, with degree of completion as:
+ Materials: 100%
+ Conversions: 40%
- Costs incurred in the period:
+ Material costs: $6,300
+ Conversion costs: $5,700
There were no process losses.
Required: Using the weighted average method. prepare the process account for
Jan 20X1.

Solution:
Step 1: Opening WIP (physical unit) + Physical units started - Physical units
completed and transferred out = Closing WIP (physical unit)
=> Physical units completed and transferred out = Opening WIP + Physical units
started - Closing WIP = 400 + 1,400 – 300 = 1,500
In which:
- Opening WIP that is finished in period: 400
- Introduced and completed in period: 1,500 – 400 = 1,100

Step 2 & 3: Calculate EU and cost per EU

Physical Material Conversion

units
% EU % EU

Opening WIP finished in period 400 - - 70% 280

Introduced and completed in 1,100 100% 1,100 100% 1,100

period

Closing work in progress 300 100% 300 40% 120

Total 200 1,400 1,500

Costs incurred in the period $6,300 $5,700

Cost per EU $4.5 $3.8

Step 4: Calculate cost of finished goods and cost of WIP

Finished goods:
▪ Opening WIP that is finished in period = opening value from last period +
works completed in this period = 2,580 + $3.8 × 280 = $3,644

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 ▪ Introduced and completed in period = cost per unit * number of units = ($4.5
+ $3.8) * 1,100 = 9,130
Closing WIP:
▪ Material: $4.5 × 300 = $1,350
▪ Conversion: $3.8 × 120 = $456
Value of closing WIP = $1,806

Process 1 account

Units $ Units $

Opening WIP 400 2,580 Transfer to next 1,500 12,774

process

Input 1,400 6,300 Work in progress 300 1,806

Labour and 5,700

overhead

1,800 14,580 1,800 14,580

COMPARISON OF WEIGHTED AVERAGE AND FIFO METHODS

The most significant feature to highlight the difference between the weighted
average and FIFO method is how each method treats the beginning work in
process inventory.
For the weighted average method, the costs of beginning work in process and
the equivalent units of work done on it are included as the cost per equivalent
unit is calculated. The resulting figure of this method is a weighted average of
costs coming from both the previous and the current calculating period.
For the FIFO method, the costs of beginning work in process is not included,
only the equivalent units of work done in the current calculating period is
counted.
The difference in value between the two methods, therefore, lays in the amount of
beginning work in process, without it, there is no difference.

2.3. Loss in process costing

Loss is due to the nature of the process, defective material or a mistake made by
workers. In a process, the expected loss is the normal loss. The loss in materials or
the loss in the form of finished goods can still be sold and the amount gained from

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 this is the scrap value, which is also included in the process account. In the exam, if
the scrap value is not mentioned, its value is 0 in the process account.
Cost per unit formula:
Expected output = Input - expected loss = Input × (1 - % of normal loss)

Total cost of inputs - Scrap value of the normal loss

Average cost per unit =
Expected output

EXAMPLE 7
The following data relates to Process 1 at a manufacturing company:
Materials input: $3,000 for 200 units
Labour costs: $1,000.
Overheads costs: $800
Normal loss is 5% of input and is sold at $5 per unit.
Actual output = 190 units
Required: Calculate the average cost per unit in Process 1 and complete the
process account.

Solution:

Process 1 account

Units $ Units $

Material 200 3,000 Transfer to 190 4,750

next process

Labour 1,000 Normal loss 10 50

Overhead 800

200 4,800 200 4,800

Workings
(W1) Normal loss = 5% × 200 = 10 units. Expected output = 200 – 10 = 190 units
Scrap value of normal loss = 10 × $5 = $50

(W2)

Total cost of inputs - Scrap value of normal loss

Average cost per unit =
Expected output

= $4,800 – $50

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 190

= $ 25 per unit
Value of goods transferred = 190 × $25 = $4,750

2.3.1 Abnormal loss and abnormal gains

In reality, the actual loss may be different from the expected loss.
- Abnormal loss is the amount of actual loss that exceeds expected loss by
- Abnormal gain is the amount expected loss exceeds actual loss by.
In the case there is an abnormal loss or abnormal gain, the cost of a unit gained or
loss is the same as the cost of a unit of normal output. The abnormal losses or
gains may have a scrap value. In this case, the scrap value should be
reduced/increased to the abnormal gain/loss account.

EXAMPLE 8
The following data relates to Process 2 at a manufacturing company:
Materials input: $2,800 for 300 units
Labour costs: $630.
Overheads costs: $260
Normal loss is 4% of input and is sold at $7.5 per unit. Actual output = 280 units
Required: Calculate the average cost per unit in Process 1 and complete the
process account.

Solution:

Process 2 account

Units $ Units $

Material 300 2,800 Transfer to next 280 3,500

process

Labour 630 Abnormal loss 8 100

Overhead 260 Normal loss 12 90

300 3,690 300 3,690

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 Abnormal gains and losses account

$ $

Process 2 100 Scrap 60

Statement of profit 40
and loss

100 100

Scrap value

$ $

Process 2 (normal 90 Cash received (20 150

loss) units * $7.5)

Abnormal loss 60

150 150

Workings
(W1) Normal loss = 4% × 300 = 12 units. Expected output = 300 – 12 = 288 units
Scrap value of normal loss = 12 × $7.5 = $90

(W2)

Total cost of inputs - Scrap value of normal

loss

Average cost per unit =

Expected output

$3,660 – $60

288

= $ 12.5 per unit

Value of goods transferred = 280 × $12.5 = $3,500
Actual loss = 300 – 280 = 20 => Abnormal loss: 20 – 12 = 8 units.
Value of abnormal loss = 8 × $12.5 = $100
Value of abnormal loss transferred to the scrap account = 8 × $7.5 = $60

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 2.4. Joint product and by-product
Process costing is created for businesses with multi-operational processes for an
end-product, so they often produce products at different stages. These products
may either fall into the category of joint products or by-products.
Joint products are two or more products produced along the process, each
having a sufficiently high value for sale. Joint product is intendedly produced
and is among the main products.
By-products are incidentally produced outputs in the process of making
something else (main products). By-products have a relatively low sales value
compared to joint products.

Accounting for joint products

If joint process costs occur before the split-off point then these can be categorized
as common costs.
The remaining costs incurred from the split-off point and the joint product
completion point need to be apportioned to determine the value of closing inventory
and cost of sales.
The apportionment of joint costs to products is usually based on one of the
following:
▪ market value
▪ production units
▪ net realizable value.

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 When preparing process accounts, joint products should be treated as main
products while by-products in process accounts are treated similar to that of normal
loss.
Income from by-product is credited to the process account and debited to the by-
product account.

EXAMPLE 9
T&T is a manufacturing company. It combines the manufacturing processes of two
products called M and A in a single joint process. Last month, the total costs of the
joint process amounted to $120,000, with the relating information about the two
products are as follows:

Product M Product A

Output (units) 12,000 15,000

Additional processing costs ($) 30,000 18,000

Selling price $20 $16

1. If the physical units method was used, the joint cost allocations to Products M
and A would be:
M: $120,000 ÷ 27,000 units × 12,000 units = $53,333
A: $120,000 ÷ 27,000 units × 15,000 units = $66,667

2. If the sales value method was used, the joint cost allocations to Products M and
A would be:
Calculate the total sales value:
M: 12,000 × $20 = $240,000
A: 15,000 × $16 = $240,000
Total sales value = $480,000
Calculate the joint cost allocation:
M: $120,000 ÷ 480,000 × $100,000 = $60,000
A: $120,000 ÷ 480,000 × $100,000 = $60,000

3. The joint cost allocations to Products M and A using the net realisable value
method would be:
Calculate the total net realisable value:
M: (12,000 units × $20) – $30,000 = $210,000
A: (15,000 units × $18) – $18,000 = $222,000

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 Total net realisable value = $432,000
Calculate the joint cost allocation:
M: $120,000 ÷ $432,000 × $210,000 = $58,333
A: $120,000 ÷ $432,000 × $222,000 = $61,667

2.5 Service costing

Service businesses offer help, care, utility, or provide an experience, information or
other intellectual content. The products of these businesses, as mentioned above,
are usually intangible rather than physical, which are harder to determine
production costs, so service costing is used to establish the costs of services
performed.
DIFFERENCES BETWEEN SERVICE AND MANUFACTURING
BUSINESSES:
Four major features differentiate between manufacturing and most service
businesses:
Basis for Service businesses Manufacturing businesses
comparison
Form of The majority of the outputs The majority of outputs
products service businesses produce manufacturers produce are
are intangible. physical.
Production Service products are usually Manufacturers usually produce
quantity heterogeneous. Each product a range of repetitive products.
is different or is tailor-made The product portfolio (collection
per the customer’s of all the products or services
requirements. offered by a company) of a
manufacturer is limited, these
products tend to involve
common features or processes.
Consumption Services are consumed Goods can be stored in
point immediately as they are warehouses and consumed
produced. later when they are sold.
Product Services cannot be stored, Goods can be stored in
perishability saved for future sale, and warehouses for sale in the
cannot be returned or resold future.
once they have been
consumed.

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 Unit cost measures for service costing:
Since services are intangible products, one of the major difficulties in service
costing is the establishment of an appropriate cost unit. Service businesses,
depending on the kinds of service they provide, can use a variety of cost units
Examples for a hotel might include:
▪ Meals served in the hotel’s restaurant
▪ Room-service-hour worked by the cleaning staff
▪ Hours worked for the reception staff.
▪ A composite cost unit is more appropriate if a service is based on two
variables (or more). For example room-night.

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 CHAPTER SUMMARY
Job costing is a costing method used to determine the cost of specific jobs,
which are performed according to the customer's order.
Batch costing, a specific costing method, used when the good/service is
produced in batches or mass-produced following specific requirements
For each individual order costing situations, different accounts are kept for each
job or batch.
Direct costs are debited to each account. Overheads are charged (debited)
using overhead absorption rates (Chapter 7).
Service businesses offer help, care, utility, or provide an experience,
information or other intellectual content. The products of these businesses are
usually intangible rather than physical, which are harder to determine
production costs, so service costing is used to establish the costs of services
performed.
Process costing is a costing system that assigns all production costs to
processes or departments and averages them across all units produced.
Process costing is used for businesses with a sequence of repetitive production
processes.
For losses, the key points are:
• Normal losses are a cost of manufacture;
• Abnormal losses are an overhead cost;
• Cost per unit is based on expected good output.
In processes involving losses, the value per unit of output is equal to total costs
of inputs less scrap value of normal loss (if any), spread over the expected
number of units of good output.
Normal losses are valued at scrap value per unit.
Abnormal gains and losses are costed at the same amount per unit as good
output.
In some processes, there may be WIP at the beginning and/or end of a period.
In this case, it is necessary to calculate the equivalent units (EU) of production
during the period.
In calculating EUs, two methods are used. For the weighted average method,
the costs of beginning work in process and the equivalent units of work done
on it are included as the cost per equivalent unit is calculated. For the FIFO
method, the costs of beginning work in process is not included, only the
equivalent units of work done in the current calculating period is counted.
Process costing is created for businesses with multi-operational processes for
an end-product, so they often produce products at different stages. These
products may either fall into the category of joint products or by-products.
Joint products are significant, whereas by-products have little (if any) value. The
apportionment of joint costs to products is usually based on one of the following:
market value, production units, net realizable value, etc.

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