Absorption costing and marginal costing

Transcription

1 Chapter 5 Absorption costing and margina costing Rea word case 5.1 This case study shows a typica situation in which management accounting can be hepfu. Read the case study now but ony attempt the discussion points after you have finished studying the chapter. The costing of a services deivered by NHS providers shoud be governed by the foowing principes: costs (and income) shoud be: (a) cacuated on a fu absorption basis to identify the fu cost of services deivered; (b) aocated and apportioned accuratey by maximising direct charging and where this is not possibe using standard methods of apportionment; and (c) matched to the services that generate them to avoid cross subsidisation. The costing process shoud aso be transparent with a cear audit trai. Where costs have not been directy attributed to the patient, costing poos shoud be constructed so that the costs incuded can be aocated or apportioned using the same method. Costing poos can be constructed in different ways dependent on the nature of the costs incuded in them. The manua gives exampes. One absorption rate is cacuated by dividing the combined fixed and semi-fixed costing poos for wards, theatres and outpatients by the appropriate activity units i.e. bed-days, theatre-hours or attendances. Source, Department of Heath, NHS Costing Manua 2008/09, PubicationsPoicyAndGuidance/DH_ Discussion points 1 What probems might be faced in apportioning overhead costs? 2 Why might it be important that the costing process shoud be transparent with a cear audit trai?

2 106 Part 1 Defining, reporting and managing costs Contents 5.1 Introduction A note on terminoogy: margina or variabe? Iustration of absorption and margina costing Absorption costing Margina costing Expaining the difference Inventory eves faing Inventory eves rising Over- and under-absorbed fixed overheads Over-absorbed fixed overhead Under-absorbed fixed overhead Case study Absorption costing Margina costing Comparison of profit under each approach Why is it necessary to understand the difference? Absorption costing in financia accounting Arguments in favour of absorption costing Arguments in favour of margina costing What the researchers have found Fu costing in the NHS Fu cost accounting and environmenta resources Summary 121 Learning outcomes After reading this chapter you shoud be abe to: Define and expain absorption costing (fu costing) and margina costing (variabe costing). Iustrate absorption (fu) costing and margina (variabe) costing using a simpe exampe. Expain and cacuate the effect on profit of over-absorbed and under-absorbed fixed overheads. Compare profit based on absorption costing with profit based on margina costing. Expain how absorption costing is appied in financia accounting. Expain the arguments in favour of absorption costing and margina costing. Describe and discuss exampes of research into fu costing and margina costing.

3 Chapter 5 Absorption costing and margina costing Introduction Methods of apportioning (sharing) fixed production overhead costs were expained in detai in Chapter 4. Because of the probems that may arise because of apportionment, there are situations in management accounting where it is preferabe to avoid the probem by aocating ony variabe costs to products. Fixed production overhead costs are regarded as costs of the period rather than costs of the product. The question to be addressed in this section is how the choice between absorption costing (which means absorbing a costs into products) and margina costing (which means taking in ony the variabe costs of production) may be dependent on the purpose to which management accounting is being appied. Definitions In absorption costing (fu costing), a production costs are absorbed into products. The unsod inventory is measured at tota cost of production. Fixed production overhead costs are treated as a product cost. In margina costing (variabe costing), ony variabe costs of production are aocated to products. The unsod inventory is measured at variabe cost of production. Fixed production overhead costs are treated as a period cost of the period in which they are incurred. 5.2 A note on terminoogy: margina or variabe? Some authorities on management accounting refer to margina costing whie others refer to variabe costing. The strict interpretation of margina cost in economics is the additiona cost of one more unit of output. From the economists viewpoint that extra cost coud incude a stepped increase in fixed cost if capacity has to be expanded to produce one more unit of output or if a new empoyee is required. For this chapter we assume that the range of activity is narrow so that a margina change in cost invoves variabe costs ony. 5.3 Iustration of absorption and margina costing This exampe iustrates the appication of absorption costing and margina costing. It uses the same basic data for both iustrations Absorption costing In absorption costing (fu costing), a production costs are absorbed into products. The unsod inventory is measured at tota cost of production. Fixed production overhead costs are treated as a product cost. From the data in Exhibit 5.1, the budgeted fixed overhead cost rate is 3 per unit (cacuated as 30,000/10,000 units). The fu cost of production per unit is 16 (cacuated as variabe cost 13 pus fixed cost 3). The profit and oss statement for Juy, based on absorption costing is shown in Tabe 5.1.

4 108 Part 1 Defining, reporting and managing costs Exhibit 5.1 Data for iustration: absorption and margina costing Mirror View Ltd produces freestanding magnifying mirrors for use in the home. The budgeted seing price and costs are as foows: Budget for one unit: Seing price 20 Direct materias 8 Direct abour 3 Variabe production overhead 2 Tota variabe cost 13 The fixed production overhead cost for one month is budgeted as 30,000. The budgeted production voume is 10,000 units per month. Budgeted saes are expected to equa budgeted production voumes. For the months of January to June the production and saes were 10,000 per month as budgeted. In the month of Juy the production was 10,000 but the saes were ony 9,600 units, eaving 400 units in inventory (stock) as unsod goods. In the month of August the production was again 10,000 but the saes were 10,400 units. For the months of September to December the production and saes were again 10,000 units as budgeted. Tabe 5.1 Profit and oss statement, month of Juy, based on absorption costing Month of Juy Saes (9,600 at 20) 192,000 Opening inventory Costs of production (10,000 at 16) 160,000 Less cosing inventory (400 at 16) (6,400) Cost of goods sod (153,600) Profit 38,400 Comment There is no opening inventory because unti the end of June the saes and production were equa. The costs of production are recorded at the fu cost of 16 to be absorbed by each unit. The cosing inventory is vaued at the fu cost of production of 16 per unit Margina costing In margina costing (variabe costing), ony variabe costs of production are aocated to products in Tabe 5.2. The unsod inventory is measured at variabe cost of production. Tabe 5.2 Profit and oss statement, month of Juy, based on margina costing Month of Juy Saes (9,600 at 20) 192,000 Opening inventory Costs of production (10,000 at 13) 130,000 Less cosing inventory (400 at 13) (5,200) Variabe cost of goods sod (124,800) Contribution to fixed overhead cost 67,200 Fixed overhead costs (30,000) 37,200

5 Chapter 5 Absorption costing and margina costing 109 Fixed production overhead costs are treated as a period cost of the period in which they are incurred. The cacuations are shown in Tabe 5.2. Comment As in the previous cacuation, there is no opening inventory because unti the end of June, the saes and production were equa. The costs of production are recorded at the variabe cost of 13 to be absorbed by each unit. The cosing inventory is vaued at the variabe cost of production of 13 per unit. Saes minus variabe costs gives a contribution to fixed overhead costs. (Contribution is discussed in more detai in Chapter 9.) The fixed overhead costs of production are treated as a period cost and reported as a separate ine in the profit and oss statement Expaining the difference The difference in profit is 38,400 37,200 = 1,200. The profit based on absorption costing is higher in this exampe because the cosing stock of 400 units carries 3 of fixed overhead per unit, as a product cost, to the next accounting period. Activity 5.1 Now try for yoursef to carry out the cacuations using absorption costing and margina costing for the month of August. In August there is an opening stock of 400 units but no cosing stock. When you have tried this, check with the next section Inventory eves faing Over the month of August the inventory fas from 400 units at the start of the month to ni at the end of the month (see Tabes 5.3 and 5.4). Tabe 5.3 Profit and oss statement, month of August, based on absorption costing Month of August Saes (10,400 at 20) 208,000 Opening inventory (400 at 16) 6,400 Costs of production (10,000 at 16) 160,000 Less cosing inventory Cost of goods sod (166,400) Profit 41,600 Tabe 5.4 Profit and oss statement, month of August, based on margina costing Month of August Saes (10,400 at 20) 208,000 Opening inventory (400 at 13) 5,200 Costs of production (10,000 at 13) 130,000 Less cosing inventory Variabe cost of goods sod (135,200) Contribution to fixed overhead cost 72,800 Fixed overhead costs (30,000) Profit 42,800

6 110 Part 1 Defining, reporting and managing costs Comment The difference in profit is 42,800 41,600 = 1,200. The profit based on absorption costing is ower in this exampe because the opening inventory of 400 units carries 3 of fixed overhead per unit, as a product cost, from the previous accounting period. Activity 5.2 Work out how the answers in Tabes 5.3 and 5.4 woud change if the inventory eves were rising. Then check with the next section Inventory eves rising Suppose that, over the month of August, the inventory rises from 400 units at the start of the month to 600 at the end of the month (see Tabes 5.5 and 5.6). Assume the production remains the same at 10,000 units. The saes are therefore 9,800 units. Tabe 5.5 Profit and oss statement, month of August, based on absorption costing Month of August Saes (9,800 at 20) 196,000 Opening inventory (400 at 16) 6,400 Costs of production (10,000 at 16) 160,000 Less cosing inventory (600 at 16) (9,600) Cost of goods sod (156,800) Profit 39,200 Tabe 5.6 Profit and oss statement, month of August, based on margina costing Month of August Saes (9,800 at 20) 196,000 Opening inventory (400 at 13) 5,200 Costs of production (10,000 at 13) 130,000 Less cosing inventory (600 at 13) (7,800) Variabe cost of goods sod (127,400) Contribution to fixed overhead cost 68,600 Fixed overhead costs (30,000) 38,600 Comment The difference in profit is 39,200 38,600 = 600. The profit based on absorption costing is higher in this exampe because the cosing inventory of 600 units carries 3 of fixed overhead per unit as product cost whie the opening inventory of 400 units carries 3 of fixed overhead per unit, as a product cost, from the previous accounting period. The difference is an increase of 200 units carrying forward 3 of fixed cost per unit, which is 600 in tota. This cost of 600 is carried forward to the next period with the unsod inventory. 5.4 Over- and under-absorbed fixed overheads In Chapter 4 the cacuation of over-recovery and under-recovery of fixed overhead costs is expained. This is aso caed over-absorbed and under-absorbed fixed

7 Chapter 5 Absorption costing and margina costing 111 overheads. The adjustment of costs for over- and under-absorption is made in the cost of saes as shown in this section Over-absorbed fixed overhead Now change the data in Exhibit 5.1 so that the eve of production is different from that budgeted. In Exhibit 5.2 the actua production overhead eve in Juy is higher at 10,100 than the budgeted eve of 10,000. The actua production eve in August is ower at 9,900 than the budgeted eve of 10,000. Tabe 5.7 shows the absorption costing profit for Juy, whie Tabe 5.8 shows the margina costing profit for Juy. Exhibit 5.2 Data for iustration: absorption and margina costing Mirror View Ltd produces freestanding magnifying mirrors for use in the home. The budgeted seing price and costs are as foows: Budget for one unit: Seing price 20 Direct materias 8 Direct abour 3 Variabe production overhead 2 Tota variabe cost 13 The fixed production overhead cost for one month is budgeted as 30,000. The budgeted production voume is 10,000 units per month. Budgeted saes are expected to equa budgeted production voumes. For the months of January to June the production and saes were 10,000 per month as budgeted. In the month of Juy the production was 10,100 but the saes were ony 9,700 units, eaving 400 units in inventory (stock) as unsod goods. In the month of August the production was again 9,900 but the saes were 10,300 units. For the months of September to December the production and saes were again 10,000 units as budgeted. Tabe 5.7 Profit and oss statement, month of Juy, based on absorption costing Month of Juy Saes (9,700 at 20) 194,000 Opening inventory Costs of production (10,100 at 16) 161,600 Less over-absorbed overhead (100 at 3) (300) Less cosing inventory (400 at 16) (6,400) Cost of goods sod (154,900) Profit 39,100 The over-absorbed overhead arises because the actua eve of production was 100 units higher than expected. A tota cost of 16 was charged to each of the additiona units produced. The variabe cost eement of this charge, at 13 each, was justified because the additiona units required additiona variabe costs of materias and abour. However, the fixed cost eement of 3 per unit is not justified because the fixed cost does not increase with additiona production. This part of the additiona production cost charge must therefore be removed by deducting 300 (100 3).

8 112 Part 1 Defining, reporting and managing costs Tabe 5.8 Profit and oss statement, month of Juy, based on margina costing Month of Juy Saes (9,700 at 20) 194,000 Opening inventory Costs of production (10,100 at 13) 131,300 Less cosing inventory (400 at 13) (5,200) Variabe cost of goods sod (126,100) Contribution to fixed overhead cost 67,900 Fixed overhead costs (30,000) Profit 37,900 The absorption costing profit is greater than the margina costing profit. The difference is 1,200 measured as fixed overhead cost carried forward in cosing inventory (with opening inventory ni) Under-absorbed fixed overhead For the month of August the information in Exhibit 5.2 shows that the saes are 10,300 units and the production is 9,900 units (see Tabes 5.9 and 5.10). Tabe 5.9 Profit and oss statement, month of August, based on absorption costing Month of August Saes (10,300 at 20) 206,000 Opening inventory (400 at 16) 6,400 Costs of production (9,900 at 16) 158,400 Add under-absorbed overhead (100 at 3) 300 Less cosing inventory Cost of goods sod (165,100) Profit 40,900 The under-absorbed overhead arises because the actua eve of production was 100 units ower than expected. The ower variabe cost is justified by the ower voume. However, the fixed cost eement of 3 per unit must be charged on the expected basis of 10,000 units because fixed costs do not decrease when production voume decreases. This part of the production cost charge must therefore be incuded by adding 300 (100 3). Tabe 5.10 Profit and oss statement, month of August, based on margina costing Month of Juy Saes (10,300 at 20) 206,000 Opening inventory (400 at 13) 5,200 Costs of production (9,900 at 13) 128,700 Less cosing inventory Variabe cost of goods sod (133,900) Contribution to fixed overhead cost 72,100 Fixed overhead costs (30,000) Profit 42,100

9 Chapter 5 Absorption costing and margina costing 113 The absorption costing profit is ess than the margina costing profit. The difference is 1,200 measured as fixed overhead cost brought forward in the opening inventory with cosing inventory ni. 5.5 Case study This case study compares the effect of carrying fixed production overheads as a product cost or a period cost and aso shows the effect of under-absorbed and overabsorbed fixed production overheads. Casua Tabes is a business that manufactures pastic tabes for use in pavement cafés and bars. A tabes are identica. The panning manager of Casua Tabes is panning its operations for the next five months. Data regarding budgeted seing price, budgeted variabe cost per unit and fixed production overheads are given in Tabe 5.11, together with budgeted voumes of production and saes over the next five months. The question to be answered is, How much profit is expected for each of the five months? Tabe 5.11 Data for comparing absorption costing and margina costing Seing price per unit 20 Variabe cost per unit 9 Fixed costs for each period 500 Month 1 Month 2 Month 3 Month 4 Month 5 units units units units units Produced Sod Hed in stock at end of period ni Under absorption costing the first task is to decide how the fixed production costs for each month shoud be aocated to products. Where production voume is varying in the manner shown in Tabe 5.11, a common practice is to base the predetermined overhead cost rate on the norma eve of activity. There is no precise definition for this, but it woud take into account the budgeted eve of activity in recent periods, the activity achieved in recent periods, and the expected output from norma working conditions. In this case, it might be reasonabe to take a norma eve of activity as the average production eve, which is 250 units per month. The predetermined fixed overhead cost rate is therefore 2 per unit Absorption costing Using absorption costing, the opening and cosing stock is vaued at tota cost of 11 per unit, comprising variabe cost per unit of 9 and fixed cost per unit of 2. Tabe 5.12 iustrates the absorption costing approach. The ine abeed under/(over) absorbed refects the absorption of overhead where the production of the months is above or beow the base eve of 250 units used to cacuate the fixed overhead cost rate.

10 114 Part 1 Defining, reporting and managing costs Tabe 5.12 Expected profit per month under absorption costing Month 1 Month 2 Month 3 Month 4 Month 5 Tota Saes 4,000 4,200 5,200 5,600 6,000 25,000 Production units Opening inventory at 11 ni ni Cost of production: At 11 per unit 2,530 2,970 2,860 2,640 2,750 13,750 Under/(over) absorbed 40 (40) (20) 20 Cosing inventory at 11 (330) (990) (990) (550) ni ni Cost of goods sod 2,240 2,270 2,840 3,100 3,300 13,750 Profit 1,760 1,930 2,360 2,500 2,700 11,250 In month 1 the production, at 230 units, is 20 units ess than the base eve of 250. The cost absorbed by 230 units is 460 which is 40 ess than the expected fixed overhead cost of 500 for the month. Another way of arriving at the same concusion is to say that overhead is under-absorbed by 40 (mutipying 20 units by the fixed overhead cost rate of 2 each). In order to increase the absorbed cost of 460 to the expected (or actua) cost of 500, the 40 difference must be added to production cost in cacuating the cost of saes. In month 2 the production eve is 270 units, which is 20 units higher than the base eve of 250. This means that fixed overhead is over-absorbed by 40 (20 units at 2). The over-absorbed cost must be deducted from the cost of production to arrive at the cost of goods sod. In month 3 the production eve is 260 units, which is 10 units higher than the base eve of 250. This means that fixed overhead is over-absorbed by 20 (10 units at 2). The over-absorbed cost is deducted from the cost of production. In month 4 the production eve is 240 units, which is 10 units ess than the base eve of 250. This means that fixed overhead is under-absorbed by 20 (10 units at 2). The under-absorbed cost is added to the cost of production. In month 5 the production eve is 250 units, equa to the base eve. This means that exacty the correct amount of overhead cost is absorbed and no adjustment is needed. Activity 5.3 Go back to the data of Tabe Cover up the answer in Tabe 5.12 and then attempt to write out the profit cacuation under absorption costing. Add a note of narrative expanation to each ine as a means of heping understanding by yoursef and others. Make sure that you understand the absorption costing approach fuy. Activity 5.4 Look back at the data of Tabe Before turning to the answer in Tabe 5.13 attempt to write out the profit cacuation under margina costing. Add a note of narrative expanation to each ine as a means of heping understanding by yoursef and others Margina costing Using margina costing, the stock of unsod output at the end of each month woud be vaued at the variabe cost of 9 per unit. The fixed cost woud be regarded as a cost of the month, without aocation to products. Tabe 5.13 iustrates the margina costing approach.

11 Tabe 5.13 Expected profit per month under margina costing Chapter 5 Absorption costing and margina costing 115 Month 1 Month 2 Month 3 Month 4 Month 5 Tota Saes 4,000 4,200 5,200 5,600 6,000 25,000 Production units Opening inventory at 9 ni Ni Cost of production at 9 2,070 2,430 2,340 2,160 2,250 11,250 Cosing inventory at 9 (270) (810) (810) (450) ni ni Variabe cost of goods sod 1,800 1,890 2,340 2,520 2,700 11,250 Fixed costs of month ,500 Tota costs 2,300 2,390 2,840 3,020 3,200 13,750 Profit 1,700 1,810 2,360 2,580 2,800 11,250 Comparing Tabe 5.13 with Tabe 5.12, it may be seen that there is no under- or over-absorption in the margina costing exampe because it treats fixed overhead cost of production as a period cost, not a product cost Comparison of profit under each approach Tabe 5.14 compares the profit cacuated under each approach. Tabe 5.14 Comparison of profit, using absorption costing and margina costing Month 1 Month 2 Month 3 Month 4 Month 5 Tota Absorption costing 1,760 1,930 2,360 2,500 2,700 11,250 Variabe costing 1,700 1,810 2,360 2,580 2,800 11,250 Difference In month 1, the absorption costing profit is higher by 60, because there is an increase in inventory of 30 units, carrying a fixed overhead cost of 2 each. The increased inventory carries that cost forward to the next accounting period. In month 2, the absorption costing profit is higher by 120, because there is an increase in inventory of 60 units, carrying a fixed overhead cost of 2 each. In month 3, the absorption costing profit and the margina costing profit are the same, because there is no change in inventory eves. In month 4, the absorption costing profit is ower by 80, because there is a decrease in inventory of 40 units, bringing an additiona fixed overhead of 2 each. In month 5, absorption costing profit is ower by 100, because there is a decrease in inventory of 50 units, bringing an additiona fixed overhead of 2 each. Over the tota period of five months the saes and production are equa, so absorption costing and margina costing give the same tota profit of 11,250. Activity 5.5 Before reading the rest of this section, write a brief commentary on the most significant features of Tabe 5.14.

12 116 Part 1 Defining, reporting and managing costs Points to note 1 Over the tota period of time, where tota production equas tota saes, there is no difference in tota profit (see Tabe 5.14). The difference between absorption costing and margina costing is purey a resut of timing of the matching of fixed overhead costs of production with saes. 2 In any period when stock eves are constant, both approaches give the same answer. During month 3, stock eves remain constant and therefore both approaches give the same answer. 3 The differences between the two profit cacuations in any period are based entirey on the change in voume of stock during the month, mutipied by the fixed overhead cost rate of 2 per unit. During month 1, stock increases by 30 units over the month and, as a consequence, profit under absorption costing is 60 higher than under margina costing. During month 2, stock increases by 60 units over the month and, as a consequence, profit under absorption costing is 120 higher. During month 4, stock eves decrease by 40 units so that profit under absorption costing is 80 ower. During month 5, stock eves decrease by 50 units and therefore profit under absorption costing is 100 ower. 4 The overa effect of the positive and negative differences over the business ife is zero, provided the aocation process is appied consistenty. Different aocation processes wi cause costs to fa in different time months, but they cannot create or destroy costs in the tota. 5 The effect of the change in stock eves may be understood using Tabe Making a genera statement from this specific exampe, it appears safe to say that when stock eves are increasing, profit under absorption costing is higher than it is under margina costing. That is because a portion of the fixed production cost incurred in the month is carried forward to the next month as part of the cosing stock vauation. 6 Generaising further from the anaysis, it may be said that when stock eves are decreasing, profit under absorption costing is ower than it is under margina costing. That is because fixed costs incurred in earier months are brought to the current month as part of the opening stock, to be sod during the month. 5.6 Why is it necessary to understand the difference? In Chapter 1 it was shown that management accounting has three major roes in directing attention, keeping the score and soving probems. The particuar roe which appies in any situation wi depend upon the management function which is being served. That management function coud reate to the formation of a judgement or to making a decision about a course of action. Chapter 2 showed that the cassification of costs very much depends on which of the three management accounting roes is dominant in any specific situation and on the type of management function. Where the management function reates to panning and contro, the management accountant is carrying out a score-keeping function and it is usuay necessary to account for fixed overhead costs of production as a part of the product cost. That means absorption costing is the appropriate approach. In this situation there is a strong overap with financia accounting and with externa reporting to stakehoders in a business. If the stakehoders are company sharehoders, then the externa reporting wi be reguated by company aw and accounting standards that require fixed costs of production to be treated as product costs and provide guidance on the aocation process. Where the stakehoders are the eectorate, in the case of a pubic sector body, or partners in a business partnership, the rues may be more fexibe, but in many cases they conventionay foow the practice recommended for companies.

13 Chapter 5 Absorption costing and margina costing 117 Rea word case 5.2 This extract from a newspaper artice discusses the fu cost of absorbing operating costs. TRANSPORT group Go-Ahead expects a hit to profits from its bus business after faiing to recover 2.5m of additiona fue costs, athough the company expects overa group profits to be in ine with expectations. The Newcaste firm, which with a feet of 3,400 buses is one of the UK s biggest operators, said it was ooking to cut costs. Some vacancies were not being fied. The company said fue costs were ikey to increase by 10m in the year to the end of June 2009 after this year s oi price spike at $145 a barre. It has recovered 5m of the estimated 7.5m increase in the first haf through fare rises and efficiency improvements, but the company said this sti eft 2.5m of unrecovered fue costs. In a trading update for the six months to the end of this month, the company said its performance shoud be in ine with expectations for the fu year to June, despite the aiing UK economy. Finance director Nick Swift said the company had been cost-cutting to weather the downturn and was aso protected by reguated fare increases. We saw this coming, athough we may not have seen it being as grim as it is... ike-for-ike costs are down a coupe of per cent on a year ago. Go-Ahead hedged its fue for the year at 43p a itre, compared with 34p a itre in 2007/08. It has hedged 50% of the foowing year at 52p, but expects to hedge the rest of its requirements at a ower price. Source: Peter McCusker, The Journa, 17 Dec Fue cost hits bus profit but passengers rise. business-news/atest-business-news/2008/12/17/fue-cost-hits-bus-profit-but-passengers-rise /. Discussion points 1 What kinds of overhead costs are ikey to be invoved in bus operation? 2 The company uses hedging transactions (advance purchase) to eiminate the unpredictabe nature of the cost of fue. What other operating costs might have an eement of unpredictabiity? 5.7 Absorption costing in financia accounting In the vauation of inventory (stock), management accounting interacts with financia accounting. The accounting standards for inventory vauation set out rues which appy principes of absorption costing. This means that a portion of the fixed overheads must be aocated to inventory. If there was tota freedom of choice in aocating fixed overheads, some managers woud seek to aocate a high proportion of fixed overheads to inventory, in order to report the highest possibe profit and so maintain stock market confidence, whie other managers woud seek to aocate a ow proportion of fixed overheads to inventory, in order to report the owest possibe profit and so reduce the tax bi payabe. In order to encourage confidence in the reiabiity of accounting information, and to reduce opportunities for earnings management, there must be rues on the manner of aocating fixed overhead costs of production. The financia reporting standards are aso concerned with prudence meaning that profits shoud not be overstated. The rues of the Internationa Accounting Standards Board

14 118 Part 1 Defining, reporting and managing costs Exhibit 5.3 Inventory vauation, IAS 2 9. Inventories sha be measured at the ower of cost and net reaisabe vaue. 10. The cost of inventories sha comprise a costs of purchase, costs of conversion and other costs incurred in bringing the inventories to their present ocation and condition. 11. The costs of purchase of inventories comprise the purchase price, import duties and other taxes (other than those subsequenty recoverabe by the entity from the taxing authorities), and transport, handing and other costs directy attributabe to the acquisition of finished goods, materias and services. Trade discounts, rebates and other simiar items are deducted in determining the costs of purchase. Costs of conversion 12. The costs of conversion of inventories incude costs directy reated to the units of production, such as direct abour. They aso incude a systematic aocation of fixed and variabe production overheads that are incurred in converting materias into finished goods. Fixed production overheads are those indirect costs of production that remain reativey constant regardess of the voume of production, such as depreciation and maintenance of factory buidings and equipment, and the cost of factory management and administration. Variabe production overheads are those indirect costs of production that vary directy, or neary directy, with the voume of production, such as indirect materias and indirect abour. 13. The aocation of fixed production overheads to the costs of conversion is based on the norma capacity of the production faciities. Norma capacity is the production expected to be achieved on average over a number of periods or seasons under norma circumstances, taking into account the oss of capacity resuting from panned maintenance. The actua eve of production may be used if it approximates to norma capacity. The amount of fixed overhead aocated to each unit of production is not increased as a consequence of ow production or ide pant. Unaocated overheads are recognised as an expense in the period in which they are incurred. In periods of abnormay high production, the amount of fixed overhead aocated to each unit of production is decreased so that inventories are not measured above cost. Variabe production overheads are aocated to each unit of production on the basis of the actua use of the production faciities. 14. A production process may resut in more than one product being produced simutaneousy. This is the case, for exampe, when joint products are produced or when there is a main product and a by-product. When the costs of conversion of each product are not separatey identifiabe, they are aocated between the products on a rationa and consistent basis. The aocation may be based, for exampe, on the reative saes vaue of each product either at the stage in the production process when the products become separatey identifiabe, or at the competion of production. Most by-products, by their nature, are immateria. When this is the case, they are often measured at net reaisabe vaue and this vaue is deducted from the cost of the main product. As a resut, the carrying amount of the main product is not materiay different from its cost. Source: Internationa Accounting Standard IAS 2 (2003) Inventories, Internationa Accounting Standards Board Internationa Accounting Standards Committee Foundation. are set out in Exhibit 5.3, with added emphasis to bring out points of particuar interest for absorption costing. The requirement for absorption costing is indicated by the wording of paragraph 10. The words systematic aocation in paragraph 12 are open to interpretation, giving scope for appying management accounting principes. Paragraph 12 aso confirms that ony production overheads are incorporated in the vauation of inventories, consistent with the condition in paragraph 9 of bringing the inventories to their present condition and ocation (i.e. produced and ready for sae). 1 Simiar principes are appied in the UK accounting standard SSAP 9 (1988) but it gives more detaied guidance on the meaning of norma activity. SSAP 9 contains simiar definitions in paragraphs 17 to 21. Appendix 1 Further practica considerations contains a section on The aocation of overheads (paras 1 to 10) which gives detaied guidance on the appication of absorption costing.

15 Exhibit 5.4 SSAP 9 and norma eve of activity Chapter 5 Absorption costing and margina costing The aocation of overheads incuded in the vauation of stocks and ong-term contracts needs to be based on the company s norma eve of activity, taking one year with another. The governing factor is that the cost of unused capacity shoud be written off in the current year. In determining what constitutes norma the foowing factors need to be considered: (a) the voume of production which the production faciities are intended by their designers and by management to produce under the working conditions (e.g. singe or doube shift) prevaiing during the year; (b) the budgeted eve of activity for the year under review and for the ensuing year; (c) the eve of activity achieved both in the year under review and in previous years. Source: Statement of Standard Accounting Practice SSAP 9 (1988). Stocks and Long-Term Contracts, Accounting Standards Board (UK). Appendix Arguments in favour of absorption costing The arguments put forward in favour of absorption costing are: 1 Since a production costs are incurred with a view to creating a product for sae, a costs shoud attach to products unti they are sod. 2 In the onger term, fixed overhead costs must be recovered through saes if the business is to survive. Setting the stock vaue by reference to fu costs encourages a pricing poicy which covers fu cost. 3 If fixed production costs are treated as period costs (as happens in margina costing) and there is a ow eve of saes activity in a period, then a reativey ow profit or oss wi be reported. If there is a high eve of saes activity, there wi be a reativey high profit. Absorption costing smooths out these fuctuations by carrying the fixed costs forward unti the goods are sod. 4 Absorption costing heps the matching concept of matching saes with the cost of saes of the same period 5 Where overhead costs are high in reation to direct costs, and fixed overheads are high in reation to variabe costs, a margina costing approach woud bring out ony a sma portion of the tota cost picture. 6 Absorption costing can be used in a cost pus profit approach to pricing a contract for a customer. 5.9 Arguments in favour of margina costing Where the management accounting roe is primariy that of directing attention and the management function is primariy one of decision making, it may be dangerous to regard fixed production costs as product costs. The attractions of using margina costing in such a situation are as foows: 1 In the short term, reevant costs are required for decision making and fixed overheads are argey non-reevant because they cannot be avoided. They are best seen as a committed cost of the period. 2 Margina costing avoids the arbitrary aocations of absorption costing, which may be miseading for short-term decision making. 3 Profit cacuation is not dependent on changes in stock eves. The tabes in this chapter iustrate the practica effect of disentanging fixed costs from stock vaues.

16 120 Part 1 Defining, reporting and managing costs 4 There is no risk of carrying forward in stock an eement of fixed production overhead cost which may not be recovered through saes. 5 Aocating a production costs to products and then appying fu-cost pricing may resut in oss of saes which woud have made a contribution to fixed production costs and profit. 6 Where saes voumes are decining but output is sustained, margina costing provides the profit warning more rapidy than does absorption costing in a situation where attention needs to be drawn urgenty to the profit impications. Activity 5.6 Now that you understand the difference between margina costing and absorption costing, write a short evauation of the two approaches. Rea word case 5.3 The foowing extract discusses whether companies shoud give away their products free when the margina cost of production is reativey high. Giving products away free, from browsers to newspaper artices, is commonpace in the technoogy and media industries. The trend has now spread to vaccines. Pharmaceuticas companies, scarred by years of osing the pubic reations batte to campaigners over the price of HIV/Aids drugs in Africa, are eager not to be caught out by swine fu. Andrew Witty, chief executive of GaxoSmithKine, has offered to donate 50m doses of GSK s panned swine fu vaccine to the Word Heath Organisation. He has caught the pubic mood: Margaret Chan, WHO director-genera, has urged soidarity with poor countries over the H1N1 fu virus. Mr Witty and Ms Chan have forced Danie Vasea, chief executive of Novartis, to defend the profit motive. He tod the FT this week that Novartis did not want to foow the GSK exampe by giving away doses of its panned vaccine because if you want to make production sustainabe, you have to create financia incentives....[the artice continues with a discussion of the arguments against free gift]... First, if deveoping countries do not pay for vaccines, there is a danger that drugs companies wi stop producing enough of them. Vaccines have a high margina cost of production because they have to be cutured in eggs, and stored and distributed carefuy. Second, whie there is a benefit to one-off donations of vaccines against adut pandemics such as swine fu, there is no point in a deveoping country vaccinating chidren one year with a donation of free medicines if it cannot afford to carry on with the programme. Source: John Gapper The hidden cost of giving away vaccines Financia Times, 17 June Discussion points 1 Can a company sustain making free gifts of its products when the margina cost of production is reativey high? 2 What does the first company see as the risk of charging the fu cost of vaccines to a countries?

17 Chapter 5 Absorption costing and margina costing What the researchers have found Fu costing in the NHS Northcott and Leweyn (2003) reported opinions on the UK nationa reference costing index as a measure of the adder of success in heathcare services. The Rea word cases 5.1 and 5.3 in this chapter have given a brief insight into the depth of detai of the guidance given on recording costs in the NHS. Northcott and Leweyn expored views on the way that these costs are aggregated to give a comparative index for hospita costs. They found probems in the absence of a standard against which to compare actua costs, in non-comparabiity of hospitas featured in the index, and in ack of standardisation of costing practices. The comments made by interviewees incuded concerns about the process of cost aocation. Heathcare activities are categorised within heathcare resource groups (HRGs). The costs of these HRGs are cacuated retrospectivey based on actua costs incurred by hospita trusts. To cacuate the HRG costs, the trusts produce costed care profies. There is no standard approach to working out these costs, so trusts can use different cost poos and different methods of apportionment. Tabes are pubished with the intention that performance can be compared but if the processes are not standardised then the comparisons may not be vaid. The authors recommend separate reporting of direct and indirect costs, more carefu definition of custers of trusts having simiar characteristics, target cost outcome for each custer rather than judging a against the overa average, and a focus on seective comparison rather than coverage of a treatments. However, they aso recognise that such changes are unikey because making the indexes more meaningfu coud reduce the poitica power of a singe index Fu cost accounting and environmenta resources Bebbington et a. (2001) expained the probems of measuring the fu cost of production when environmenta costs are taken into account. If the fu costs are not measured then it is not possibe to say whether the activity is sustainabe in the onger term. For this exercise fu cost has a very broad meaning. It starts with the direct and indirect costs usuay associated with production, as expained in Chapters 3 and 4. It then ooks for hidden costs of sustaining production, such as monitoring and safety costs. Next come the iabiities to make good environmenta damage. Then there are costs and benefits associated with the reputation of the business as good or insensitive to the environment. Finay there are the costs that the organisation woud incur if it had a positive attitude towards maintaining and improving the environment. The authors ca for a fu cost framework based on these ideas. There is no practica framework in pace as yet but, given the continued poitica interest in matters of sustainabiity, it seems quite ikey that the debate on fu costing wi continue Summary This chapter has expained the differences between absorption costing and margina costing. Key themes in this chapter are: In absorption costing (fu costing), a production costs are absorbed into products. The unsod inventory is measured at tota cost of production. Fixed production overhead costs are treated as a product cost.

18 122 Part 1 Defining, reporting and managing costs In margina costing (variabe costing), ony variabe costs of production are aocated to products. The unsod inventory is measured at variabe cost of production. Fixed production overhead costs are treated as a period cost of the period in which they are incurred. Under-absorbed or over-absorbed fixed overhead cost may arise in absorption costing. It is reported in the profit and oss statement as an adjustment to cost of saes. Profit under absortion costing differs from profit under margina costing when inventory eves are changing. If tota production equas tota saes there is no difference in tota profit. When inventory eves are faing, profit under absorption costing is ower than profit under margina costing. The difference is equa to the decrease in inventory eves mutipied by the fixed overhead cost rate. When inventory eves are rising, profit under absorption costing is higher than profit under margina costing. The difference is equa to the increase in inventory eves mutipied by the fixed overhead cost rate. Absorption costing is usuay required for inventory vauation in financia accounting standards or other reguations. Those using such financia statements need to be aware that reported profit can be affected by the change in the voume of inventory over the period. Margina costing may be more usefu for decision making because it treats fixed production overhead costs as a cost of the period. Reported profit is not affected by the changes in inventory hed. References and further reading Bebbington, J., Gray, R., Hibbitt, C. and Kirk, E. (2001) Fu cost accounting: an agenda for action. London: Association of Chartered Certified Accountants. Northcott, D. and Leweyn, S. (2003) The adder of success in heathcare: the UK nationa reference costing index, Management Accounting Research, 14: QUESTIONS The Questions section of each chapter has three types of question. Test your understanding questions to hep you review your reading are in the A series of questions. You wi find the answer to these by reading and thinking about the materia in the textbook. Appication questions to test your abiity to appy technica skis are in the B series of questions. Questions requiring you to show skis in Probem soving and evauation are in the C series of questions. A symbo [S] means that there is a soution avaiabe at the end of the book. A Test your understanding A5.1 Define absorption costing (section 5.3.1). A5.2 Define margina costing (section 5.3.2). A5.3 Expain why absorption costing and margina costing may ead to different measures of profit in a period (section 5.3.3). A5.4 When the voume of cosing inventory is ower than the voume of opening inventory, which wi show the greater profit, absorption costing or margina costing (section 5.3.4)?

19 Chapter 5 Absorption costing and margina costing 123 A5.5 When the voume of cosing inventory is greater than the voume of opening inventory, which wi show the greater profit, absorption costing or margina costing (section 5.3.5)? A5.6 When the voume of cosing inventory is the same as the voume of opening inventory, which wi show the greater profit, absorption costing or margina costing (sections and 5.3.5)? A5.7 What are the requirements of financia reporting with regard to the absorption of fixed overhead costs of production (section 5.7)? A5.8 Set out the arguments in favour of absorption costing (section 5.8). A5.9 Set out the arguments in favour of margina costing (section 5.9). A5.10 What have researchers found about fu costing in the NHS (section )? A5.11 How is the idea of fu costing extended when ong-term environmenta costs are considered (section )? B Appication B5.1 [S] Bookcases Ltd produces packs of book sheves for sef-assemby. The budgeted seing price and costs are as foows: Budget for one unit: Seing price 60 Direct materias 36 Direct abour 5 Variabe production overhead 3 Tota variabe cost 44 The fixed production overhead cost for one month is budgeted as 40,000. The budgeted production voume is 5,000 units per month. In the month of February saes are ower than expected. At the start of March there are 200 unsod units in stock. Production is maintained at 5,000 units in the month of March. Required Cacuate the profit for March under (a) absorption costing and (b) margina costing for each of the foowing situations: (1) Situation A: saes in March are 4,700 units (2) Situation B: saes in March are 5,100 units B5.2 [S] Paytime Ltd produces jigsaws for sae in mode shops. The foowing information reates to the saes and costs of producing the jigsaws. Seing price per unit is 20 Variabe cost per unit is 10 Fixed costs of the period are 800 Voumes of production and saes are as foows for periods 1, 2 and 3. Period 1 Period 2 Period 3 units units units Produced Sod Hed in stock at end of period ni

20 124 Part 1 Defining, reporting and managing costs Required (a) Using absorption costing, what is the profit of Period 2? (b) Using margina costing what is the profit of Period 2? (c) Compare the profit of Period 1 under absorption costing with that cacuated under margina costing and expain the difference. (d) Using absorption costing, cacuate the vaue of cosing stock at the end of Period 1. (e) Using margina costing, cacuate the vaue of cosing stock at the end of Period 1. B5.3 Resistor Ltd manufactures eectrica units. A units are identica. The foowing information reates to June and Juy Year 5. (a) Budgeted costs and seing prices were: June Juy Variabe manufacturing cost per unit Tota fixed manufacturing costs (based on budgeted 40,000 44,000 output of 25,000 units per month) Tota fixed marketing cost (based on budgeted saes 14,000 15,400 of 25,000 units per month) Seing price per unit (b) Actua production and saes recorded were: Units Units Production 24,000 24,000 Saes 21,000 26,500 (c) There was no stock of finished goods at the start of June Year 5. There was no wastage or oss of finished goods during either June or Juy Year 5. (d) Actua costs incurred corresponded to those budgeted for each month. Required Cacuate the reative effects on the monthy operating profits of appying: (a) absorption costing; (b) margina costing. B5.4 (a) Expain what is meant by (i) absorption costing; and (ii) variabe costing. (b) Expain the arguments in favour of absorption costing and the arguments in favour of variabe costing. B5.5 [S] [CIMA question] A company produces and ses one type of product. The detais for ast year were as foows: Production and saes Budget Actua Production (units) 25,000 22,000 Saes (units) 23,000 20,000