Learning Objectives
After completing this chapter, students should be able to;
1. Understand and explain the nature of variable costing and
absorption costing
2. Describe the advantages and limitations of absorption and
variable costing
3. Differentiate and understand the elements of cost involved in
absorption costing and variable costing respectively
4. Understand allocation, apportionment and absorption of Fixed
Factory Overhead Cost accordingly
5. Calculate profit using variable costing and absorption costing
6. Know how to analyse the degree of profit based on inventory
Overview
Manufacturing firms passes on all the costs incurred in the production
process to the final goods or services produced.
 Variable costing and Absorption costing are both used to determine
COGS and profit. However, the applications are different.
 Absorption costing – includes all of the costs associated with
manufacturing a product, while variable costing can exclude some costs
(fixed overhead costs).
 Absorption costing – also known as full costing, involves allocating fixed
overhead costs across all units produced for the period, resulting in a
per-unit cost.
 Variable costing – also known as Marginal Costing, includes all of the
variable direct costs in COGS but excludes direct, fixed overhead costs.
Absorption Costing & Variable Costing
 Differences in computing for profit;
The difference between the absorption and variable costing
methods depends on the treatment of fixed factory overhead
costs.
 Absorption costing “absorbs” all variable unit costs used in
production and also the unit cost of fixed factory overhead as
product costs and is part of inventory.
 Variable costing (Marginal Costing) – Considers only the
variable unit costs as production cost and does not consider
unit cost of fixed factory overhead as part of a product cost.
Thus, fixed factory overhead is treated as expense and not part
of inventory.
Advantages & Disadvantages of Absorption Costing
Advantages
Disadvantages
• Covering all relevant production
• Confusion in the basis of
cost – (GAAP/IAS)
• It sets competitive and realistic
Selling Price (SP)
• Over/under absorption can
identify inefficient use of
production resource.
• Cost charges fairly to the
product
• It accounts for All Production
Costs
apportionment
• Have to adjust over/under
absorbed of o/h cost at the
end of the acc. Period.
• Profits are usually affected by
production volume. Can be
inaccurate.
Advantages & Disadvantages of Marginal Costing
Advantages
Disadvantages
• Apportionment & Allocation are
• Does not comply with
not needed
• No over/under absorbed cost.
Write off fixed cost in the income
statement
• Production cost is more realistic.
There is no misrepresentation.
• Profit depends on sales volume
and not production volume
• Helpful in short-term decision,
esp. identify relevant costs
GAAP/IAS
• Difficult to split the VC & FC
• Does not recover full cost in
the production
(uncertain Pricing)
Cost elements vs. Marginal & Absorption Costing
Absorption costing involves allocating all of the costs (variable and
fixed cost) associated with production. Fixed factory overhead is
inventoried. Thus, absorption costing includes:




Cost of raw materials
Hourly cost of labor
Variable overhead costs
Fixed factory overhead
Marginal costing involves allocating only the variable costs
associated with production. Fixed factory overhead cost is expensed.
Thus, variable costing includes:
 Cost of raw materials
 Hourly cost of labor
 Variable overhead costs
Allocation of Fixed Factory Overhead
1 - Allocation of Fixed Factory Overhead Costs
 The process of allocating/distributing factory overhead costs to cost objects/units
based on assigned allocation driver/basis. Allocation of factory O/H costs is
commonly measured on the basis of direct labour hours (DLH) or machine hours
(MH). Thus, overhead allocation rate are determined on the basis of DLH & MH.
2 - Apportionment of Fixed Factory Overhead Costs
 The process of fair distribution of factory overhead costs to cost objects/units. Fixed
factory overhead costs are apportioned, or fairly distributed (propositionally) on the
basis of benefits or cost resulted from cost objects/units.
3 - Absorption of Fixed Factory Overhead Costs
 This is the process of assigning factory overhead costs to cost objects/units on the
basis of per items produced (production volume). (more on absorption)
Profit: Absorption & Marginal Costing
 Differences in computing for profit;
Refer to handouts;
Marginal Costing & Management Decision
 One of the fundamental consideration of variable cost is that the
fixed overhead is treated as a period cost which is expensed
within the reporting period.
 Marginal Costing is the tool for various managerial decision
made internally. Most of the decisions are based on CVP analysis
where the benefits of production volumes are measured with its
related costs and profit.
 CVP Purpose is to;
 Determine the number of units that must be sold to break even or to earn a
targeted profit.
 Calculate the amount of revenue required to break even or to earn a
targeted profit.
10
Managerial Decision with Marginal Costing
 Marginal Revenue
Marginal revenue measures the change in the revenue when there
is change in volume of sales, SP, or VC.
Usual production data
•
•
•
•
Unit selling price – K10
Variable cost per unit – K4
Fixed cost p.a. – K90,000
Sales unit p.a. – 40,000
Changes in production data
•
•
•
•
Unit selling price – K15
Variable cost per unit – K6
Fixed cost p.a. – K90,000
Sales unit p.a. – 30,000
NB: Fixed cost has not changed.
What is the effect of the change in production data?
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Analysing the degree of profit based on inventory
Closing inventory > Opening inventory = AC profit > MC profit
Closing inventory < Opening inventory = AC profit < MC profit
Closing inventory = Opening inventory = AC profit = MC profit
Over & Under Absorption of Overhead Costs
Over/under absorption of overhead costs is only considered
under Absorption Costing.
 Over Absorption – Occurs when the overheads absorbed are higher
than the actual overheads incurred
 Under Absorption – This occurs when the overhead absorbed is lower
than the actual overheads incurred during the accounting period
Reasons for Over/under Absorption of Overhead Costs
1. The actual hours worked is more or less than the budgeted hours.
2. The actual overhead costs are different from budgeted overheads.
3. Both actual overhead costs and actual activity level are different from the
budgeted costs and level.
4. The method of overhead absorption may be wrong.
5. Unexpected expenses may be incurred during the accounting period.
6. Extra ordinary expenses might have been included in the calculation of
overhead absorption rate.
7. Major changes like replacement of manual labour with machines. This leads to
increase in capacity levels.
8. Seasonal fluctuations in the overhead expenses from period to period.
Treatment of Over/Under absorbed overhead Costs
The over or under absorbed overheads are treated in the cost accounts in
any one of the following ways.
1. Applying supplementary rate
2. Adjust to costs of sales or Adjusted to gross profit (write-off)
Summary
 The treatment of factory overhead costs, whether as part of product cost or




expense, distinguishes marginal costing from absorption costing.
Marginal Costing is more useful for internal reporting and decision making
Marginal Costing does not comply with GAAP standards, thus, it is not used by
public companies
Absorption costing is compliant with GAAP, and is used for financial reporting
by public companies (listed companies)
Variable cost and period cost are the basis of consideration for calculating
marginal and absorption costing.
End of Lecture
Complete the
exercise on the
student course
book