part three

Medium-term
Planning and
Decision-making
list of chapters
8 Marginal costing and absorption costing
9 Activity-based costing
10 Budgeting
11 Types of budget
12 Cash budgets
Overview
Part 3 lays the foundations for considering the control function of management accounting,
which is developed in Part 4.
Chapter 8 examines marginal costing and absorption costing while Chapter 9 describes activity-
based costing. These are three alternative ways of analysing and presenting cost information.
Chapter 10 looks at how budgets are prepared and establishes methods for building up
budgets in extraction, manufacturing and service businesses.
Chapter 11 considers the merits and mechanics of xed, exible, rolling and activity-based
budgets.
Chapter 12 covers cash budgeting, which is an important management tool for optimising the
use of a scarce resource, apart from its value as a business survival technique.
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Marginal costing and
absorption costing
chapter
8
contents
1 Costing systems general considerations
2 Marginal costing
3 Absorption costing
4 Comparison between marginal and
absorption costing
learning outcomes
This chapter introduces the syllabus sub-section entitled Medium-term planning and decision-
making. Specic syllabus topics are: Semi-variable costs; marginal costing; impact of
absorption costing on decision-making and behaviour. After carefully working through the
material contained in this chapter, you should be able to:
Explain the signicance of contingency theory for the design of management accounting
systems.
Explain the advantages and limitations of marginal costing.
Design operating statements for manufacturing, extractive and service industry
organisations, using a marginal costing format.
Calculate marginal costing prots and losses.
Describe and illustrate the absorption costing process.
Discuss the impact of absorption costing systems on management behaviour.
Explain the benets and drawbacks of absorption costing systems.
Design operating statements for manufacturing organisations, using an absorption costing
format.
Calculate absorption costing prots and losses.
Discuss the application of absorption costing for service activities.
Compare the effects of marginal and absorption costing on reported prots.
The medium term for most businesses is any period from one to three years. It can also be
described as the time scale during which businesses are able to make limited changes to some
of their xed costs, even if they are unable to avoid them entirely. All the short-term planning
and decision-making techniques covered in Part 2 can be used to assist management in
making medium-term plans and decisions. In Part 3 we will also consider the third strand of
management accounting using management accounting information for control purposes.
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1 Costing systems general considerations
Planning and decision-making are sporadic activities and can, if necessary, use ad hoc
information. However, for control we need to move beyond ad hoc data collection
and problem solving.We need:
a routine cost collection system;
a set of consistent, well understood, cost analysis principles;
regular management reports;
a standard reporting format.
In other words, we need a cost information system. Ideally, this information system
should be multi-purpose. It should be able to provide all the information that we
need for planning, decision-making, control and appraisal. However, the manage-
ment accounting profession has yet to come up with a coherent, integrated set of
costing principles, which will suit all these purposes. In fact, all the attempts to use a
single costing system for all purposes have, so far, resulted in management account-
ants providing information that is misleading for at least one purpose. In the most
extreme cases, attempts at a one-size-ts-all management accounting system have
resulted in information that is misleading for all four purposes.
1.1 Contingency theory
Most modern management accountants now accept the precepts of contingency
theory, which can be summarised as choose the most appropriate method for the
purpose.
CIMA Ofcial Terminology describes contingency theory as The hypothesis that there
can be no universally applicable best practice in the design of organisational units or
of control systems such as management accounting systems.The efcient design and
functioning of such systems is dependent on an awareness by the system designer of
the specic environmental factors which inuence their operation, such as the
organisational structure, technology base and market situation.
This is why management accounting can seem very difcult to those who are new
to the subject. Instead of a consistent, logical and easy-to-follow set of rules, we have
what appears to be a mish-mash of principles, techniques and systems, from which
you the student have to select the most appropriate for the current problem.
However, we should not be too hard on management accountants. The nearest
academic discipline to management accounting is economics, and, while economists
can usually explain what has happened, they are usually very poor at predicting what
will happen and are even worse at providing workable solutions to problems.
Fortunately, management accountants have an advantage over economists, in that
they work in business organisations that offer a controllable, autonomous, internal
environment, which should be capable of reacting to changes in the external legal,
economic and market environments.
1.2 Revenue
We use the term costing system to cover the collection, analysis and reporting of
both revenue and cost data. However, although the treatment of cost may vary
depending on which system is used, the treatment of revenue is always the same.
Management accountants apply the realisation concept from nancial
accounting, and so treat revenue as the cash receivable from customers for services
that have been consumed or for tangible products that have been delivered. CIMA
Terminology denes the realisation concept as The principle that increases in value
should only be recognised on realisation of assets by arms length sale to an
independent purchaser.
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contingency theory
The hypothesis that there
can be no universally
applicable best practice in
the design of organisational
units or of control systems
such as management
accounting systems. The
efcient design and
functioning of such systems
is dependent on an
awareness by the system
designer of the specic
environmental factors which
inuence their operation,
such as the organisational
structure, technology base
and market situation.
realisation concept
The principle that increases
in value should only be
recognised on realisation of
assets by arms length sale
to an independent
purchaser.
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1.3 Alternative costing systems
We should distinguish costing systems from costing techniques. Differential costing,
CVP analysis, limiting factor analysis and sensitivity analysis are all techniques that
can provide useful information for planning or decision-making. They are not
systems. A system is dened, in Chapter 3 section 5.2, as an orderly, inter-connected
arrangement of parts. In theory every organisation could use a unique costing
system. However, costing systems tend to t into three major categories. These are:
marginal costing, absorption costing and activity-based costing. Sub-systems,
such as standard costing, can t within any one of these three, distinct, costing
systems.
1.4 Operating statements
The way in which the information used for planning or decision-making is
presented to managers will depend on the problem being tackled.The only criterion
is ease of use, i.e. clarity. The information that managers need for control purposes
should be presented as regular reports that show the quantities, revenues, costs,
prots and losses for the previous month, quarter or year. These reports are called
operating statements. Operating statements are simply regular prot and loss
accounts prepared in a format that is informative for managers.The format will be the
same, or similar, for each department, activity or division in the organisation. Also,
the format will not change from period to period.The use of a standard format aids
comparison between periods and parts of the organisation, and enables managers to
become familiar with the contents and meaning of their operating statements. An
operating statements precise format will depend on the organisation and on the
costing system it uses. Consequently, a key management accounting skill is the ability
to design intelligent and clear operating statements.
1.5 Semi-variable costs revisited
Semi-variable costs are discussed in Chapter 4 section 3.1, where they are dened as
A cost containing both xed and variable components and which is thus partly
affected by a change in the level of activity (CIMA Ofcial Terminology). Although semi-
variable costs can be present in short-term planning and decision models they do not
present a particular problem, as they can be split into their xed and variable
elements. However, it is not always feasible to split a semi-variable cost into its two
components on an operating statement. Also, budgeting can be more complicated in
businesses that have signicant semi-variable costs.
1.6 The valuation of nished stocks and work in progress
The details of the valuation of nished stocks and work in progress will be ignored in
this text, and in the ICSAs Management Accounting examination. There are three
reasons for this:
1 Work in progress and stock valuation adds considerably to the complexity of
examination problems and text examples, without adding signicantly to your
understanding of management accounting principles.
2 The introduction of JIT production has reduced the value of nished stocks and
work in progress in many manufacturing businesses to insignicant levels. As a
result, such rms often ignore the value of stocks and work in progress in their
operating statements.
3 Stock valuation methods such as rst in rst out (FIFO), last in rst out (LIFO)
and average cost (AVCO) are included in the Financial Accounting study text.
Note: CIMA Ofcial Terminology denes FIFO as The principle that the oldest items or
costs are the rst to be used. Most commonly applied to the pricing of the issues of
materials, based on using rst the costs of the oldest materials in stock, irrespective of
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operating statement
Regular prot and loss
accounts prepared in a
format that is informative for
managers.
rst in, rst out
The principle that the oldest
items or costs are the rst to
be used. Most commonly
applied to the pricing of the
issues of materials, based on
using rst the costs of the
oldest materials in stock,
irrespective of the sequence
in which actual material
usage takes place. Closing
stock is therefore valued at
relatively current costs.
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the sequence in which actual material usage takes place. Closing stock is therefore
valued at relatively current costs.
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2 Marginal costing
Marginal costing extends the contribution idea that is used for CVP analysis through
to the routine operating statements that are prepared to assist management control.
In a marginal costing system a products production cost is its variable production
cost. Therefore, any unsold production, i.e. closing stocks or work in progress, will
also be valued at its variable production cost.
Contribution will be revenue less the variable cost of sales.The variable cost of
sales is the variable production cost of the goods or services sold in a period plus any
variable selling and distribution costs. All the xed costs for a period will be charged
to that periods prot and loss account.
The CIMA Ofcial Terminology denes marginal costing as The accounting system in
which variable costs are charged to cost units and xed costs of the period are written
off in full against the aggregate contribution. Its special value is in recognising cost
behaviour, and hence assisting in decision-making.
Marginal costing has a number of distinct advantages:
(a) It uses the same cost logic as CVP, so is consistent with short-term decision-
making techniques. Therefore, a marginal costing system will provide a ready
source of data for solving decision problems.
(b) It is easy for managers to understand the distinction between variable (or
marginal) costs and xed costs.
(c) Highlighting contribution encourages managers to concentrate on sales volume,
rather than production volume, as surplus production does not add to prots.
This may seem obvious, but, as we shall see when we look at absorption costing,
a costing system can encourage production managers to produce goods for stock
without too much concern for eventual sales.
(d) A marginal costing system is simple to operate. Materials costs, direct labour
costs and sales commissions are the main variable costs and they are all
comparatively easy to trace to individual products. Almost all other costs are
period costs, i.e. xed, and can be collected from the routine nancial
accounting records.
test your knowledge 8.1
Classify the following costs as variable (V), semi-variable (S), or xed (F).
Remember, variable costs are costs that change with the level of activity. A cost,
such as rent, which is subject to ination or market-related changes, is not a
variable cost.
1 Ofce rent
2 Direct materials
3 Telephone bill
4 Salaries of sales staff, which contain a commission element
5 Factory power
6 Straight line depreciation of a machine
7 A security guards salary
8 Fuel consumed by a delivery vehicle
9 Supervision
10 A licensing agreement, which contains an annual fee and a volume-related
royalty.
marginal costing
The accounting system in
which variable costs are
charged to cost units and
xed costs of the period are
written off in full against the
aggregate contribution. Its
special value is in
recognising cost behaviour,
and hence assisting in
decision-making.
variable cost of sales
The variable production cost
of the goods or services sold
in a period plus any variable
selling and distribution
costs.
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(e) Marginal costs are useful for identifying minimum selling prices.
The limitations of a marginal costing system are:
(a) As more and more production costs become xed (a salaried workforce, vastly
reduced direct labour content, etc.) materials have become the only signicant
short-term variable production cost. Consequently, alternative systems, such as
activity-based costing are being introduced. Marginal costing is not invalidated,
but its range of applicability, particularly in manufacturing, is decreasing.
(b) Marginal costing can encourage managers to concentrate on maximising contri-
bution per unit, by increasing selling prices and/or reducing variable costs. As a
result, xed costs may be ignored until there is a reduction in sales volume and
panic cuts ensue.
(c) It is a simplistic system, which fails to recognise that upward, or downward,
trends in volume should eventually lead to increased or reduced xed costs.
(Activity-based costing, which is covered in Chapter 9, recognises this and
works to encourage managers to cut xed overhead costs when volume falls
and to extract the maximum value from xed overhead costs when volume
increases.)
(d) Using marginal costs as a basis for determining selling prices can be dangerous,
except for peripheral activities or jobs. A business will be unprotable unless
sufcient contribution is earned to cover all its xed costs.
You may have noticed, in both the advantages and limitations above, that there are
references to the way the costing system can affect how managers behave.The effect
of cost reporting on management behaviour is a theme to which we will return regu-
larly in the remainder of this study text.
Despite the apparent disadvantages of marginal costing it is a powerful costing
system that works well, provided its limitations are understood.
2.1 Marginal costing in manufacturing
Variable production overheads
In a manufacturing business the variable product costs will be materials, direct
labour (provided it varies with output), sales commission, packaging, delivery, royal-
ties and variable production overheads.
Variable production overheads are hard to identify. In fact CIMA Ofcial Terminology
does not have a denition for variable production overheads. Obviously they are
those overheads that alter with the level of manufacturing activity, but in practice
variable production overheads are often insignicant. The cost of some overheads,
such as machine lubricants, disposable tools, some machine maintenance activities,
and factory power, will tend to change in line with output, but it can be hard to
identify them with specic products. Even so, you will often have to deal with manu-
facturing problems that contain variable production overheads. As some of these
variable overheads will be part of semi-variable costs, such as factory power, you may
be expected to use the high-low method described in Chapter 4 section 2.3 to
separate out the xed from the variable cost elements.
Fixed costs
Where possible, the xed costs shown on an operating statement should be grouped
into logical categories, such as xed production overheads, xed selling overheads,
xed distribution and xed administration costs.
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variable production
overhead
Overheads that alter with the
level of manufacturing
activity, such as machine
lubricants, disposable tools,
some machine maintenance
activities, and factory power.
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The above example relates to a single-product rm. However, few rms have only one
product. Businesses that have more than one product will need to have an operating
statement for the whole rm that shows the contribution from each product or
product group separately.The xed costs can then be subtracted from the total of all
the products contributions to arrive at a prot for the period.
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worked example 8.1
Coalesce Ltd manufactures a single product, a food supplement called Pulp. The budgeted sales and cost
gures for the next year are set out below:
Opening stock of nished product at 1 January nil
Production 600,000 kg
Anticipated sales 500,000 kg
Selling price 10.00 per kg
Material cost 2.25 per kg
Variable production overheads 2.65 per kg
Variable selling and distribution overheads 1.10 per kg
Fixed production overheads 900,000 per year
Fixed selling and distribution overheads 500,000 per year
Fixed administration overheads 200,000 per year
Required
Prepare Coalesce Ltds budgeted operating statement for the next year, using a marginal costing format.
Answer
Coalesce Ltd Budgeted operating statement for the next year
Quantities 000 kg per kg 000 000
Sales 500 10.00 5,000
Variable production costs:
Opening stock Nil
Materials 600 2.25 1,350
Variable production overheads 600 2.65 1,590
2,940
Less Closing stock 100 4.90 490
2,450
Variable selling & distribution costs 500 1.10 550
Total variable costs 500 6.00 3,000
Contribution 2,000
Fixed costs:
Production 900
Selling and distribution 500
Administration 200
1,600
Prot (loss) 400
Note: the stock is valued at its variable production cost. Variable selling and distribution costs will not be
incurred until the product has been sold.
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2.2 Marginal costing in service industries
The format for marginal costing operating statements in service industries is similar
to that used in manufacturing.The only difference is that there are no stocks, variable
production overheads or xed production costs. These will be replaced by the vari-
able and xed costs that are relevant to the particular service activity. Variable
materials costs will still occur in service activities such as restaurants and power
generation.
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worked example 8.2
Southwick Carpet Factory has three product-groups: Rugs, Rolls and Underlay. Southwick Carpet Factory uses
JIT purchasing and production, so its opening and closing stocks are insignicant. The budgeted production,
sales and costs for the next year are set out below.
Product Rugs Rolls Underlay

Sales for the year 1,000,000 2,000,000 500,000
Materials 400,000 700,000 250,000
Direct labour 250,000 340,000 50,000
Variable production overheads 30,000 80,000 10,000
Fixed costs:
Production overheads 1,300,000
Selling and distribution overheads 800,000
Administration overheads 280,000
Required
Prepare Southwick Carpet Factorys budgeted operating statement for the next year, using a marginal costing
format.
Answer
Southwick Carpet Factory Budget for next year
Product Rugs Rolls Underlay Total

Sales 1,000,000 2,000,000 500,000 3,500,000
Variable costs:
Materials 400,000 700,000 250,000 1,350,000
Direct labour 250,000 340,000 50,000 640,000
Variable production overheads 30,000 80,000 10,000 120,000
Total variable costs 680,000 1,120,000 310,000 2,110,000
Contribution 320,000 880,000 190,000 1,390,000
Fixed costs:
Production overheads 1,300,000
Selling and distribution overheads 800,000
Administration 280,000
Total xed costs 2,380,000
Prot (loss) (990,000)
Note: do not assume that a business will always make prots. Examination questions often relate to loss-
making enterprises or activities.
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2.3 Marginal costing in extractive industries
There will be little difference between the style of marginal costing operating state-
ment used for extractive industries and that used in manufacturing.There may be no
variable material costs if the business owns the sites from which it operates. However,
mining and similar rms often have to pay a fee or royalty, based on the weight or
volume of raw material extracted, to the owners of the mineral rights.
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theory into practice 8.1
Starburst Displays provides spectacular rework displays for a variety of private and public sector customers.
The costs for the last year were:
Private displays Public displays
Number of displays 85 15
Revenue 465,000 1,240,000
Purchase cost of reworks used 123,000 845,000
Variable labour costs 85,000 45,000
Variable transport costs 17,000 6,000
Fixed costs:
Transport 33,000
Marketing 42,000
Administration 37,000
Required
Prepare a marginal costing operating statement for the last year.
Answer
Starburst Displays Operating statement for last year
Private displays Public displays Total
Number of displays 85 15 100

Revenue 465,000 1,240,000 1,705,000
Variable costs:
Purchase cost of reworks used 123,000 845,000 968,000
Variable labour costs 85,000 45,000 130,000
Variable transport costs 17,000 6,000 23,000
Total variable costs 225,000 896,000 1,121,000
Contribution 240,000 344,000 584,000
Fixed costs:
Transport 33,000
Marketing 42,000
Administration 37,000
Total xed costs 112,000
Prot (loss) 472,000
test your knowledge 8.2
List and explain the advantages and limitations of a marginal costing system.
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3 Absorption costing
3.1 Cost of sales
In an absorption costing system the xed production costs for a period are shared
across the output for that period. Therefore, a products costs will consist of its vari-
able costs, (direct materials, direct labour, and variable (direct) production over-
heads) plus a share of xed production overheads. Closing stocks and work in
progress will therefore include a share of the current periods overheads. As a result,
some of the current periods xed costs will be carried into the next periods
production cost of sales. This is because the production cost of sales, i.e. absorp-
tion costing cost of sales gure is made up of:
the opening stock (including work in progress), valued at the PREVIOUS periods
production costs per unit;
plus the total of the current periods direct material and labour costs;
plus the variable and xed production overheads;
less the closing stock (including work in progress), valued at the CURRENT
periods production costs per unit.
Note: the above denition assumes that stocks are valued on a rst in rst out (FIFO)
basis.
CIMA Ofcial Terminology denes absorption costing as A method of costing that, in
addition to direct costs, assigns all, or a proportion of, production overhead costs to
cost units by means of overhead absorption rates and overhead absorption rate as
a means of attributing overhead to a product or service, based for example on direct
hours, direct labour cost or machine hours.
3.2 The overhead absorption process
In an absorption costing system xed production overheads can be shared
between products (absorbed) in a wide variety of ways. The simplest method is to
divide the total of the xed production overheads for a period by the output in
that period. However, this method will only work where there is a single product.
In multi-product rms, it is usual to go through a complicated four-stage process,
as follows:
Stage 1
Where possible allocate overhead costs to cost centres.Allocated costs are those costs
which clearly belong in total to a particular cost centre, such as the salaries of the staff
employed in that cost centre. Cost centres were described in Chapter 1 section 4.3.
CIMA Ofcial Terminology denes the verb allocate as To assign the whole item of cost,
or of revenue, to a single cost unit, centre, account or time period.
Stage 2
Apportion those costs which cannot be allocated to cost centres, using appropriate
apportionment bases. For example, space costs, such as rent, heat, light and buildings
insurance can be apportioned between cost centres in proportion to the oor area
occupied by each cost centre, using a rate per square metre.
Stage 3
Apportion the costs of non-manufacturing cost centres to manufacturing cost
centres. For instance, the costs of the Maintenance Department could be shared
between manufacturing cost centres in proportion to each manufacturing cost
centres budgeted maintenance requirements.
Stage 4
Share (absorb) the costs of each manufacturing cost centre into the costs of the prod-
ucts that ow through that cost centre, using a predetermined overhead absorption
rate.
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cost of sales (ii)
The sumof the variable cost
of sales plus factory overhead
attributable to the sales. In
management accounts this
may be referred to as the
production cost of sales or
cost of goods sold.
production cost of sales
The absorption costing cost
of sales. The gure is made
up of the opening stock
(including work in progress),
valued at the previous
periods production cost per
unit, plus the total of the
current periods direct
material and direct labour
costs plus the variable and
xed production overheads
less the closing stock
(including work in progress),
valued at the current periods
production cost per unit.
Note: the above denition
assumes that stocks are
valued on a rst in rst out
(FIFO) basis.
absorbed overhead
Overhead costs that are
added to the direct costs of
products or services using
an absorption rate such as
x per direct labour hour.
absorption/overhead
absorption rates
A means of attributing
overhead to a product or
service, based for example
on direct hours, direct labour
cost or machine hours.
allocate
To assign the whole item of
cost, or of revenue, to a
single cost unit, centre,
account or time period.
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3.3 Overhead absorption rates
The sum of each manufacturing cost centres allocated and apportioned costs can be
absorbed by the products that ow through that cost centre in many different ways.
The most common overhead absorption methods are:
1 A rate per direct labour hour.The cost centres budgeted (or actual) total overhead
cost is divided by the cost centres budgeted (or actual) direct labour hours
worked. This is similar to the approach used by the accounting and legal
professions (and garages) where the expected total costs for a period are divided
by the expected chargeable hours to be worked in that period to arrive, after an
addition for prot, at an hourly charging rate.
2 A percentage rate added onto the direct labour cost. The total overhead cost for a
cost centre is divided by the cost of its direct labour, and the result converted to a
percentage. This method and the previous one will be used for labour-intensive
cost centres.
3 A machine hour rate, where the cost centres total overhead cost for a period is
divided by the total machine hours spent on production. This can be used for
highly mechanised processes.
3.4 The impact of absorption costing on management behaviour
As you can see from the previous two sections, full-blown absorption costing is a
complicated process. Early manufacturing rms were comparatively simple, and
xed overheads were a small proportion of total costs.Therefore, it seemed logical to
attach a share of overhead cost to products so that comparisons could be made with
selling prices. However, due to a series of internal and external pressures, manage-
ment accountants during the rst half of the twentieth century developed the over-
head absorption system to a high state of sophistication without realising that the
gures that were being produced were at best irrelevant and at worst misleading.
If you go back and look at the four stages in section 3.2 above you will notice
that only the rst stage is objective. Each of the subsequent stages relies on sharing
costs between cost centres and products, without any serious attempt to link cause
and effect. This means that the only reliable part of a products costs in an absorp-
tion costing are its direct costs, all the other costs are arbitrary additions, the
amount of which depend on the apportionment and absorption bases used. This
means that absorption costing is useless for decision-making, misleading for plan-
ning purposes and may produce unintended management behaviour if it is used
for control.
For an elaboration of these arguments, see Chapter 9 section 1 particularly the
reference to Johnson and Kaplans Relevance Lost (Chapter 9 section 1.3).
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absorption costing
A method of costing that, in
addition to direct costs,
assigns all, or a proportion
of, production overhead
costs to cost units by means
of overhead absorption
rates.
worked example 8.3
Dunster Margins Ltd makes two sizes of moulded plastic container. The company has a single manufacturing
cost centre, the moulding department. Budgeted sales and costs for the next year are:
Product 1 m
3
container 2 m
3
container
Sales volume (units) 100,000 200,000
Selling price per unit 5 10.50
Direct materials cost per unit 2 6
Direct labour hours per unit 0.1 0.1
Moulding machine hours per unit 0.1 0.4
The direct labour wage rate is 10 per hour.
The allocated and apportioned costs for the moulding department for the coming year are expected to be
900,000.
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worked example 8.3 continued
Required
Calculate the budgeted production cost per unit and gross prot per unit for each product, using the following
absorption bases:
(a) direct labour hours;
(b) moulding machine hours.
Answer
(a) First calculate the total labour hours for the year:
(100,000 units 0.1) (200,000 units 0.1) 30,000 direct labour hours.
Then calculate the absorption rate per hour 900,000 30,000 30 per direct hour
Product 1 m
3
container 2 m
3
container
Direct labour hours per unit 0.1) 0.1
)
Selling price per unit (given) 5.00) 10.50
Costs
Direct materials cost per unit (given) 2.00) 6.00
Direct labour per unit @ 10 per hour 1.00) 1.00
Moulding overhead per unit @
30 per labour hour 3.00) 3.00
Total cost per unit 6.00) 10.00
Gross prot (loss) per unit (1.00) 0.50
(b) Total machine hours for the year (100,000 units 0.1) (200,000 units 0.4) 90,000
Absorption rate per machine hour 900,000 90,000 10 per machine hour
Product 1 m
3
container 2 m
3
container
Moulding machine hours per unit 0.1 0.4

Selling price per unit (given) 5.00 10.50
Costs
Direct materials cost per unit (given) 2.00 6.00
Direct labour per unit @ 10 per hour 1.00 1.00
Moulding overhead per unit
@ 10 per machine hour 1.00 4.00
Total cost per unit 4.00 11.00
Gross prot (loss) per unit 1.00 (0.50)
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As you can see, even with a simple case the choice of absorption basis can profoundly
affect the apparent cost and protability of products.
One benet that can be obtained from an absorption costing system is that it can
encourage production managers to economise on their consumption of the resource
that is used as an absorption basis. For instance, in the above example Dunster
Margins Ltd are, in fact, breaking even. (Check and you will nd that the total prot
from one container matches the total loss from the other, whichever absorption basis
you choose.) Therefore, if the top management at Dunster Margins Ltd wanted to
encourage the Production Manager to economise on labour, they could adopt direct
labour hours as the absorption basis.The Production Manager would be encouraged
to reduce the labour hours per unit, and prots should follow.
However, Dunster Margins Ltds Production Manager could attempt an alternative
tactic s/he could increase output. This would spread the xed costs over a greater
volume and result in an increased stock of nished goods at the end of the year.
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theory into practice 8.2
(Same facts as Worked Example 8.3 above)
Calculate the unit prots for the 1 m
3
and 2 m
3
containers if Dunster Margins Ltd used a rate per of direct
materials cost to absorb the moulding department overhead.
Answer
Total material cost for the year = (100,000 units 2) + (200,000 units 6) = 1,400,000
Absorption rate per material = 900,000 1,400,000 = 0.643
Product 1 m
3
container 2 m
3
container

Selling price per unit (given) 5.00 10.50
Costs
Direct materials cost per unit (given) 2.00 6.00
Direct labour per unit @ 10 per hour 1.00 1.00
Moulding overhead @ 0.643 per material 1.28 3.86
Total cost per unit 4.28 10.86
Gross prot (loss) per unit 0.72 (0.36)
If Dunster Margins Ltd uses direct labour hours as the overhead absorption basis the 1m
3
container appear to
be loss-making, and the 2m
3
container would seem to be prot-making. Therefore, management might decide
to concentrate production on the 2m
3
container. However, if Dunster Margins Ltd used machine hours, or
materials costs, as the overhead absorption basis, the reverse would be the case.
theory into practice 8.3
(Based on Worked Example 8.3)
Dunster Margins Ltd makes two sizes of moulded plastic container. The company has a single manufacturing
cost centre, the moulding department. Budgeted sales and costs for the next year are:
Product 1 m
3
container 2 m
3
container
Sales volume (units) 100,000 200,000
Selling price per unit 5 10.50
Direct materials cost per unit 2 6
Direct labour hours per unit 0.1 0.1
Moulding machine hours per unit 0.1 0.4
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3.5 Benets and drawbacks of absorption costing
Despite the fact that the use of absorption costing is still widespread, there appear to
be only two benets from using the system:
1 It can encourage managers to economise on their consumption of whichever
production factor, (material, labour, machine time), is used as an absorption basis.
2 It complies with the stock and work in progress valuation criteria set out in
Statement of Standard Accounting Practice 9 (SSAP 9). However, for rms which
use JIT manufacturing, this particular advantage is of historical signicance only.
The drawbacks are:
1 The apportionment and absorption bases used are arbitrary and subjective. This
can lead production managers to spend time arguing for alternative apportion-
ment or absorption bases, in an attempt to reduce the perceived costs of their
activities or products.
2 The process of building up absorption costs in rms with many different overhead
and manufacturing cost centres is extremely complicated.
3 Product costs can be misleading, as we saw in the examples above.
4 Production managers may manufacture excess output in an attempt to bring down
unit costs.
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theory into practice 8.3 continued
The direct labour wage rate is 10 per hour.
The allocated and apportioned costs for the moulding department are expected to be 900,000 for the coming
year.
In an effort to reduce unit costs, Dunster Margins Ltds Production Manager has decided to produce 150,000
1m
3
containers and 300,000 2m
3
containers. This means that year-end stocks will increase by 50,000 1m
3
containers and 100,000 2m
3
containers.
Required
Calculate the budgeted production cost per unit and gross prot per unit for each product using the direct
labour hours absorption basis.
The total labour hours for the year (150,000 units 0.1) (300,000 units 0.1) 45,000
The absorption rate per hour 900,000 45,000 20 per direct hour
Product 1 m
3
container 2 m
3
container
Direct labour hours per unit 0.1 0.1

Selling price per unit (given) 5.00 10.50
Costs
Direct materials cost per unit (given) 2.00 6.00
Direct labour per unit @ 10 per hour 1.00 1.00
Moulding overhead per unit @ 20 per labour hour 2.00 2.00
Total cost per unit 5.00 9.00
Gross prot (loss) per unit Nil 1.50
The budgeted operating statement for Dunster Margins Ltd will now show a gross prot of 300,000 (200,000
2m
3
containers @ 1.50 per container). Unsold stocks will be valued at their absorption cost, i.e. (50,000
1m
3
containers 5.00) (100,000 2m
3
containers 9) 250,000 900,000 1,150,000.
The stock value will be made up of direct (variable) cash costs of (50,000 3) (100,000 7)
850,000 and absorbed overheads carried forward of 300,000, i.e. 150,000 units @ 2 per unit.
Dunster Margins Ltd will achieve a 300,000 prot in the year, due to the overheads carried forward, but will
be left with excess stock, which will require an additional cash outlay of 850,000. If this excess output
cannot be sold in the following year there could be a signicant fall in the companys prots.
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5 Stock valuations bear no relation to the real cost of producing the stock, i.e. the
cash cost, avoidable cost or opportunity cost.
The consequences of these drawbacks are that, since the mid 1980s, many manufac-
turers have abandoned absorption costing in favour of a new system called activity-
based costing. Activity-based costing (ABC) attempts to deal with the problems
caused by an uncritical use of absorption costing, by focussing managers attention
on the overhead costs that are CAUSED by a product. ABC is covered in the next
chapter.
3.6 Absorption costing in service industries
It is difcult to apply absorption costing in service industries because the necessary
cost tracking systems do not normally exist. It is comparatively easy to follow a
tangible product through the manufacturing processes needed to produce it.
Imagine trying to set up an absorption costing system for a bus company.
However, many service organisations calculate average costs for their outputs, i.e.
total variable and xed costs divided by units of service.The information gained may
be less useful than separating out the variable costs (if any) and calculating the
contribution from each product, but it is reasonably easy to understand. Average
costing does encourage service providers to increase volume and to drive down
costs, albeit in an indiscriminate fashion. (Anyone who has worked for a service
organisation that imposes freezes or cuts whenever the sales levels go down can
appreciate this point.) Fortunately, as one of the characteristics of services is that they
are perishable, i.e. cannot be stored (see Chapter 2.2), average costing cannot
encourage service providers to produce for stock.
Those professions and businesses which charge for their services using an hourly
rate, such as accountants, lawyers and motor repair workshops, should have no dif-
culty in calculating an average cost per hour. They can simply take the sum of their
budgeted costs for the next period and divide by the anticipated workload expressed
in chargeable hours.This information can be valuable for monitoring cost-efciency
and for comparison with market charging rates.
More complex businesses may have a variety of disparate outputs. For instance, a
typical hotel will provide at least three distinct services: accommodation, restaurant
meals, and a bar or caf. In theory, one could set up an absorption costing system that
shared (apportioned) all the xed costs between these three product-groups, and
then attached the allocated and apportioned costs to units of product, e.g. bed-nights,
meals served, bar turnover. However, it is unlikely that this process would provide any
information of value for decision-making, planning or control.
4 Comparison between marginal and absorption
costing
It is worth ending this chapter with a more complex manufacturing example, to
show how the apportionment stage of absorption costing works, and to illustrate the
differing effect on prots of marginal and absorption costing systems.
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worked example 8.4
Rebatll Plastics Plc plans to open a new factory to manufacture plastic water supply pipes in standard 3
metre lengths. You have been given the task of preparing the budget for the factorys rst year of operations.
You have obtained the cost information set out below.
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worked example 8.4 continued
000
Factory:
Raw materials 2,400
Direct labour 4,500
Variable overheads 2,100
Indirect materials 91
Indirect wages and salaries 600
Depreciation 800
Administration, selling and distribution:
Stationery and other ofce expenses 100
Salaries 400
Depreciation 150
Maintenance department:
Materials 65
Wages and salaries 175
Depreciation 30
Space costs:
Rent and rates (property tax) 1,200
Heat and light 200
Building insurance 100
Cleaning and security 300
Total space costs 1,800
Maintenance department hours:
Factory 18,000 (90 per cent)
Administration, selling and distribution 2,000 (10 per cent)
Total 20,000
Floor area, in square metres:
Factory 900 (60 per cent)
Administration, selling and distribution 150 (10 per cent)
Maintenance department 450 (30 per cent)
Total 1,500
Selling price per pipe 60
Sales, number of pipes 270,000
Production, number of pipes 300,000
Sales commission, as a percentage of sales revenue 10 per cent
Required
Produce two summary budgeted prot and loss accounts for the year
(a) using absorption costing principles
(b) using marginal costing principles.
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worked example 8.4 continued
Answer
It may be helpful if you review the stages in the overhead absorption process set out in section 3.2 above
before working through the suggested solution below.
(W1) Apportionment of overheads:
Factory Admin., etc. Maintenance Total
000 000 000 000
Allocated costs:
Indirect materials & expenses 91 100 65 256
Indirect wages & salaries 600 400 175 1,175
Depreciation 800 150 30 980
Total allocated costs 1,491 650 270 2,411
Space costs (1,800,000 per cent oor area) 1,080 180 540 1,800
Total xed costs 2,571 830 810 4,211
Maintenance Dept. (810,000 per cent hours) 729 81 (810) 0
Total xed overheads 3,300 911 0 4,211
(a) Rebatll Plastics Plc Budgeted prot and loss account (absorption costing):
Units 000 per unit 000 000
Sales 270 60 16,200
Production costs:
Raw materials costs 300 8 2,400
Direct labour 300 15 4,500
Variable overheads 300 7 2,100
Fixed factory overheads (W1) 300 11 3,300
Total production costs 300 41 12,300
Less Closing stock 30 41 1,230
Production cost of sales 270 41 11,070
Gross prot 5,130
Administration selling and distribution costs:
Sales commission, 10 per cent of sales 1,620
Fixed overheads (W1) 911
2,531
Prot 2,599
Note: there are no opening stocks as this is Rebatll Plastics Ltds rst year in business.
(b) Rebatll Plastics Plc Budgeted prot and loss account (marginal costing):
Units 000 per unit 000 000
Sales 270 60 16,200
Variable production costs:
Raw materials costs 300 8 2,400
Direct labour 300 15 4,500
Variable overheads 300 7 2,100
Total variable production costs 300 30 9,000
Closing stocks 30 30 900
270 30 8,100
Sales commission 270 6 1,620
Variable cost of sales 270 36 9,720
Contribution 270 24 6,480
Fixed costs: (total from W1) 4,211
Prot 2,269
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theory into practice 8.4
(Using the same data as Worked Example 8.1)
Coalesce Ltd manufactures a single product, a food supplement called Pulp. The budgeted sales and cost
gures for the next year are set out below.
Opening stock of nished product at 1 January Nil
Production 600,000 kg
Anticipated sales 500,000 kg
Selling price 10.00 per kg
Material cost 2.25 per kg
Variable production overheads 2.65 per kg
Variable selling and distribution overheads 1.10 per kg
Fixed production overheads 900,000 per year
Fixed selling and distribution overheads 500,000 per year
Fixed administration overheads 200,000 per year
Required
Prepare Coalesce Ltds budgeted operating statement for the next year, using an absorption costing format.
Answer
Coalesce Ltd Budgeted operating statement for the next year
Quantities (kg) per kg 000 000
Sales 500,000 10 5,000
Production costs:
Opening stock nil
Materials 600,000 2.25 1,350
Other variable costs 600,000 2.65 1,590
Fixed production costs 600,000 1.50 900
3,840
Closing stock 100,000 6.40 640
3,200
Gross prot 1,800
Administration 200
Selling & distribution variable cost 500,000 1.10 550
Selling & distribution xed cost 500
1,250
Prot (loss) 550
theory into practice 8.5
Explain, using the gures contained in the answers to
Worked Examples 8.1 and 8.4 above, why Coalesce
Ltds budgeted absorption cost prot gure is
different from its marginal costing prot.
Answer
Explanation for the difference between Coalesce Ltds
marginal and absorption costing prots:
In the marginal costing version xed production
costs have been treated as a period cost and the
whole amount taken into the budgeted costs for
the year.
In the absorption costing version xed production
costs have been shared across the production for
the period, i.e. at 900,000 600,000 1.50
per kg. As production was 100,000 kg greater
than sales 100,000 1.50 of the budgeted
xed production costs are included in closing
stock in the absorption costing version
150,000. This 150,000 has been carried
forward into the next trading year.
Note: when sales volume exceeds production volume
the stocks of nished goods are reduced. As a result
the marginal costing prot will be larger than the
absorption costing prot.
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test your knowledge 8.3
(a) List and explain the benets and drawbacks of an absorption costing system.
(b) What are the three most common overhead absorption methods?
(c) Why is it difcult to apply absorption costing to service industries?
(d) What is the difference between absorption and marginal costing systems?
CHAPTER SUMMARY
This chapter introduces two different types of costing
system, both of which will be referred to in the later chapters
on budgeting, budgetary control and standard costing. It:
explains the need for formal costing systems, as opposed
to ad hoc enquiries;
discusses the relevance of contingency theory to
management accounting;
explains that different costing systems will all base their
denitions of revenue on the realisation concept;
describes the content of operating statements;
revises semi-variable costs;
explains why the detailed valuation of nished stocks and
work in progress will be ignored in this text and in the
examination;
describes how marginal costing systems work;
discusses the advantages and limitations of marginal
costing;
illustrates the preparation of marginal costing operating
statements in manufacturing;
illustrates the preparation of marginal costing operating
statements in a service activity;
describes the preparation of marginal costing operating
statements in extractive industry;
describes the calculation of production cost of sales in an
absorption costing system;
describes the overhead absorption process in
manufacturing;
denes the calculation of labour hour, labour cost,
machine hour and material cost overhead absorption
rates;
discusses the impact of absorption costing on
management behaviour;
lists the benets and drawbacks of absorption costing;
discusses the application of absorption costing in service
industries;
compares the effects of marginal and absorption costing
on reported prots.
The marginal costing format is the default design for
operating statements in the ICSAs Management Accounting
syllabus and examination. Therefore, you should expect to
be required, in the examination, to prepare budgeted and
actual operating statements in a marginal costing format. In
fact, you should always organise your answers around a
marginal costing format, unless you are specically required
to use a different layout.
The absorption costing areas that you should concentrate on
are:
recognition that the absorption costing system attributes
costs to products in a subjective, arbitrary fashion; which
does not discriminate between xed and variable costs;
an appreciation of its behavioural impact, both negative
and positive;
the ability to calculate prots using an absorption costing
operating report format.
You will not be expected to carry out the full, four-stage,
absorption costing process in the examination, but you
should be able to describe it.
PRACTICE QUESTIONS
Section A (4 marks each)
8.1 Write brief notes describing contingency theory and explaining its signicance for management accounting.
8.2 The accounts of Ebbsbourne Chemicals contain the following gures in respect of its rst trading period:
Output 100,000 units
Sales 80,000 units
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Variable production costs 600,000
Fixed production costs 500,000
Required
(a) What would be the cost of sales for the trading period if Ebbsbourne Chemicals operates a
marginal costing system?
(b) What would be the cost of sales for the trading period if Ebbsbourne Chemicals operates
an absorption costing system?
8.3 What is an operating statement? What information should an operating statement contain,
and why should it be prepared to a standard format?
8.4
(a) Dene the term variable cost of sales.
(b) Describe how the production cost of sales is calculated in an absorption costing system.
8.5
(a) Dene the term allocated cost.
(b) List the four stages in the overhead absorption process.
Section B (20 marks each)
8.6 Crondle Aggregates Ltd operates at several sites in the UK, where the company extracts
gravel, sand and granite chippings. Revenues, costs and quantities in the last year were:
Product Gravel Sand Granite chippings
Tonnes Tonnes Tonnes
Extracted and sold 25,000 32,000 60,000

Revenue 250,000 640,000 1,800,000
Royalties 50,000 96,000 240,000
Direct labour 125,000 134,000 250,000
Variable extraction costs 75,000 64,000 300,000
Variable transport costs 25,000 32,000 60,000
Fixed costs:
Extraction 485,000
Transport 342,000
Administration 79,000
Opening and closing stocks were minimal.
Required
(a) Prepare an operating statement, in a marginal costing format, for Crondle
Aggregates Ltd, which covers the last year. (10 marks)
(b) Set out the advantages and the drawbacks of using a marginal costing system. (10 marks)
8.7 Claybrook plc owns a small brickworks that produces three types of paving brick.
Details for each type of brick are:
Selling price Material cost Weight
per brick per brick per brick
Blue-black Victorian (BVs) 1.90 0.60 5 kg
Deep red Dutch (DRs) 1.34 0.50 4 kg
Yellow Peterboroughs (YPs) 0.99 0.27 3 kg
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The brickworks costs 22,000 per week to run. This cost is not affected by the quantity of
paving bricks produced.
Claybrook plcs accounting policy is to apportion the weekly running costs to each type of brick
according to the number of bricks produced. For instance, if 10,000 bricks were produced in a
week then running costs would be apportioned on the basis of 2.20 per brick. This gure is
then added to the material cost for each type of brick to obtain a cost for each type, which can
be compared with its selling price.
Current weekly production is 5,000 BVs; 7,500 DRs and 15,000 YPs.
The maximum weekly demand is 6,000 BVs; 20,000 DRs and 15,000 YPs.
The brickworks has the capacity to produce a maximum of 100 tonnes of bricks per week.
A new General Manager has examined the accounts and found that the YPs show a loss.
Consequently he proposes a revised plan: to produce 6,000 BVs per week, plus as many DRs
as are possible with the remaining capacity.
Required
(a) Comment on the usefulness of the accounting method adopted by Claybrook plc.(5 marks)
(b) Produce what you consider to be the optimum weekly production plan and calculate the
increase in prot, which will result, compared with (i) the current production pattern and
(ii) the General Managers plan. (15 marks)
8.8 Landseer Ltd manufactures parts and components, which it supplies from stock to the
motor industry. As company secretary, you have just taken over responsibility for supervising
the production of management accounting information, following the retirement of the
management accountant and his replacement by a new recruit. Landseer Ltd uses a
conventional absorption costing system in which overheads are absorbed by products using a
rate per labour hour. This information is used for budgetary control, pricing and product
protability analyses.
Required
(a) Prepare a short paper, for submission to the next board meeting, detailing the drawbacks
of using absorption costing in the three areas mentioned above. (13 marks)
(b) The new management accountant wishes to replace the absorption costing system, but
seems unable to nd a costing system that meets all the organisations needs. Advise her.
(7 marks)
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