The joys of costing: part 1
There are several topics that are likely come to mind when students think back to their good old Business Management (BM) Days. A straw poll of former BM students revealed that absorption and marginal costing still give some nightmares!
With that in mind, we focus on the different costing methods and modules introduced in BM and get back to basics with costing.
There is a valid reason for the variety of options; in practice, businesses use a wide variety of different costing methods and it’s essential to reflect that in the CA qualification. These methods will then be taken and expanded upon elsewhere in the qualification – for example:
- ABS and FR have both been known to use the standard costing (variance analysis) introduced in BM, in larger TPS situations.
- FR could also ask students to look at the cost of inventory using absorption costing, while having an awareness of fixed and variable costs.
- Afin requires students to have a good understanding of the idea of fixed and variable costs, not to mention relevant, opportunity and sunk costs.
- And as ever, TPE could cover any of the costing methods from BM. For example, you could have to assess the costing of a new or existing product as part of a larger case study scenario.
Let’s start with everyone’s ‘favourite’, which is covered in BM module five. Under absorption costing, you include all of the costs of producing a product in its stock and cost of sales value.
Stock will include:
- Variable production costs, like direct labour and direct materials in the stock value; but also
- Fixed production costs, otherwise known as the OAR in the stock value.
The OAR, or overhead absorption rate, is normally calculated as: Budgeted Fixed production cost / a budgeted basis.
The budgeted basis is often budgeted production units – this gives you an OAR per unit. However, it could also be budgeted labour hours or budgeted machine hours for example, which gives you an OAR per hour.
Imagine that you calculate an OAR of £5 per unit. This means that for every unit you actually produce during the year, you will absorb £5 into your P/L in relation to fixed costs.
At the period end, you compare your absorbed amount (OAR x actual production units) to your actual fixed cost. This usually results in an over or under absorption adjustment, which needs to be posted through your P/L.
Marginal costing by contrast only includes the variable costs of production in the stock value and cost of sales. As such, any fixed cost is written off in the year incurred. Marginal costing utilises another popular BM concept of contribution.
Contribution is a key feature of a marginal costing profit statement, and it allows marginal costing to split out the fixed and variable costs as follows:
Check out Part 2 in our Costing basics; featuring standard costing, overhead accounting, costs and revenues, activity-based costing, and process costing.