The Institute of Finance Management

Department of Accounting and Finance

Lecture Notes
Management Accounting
By Dr Zawadi Ally 2023

Cost Accounting Techniques

1 Income Effect of Alternative Cost Accumulation
System

Learning aims

Students should be able to

• Illustrate the overhead cost allocation and apportionment

• Understand the nature of marginal and absorption costing
• Differentiate between marginal and absorption costing
• Prepare profit statements based on marginal and absorption costing
• Explain the differences and reconcile the profits between marginal and
absorption costing
• Explain the argument for and against marginal and absorption costing
1.1.1 Introduction

This section will explain and demonstrate the alternative cost accumulation system
of marginal costing and absorption costing. The section will then recognize the
alternative uses of cost accounting information and the appropriateness of each
system to those uses.

1.1.2 Overhead Costs Allocation and Apportionment

Overhead costs are all costs on the income statement except for direct labour,
direct materials, and direct expenses. Overhead costs are also known as indirect
costs; including accounting fees, advertising, insurance, interest, legal fees, labor
burden, rent, repairs, supplies, taxes, telephone bills, travel expenditures,
depreciation, advertising, ordering costs, utilities etc.

Allocation and apportionment are methods that are used to assign various overhead
costs to their respective cost centres. Allocation can only be used when the entire
overhead cost is directly related to one product or department and apportionment
is used when proportions of the overhead costs arise from a number of different
products or departments.

1.1.3 Overhead Cost Allocation

Overhead cost allocation occurs when overhead costs are charged directly to the
cost center. For example, if an air conditioning unit is used separately by one
department, the entire cost of using the air conditioner will be allocated to that
specific department. There are a number of conditions that needs to be met for an
overhead to be allocated. These conditions are that the expense must have been
caused by the cost centre and the specific amount of overhead costs should be
known. Hence, allocation is the process of charging a cost directly to the source of
the expenditure

1.1.4 Overhead Cost Apportionment

Overhead cost apportionment occurs when a specific cost cannot be directly

identified with one specific cost centre. Any cost that does not belong to one
product or department and is shared by several products/ departments will be
divided among these departments using apportionment.
1.1.5 Difference between Allocation and Apportionment

Allocation and apportionment are methods that are used to divide up overhead
costs among various cost centres depending on which product, department or cost
centre each cost or portions of each cost belongs. The major difference between
allocation and apportionment methods are that allocation is used when the
overhead cost can be directly related to one product, department or cost centre,
and apportionment is used when the overhead cost arises from a number of
products or departments. In allocation, the entire amount of the overhead cost will
be allocated to one product or department, and in apportionment proportions of
the costs will be divided among their respective cost centre.

1.1.6 Overhead Costs Absorption

Absorption of overhead cost is also known as recovery, or application of overhead.

Overhead cost absorption refers to the process of absorbing all overhead costs to
a particular cost centre, product or department by the base applicable to the cost
centre. This is the process by which overhead costs are included in total cost of a
product or department.

The apportionment of overhead expenses is done by adopting suitable basis such as

output, materials, prime cost, labour hours, machine hours etc. In order to
determine the absorption of overhead in costs of jobs, products or department, a
rate is calculated and it is called as "Overhead Absorption Rate" or "Overhead
Rate." The overhead rate can be calculated as below:

Total Budgeted Overhead of Cost Centre

OAR( overhead absorption rate) =
Base Applicable to the Cost Centre

1.1.7 Methods of Absorption of Overhead

There are a number of methods applicable for computing overhead absorption rate.
The following are the various methods of absorbing “Overhead Cost" depending
upon the suitable basis selected for the purpose

1. Direct Material Cost Method

 2. Direct Labour Cost Method
3. Direct Labour Hours Method
4. Prime Cost Method
5. Unit of Output Method
6. Machine Hour Rate Method

1. Direct Material Cost Method: Under this method, the rate of absorption is
calculated on the basis of direct material cost method. The rate of
manufacturing overhead absorption is determined by dividing the overhead
cost by the direct material cost. The result obtained the rate of absorption is
expressed as percentage.
2. Direct Labour Cost Method: Direct Labour Cost Method is also termed as
Direct Wages Method. Under this method direct wage rate can be determined
by dividing the estimated factory overhead cost apportioned by the
predetermined direct wages, and the result obtained is expressed as a
percentage.
3. Direct Labour Hours Method: Under this method the rate is determined by
dividing the production overheads by direct labour hours of each department.
This method is designed to overcome the objections of direct labour cost
method. This method is most suitable in such industries where the production
is carried out manually or by skilled labours.
4. Prime Cost Method: Under this method, both direct material cost and direct
labour cost are taken into account for determination of recovery rate. The
actual or predetermined rate of factory absorption is computed by dividing
actual or budgeted overhead expenses by the aggregate of direct material or
direct labour cost of the department.
5. Unit of Output Method: This method is also termed as Production Unit
Method or Cost Unit Rate Method. Under this method absorption rate is
determined on the basis of number of units produced is known as Cost Unit
Rate. The recovery rate is calculated by dividing the actual or budgeted
factory overheads by the number of cost units produced.
6. Machine Hour Rate: Machine hour rate means the cost or expenses incurred in
running a machine for one hour. It is one of the scientific methods of
absorbing factory expenses where the process of manufacturing are carried
out by machines. Under this method overhead costs are allocated on the basis
of the number of hours a machine or machines are used for a particular job.
The following data will be used to demonstrate the calculation of various method of
overhead absorption rate

Data relating to BM shop for December 2016

Total overhead costs Shs. 60,000
Total direct labour hours 8,000
Total direct wages Shs. 16,000
Total direct material used Shs. 30,000
Total machine hours 12,000
Total units produced 450 units

Calculation of overhead absorption rate

• Direct labour hour overhead absorption rate (OAR)

OAR = Shs. 60,000/ 8,000hrs = Shs. 7.50 per direct labour

• Direct wages overhead absorption rate (OAR)

OAR= Shs. 60,000/Shs. 16,000 = 375% of wages

• Direct Material overhead absorption rate (OAR)

OAR = Shs. 60,000/Shs. 30,000 = 200% of Material

• Prime cost overhead absorption rate (OAR)

OAR= Shs. 60,000/Shs. 4,600 = 130% of prime cost

• Machine hour overhead absorption rate (OAR)

OAR = Shs. 60,000/12,000 hrs = Shs. 5.00 per machine hours

• Cost unit overhead absorption rate (OAR)

OAR = Shs. 60,000/450 units = Shs. 133 per unit produced

1.1.8 Applying the overhead absorption rate

The above example illustrates the most common methods of calculating overhead
absorption rates but only one of them would be selected for each cost centre. The
example shown below will illustrate the application of overhead absorption rate in
the computation the cost of a product.

Unit XA in the BM shop

Direct material Shs. 23.00
Direct wages Shs. 27.50
Direct labour hours 12 hours
Machine hours 17 hours

To calculate the full cost of unit XA using a direct labour hours overhead
absorption rate
Shs
Direct material 23.00
Direct labour 27.50
Prime cost 50.50
Overhead cost 12 x Shs. 7.50 90.00
Full cost 140.50

Comparison of Alternative Base

Absorption base OAR Cost Data Calculation OAR per unit
Direct labour Shs. 12 12 x Shs. 7.50 Shs. 90.00
hour 7.50
Direct wages 375% Shs. 3.75 x Shs. Shs. 103. 13
27.50 27.50
Direct material 200% Shs. 23 2 x Shs. 23.00 Shs. 46.00
Prime cost 130% Shs. 1.3 x Shs. 50.50 Shs. 65.65
50.50
Machine hour Shs. 17 hrs 17hrs x Shs.5.00 Shs. 85.00
5.00
Cost unit Shs. 1 unit 1unit x Shs. 133 Shs. 133.00
133

1.1.9 Under Absorption and Over Absorption of Overheads

Absorption of overhead may be based either on the actual rate or predetermined

rate. If the actual rates are used, the costs having been actually incurred and
overhead absorbed are equal. But in the case of predetermined rates, the costs
have been determined in advance of incurrence of the overhead expenditure. This
may lead to difference of overhead incurred and overhead absorbed. Such a
difference of Overhead is said to be under absorption of overhead or over
absorption of overhead. According the term over absorption means that the
amount of overhead absorption is more than the actual overhead is said to be over
absorption of overhead. The term under absorption of overhead means that the
amount of overhead absorption is less than the actual overhead incurred is said to
be under absorption of overhead.

Example 1
Company recovers its overheads based upon direct labour hours. The planned
overhead expenditure is Shs. 2,500,000 per month and the planned direct labour
hours are 1,000 per month. The results for the first 3 months were as follows:

Month 1 Month 2 Month 3

Actual Overhead (Shs.) 4,000,000 5,000,000 3,500,000
Direct labour hours 1,000 2,000 2,000

Required:
(a) Compute the overheads absorption rate in each month;
(b) Compute the total overheads over/under-absorbed

Solution:
(a) The pre-determined overhead absorption rate:
= Budgeted overhead cost per month/Budgeted direct labours per month
=Shs. 2,500,000/1,000 hours=Shs. 2,500 per direct labour hour.

Month 1 Month 2 Month 3

Actual Overhead (Shs.) 4,000,000 5,000,000 3,500,000
Direct labour hours (a) 1,000 2,000 2,000
Overhead Recovery per direct labour 2,500 2,500
2,500
hour (b)
Overhead recovered or absorbed (a x 2,500,000 5,000,000
5,000,000
b)

(b) The monthly over/under absorption of overheads is the difference between

the overhead recovered or absorbed and the actual level of overhead for
the period
 Month 1 Month 2 Month 3
Actual Overhead (a) 4,000,000 5,000,000 3,500,000

Overhead recovered (b) 5,000,000

5,000,000
2,500,000

Over/(under) absorbed overhead (1,500,000) 1,500,000

0
(a)-(b)

Example 2
Moro Limited is an engineering company which uses job costing to attribute costs
to individual products and services provided to its customers. It has commenced
the preparation of its fixed production overhead cost budget for 20X7 and has
identified the following costs:

(Shs.000)
Machining 600
Assembly 250
Finishing 150
Stores 100
Maintenance 80
1 180

The stores and maintenance departments are production service departments.

An analysis of the services they provide indicates that their costs should be
apportioned accordingly:

Machining Assembly Finishing Stores Maintenance

Stores 40% 30% 20% —
10%
Maintenance 55% 20% 20% 5% —

The number of machine and labour hours budgeted for 20X7 is:
 Machining Assembly Finishing
Machine hours 50 000 4 000 5 000
Labour hours 10 000 30 000 20 000

Required
(a) Calculate appropriate overhead absorption rates for each production
department for 20X7.
(b) Prepare a quotation for job number XX34, which is to be commenced early in
20X7, assuming that it has:
Direct materials costing Shs 2400
Direct labour costing Shs 1500
and requires:
Machine Labour
hours hours
Machining department 45 10
Assembly department 5 15
Finishing department 4 12
and that profit is 20% of selling price.

(c) Assume that in 20X7 the actual fixed overhead cost of the assembly
department totals
Shs. 300, 000 and that the actual machine hours was 4,200 and actual labour
hours were 30,700. Prepare the fixed production overhead control account for
the assembly department, showing clearly the causes of any over-/under-
absorption.

Solution

Example 3
A manufacturing company has two production cost centres (Departments A and B)
and one service cost centre (Department C) in its factory.
A predetermined overhead absorption rate (to two decimal places of Shs.) is
established for each of the production cost centres on the basis of budgeted
overheads and budgeted machine hours.
The overheads of each production cost centre comprise directly allocated costs
and a share of the costs of the service cost centre.

Budgeted production overhead data for a period is as follows:

 Department A Department B Department C
Allocated costs Shs. 217,860 Shs. 374,450 Shs. 103,970
Apportioned costs Shs. 45,150 Shs. 58,820 (Shs. 103,970)
Machine hours 13,730 16,110
Direct labour hours 16,360 27,390

Actual production overhead costs and activity for the same period are:

Department A Department B Department C

Allocated costs Shs 219,917 Shs 387,181 Shs. 103,254
Machine hours 13,672 6,953
Direct labour hours 16,402 27,568

70% of the actual costs of Department C are to be apportioned to production cost

centres on the basis of actual machine hours worked and the remainder on the
basis of actual direct labour hours.
Required:
(a) Establish the production overhead absorption rates for the period.
(b) Determine the under- or over-absorption of production overhead for the
period in each production cost centre
Solution
(a) Department A Department B
Allocated costs Shs. 217,860 Shs. 374,450
Apportionment costs Shs. 45,150 Shs. 58,820
Total dept. overheads Shs. 263,010 Shs. 433,270

Overhead absorption rate Shs.19.16 (Shs. 263,010/13,730) Shs.26.89

(Shs 433,270/16,110)

(b) Dept. A Dept. B Dept. C

Shs Shs Shs
Allocated costs 219,917 387,181 103,254
Apportionment of 70%a 32,267 40,011 (72,278)
Apportionment of 30%b 11,555 19,421 (30,976)
Total dept. overheads 263,739 446,613
Overheads charged to prod 261,956 c 446,613 d
Under/(over-recovery) 1,783 (9,253)
 Notes
a
Allocated on the basis of actual machine hours
b
Allocated on the basis of actual direct labour hours
c
Shs.19.16 x 13,672 actual machine hours
d
Shs.26.89 x 16,953 actual direct labour hours

1.1.10 Causes of Under or Overhead Absorption of Overhead

The following reasons for over and under-absorption of overheads:

• Actual overhead cost incurred may be more or less than the applied overhead
cost.
• Actual machine hours, labour hours and output may be lower or higher than the
budgeted or predetermined base.
• Seasonal fluctuations
• Wrong computation of overhead absorption rate, output and machine hours:
• Under or overutilization of production capacity

1.2 Absorption Costing and Marginal Costing

The main principles underlying the content of this section should be familiar to you
from your earlier studies of cost accounting. You should already be able to apply a
system of marginal costing and understand how it differs from absorption
costing. Whereas absorption costing recognises fixed costs (usually fixed
production costs) as part of the cost of a unit of output and hence as product
costs, marginal costing treats all fixed costs as period costs.

1.2.1 Absorption Costing

Absorption costing is the cost system technique whereby the cost of a product or
service is established by adding a share of fixed production overheads to direct
costs. It is consistent with the requirements for stock valuation in financial
reporting. It is usual to absorb production overheads only into product costs.
Other overheads are written off as an expense when they arise. Production
overhead costs are first allocated, then apportioned and finally absorbed into
production costs (or service costs).
Absorption costing means that all of the manufacturing costs are absorbed by the
units produced. In other words, the cost of a finished unit in inventory will include
direct materials, direct labour, and both variable and fixed manufacturing
overhead. As a result, absorption costing is also referred to as full costing or the
full absorption method. The cost of a unit of product under the absorption costing
system, therefore consists of

1. Direct materials
2. Direct labour and
3. Both variable and fixed production (manufacturing) overhead

Thus, absorption costing allocates a portion of fixed production overhead cost to

each unit of product, along with the variable production costs.

Absorption Costing = Direct labour

+
Direct materials
+
Variable production overheads
+
Fixed production overheads
• In absorption costing, inventories of work-in-progress and finished goods are
valued at their full production cost.
• In absorption costing, product profitability is measured as sales income from
each product minus the full absorption costs of the product.

1.2.2 Marginal Costing

Marginal costing is another method of costing products or services and measuring

profitability. Products or services are valued at their marginal cost (variable cost)
only. Inventories of work-in-progress and finished goods are valued at their
variable production cost. All fixed costs are treated as period costs and charged
against profit in the period to which they relate.
• Contribution is the difference between sales and the variable cost of sales:
Contribution = Sales – Variable cost of sales
Contribution is short for ‘contribution to fixed costs and profits’.
In a marginal costing system, the measure of product profitability is the total
contribution earned by each product, without charging any fixed costs to the
product. Changes in the volume of sales, or in sales prices, or in variable costs will
all affect profit by altering the total contribution. Marginal costing techniques can
be used to help management to assess the likely effect on profits of higher or
lower sales volume, or the likely consequences of reducing the sales price of a
product in order to increase demand, and so on.

It should be noted that, under this costing system fixed production overheads are
charged in the period incurred as expenses, only variable production costs are
charged to cost units. Under marginal costing only those costs of production those
vary with output are treated as product costs. These would usually include the
following;

1. Direct materials
2. Direct labour and
3. Variable portion of production overhead

However fixed production (manufacturing) overhead is not treated as a product

cost under this costing system, rather than fixed production (manufacturing)
overhead is treated as a period cost like selling and administrative expenses
against the aggregate contribution.

The term ‘contribution’ mentioned above is the term given to the difference
between Sales and Marginal cost. Thus

Marginal cost = Direct materials

+
Direct labour
+
Variable production overheads

1.2.3 Features of Absorption and Marginal Costing System:

The main features of absorption costing are as follows

• In absorption costing, items of inventory are costed to include a ‘fair share’ of
fixed production overhead. In this case the value of ending inventory will be
higher in absorption costing than in marginal costing.
• As a consequence of carrying forward an element of fixed production overheads
in ending inventory values, the cost of sales used to determine profit in
absorption costing will include some fixed production overhead costs incurred in
a previous period but carried forward into beginning inventory values of the
current period and exclude some fixed production overhead costs incurred in
the current period by including them in ending inventory values.
• In absorption costing, ‘actual’ fully absorbed unit costs are reduced by
producing in greater quantities,). Thus, Profit per unit in any period can be
affected by the actual volume of production.
• In absorption costing, however, the effect on profit in a period of changes in
both production volume and sales volume

The main features of marginal costing are as follows:

• Cost Classification: The marginal costing technique makes a sharp distinction

between variable costs and fixed costs. It is the variable cost on the basis of
which production and sales policies are designed by a firm following the marginal
costing technique.

• Stock/Inventory Valuation: Under marginal costing, inventory/stock for profit

measurement is valued at marginal cost. It is in sharp contrast to the total unit
cost under absorption costing method.

• Marginal Contribution; Marginal costing technique makes use of marginal

contribution for marking various decisions, Marginal contribution is the
difference between sales and marginal cost. It forms the basis for judging the
profitability of different products or departments.

1.2.3 Marginal and Absorption Costing Compared

Advantages of absorption costing
• Fixed production costs can be a large proportion of the total production
costs incurred. Unless production overheads are absorbed into product
 costs, a large proportion of cost would be excluded from the measurement
of product costs.
• Absorption costing follows the matching concept (accruals concept) by
carrying forward a proportion of the production cost in the inventory
valuation to be matched against the sales value when the items are sold.
• It is necessary to include fixed production overhead in inventory values for
financial statements; absorption costing achieves this.
• In job costing, absorption costing can help to decide on the price to quote to
a customer for a job. The job cost estimate includes a share of overhead
cost, and the price can be decided by adding a profit margin to this
estimated cost. This method of ‘cost plus pricing’ can help to ensure that
sales income is sufficient to cover all costs, fixed as well as variable.
• Analysis of under-/over-absorbed overhead may be useful for identifying
inefficient utilisation of production resources.
• There is an argument that in the longer term, all costs are variable, and it is
appropriate to try to identify overhead costs with the products or services
that cause them. This argument is used as a reason for activity-based
costing (ABC).
Disadvantages of absorption costing
• The apportionment and absorption of overhead costs is arbitrary.
• Absorption costing is dependent on the levels of output which may vary from
period to period, and consequently cost per unit changes due to the
existence of fixed overhead. Such changed costs are not helpful for the
purposes of comparison and control.
• Profits vary with changes in production volume. For example, by increasing
output, more fixed overhead is absorbed into production costs, and if the
extra output is not sold, the fixed overhead costs are carried forward in the
closing inventory value

Advantages and disadvantages of marginal costing

• Marginal costing has several advantages:
– Simpler costing system, there is no requirement to apportion and absorb
overhead costs.
– Variable production cost is a more realistic estimate of inventory value
than full production cost.
 – Marginal costing reflects the behaviour of costs in relation to activity, i.e.
when sales increase, the cost of sales rise only by the additional variable
costs
• However, marginal costing has weaknesses:
– When fixed costs are high relative to variable costs, and when overheads
are high relative to direct costs, the marginal cost of production and
sales is only a small proportion of total costs. A costing system that
focuses on marginal cost and contribution might therefore provide
insufficient and inadequate information about costs and product
profitability.
– Marginal costing is useful for short-term decision-making but not over
the longer term.
– The treatment of direct costs as a variable cost item is often unrealistic.
When direct labour employees are paid a fixed wage or salary, their cost
is fixed, not variable.
• Since both absorption costing and marginal costing have advantages and
weaknesses as methods of measuring the costs and profitability of products
and services, neither can be regarded as superior to the other.
In view of the recognised weaknesses in both costing methods, new
approaches to costing have been devised
1.2.4 Proforma Income Statements for Absorption and Marginal Costing
The following presentations of Performa show the presentation of information
according to absorption and marginal costing techniques:

(a) Absorption costing

Shs Shs Shs
Sales xxx
Opening inventory (full production cost) xxx
Production costs:
Direct materials xxx
Direct labour xxx
Production overheads absorbed xxx
xxx

Less closing inventory (full production

cost) xxx
Production cost of sales: Xxx

Production overhead absorbed xxx

Production overhead incurred xxx
Over-absorbed/(under-absorbed)
overheads xxx
cost of sale xxx
Gross profit xxx
Administration overheads incurred xxx
Selling and distribution costs incurred xxx xxx
Operating Profit xxx
(b) Marginal Costing

Shs Shs Shs

Sales xxx
Opening inventory (marginal production
cost) xxx
Variable production cost incurred:
Direct materials xxx
Direct labour xxx
Variable production overheads xxx xxx
Less closing inventory (marginal
production cost) xxx
Variable production cost of sales xxx
Variable selling and distribution costs xxx
Total variable cost of sales xxx
Contribution xxx
Fixed costs (period costs)
Fixed production costs xxx
Fixed administration costs xxx
Fixed selling and distribution costs xxx
Total fixed costs xxx
Profit xxx

1.2.5 Reconciliation Statement for Marginal Costing and Absorption Costing

Profit
The net profit reported by absorption and marginal costing systems may not be the
same owing to the differing treatment of fixed production overhead costs. As has
been demonstrated above, whilst marginal costing systems treat fixed production
overhead costs as period costs (i.e. a charge against profit in the period incurred),
in absorption costing systems they are absorbed into the cost of goods produced
and are only charged against profit in the period in which those goods are sold.

As a result, if quantities produced and sold in a period are not the same (i.e., if the
levels of work-in-progress or finished goods stock change) a different profit will
be reported by the two systems. The differing profits can be reconciled, and the
difference explained, by an analysis of the product of the stock change and the
fixed production overhead absorption rate

Hence the difference in the profit reported by the two costing systems therefore
results from the fixed production overhead cost that is carried forward in
inventory in an absorption costing system. Then, the profit can be reconciled as
follows;

Shs
Marginal costing profit xxx
Add (Closing stock – opening stock) x OAR (fixed prodn.) xxx
= Absorption costing profit xxx