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UNIVERSITY OF EDUCATION

WINNEBA
SCHOOL OF BUSINESS
DEPARTMENT OF ACCOUNTING
LECTURE SLIDES ON COSTING TECHNIQUES

I.A. AHMED
Introduction
• Costing techniques are used by cost accountants to determine the cost of production.
• They are the techniques accountants use in treating manufacturing costs of products.
• Costing techniques are not an alternative to costing methods since they are applied to
costing methods such as job, process etc. to determine product cost.
• For instance, job costing as a costing method could apply either marginal or
absorption costing as a technique to cost a job.
• Costing techniques basically answer the question-
should production cost (both variable and fixed) form part of product cost or some
cost should be exclude?
• If some costs are excluded, there should be reasons provided for such a decision.
TYPES OF COSTING TECHNIQUES

• There are basically two costing techniques.


• These are:
1. Absorption costing where product cost is made up of all costs, both
fixed and variable

2. Marginal costing where only variable manufacturing or production


cost is used to determine product cost.
ABSORPTION COSTING

• Absorption costing is also referred to as FULL COSTING or TOTAL


COSTING because it involves all cost of production as part of product
cost.
• Conventionally or traditionally, product cost has been determined by
accumulating all costs of production.
• That is, prime cost plus production costs regardless of whether the
cost is fixed or variable in nature.
• This method of determining cost is termed absorption costing.
ABSORPTION COSTING

• Absorption costing therefore allocates a portion of fixed production


cost to each unit of a product along with variable cost.
• The cost of a unit or product under absorption costing therefore
consists of
1. Direct material
2. Direct labor and
3. Both fixed and variable production overheads.
MARGINAL COSTING

• This technique is referred to as VARIABLE, DIRECT or MARGINAL


COSTING. Since the method dwells on the notion that only variable
production cost should form part of product cost,
• Thus, only variable production overheads are added to direct material
and direct labor.
• Fixed production overheads which do not form part of product cost
under this technique are classified and treated as period cost.
MARGINAL COSTING

• These overheads are charged entirely against revenue for the period.
• Consequently, the inventory cost of a unit of a product under this
technique contains no fixed production cost.
• The proponents of marginal costing as a technique argue that, fixed
overheads are time related.
• Thus items such as rent and rates, property taxes- which are time
related should not form part of product cost.
FORMAT FOR DETERMINING PRODUCT COST UNDER
THE TWO TECHNIQUES

  Absorption costing Marginal costing


Direct material X X
Direct labor X X
Direct expenses X X
Prime cost XX XX
Add: production overheads    
Variable overheads X X
Fixed overheads X X -
Cost of production XX XX
FEATURES OF MARGINAL COSTING

1. Costs are separated into the fixed and variable elements and semi-
variable costs are also differentiated like wise.

2. Only the variable costs are taken into account for computing the
value of stocks of work-in-progress and finished products.

3. Fixed costs are charged off to revenue wholly during the period in
which they are incurred and are not taken into account for valuing
product cost/inventories.
FEATURES OF MARGINAL COSTING

4. Prices may be based on marginal costs and contribution but in


normal circumstances prices would cover costs in total.

5. It combines the techniques of cost recording and cost reporting.

6. Profitability of departments or products is determined in terms of


marginal contribution.
7. The unit cost of a product means the average variable cost of
manufacturing the product.
ADVANTAGES OF MARGINAL
COSTING
1. Cost-volume-profit relationship data wanted for profit planning purposes is
readily obtained from the regular accounting statements. Hence management
does not have to work with two separate sets of data to relate one to the other.
2. The profit for a period is not affected by changes in absorption of fixed expenses
resulting from building or reducing inventory. Other things being equal profits
move in the same direction as sales when direct costing is in use.
3. Manufacturing cost and income statements in the direct cost form follow
management’s thinking more closely than does the absorption cost form for
these statements. For this reason, management finds it easier to understand and
use direct cost reports.
4. The impact of fixed costs on profits is emphasized because the total amount of
such cost for the period appears in the income statement.
LIMITATIONS OF MARGINAL
COSTING
• In marginal costing, costs are classified into fixed and variable.
Segregation of costs into fixed and variable is rather difficult and cannot
be done with precision.
• Marginal costing assumes that the behavior of costs can be represented
in straight line. This means that fixed costs remains completely fixed
over a period at different levels and variable costs change in linear
pattern i.e. the change is proportion to the change in volume. In real or
practical situations, fixed costs are liable to change at varying levels of
production especially when extra plant and equipment are introduced
and hence variable costs may not vary in the same proportion as the
volume.
LIMITATIONS OF MARGINAL
COSTING
• Under marginal costing technique fixed costs are not included in the value of
stock of finished goods and work-in-progress. As fixed costs are incurred,
these should also form part of the costs of the product. Due to the
elimination of fixed costs from finished stock and work-in-progress, the
stocks are understated. This affects the results of profit and loss account and
the balance sheet. Thus, profit may be unnecessarily deflated.
• In the marginal costing system monthly operating statements will not be as
realistic or useful as under the absorption costing system. This is because
under this system, marginal contribution and profits vary with change in
sales value. Where sales are occasional, profits fluctuate from period to
period.
APPLICATIONS OF MARGINAL
COSTING
• Profit planning
• Evaluation of Performance
• Make or Buy Decisions
• Closure of a Department or Discontinuance of a Product
• Maintaining a Desired Level of Profit
• Offering Quotations
• Accepting an Offer or Exporting below Normal Price
• Alternative Use of Production Facilities
• Problem of Key Factor
• Selection of a Suitable Product Mix
STOCK VALUATION UNDER THE TWO TECHNIQUES

• Since there are differences in the computation of product cost under the
two methods, stock valuation will also result in different result even though
stock quantities might be the same.
• The difference is as a result of the inclusion of fixed production cost and the
exclusion of same under different techniques when computing product cost.
• Costing provides stock valuation for income determination.
• The value of stock or inventory therefore has a significant impact on income
levels.
• It follows therefore that, income figures will differ between the two
approaches to product costing any time that there are unsold stocks.
The scenarios are explained below:

1. When production equals sales then absorption costing income equals marginal
costing income. This is because, both methods charge equal fixed costs to the
period.
2. When production exceeds sales. That is, there is unsold stock. In this case,
absorption costing income will be higher or exceed marginal costing income.
This is because, absorption charges less fixed costs to the period than marginal
costing. Part of the fixed cost is therefore deferred to the next period.
3. When sales exceeds production there will be an opening stock. In this case,
marginal costing income will be higher than absorption costing income. The
reason being that, more fixed cost is charged to the period in absorption than
marginal costing. The fixed cost is made up of those incurred under the current
period and those brought forward from the previous period.
RECONCILIATION OF NET OPERATING PROFIT UNDER
THE TWO TECHNIQUES

• From the scenarios above, the difference in operating income under


the two techniques is due solely to the movement of fixed production
overhead into inventory as they increase and out of inventory as they
decrease.
• The difference between the operating income under absorption and
marginal costing can be reconciled
Reconciliation statement

Net income as per absorption costing XX


Add: difference in valuation of opening stock
(Absorption cost per unit –marginal cost per unit) X quantity of opening stock XX
XXX
Less: difference in valuation of closing stock
(Absorption cost per unit –marginal cost per unit) X quantity of closing stock XX
Net income as per marginal costing XXX
• End of slides

• Refer to main text for worked examples on costing techniques