Traditional costing methods

Accounting AS · Cost and management accounting. The idea in plain words, the rules to remember, the mistake to avoid and a worked example, written and checked by Mega Lecture.

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The idea

Unit, job and batch costing find the cost of what is made or supplied. The cost is collected for one unit, one customer's order, or one group of identical items.

Absorption costing charges all production costs to units, including fixed overheads. Overheads are allocated or apportioned to cost centres, service department costs are reapportioned to production departments, and an overhead absorption rate then charges them to cost units.

Marginal costing charges only variable costs to units. Selling price less variable cost is the contribution, which first covers fixed costs and then gives profit. Break-even analysis and short-term decisions, such as make or buy and special orders, are based on contribution.

Rules to remember

Overhead absorption rate = budgeted overheads ÷ budgeted activity (machine hours or direct labour hours). Overhead absorbed = rate × actual activity.
Absorbed less than actual overhead: under-absorbed, which reduces profit. Absorbed more than actual: over-absorbed, which increases profit.
Contribution per unit = selling price − variable cost per unit. Contribution to sales ratio = contribution ÷ selling price.
Break-even point (units) = fixed costs ÷ contribution per unit. Break-even revenue = fixed costs ÷ contribution to sales ratio.
Units for a target profit = (fixed costs + target profit) ÷ contribution per unit. Margin of safety = budgeted sales − break-even sales.
Absorption profit − marginal profit = (closing inventory units − opening inventory units) × fixed production overhead per unit.
Decisions: ignore fixed costs that will not change. With a limiting factor, rank products by contribution per unit of the scarce resource.

Common mistake

Subtracting the fixed cost per unit when working out contribution. Contribution is selling price less variable costs only; fixed costs are taken off in total afterwards.

Worked example

A product sells for $25 per unit and has variable costs of $16 per unit. Fixed costs are $54,000. Budgeted sales are 8,000 units. Find the break-even point, the margin of safety as a percentage and the budgeted profit.

Contribution per unit = $25 − $16 = $9.
Break-even point = $54,000 ÷ $9 = 6,000 units.
Margin of safety = 8,000 − 6,000 = 2,000 units; 2,000 ÷ 8,000 × 100 = 25%.
Budgeted profit = 2,000 units × $9 = $18,000. Check: 8,000 × $9 − $54,000 = $18,000.

Answer: Break-even is 6,000 units, the margin of safety is 25% and the budgeted profit is $18,000.

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