The ladder / Level 3 · Manufacturer/ Business math
Unit costing: absorption and marginal
Material, labour and overheads; fixed and variable costs and the high-low method; overhead absorption rates; why absorption and marginal costing give different profits.
How numbers are rounded on these pages. Calculations are done at full precision and rounded only at the end, half up. Rupee amounts are rounded to the nearest rupee unless shown with paise, in which case to the nearest paisa. Percentages are shown to two decimal places; payback periods in years, and ratios such as degree of operating leverage, to two decimal places. Quantities you must start, buy or sell to reach a target are rounded up to the next whole unit or kg. Depreciation uses textbook straight line and written down value methods, not the rates or lives set by tax or company law. All examples and quiz questions are Hypothetical: they show the method, not real prices or rates.
Unit costing: material, labour, overheads; fixed and variable
The cost of one unit is built in layers. Direct material and direct labour (plus any direct expenses) make the prime cost. Add factory overheads (power, supervision, rent, maintenance) and you get the factory or works cost. Add office and selling overheads for the total cost.
Separately, ask how each cost behaves. A variable cost rises with every unit made (material, piece-rate pay, power per unit). A fixed cost stays the same for the month whatever you make, within normal capacity (rent, salaries, insurance). Fixed cost per unit therefore falls as volume rises. If you only have total costs for two months, the high-low method splits them into fixed and variable parts.
The standard formulas
Terms used
- Direct material
- Material that becomes part of the product and can be traced to it, such as steel in a bracket.
- Direct labour
- Pay for work done directly on the product.
- Overheads
- Costs that cannot be traced to one unit: indirect material, indirect labour and other factory, office and selling costs.
- Prime cost
- Direct material + direct labour + direct expenses.
- Variable cost
- A cost that changes in proportion to output.
- Fixed cost
- A cost that does not change with output within a relevant range and period.
- High-low method
- Splitting a mixed cost using the totals at the highest and lowest activity levels.
Worked examples
HypotheticalBasicPrime and variable cost of a bracket
A steel bracket uses ₹42 of material and ₹18 of direct labour; variable overheads (power, consumables) are ₹6 a unit.
- Prime cost = ₹42 + ₹18 = ₹60
- Variable cost per unit = ₹60 + ₹6 = ₹66
HypotheticalIntermediateAdding fixed overheads
Fixed factory overheads are ₹3,00,000 a month and the plant makes 20,000 brackets a month.
- Fixed cost per unit = ₹3,00,000 ÷ 20,000 = ₹15
- Full cost per unit = ₹66 + ₹15 = ₹81
HypotheticalAdvancedSplitting total cost with the high-low method
In a slow month the plant made 15,000 units for a total cost of ₹13,40,000; in a busy month 20,000 units cost ₹16,20,000.
- Variable cost per unit = (₹16,20,000 − ₹13,40,000) ÷ (20,000 − 15,000) = ₹2,80,000 ÷ 5,000 = ₹56
- Fixed cost = ₹16,20,000 − 20,000 × ₹56 = ₹5,00,000 a month
The method uses only two points, so check that neither month was unusual.
Absorption costing and marginal costing
Two standard ways to cost a product and value stock. In absorption costing (full costing), each unit carries a share of the fixed production overheads, worked out with an overhead absorption rate. Unsold stock therefore carries some of this period's fixed cost into the next period.
In marginal costing (variable costing), units and stock carry only variable production cost; all fixed overheads are charged against the period in which they happen. Marginal costing shows contribution clearly and suits decisions; absorption costing is what financial statements normally use for stock.
When production equals sales, both give the same profit. When stock rises, absorption shows the higher profit; when stock falls, marginal shows the higher profit. If actual output differs from budget, the overheads charged to units will not equal the overheads actually spent: that gap is under- or over-absorption.
The standard formulas
Terms used
- Absorption costing
- Product costs include a share of fixed production overheads.
- Marginal costing
- Product costs include only variable production costs; fixed costs are period costs.
- Overhead absorption rate
- The rate used to charge overheads to units, set in advance from budgets.
- Under-absorption
- Less overhead charged to products than was actually incurred.
- Over-absorption
- More overhead charged to products than was actually incurred.
Worked examples
HypotheticalBasicWorking out the absorption rate
Budgeted fixed production overheads are ₹6,00,000 for a period with 20,000 units budgeted (or 4,000 machine hours).
- Rate per unit = ₹6,00,000 ÷ 20,000 = ₹30
- Rate per machine hour = ₹6,00,000 ÷ 4,000 = ₹150
HypotheticalIntermediateThe same month, two profits
Variable production cost ₹70 a unit; price ₹120; fixed production overheads ₹6,00,000; 20,000 made and 18,000 sold; no opening stock; no other costs.
- Marginal: contribution 18,000 × ₹50 = ₹9,00,000, less fixed ₹6,00,000 = ₹3,00,000
- Absorption: unit cost ₹70 + ₹30 = ₹100; profit = ₹21,60,000 − 18,000 × ₹100 = ₹3,60,000
- Difference ₹60,000 = 2,000 units of closing stock × ₹30
HypotheticalAdvancedUnder-absorption when output falls short
Next period the plant absorbs at ₹30 a unit but makes only 18,000 units; actual fixed overheads are ₹6,00,000.
- Absorbed = 18,000 × ₹30 = ₹5,40,000
- Under-absorbed = ₹6,00,000 − ₹5,40,000 = ₹60,000, charged against profit
- If stock also falls by 2,000 units, absorption profit is lower than marginal profit by 2,000 × ₹30 = ₹60,000
Quiz: unit costing: absorption and marginal
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