Costing methods and cost recording: inventory valuation, absorption and marginal costing
Absorption versus marginal costing
Absorption (full) costing includes fixed production overhead in product cost, so some fixed overhead sits in closing inventory. Marginal costing treats fixed production overhead as a period cost charged in full against contribution. Profit therefore differs between the two methods whenever inventory levels change; the difference equals the change in inventory units multiplied by the fixed overhead absorption rate per unit.
Inventory valuation and recording
Under IAS 2, inventory is valued at the lower of cost and net realisable value. Cost includes direct materials, direct labour, direct expenses and production overhead absorption. FIFO and AVCO (weighted average) are permitted; LIFO is not.
Overhead absorption
Overheads are allocated where directly attributable, apportioned where shared (rent by floor area, for example), reapportioned from service to production cost centres, then absorbed using a predetermined rate: budgeted overhead divided by budgeted activity base. Over-absorption arises when overhead absorbed exceeds overhead incurred; under-absorption when it is less.
Traps
- Using actual rather than budgeted figures to set the predetermined rate.
- Reversing over- and under-absorption.
- Confusing allocation (whole cost to one centre) with apportionment (shared on a fair basis).
- Treating abnormal loss as a product cost in process costing.
Worked example
Budgeted overhead £120,000; budgeted machine hours 24,000, so the absorption rate is £5 per hour. Actual overhead £118,000 and actual hours 23,000 give absorbed overhead of 23,000 × £5 = £115,000. Overhead is under-absorbed by £3,000 because actual overhead exceeds the amount absorbed.