Costing and Pricing
Cost behaviour and absorption
Candidates must classify costs by behaviour (fixed, variable, semi-variable, stepped) and by traceability (direct, indirect). Absorption costing allocates indirect costs to cost centres and recovers them using a predetermined overhead absorption rate (OAR): budgeted overhead ÷ budgeted activity base (labour hours, machine hours, units). Because the rate is predetermined, actual overhead and actual activity rarely match, producing under- or over-absorption.
Marginal costing and pricing
Marginal costing separates variable cost from contribution. Contribution = sales − variable costs, and it is used for short-term decisions and marginal-cost-plus pricing. Cost-plus pricing may be expressed as a mark-up on cost or a margin on selling price - these are not interchangeable. Target costing works backwards from a market price to an allowable cost.
Traps in questions
- Using actual rather than budgeted activity to calculate the OAR.
- Reversing under- and over-absorption. Absorbed overhead = actual activity × OAR. If absorbed < actual, overhead is under-absorbed (a debit to the P&L); if absorbed > actual, it is over-absorbed.
- Confusing mark-up with margin. A 25% mark-up on cost of £80 gives £100; a 25% margin on price gives a cost of £60 for a £80 price.
- Treating fixed costs as product costs in marginal-cost pricing decisions.
Worked example
Budgeted overhead £120,000 and budgeted machine hours 15,000 give an OAR of £8 per machine hour. Actual overhead was £125,000 and actual hours were 14,000, so absorbed overhead = 14,000 × £8 = £112,000. Overhead is under-absorbed by £13,000 (£125,000 − £112,000).
Rule of thumb
Compute the OAR once from budgeted figures, then always absorb using actual activity and compare with actual overhead to find the variance.