Cost and management accounting: cost classification, manufacturing accounts, marginal and absorption costing, and decision making
Domain 8 covers cost classification, manufacturing accounts, marginal and absorption costing and short-term decisions. Direct costs are traceable to a unit (direct materials, direct labour, direct expenses); indirect costs are overheads. Prime cost = direct materials + direct labour + direct expenses. Manufacturing cost adds factory overheads and adjusts for work in progress. Selling, distribution and administration costs are period costs, not factory costs.
Marginal versus absorption
Marginal costing values inventory at variable production cost. Contribution = sales − variable costs; contribution-to-sales ratio = contribution/sales; break-even units = fixed costs/contribution per unit. Absorption costing includes fixed production overhead in product cost using a predetermined rate; over- or under-absorption arises when actual overhead differs from absorbed overhead.
Worked example
Selling price N$50; variable cost N$30; fixed costs N$80,000. Contribution = N$20 per unit; C/S ratio = 40%. Break-even = 80,000/20 = 4,000 units. At 5,000 units, margin of safety = 1,000 units or 20% of sales. Reasoning: only variable costs are deducted to find contribution; fixed costs are recovered after contribution.
Decision making
Use relevant costs: future incremental cash flows that differ between alternatives. Ignore sunk costs, allocated fixed overheads and non-cash book values unless they change future cash flows. For a special order, compare incremental revenue with incremental variable and extra fixed costs.
Traps
Deducting fixed costs before contribution; including sunk costs in a make-or-buy decision; treating notional rent as irrelevant when it is an opportunity cost; including administration salaries in factory overhead; ignoring over- or under-absorption at year end.