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ABSORPTION COSTING

by Angela Newman
30 Jan 2003

Absorption costing is one area of the syllabus that I am sure most students would rank
among their least favourite. The question in the December 2001 exam required students to
prepare an absorption costing profit and loss account from a marginal costing one. This
question was the most popular question in Section B although it was by no means the best
attempted! It would appear that students know that they should be able to do it but often fall
down when it comes to the mechanics of the numbers and layout for the solution. So let’s
take this question from the December 2001 exam and have a look at the best way to
attempt it. (See Figure 1).

Figure 1
Surat is a small business which has the following budgeted marginal costing profit and
loss account for the month ended 31 December 2001:

£’000 £’000
Sales 48
Cost of sales:
Opening stock 3
Production costs 36
Closing stock (7)
(32)
16
Other variable costs:
Selling (3.2)

Contribution 12.8
Fixed costs:
Production overheads (4)
Administration (3.6)
Selling (1.2)
Net profit 4.0

The standard cost per unit is:

£

Direct materials (1kg) 8

Direct labour (3 hours) 9
Variable overheads (3 hours) 3
20

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Budgeted selling price per unit 30

The normal level of activity is 2,000 units per month. Fixed production costs are budgeted
at £4,000 per month and absorbed on the normal level of activity of units produced.

Required:

a. Prepare a budgeted profit and loss account under absorption costing for the month
ended 31 December 2001 (6 marks)
b. Reconcile the profits under these two methods and explain why a business may
prefer to use marginal costing rather than absorption costing. (4 marks)
(10 marks)

Solution
The first thing that needs to be thought about is the layout of the absorption costing profit
and loss account. We then need to consider the standard cost per unit under this method.
Once these ‘bare bones’ have been sorted out we can start to ‘flesh out’ our answer with
some numbers.

Presentation of an absorption costing profit and loss account

You need to know the presentation of the absorption costing profit and loss account as it
will help to drive the solution. Easy numbers can be filled in from the marginal costing profit
and loss – some of the numbers can just be brought across without any need for
calculations – and then workings can be used to establish the other figures. An example of
a proforma for an absorption costing profit and loss that students would do well to become
familiar with is shown in Figure 2.

Figure 2: An absorption costing profit and loss account proforma

£’000 £’000
Sales
Cost of sales:
Opening stock
Production costs
Variable costs
Fixed costs
Closing stock
Under / Over absorption

Gross profit
Administration
Selling – fixed
Selling – variable
Net profit
So what are the key differences between the two costing methods and their profit and loss
accounts? Figure 3 has the answers.

Figure 3

Marginal costing Absorption costing

Key word / phrase Contribution Gross profit

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All (production and non

Variable costs production) above the
contribution line
Fixed production costs All below the contribution line
Production costs
Included in the cost per
including fixed
unit so above gross profit
overheads
Non production costs All below gross profit

Essentially marginal costing separates costs into their variable and fixed elements using
contribution as the dividing line, whereas absorption costing separates them according to
whether they are production or non-production, with gross profit as the divide.

Standard cost per unit using absorption costing

With the proforma drawn up, the next step is to establish the standard cost per unit using
absorption costing. Most students will know that this requires fixed production costs to be
included in the cost per unit.

It could be that total fixed overheads are given for various categories, for example canteen
or maintenance costs, and these need to be shared out to various cost centres. Students
will be familiar with the terms and methods of allocating and apportioning fixed production
overheads into various cost centres, using an appropriate method and then reapportioning
the fixed overheads from the service centres into the production centres so that the costs
can then be absorbed. There was a question on this in the December 2001 examination in
Section A and most candidates answered it correctly.

The costs from the production centres then need to be absorbed into the standard cost per
unit using an appropriate method. For this paper this method will usually (but not always)
be on a per unit basis, on a machine hour basis or on a labour hour basis but others are
possible.

For this question most of the work has been done in that there is no allocating, apportioning
or reapportioning required. All that is required is to calculate the standard cost per unit from
the information. So what needs to be done? The variable costs per unit need to be
established and these are given in the question. The fixed overhead absorption rate can
then be calculated from the information given.

Let’s look at the question again and extract the relevant pieces of information. See Figure
4.

Figure 4

The standard cost per unit is:

£
Direct materials (1kg) 8
Direct labour (3 hours) 9
Variable overheads (3 hours) 3
20
Budgeted selling price per unit 30
The normal level of activity is 2,000 units per month. Fixed production costs are budgeted
at £4,000 per month and absorbed on the normal level of activity of units produced.

The standard cost per unit given is the standard cost under marginal costing. Although it
doesn’t say this we know it is the case as there are no fixed overheads included in the

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standard cost per unit. This means that the fixed production overheads need to be
absorbed. We are told that £4,000 worth of fixed production overheads per month were
absorbed on the basis of 2,000 units. So the fixed overhead absorption rate can be
calculated and the standard cost per unit using absorption costing can be established. See
Figure 5.

Figure 5
Fixed overhead absorption rate =
£4,000 = £2 per unit
2,000 units

Standard cost per unit using absorption costing:

£
Direct materials (1kg) 8
Direct labour (3 hrs) 9
Variable overheads (3 hrs) 3
Fixed overheads 2 from above
22
The only calculation required to establish the standard cost under absorption costing is the
fixed overhead absorption rate. All other numbers remain as they are using marginal
costing.

Filling in the absorption costing profit and loss account

With the proforma for the profit and loss account written, and the standard cost per unit
now established using absorption costing, it should now be possible to start filling in some
of the figures. As with any question it is better to start with the easy numbers (and so get
some of the easy marks) and then move onto the calculations. So which are the easy
numbers?

If we look at the marginal costing profit and loss account in Figure 1 we need to consider
which numbers change under the new costing method. For example, would the sales
revenue change as a result of using absorption costing rather than marginal costing? The
answer is obviously no; we are not told that the selling price changes nor would we expect
it to. The change in costing method only affects the cost per unit, not the selling price. So
the sales revenue figure in the marginal costing profit and loss account can be transferred
directly into the absorption costing profit and loss account.

The next line is opening stock, so would that change? Yes it would. Since we are now
using absorption costing this figure needs to include some fixed overheads in its valuation.
The number of units of opening stock would not change but the monetary value would.
What needs to be established is the number of units of opening stock. Since we know the
standard cost per unit under marginal costing and the total valuation of the stocks under
marginal costing, we can calculate the number of units. However, at this stage we said that
we were looking for easy numbers to get easy marks so let’s leave this calculation for now
and come back to it after we have completed the review of the profit and loss account.

Production costs is the next line in the profit and loss account and since we know this is a
marginal costing profit and loss account, these must be variable production costs only. If
you consider the proforma for the absorption costing profit and loss, we have a line for
variable production overheads separate from the fixed production overheads. This means
that the figure from the marginal costing profit and loss can be transferred straight across.

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If we continue with our review in this way, establishing the easy numbers and those that
need some calculation, we would have the results shown in Figure 6 (including those that
we have already looked at).

Figure 6

Would the figure change? Copy straight across?

Sales Selling price is unaffected by Yes
the change in costing method.
Opening stock The valuation would change as No
fixed overheads would now
need to be included but the
units would be the same.
Production Since these must be variable Yes
costs production costs these can be
easily transferred to the
absorption costing profit and
loss.
Closing stock The valuation would change as No
fixed overheads would now
need to be included but the
units would be the same.
Variable selling This cost would be unaffected Yes
costs by a change in costing method.
Fixed production These need to be absorbed No – but we have already
overheads into the standard cost per unit. established the absorption costing
standard cost per unit. We do,
however, need to calculate the
under / over absorption.
Fixed Will not change. Yes
administration
costs
Fixed selling Will not change. Yes
costs
If we know that some of the numbers can just be transferred from one profit and loss to the
other we can start to complete the absorption costing profit and loss account as shown in
Figure 7.

Figure 7
Absorption costing profit and loss account for Surat for the month ended 31
December 2001:
£’000 £’000
Sales (Figure 1) 48
Cost of sales:
Opening stock
Production costs
Variable costs (Figure 1) 36
Fixed costs

Closing stock
Under / Over absorption

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Gross profit
Administration (Figure 1) (3.6)
Selling – fixed (Figure 1) (1.2)
Selling – variable (Figure 1) (3.2)
Net profit

We can now turn our attention to the numbers that need to be calculated.

Stocks
The stock valuation will always need to be recalculated if you are going from one costing
method to another. Remember stock under marginal costing will only have variable
production costs included in the unit cost, whereas absorption costing will include fixed
production costs as well. The number of units will, however, be the same for both methods.

Figure 8
Under marginal costing:
Opening stock £3,000 (Figure 1)
Closing stock £7,000 (Figure 1) Standard cost per unit £20 (Figure 1)

Units of stock:
Opening stock =£3,000 = 150 units
£20
Closing stock =£7,000 = 350 units
£20
Under absorption costing:
Opening stock = 150 units x £22 (from Figure 5) = £3,300
Closing stock = 350 units x £22 (from Figure 5) = £7,700

If we look at the figures for this example we see that opening stock is valued at £3,000 and
closing stock at £7,000. Each unit is valued at a standard cost per unit of £20 (under
marginal costing which was given in the question) so it is a straightforward exercise to
establish the stock units and then the absorption costing stock valuation. See Figure 8.
These figures can then be filled into the absorption costing profit and loss account. See
Figure 9.

Figure 9
Absorption costing profit and loss account for Surat for the month ended 31 December
2001

£’000 £’000
Sales (Figure 1) 48
Cost of sales:
Opening stock (Figure 8) 3.3
Production costs
Variable costs (Figure 1) 36
Fixed costs

Closing stock (Figure 8) (7.7)

Under / Over absorption

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Gross profit
Administration (Figure 1) (3.6)
Selling – fixed (Figure 1) (1.2)
Selling – variable (Figure 1) (3.2)
Net profit
Production overheads
The final few calculations that need to be carried out to complete the profit and loss
account involve the fixed overheads. In order to establish the fixed production overheads
absorbed and so the under or over absorption, the numbers of units produced will need to
be calculated. In this example it can be done in one of two ways; either by calculating the
figure for the units from the production costs in marginal costing profit and loss account or
by using the ‘sales = cost of sales’ equation. (See Figure 10). Method 1 is much quicker in
this instance but Method 2 is always worth knowing just in case the cost per unit is not
given.

Figure 10
Calculation of production units:
Method 1
Production costs from marginal P&L = £36,000 (Figure 1)
Standard cost per unit = £20 (Figure 1)
Number of units = £36,000 = 1,800 units
20

Method 2
Sales units = Cost of sales units
Sales units = Opening stock units + Production units - Closing stock units

Sales units = £48,000 = 1,600 units

30
Opening stock = 150 units (Figure 8)
Closing stock = 350 units (Figure 8)

So 1,600 = 150 + production units - 350

1,600 = production units - 200
Giving production units = 1,600 + 200 = 1,800 units
Absorption and under / over absorption
With the production units now established, it is now possible to work out the fixed
overheads absorbed. This is as straightforward as taking the fixed production overheads
per unit and multiplying it by the number of units produced. See Figure 11. The profit and
loss account is now almost complete. See Figure 12.

Figure 11
Fixed production overheads absorbed
= production units x fixed production overheads per unit
= 1,800 units (Figure 10) x £2 (Figure 6)
= £3,600

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Figure 12
Absorption costing profit and loss account for Surat for the month ended 31 December
2001

£’000 £’000
Sales (Figure 1) 48
Cost of sales:
Opening stock (Figure 8) 3.3
Production costs
Variable costs (Figure 1) 36
Fixed costs (Figure 11) 3.6
42.9
Closing stock (Figure 8) (7.7)
Under / Over absorption

Gross profit
Administration (Figure 1) (3.6)
Selling – fixed (Figure 1) (1.2)
Selling – variable (Figure 1) (3.2)
Net profit
The final figure is the under / over absorption figure. This calculation should be very familiar
to students and so should not take very long to do. See Figure 13.

Figure 13
Budgeted fixed production overheads £4,000 (Figure 1)
Absorbed fixed production overheads £3,600 (Figure 11)
Under absorbed £400
Another way to calculate the figure is to focus on the profit and loss account. At the
moment (in Figure 12) the fixed production overheads included in the profit and loss
account are £3,600. The budget says that there should be £4,000, so the amount included
in the profit and loss account needs to be increased by £400. The figure already in the
profit and loss is too low – hence under absorbed – by £400. Once the adjustment for this
£400 is included the total amount for fixed production overheads in the profit and loss is
£3,600 fixed production costs + £400 under absorbed = £4,000 which is what is wanted.

Do not be put off by the fact that this is a budgeted profit and loss account, the calculations
are the same as if it were an actual profit and loss. The under / over absorption always
needs to be looked for and calculated as necessary. Having now worked out the under
absorbed figure the profit and loss can be completed. See Figure 14.

Figure 14
Absorption costing profit and loss account for Surat for the month ended 31 December
2001

£’000 £’000
Sales (Figure 1) 48
Cost of sales:
Opening stock (Figure 8) 3.3
Production costs

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Variable costs (Figure 1) 36

Fixed costs (Figure 11) 3.6
42.9

Closing stock (Figure 8) (7.7)

Under / Over absorption (Fig 13) 0.4
35.6
Gross profit 12.4
Administration (Figure 1) (3.6)
Selling – fixed (Figure 1) (1.2)
Selling – variable (Figure 1) (3.2)
Net profit 4.4
Reconciliation of the two profit figures
It is now an easy step to reconcile the two profit figures. The only difference between the
two costing methods is that one includes fixed production overheads in stock and the other
does not. As this is the only difference between the two methods this is all that will appear
in the reconciliation statement (see Figure 15). Students should take note of the proforma
and ensure that they can reproduce it if required.

Figure 15

£
Profit under absorption costing (Figure 14) 4,400
Add fixed production costs in opening stock
300
(150 (Figure 8) x 2 (Figure 5))
Less fixed production costs in closing stock
(700)
(350 (Figure 8) x 2 (Figure 5))
Profit under marginal costing (Figure 2) 4,000

Completing section b
The rest of the question asks why marginal costing may be preferred to absorption costing.
Marginal costing is better for decision-making as it only includes costs that are likely to
change, that is, the variable one.

This was all that was required to gain two marks in this section.

Conclusion
SSAP 9 requires that stock is valued using absorption costing for financial accounting
purposes and so the method needs to be known. Many businesses are seeing an increase
in their level of fixed production costs. It would seem inappropriate to ignore these high
costs when considering the value of the stock. In fact, Activity Based Costing takes
absorption costing one step further by attempting to absorb fixed production overheads on
a more relevant and appropriate basis looking at each cost individually and seeing what
drives or causes the cost to increase.

So it would seem that absorption costing will be with us for a while yet and whilst it is
around it is very important that students sitting Paper 1.2 know how to manage questions
on it. I consider this to be a key area of the syllabus, and students would be well advised to
take time to get to know it properly.

Angela Newman is Examiner for Paper 1.2

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