Marginal & activity based costing Lecture 6

On completion of this topic you should
be able to:
• Recognise standard costs
• Use variance analysis
• Outline marginal costing
• Use break even analysis
• Identify absorption & activity based costing
• Critically assess allocation of indirect costs from a
marginal, absorption & activity based perspective
7032maa Lecture 6 1
Standard & actual cost
Budgets help to define standard costs
•A standard cost is a planned amount of
resource for an activity expressed in money
•A variance is the difference between
standard (budgeted) and actual cost
•Variance analysis is the identification &
explanation of variances from standard cost
Recap
7032maa Lecture 6 2
Uses of standard costing
• Stock valuation, pricing, control and
performance measures
• Useful control and planning tool for repetitive
activities and identical products
• Short periods are preferred for control,
corrective actions and frequent market changes
• Standard costing period is the same as the
budget period.
7032maa Lecture 6 3
Calculating standard cost
Activity: use the following information to calculate the
standard cost of delivery of a consignment from a
warehouse to a retailer using direct material, labour and
variable, fixed overheads
Total fuel 5 litres @ £1.01 per litre
Driver @ £15. 00 per hour
Total journey time 6 hours
Variable overhead absorption £5 per trip
Fixed overhead absorption £2 per hour
7032maa Lecture 6 4
Calculating variance
Using the standard costings for the delivery to a retailer previously calculated:
Standard cost
Direct material 5 x 1.01 = £5.05
fuel
Direct labour 6 x15 = £90
Var ohead 1 x 5 = £5
Fixed ohead 6 x £2 = £12
Total std cost for trip = £112.05
Actual cost
Direct material = £6.55
fuel
Direct labour = £85
Var ohead 2 x £5 = £10
Fixed ohead 6 x 2 = £12
Actual costs for trip = £113.55
7032maa Lecture 6 5
Using variance analysis
7032maa Lecture 6 6
Performance measures
100
actual direct labour hours worked
Efficiency ratio  standard hours produced 
100
budgeted direc labour hours
Capacity ratio  actual direct labour hours worked 
100
budgeted direc labour hours
Production volume ratio  standard hours produced 
Adapted from: Dyson, J.R (2010) Accounting for non-accounting students, FT
Prentice Hall p353,
7032maa Lecture 6 7
Marginal costing
• Cost of one additional or extra unit
• Useful way of dealing with overhead
• Treats overhead as a “sunk cost” ie it is
always paid over the long run
• A danger of ignoring overheads in short run
• Profits in marginal costings are a
“contribution to overheads”
7032maa Lecture 6 8
Marginal costing
7032maa Lecture 6 9
Marginal costing
7032maa Lecture 6 10
Break even analysis
Profit = Sales – total cost
Profit = Sales – (Fixed costs + Variable costs)
P = S – F – V therefore P + F = S – V
or S – V = P + F
• Sales less variable costs is a “Contribution”
or Contribution = P + F
P = Contribution – F
P = C – F
7032maa Lecture 6 11
Total cost = fixed cost + variable cost
Total revenue = price x quantity sold
Break-even: Total Cost= Total Revenue
TR = £ (q)
TC = FC + VC
TC = FC + VC TR = £ (q)
Break even analysis
7032maa Lecture 6 12
Contribution: amount of money when all
direct or product (variable) costs have
been covered
Contribution = Selling Price – Variable cost
contribution
Break – even (sales value) fixed costs sales 

contribution per unit
Break – even (units)  fixed costs
Break even analysis
7032maa Lecture 6 13
• A tool for determining the impact of changes in
price and cost to a company’s profit
• Enables businesses to:
• Calculate the level of sales to cover costs
• Examine the impact of changes in output to profit
• Evaluate the changes in price & costs
• A tool for budgeting and planning
Total Costs = Total Revenue
At Break-Even Point:
Break even point
7032maa Lecture 6 14
Margin of safety
contribution
Margin of safety (sales value) profit sales 

contribution per unit
Margin of Safety (units)  profit
7032maa Lecture 6 15
The difference between the break-even volume
and the actual or anticipated volume of
activity/output
Amount of output which can be sacrificed
before the business is no longer profitable
Margin of Safety = Current output/Sales – Break-even output/sales
Margin of safety
7032maa Lecture 6 16
Examples of BE & MoS
Source: Dyson, J.R (2010) Accounting for non-accounting students, FT Prentice
Hall p386, Example 17.8
7032maa Lecture 6 17
Break-even chart
Source: Dyson, J.R (2010) Accounting for non-accounting students, FT Prentice
Hall p380, Example 17.4
7032maa Lecture 6 18
• When resources such as labour or
materials are limited then only a certain
number of products can be made
• If limiting factors are present then choose
the product that can give the highest
contribution per unit of limiting factor
• Therefore an increase in profit depends on
an increase in contribution
Limiting factors
7032maa Lecture 6 19
Example
Products A and B are to be manufactured from 2000Kg of material.
Per unit A B
Material 10Kg 4Kg
Selling price £600 £300
Variable cost £400 £200
Contribution £200 £100
Contribution/Kg £20 £25
Product B is manufactured as it provides the highest contribution per Kg.
A B
Units/2000Kg 200 500
Total contribution £40000 £50000
Limiting factors of break
even analysis
7032maa Lecture 6 20
Assumptions:
•Total costs can be split into fixed & variable
•Fixed costs remain constant regardless of activity & do
not relate to specific units
•Variable cost vary in direct proportion to activity
•Dependent on time period, ie all costs change in LR
•Assumes all output is sold
•Relies on quality and accuracy of data
•Ignores complementary products, non-cost &
behavioural factors
Limitations of break-even
analysis
7032maa Lecture 6 21
• Overheads: indirect costs are not easily identified
with a certain activity or a cost centre
• Absorption costing: is the charging of overheads to
specific activities
• An entity (company/organisation):
production/operations department(s), other
departments that provide a service to such
departments(finance, personnel, catering,
maintenance,..)
Dealing with overheads
7032maa Lecture 6 22
Absorption costing system
Source: Dyson, J.R (2010) Accounting for non-accounting
students, FT Prentice Hall 7032maa Lecture 6 p302, Fig 14.1 23
• A product/service has some direct costs and
indirect costs, these form the total cost.
• The following procedures are normally followed
in absorbing indirect costs:
• Cost allocation to cost centres
• Apportion costs
• Absorb costs
• Cost allocation to cost centres- this is charging
the cost of an item to a cost centre. Generally the
allocation is in the form of production or service
centres
Allocating overheads using
absorption
7032maa Lecture 6 24
1.Take each service cost centre cost and charge it to
those cost centres that have benefited from the
service
2.Take the total of all the cost centres that provide
the services and charge to all other cost centres that
have benefited from the services
Combination of the above is used in practice
Apportion of costs
7032maa Lecture 6 25
The sharing out or apportionment can take the following
formats:
•Employees- if the provided service applies to employees
then employee number within the department receiving
the service is used to share the overheads
•Floor area-cost centres are charged based on the floor
area (cleaning and building maintenance)
•Activity- this is based on the number activities provided
by the service cost centre to the benefited cost centres.
(per requisition of material from stores, …)
Examples of apportioning
7032maa Lecture 6 26
total cost centre activity
Cost centre overhead absorption rate  total cost centre overhead
number of units processed in the cost centre
1) units absorption rate  total cost centre overhead
100
total direct material costs
2) direct materials cost absorption rate  total cost centre overhead
Overhead absorbing methods
100
total direct labour costs
3) direct labour cost absorption rate  total cost centre overhead 
Source: Dyson, J.R (2010) Accounting for non-accounting students, FT Prentice
Hall p306
7032maa Lecture 6 27
100
prime cost
4) prime cost absorption rate  total cost centre overhead 
total direct labour hours
5) direct labour hours absorption rate  total cost centre overhead
total machine hours
6) machine hours absorption rate  total cost centre overhead
Source: Dyson, J.R (2010) Accounting for non-accounting students, FT Prentice
Hall p307
7032maa Lecture 6 28
Overhead absorbing methods
Example charging
overhead to cost centres
Source: Dyson, J.R (2010) Accounting for non-accounting students, FT Prentice
Hall p305, Example 14.1
7032maa Lecture 6 29
• These do not specifically relate directly to product
or provided service E.g. head office admin, selling
and distribution, marketing,..
• It may be necessary to apportionment such costs
to the unit cost for control, selling price and stock
evaluation.
• In practice it can become difficult, complex and
time consuming for such apportionments
Other indirect overheads
7032maa Lecture 6 30
Comparing marginal with absorption
£ x1000 X Y Z Total
Sales 200 100 150 450
Variable
Costs
130 90 100 320
Fixed
Costs
50 10 30 90
Total
Cost
180 100 130 410
Profit 20 Nil 20 40
£ x1000 X Y Z Tota
l
Sales 200 100 150 450
Variable
Costs
130 90 100 320
Contribution 70 10 50 130
Fixed Cost 90
Profit 40
Absorption costing
statement
Marginal costing statement
7032maa Lecture 6 31
• The absorption costing method can allocate costs
to products or services that did not really incur
them or may be of a lower/higher proportion.
• This can under price or over price a
product/service and it is not desirable in a
competitive market.
• ABC identifies the true cost of a product/service
• ABC absorbs costs based on a closer
relationship between the unit and individual
activities in producing it
Activity based costing (ABC)
7032maa Lecture 6 32
ABC approach:
1.Charge overheads to common cost pools

Identifying cost drivers
3.Calculating cost driver rate
4.Charge units with their share of each pool cost
ABC identifies true cost, it is more specific, but it
can be costly to implement
Activity based costing (ABC)
7032maa Lecture 6 33
Example of ABC allocation
Source: Dyson, J.R (2010) Accounting for non-accounting students, FT Prentice
Hall p316, Example 14.5
7032maa Lecture 6 34
÷ x =
Differences between
marginal, absorption & ABC
7032maa Lecture 6 35
Summary
• Recognised standard costs
• Used variance analysis
• Outlined marginal costing
• Used break even analysis
• Identified absorption & activity based costing
• Critically assessed allocation of indirect costs
from a marginal, absorption & activity based
perspective
7032maa Lecture 6 36

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