These are two traditional product costing techniques taught under Management Accounting. Let's first try to understand how cost can be categorized into different segments in manufacturing sector.
Key Points to Know,
Products will only be costed based on Production Costs
All Direct Costs (DM & DL) are variable costs (Total cost change with the volume of production).
A Production Overhead can be either a variable or a fixed or a semi-variable cost.
Product Costing Techniques
1. Marginal Cost
The additional production cost to manufacture one extra unit. Generally, this is the sum of variable production costs.
MC of a Product = Material + Labour + Variable Prod. Overhead2. Absorption Cost
A costing technique where both variable & fixed production costs will be absorbed to the product cost. Also known as full cost as it captures all relevant production costs (Both Direct & Indirect).
AC of a Product = Material + Labour + Variable Prod.OH + Fixed Prod.OHRemember - Absorption will happen based on a pre-determined rate. You call that the Overhead Absorption Rate (OAR).
OAR = Total OH/Total Activity LevelLet's go back 10-15 years and look at the production facility of an organization. You will realize that most of the manufacturing was based on human labour. Hence, an organization back then had very high amount of direct expenses compared to overheads.
Direct expenses will not be bothering us a lot. Why?? Because it can be directly identified with a particular product unit.
The issue is how are we going to absorb production overheads to product unit......As said above we need to decide on a base.
When you have $10,000 with you, you won't think twice to give out $20 to anyone. That's simply because $20 is comparatively negligible (small). Just like that when you have very high amount of direct costs, production overheads will not make a huge impact or variation in decision making.
When you know that production overhead is small, why waste time on analysing each and every component individually. Rather take the total sum of production overheads and divide among the units based on the consumption of the selected base (Base can be units or labour hours or machine hours).
Example:
OSMI manufactures two products namely, OS1 & OS2. Refer below data and find the unit cost of each product.
Let's absorb OHs based on labour hours.
Step 1
Calculate the total labour hours for the total production.
Labour Hrs = Total for OS1 + Total for OS2
Total Labour Hours = (1,000*5) + (750*4.5) = 8,375 Hrs
Step 2
Calculate the OAR based on labour hours.
OAR = Total OH/Total Hours = $209,375/8,375Hrs = $25 per Hr
Step 3
Absorb overheads based on the OAR to product OS1 & OS2.
Since we know the labour hour consumption per unit, we can directly find the OH absorbed per unit. If not you have to absorb for the total production and then divide by the number of units to arrive at unit OH cost.Absorbed OH per Unit = Labour Hrs per Unit * OAR
OH per OS1 = 5Hrs * $25/Hr = $ 125
OH per OS2 = 4.5Hrs * $25/Hr = $ 112.50
Step 4
Calculate the total production cost for each product.
Absorption Cost = Material Cost + Labour Cost + Absorbed OH per Unit
Total Cost OS1 = $350 + $500 + $125 = $ 975
Total Cost OS2 = $650 + $450 + $112.50 = $ 1,212,50
Purindu B Jayatilake
MSc Eng (Reading), MBA, BSc (Hons) Eng, ACMA (UK), CGMA
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