Unit Cost Calculation

AFZAL AHMED, FCA

FINANCE CONTROLLER
NAGAD
 Unit Cost Calculation

Absorption costing
In absorption costing the full cost of a cost unit is equal to its
prime cost plus an absorbed share of overhead cost.

Overheads are absorbed into product or service costs using a

predetermined overhead absorption rate, usually set
annually in the budget.

The absorption rate is calculated by dividing the

budgeted overhead by the budgeted level of activity. For
production overheads, the level of activity is often measured in
terms of direct labour hours or machine hours.
 Unit Cost Calculation

Absorption costing
To calculate the full cost of an item using absorption costing
(sometimes referred to as full costing) it is necessary first to
establish its direct cost or prime cost and then to add a fair
share of indirect costs or overhead.
CU
Direct materials X
Direct labour X
Other direct expenses (if any) X
Total Direct Cost (Prime Cost) XX
Share of indirect cost/overhead X
Absorption (full) cost XX
 Unit Cost Calculation

Absorption costing
There are three stages in determining the share of overhead
to be attributed to a cost unit:
 Overhead allocation
 Overhead apportionment
 Overhead absorption

Allocation is the process by which whole cost items are

charged direct to a cost centre. A cost centre acts as a
collecting place for costs before they are analysed further.
 Unit Cost Calculation

Overhead apportionment involves apportioning general

overheads to cost centres (the first stage) and then
reapportioning the costs of service cost centres to production
departments (the second stage).

Overhead absorption
Having allocated and apportioned all overheads, the next
stage in absorption costing is to add them to, or absorb them
into, the cost of production or sales
 Sample Problem

JPE Ltd is divided into five departments that are also cost centres.
These are departments A, B and C (through which cost units physically
pass), an administrative department and a canteen.

A B C Canteen Admin
Floor area (sq metres) 5,000 5,000 4,000 4,000 2,000
Personnel (persons) 10 20 10 10 5
Remuneration per month
Direct (CU) 1,920 3,600 2,240
Indirect (CU) 360 480 240 320 870
Direct materials consumed (CU) 5,500 250 400
Machine hours per month 600 2,400 200
Power costs per month (CU) 50 500 20 80

General overheads per month (CU) 1,000 2,000 1,200 650 1,230
 Sample Problem

The monthly rent of the company’s premises is CU6,000.

The monthly takings of the canteen are CU600. Food bills for the
canteen totaled CU470. None of the administrative staff use the
canteen.
The monthly electricity charge for heat and light is CU1,000.
The administration costs are made up mainly of personnel-related
costs.

Requirement
Apportion all overheads to the production cost centres .
 Overhead Absorption Rate

In absorption costing, it is usual to add overheads into

product costs by applying a predetermined
overhead absorption rate.

The predetermined rate is usually set annually in

advance, as part of the budgetary planning process.

The absorption rate is calculated by dividing the

budgeted overhead by the budgeted level of activity.
 Overhead Absorption Rate

Overhead absorption rates are therefore

predetermined as follows:
 The overhead likely to be incurred during the
coming period is estimated.
 The total hours, units, or direct costs on which the
overhead absorption rates are to be based (the
activity level) are estimated.
 The estimated overhead is divided by the budgeted
activity level to arrive at an absorption rate for the
forthcoming period.
 Over/under absorption of overhead

The overhead absorption rate is based on estimates (of both

numerator and denominator) and it is quite likely that either one
or both of the estimates will not agree with what actually occurs.
Actual overheads incurred are unlikely to be equal to the
overheads absorbed into the cost of production.

(a) Over absorption means that the overheads charged to the

cost of production are greater than the overheads actually
incurred.

(b) Under absorption means that insufficient overheads have

been included in the cost of production.
 Self Test 1

ABC Co has been using an overhead absorption rate of CU 6.25 per labour
hour in its packing department throughout the year.

During the year the overhead expenditure amounted to CU 257,500, and

44,848 labour hours were used.

Which of the following statements is correct?

A Overheads were under absorbed by CU27,600

B Overheads were under absorbed by CU22,800

C Overheads were over absorbed by CU27,600

D Overheads were over absorbed by CU22,800

 Self Test 2

A management consultancy absorbs overheads on chargeable consulting

hours. Budgeted overheads were CU615,000 and actual consulting hours were
32,150.
Overheads were under-absorbed by CU35,000.
If actual overheads were CU694,075, what was the budgeted overhead
absorption rate per hour?
A CU19.13

B CU20.50
C CU21.59

D CU22.68
 Marginal Costing

 In a marginal costing system only variable

production costs are included in the valuation of
units
 All fixed costs are treated as period costs and are
charged in full against the sales revenue for the
period
 Contribution towards fixed costs and profit is
calculated as sales revenue less variable cost of sales
 Marginal costing profit for the period = contribution
less fixed costs
 Marginal Costing

The marginal production cost per unit usually consists

of the following:
 Variable materials
 Variable labour
 Variable production overheads

Contribution difference between sales value and

marginal cost
Contribution towards fixed overheads
and profit
 Sample Problem 1

Water Ltd makes a product, the Splash, which has a variable

production cost of CU6 per unit and a sales price of CU10 per
unit. At the beginning of September 20X0, there was no
opening inventory and production during the month was
20,000 units. Fixed costs for the month were CU45,000
(production, administration, sales and distribution). There
were no variable marketing costs.

Requirement:
Calculate the contribution and profit for September 20X0,
using marginal costing principles, if sales were as follows.
a) 10,000 Splashes b) 15,000 Splashes c) 20,000 Splashes
 Sample Problem 2

PQR Ltd makes two products, the Loo and the Wash.
Information relating to each of these products for April 20X1
is as follows.
Loo Wash
Opening Inventory (units) Nil Nil
Production (units) 15,000 6,000
Sales (units) 10,000 5,000
Sales price per unit 20 30
Variable material per unit 8 14
Variable labour per unit 4 2
Variable Production OH per unit 2 1
Variable Sales OH per unit 2 3
 Sample Problem 2

Fixed costs for the month

Production costs 40,000
Administration costs 15,000
Sales & distribution costs 25,000

Requirement:
Using marginal costing principles calculate the profit in April
20X1
 Marginal Vs Absorption Costing

In a marginal costing system inventories are valued

at marginal or variable production cost; all fixed
overhead is charged against sales for the period in
which it is incurred.
In an absorption costing system an amount of
absorbed fixed production overhead is included in
the inventory valuation.
Reported profit figures using marginal and
absorption costing will differ if there is any change in
the level of inventories during the period.
 Marginal Vs Absorption Costing

If the fixed production overhead absorption rate per

unit is the same each period, the difference in
reported profit is calculated as (the change in
inventory units x fixed production overhead
absorption rate per unit).

In the long run the total reported profit will be the
same whether marginal costing or absorption costing
is used.
 Sample Problem 3

TLF Ltd manufactures a single product, the Claud. The following figures
relate to the Claud for a one-year period.
Sales and production (units) 800
Sales (CU) 16,000
Production Cost (CU)
Variable 6,400
Fixed 1,600
Sales & distribution Cost (CU)
Variable 3,200
Fixed 2,400
The normal level of activity for the year is 800 units. Fixed costs are
incurred evenly throughout the year, and actual fixed costs are the same
as budgeted. A predetermined overhead absorption rate is used for the
year.
 Sample Problem 3

There were no inventories at the beginning of the year.

In the first quarter, 220 units were produced and 160 units sold.

Requirements:
For the First quarter:
a) Calculate the fixed production costs absorbed by Clauds if absorption
costing is used.
b) Calculate inventory values per unit using both absorption costing and
marginal costing.
c) Calculate the under/over absorption of overheads.
d) Calculate the profit using absorption costing.
e) Calculate the profit using marginal costing.
f) Explain why there is a difference between the answers to (d) and (e).
 Marginal Vs Absorption Costing

 Marginal costing and absorption costing are different

techniques for assessing profit in a period.
 If there are changes in inventories during a period,
marginal costing and absorption costing give different
results for profit obtained.
Assuming that the variable cost per unit and the fixed cost per unit are
constant:
I. If inventory levels increase, absorption costing will
report a higher profit because some of the fixed production
overhead incurred during the period will be carried forward in
closing inventory. This reduces cost of sales and carries forward
cost to be set against sales revenue in the following period.
 Marginal Vs Absorption Costing

II. If inventory levels decrease, absorption costing will

report a lower profit because as well as the fixed overhead
incurred, fixed production overhead which had been brought
forward in opening inventory is released and is included in cost of
sales.
 If the opening and closing inventory levels are the same,
marginal costing and absorption costing will give the same
profit figure if unit costs remain constant.

 In the long run, total profit for a company will be the same
whether marginal costing or absorption costing is used as
all inventory is sold. Different accounting conventions
merely affect the profit of individual accounting periods.
 Sample Problem 4

The overhead absorption rate for product X is CU10

per machine hour. Each unit of product X requires five
machine hours. Production of product X last period
was 4,800 units and the sales volume achieved was
4,750 units.

Requirement:
In which method the profit will be higher and what is
the difference in profit between two methods.
 Sample Problem 5

A company makes and sells a single product. At the beginning of period 1,

there are no opening inventories of the product, for which the variable
production cost is CU4 per unit and the sales price CU6 per unit. Fixed
costs are CU2,000 per period, of which CU1,500 are fixed production
costs.
Period 1 Period 2
Sales (units) 1200 1800
Production (units) 1500 1500

Requirements:
What profit would be reported in each period and in total using the
following costing systems?
(a) Absorption costing. Assume normal output is 1,500 units per period.
(b) Marginal costing.
 Sample Problem 6

X Ltd commenced business on 1 March making one product only. Unit

cost information for the product is as follows:
CU
Variable labour 5
Variable material 8
Variable production overhead 2
Fixed production overhead 5
The fixed production overhead figure has been calculated on the basis of a
budgeted normal output of 36,000 units per annum.
You are to assume that all the budgeted fixed expenses are incurred
evenly over the year. March and April are to be taken as equal period
months.
Selling, distribution and administration expenses are as follows:
Fixed CU120,000 per annum Variable 15% of the sales value
 Sample Problem 6 cont.…

The selling price per unit is CU35 and the number of units produced and
sold was as follows:
March April
Sales (units) 1500 3000
Production (units) 2000 3200

Requirements:
1) Assuming marginal costing:
1) Value of closing inventory for each month
2) Profit for each month
2) Assuming absorption costing:
1) Value of closing inventory for each month
2) Under/over abortion of overhead each month
3) Profit for each month
 Sample Problem 7

When opening inventories were 8,500 litres and closing

inventories 6,750 litres, a firm had a profit of Tk. 62,100
using marginal costing.

Assuming that the fixed overhead absorption rate was Tk. 3

per litre, what would be the profit,usingabsorption costing?
 Sample Problem 8

Tamim& Company gathered the following information for the year ended
December 31, 2016:

Units produced 45,000

Units expected to be produced 45,000
Units sold 43,200
Direct labour (CU) 137,200
Direct materials used (CU) 126,400
Fixed selling and administrative expenses (CU) 51,000
Variable selling and administrative expenses (CU) 58,000
Fixed manufacturing overhead (CU) 83,250
Variable manufacturing overhead (CU) 73,900
Required:
a)Under absorption costing, what is the cost of the finished goods
inventory on December 31, 2016?
b)Under variable costing, what is the cost of the finished goods inventory on
December 31, 2016?
c)Why is absorption costing more widely used than variable costing?
 Sample Problem 9

XYZ Limited is a manufacturing company which is currently reviewing the costing

arrangement for its product A. During the first quarter of the year, they sold
50,000 units of product A at BDT 30 per unit. They produced 45,000 units of
product A during the quarter and the following information has been provided for
the quarter:
Per unit cost (BDT) Total cost (BDT)
Direct materials 7.00 315,000
Direct labour 16.00 720,000
Production OH 5.00 225,000

At the beginning of January, there was a stock of 10,000 units valued as follows:

Per unit cost (BDT) Total cost (BDT)

Direct materials 6.50 65,000
Direct labour 16.25 162,500
Production OH 5.00 50,000
 Sample Problem 9

Sales and administrative overheads for the period were as follows:

Variable BDT 55,000
Fixed BDT 50,000

It is estimated that 40% of production overheads are variable, while the remainder
are fixed.

What would be the profit using absorption costing and marginal costing?
Thank you