Absorption Costing and Marginal Costing

Overhead reapportionment involves reallocating costs from service cost centres, which provide support services, to production cost centres, where the actual manufacturing occurs. This process ensures that all relevant costs are accurately reflected in the production departments, allowing for a more precise calculation of product costs. By transferring these costs, businesses can better understand the true expenses associated with producing goods, facilitating more informed financial decision-making and pricing strategies.

To determine under or over absorption, we first calculate the overhead absorption rate, which is budgeted overheads divided by budgeted activity (Rs. 600,000 / 30,000 hours = Rs. 20 per hour). For the actual activity of 28,000 hours, the absorbed overheads amount to Rs. 560,000 (28,000 hours × Rs. 20). Since the actual overheads incurred were Rs. 620,000, we find the under-absorption by subtracting the absorbed overheads from the actual overheads: Rs. 620,000 - Rs. 560,000 = Rs. 60,000. Thus, there is an under-absorption of Rs. 60,000.

Under absorption costing, all manufacturing costs, including fixed overheads, are allocated to the products produced. When production exceeds sales, some of these fixed overhead costs remain in inventory rather than being expensed in the current period. This deferral of fixed overheads leads to a higher reported profit under absorption costing compared to marginal costing, where fixed overheads are expensed in full during the period. Thus, the profit appears higher under absorption costing due to the unsold inventory absorbing some of the fixed costs.

In marginal costing, fixed production overheads are classified as period costs because they are not directly tied to the production of goods. Instead of being allocated to individual units, these costs are expensed in full during the period in which they are incurred. This approach emphasizes the variable costs associated with production, allowing for clearer analysis of contribution margins and decision-making regarding pricing and production levels. By treating fixed overheads as period costs, businesses can better assess their profitability on a more immediate basis.

Apportioning factory rent based on floor area is most appropriate because rent is a fixed cost associated with the physical space occupied by the factory. Each department or production area utilizes a specific amount of space, making floor area a logical basis for distributing costs. This method ensures that rent is allocated fairly in relation to the actual space used, reflecting the resources consumed by each section of the factory. Other bases, like number of employees or machine hours, do not directly correlate with the space occupied and may lead to inequitable cost distribution.

Marginal costing, which focuses on variable costs and excludes fixed costs from product costs, does not align with IFRS/SLFRS standards that require full absorption costing for external financial reporting. Under these standards, all manufacturing costs, including fixed overheads, must be allocated to inventory and recognized as expenses when the inventory is sold. This ensures that financial statements provide a complete and accurate representation of a company's financial position and performance, making marginal costing non-compliant for external reporting purposes.

Under-absorption of overheads occurs when the overhead costs allocated to products are less than the actual overhead incurred. This can happen when actual production activity is lower than budgeted, leading to fewer units over which to spread fixed costs, resulting in under-absorption. Additionally, if actual overhead costs exceed budgeted amounts, it contributes to under-absorption as the budgeted overheads do not cover the actual expenses incurred. Thus, both scenarios highlight a mismatch between expected and actual overheads, leading to under-absorption.

Under absorption costing, fixed overheads are allocated to all units produced, including those in closing inventory. In this case, with 4,000 units produced and fixed overheads of Rs. 360,000, each unit absorbs Rs. 90 of overhead (Rs. 360,000 / 4,000 units). The closing inventory of 800 units absorbs Rs. 72,000 (800 units x Rs. 90). This amount is included in inventory under absorption costing, reducing the expense recognized in the period compared to marginal costing, where fixed overheads are treated as period costs. Thus, absorption costing yields a higher profit by this amount.

The blanket overhead absorption rate simplifies costing by applying a single rate across the entire organization, making it easier to calculate overhead. However, this approach can lead to inaccuracies, especially when different departments have varying levels of resource consumption. In contrast, multiple departmental rates take into account the specific overhead costs associated with each department, providing a more precise allocation of costs. This distinction highlights the trade-off between simplicity and accuracy in overhead absorption methods.