Management Accounting Techniques

Absorption costing treats all production costs (direct materials, direct labour, variable production overheads, AND fixed production overheads) as product costs that are included in the cost of inventory.

Unit cost under absorption costing:

Unit cost = Direct materials + Direct labour + Variable production overhead + Fixed production overhead per unit

The fixed production overhead per unit is calculated using an overhead absorption rate (OAR):

OAR = Budgeted fixed production overheads ÷ Budgeted activity level (e.g., units, labour hours, machine hours)

Over- and under-absorption: If actual activity differs from budgeted activity, fixed overheads will be over-absorbed (actual > budget, too much absorbed → credit to P&L) or under-absorbed (actual < budget, too little absorbed → debit to P&L).

Absorption costing is required by IAS 2 for external financial reporting — inventory must include a share of fixed production overheads based on normal capacity.

Marginal costing treats only variable production costs as product costs. Fixed production overheads are treated as period costs — charged in full to the profit or loss in the period they are incurred, regardless of the level of production or inventory changes.

Unit cost under marginal costing:

Unit cost = Direct materials + Direct labour + Variable production overhead

Fixed production overheads are NOT included in inventory — they are expensed in the period.

Key concept — Contribution:

Contribution = Revenue − Variable costs (all variable costs, not just production)

Contribution per unit = Selling price − Variable cost per unit

Contribution is the amount each unit contributes towards covering fixed costs and generating profit.

Absorption and marginal costing produce different profits when inventory levels change (i.e., production ≠ sales):

Reconciliation formula:

Absorption profit − Marginal profit = Change in inventory (units) × Fixed OAR per unit

If inventory increases: absorption profit is higher by the fixed overhead absorbed into the additional closing inventory units.

If inventory decreases: absorption profit is lower because fixed overhead is released from the reduction in inventory.

Total material variance = Standard cost of actual production − Actual cost of materials used

This splits into:

Material price variance (MPV):

MPV = (Standard price − Actual price) × Actual quantity purchased

Measures whether materials were bought at a higher or lower price than standard. Responsibility: purchasing department.

Material usage variance (MUV):

MUV = (Standard quantity for actual production − Actual quantity used) × Standard price

Measures whether more or fewer materials were used than the standard allows for the actual output. Responsibility: production department.

Possible causes:

• Price variance adverse: Supplier price increases, emergency purchases at premium prices, buying higher-quality material, unfavourable exchange rates (imported materials)
• Price variance favourable: Bulk purchase discounts, cheaper supplier, lower-quality material, favourable exchange rates
• Usage variance adverse: Excessive waste/scrap, poor-quality materials (more wastage), theft, inaccurate standards, machine problems, unskilled labour
• Usage variance favourable: Higher-quality materials (less waste), improved production methods, skilled workers, tighter waste control

Interrelationship: Buying cheaper materials (favourable price variance) may lead to more waste (adverse usage variance). Buying higher-quality materials (adverse price) may reduce waste (favourable usage). Management should evaluate the net effect.

Total labour variance = Standard labour cost of actual production − Actual labour cost

Labour rate variance (LRV):

LRV = (Standard rate − Actual rate) × Actual hours worked

Measures whether workers were paid more or less per hour than standard. Responsibility: HR / production management.

Labour efficiency variance (LEV):

LEV = (Standard hours for actual production − Actual hours worked) × Standard rate

Measures whether workers took more or fewer hours than the standard allows for the actual output. Responsibility: production department.

Possible causes:

• Rate adverse: Pay rises, using higher-grade (more expensive) workers, overtime premiums
• Rate favourable: Using lower-grade (cheaper) workers, less overtime than expected
• Efficiency adverse: Poorly trained workers, machine breakdowns (idle time), poor-quality materials (harder to work with), low morale, poor supervision
• Efficiency favourable: Experienced workers, improved methods, new equipment, better materials, effective supervision

Variable overheads are typically absorbed on a labour hour basis (or machine hour basis).

Variable overhead expenditure variance:

= (Standard variable OH rate × Actual hours) − Actual variable OH cost

Or: = (Standard rate − Actual rate per hour) × Actual hours

Measures whether the actual variable overhead cost per hour was higher or lower than the standard rate.

Variable overhead efficiency variance:

= (Standard hours for actual production − Actual hours) × Standard variable OH rate

Measures the effect of labour efficiency on variable overhead absorption. If workers are inefficient (take more hours), more variable overhead is incurred. This variance uses the same hours difference as the labour efficiency variance but applies the variable overhead rate instead of the labour rate.

Under absorption costing, fixed production overheads are absorbed into products at a predetermined rate. Variances arise when actual costs or activity differ from budget.

Fixed overhead expenditure (spending) variance:

= Budgeted fixed overheads − Actual fixed overheads

Simply: did we spend more or less on fixed overheads than budgeted? Nothing to do with production volume.

Fixed overhead volume variance:

= (Actual production − Budgeted production) × Standard fixed OH per unit

Or: = Fixed OH absorbed (based on actual production) − Budgeted fixed OH

Measures the effect of producing more or fewer units than budgeted. If actual production > budget → more fixed overhead is absorbed → favourable. If actual < budget → under-absorption → adverse.

The total fixed overhead variance = Expenditure variance + Volume variance = Fixed OH absorbed − Actual fixed OH. This equals the over- or under-absorption of fixed overheads.

The most common approach. The previous period's budget or actual results are used as the starting point, and incremental adjustments are made for expected changes (inflation, volume changes, known cost increases, planned new activities).

Advantages: Simple, quick, easy to prepare, stable, minimal disruption.

Disadvantages: Perpetuates past inefficiencies (if last year's budget included waste, this year's will too), does not encourage critical review of activities, may lead to "budget padding" (managers inflate costs to create slack), not suitable in rapidly changing environments.

Zero-based budgeting starts from zero each period — every activity must be justified from scratch, as if the budget were being prepared for the first time. No expenditure is automatically carried forward.

Process: Each manager identifies all activities (decision packages), ranks them by priority, and justifies their cost. Resources are allocated based on the ranking and available funds.

Advantages: Eliminates historical inefficiencies, encourages critical evaluation of all activities, focuses resources on priorities, identifies obsolete or low-value activities.

Disadvantages: Very time-consuming and resource-intensive, may be demoralising (constantly justifying existence), difficult to rank dissimilar activities, may lead to short-termism (cutting activities with long-term benefits), requires significant management effort.

A rolling budget is continuously updated by adding a new budget period (e.g., a new month or quarter) as the most recent period expires. The budget always covers a fixed number of periods ahead (e.g., always 12 months).

Example: As January 2025 ends, the budget is extended to include January 2026 — so the budget always covers the next 12 months.

Advantages: Always provides a current, up-to-date budget reflecting the latest information, forces regular planning, reduces the "year-end mentality" (no rush to spend before year end), more realistic targets.

Disadvantages: Time-consuming (budget preparation is continuous, not annual), may create uncertainty (targets keep changing), requires disciplined process.

A flexed budget adjusts the original (fixed) budget to reflect the actual level of activity achieved. It answers the question: "What should costs have been at the actual activity level?"

This enables a meaningful comparison of actual costs against budget — because the comparison is made at the same activity level. Without flexing, a comparison is distorted by the volume difference.

How to flex:

• Variable costs: Adjust in proportion to the change in activity level (e.g., if actual output is 10% higher than budget, variable costs in the flexed budget are 10% higher)
• Fixed costs: Remain the same as the original budget (by definition, they do not change with activity within the relevant range)
• Revenue: Adjusted to reflect actual volume at the standard selling price

Variance analysis with flexed budgets:

Difference between original and flexed budget = volume variance (due to producing/selling a different quantity). Difference between flexed budget and actual = expenditure/efficiency variances (due to prices and efficiency being different from standard).