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Financial Accounting Costing

‘Most of financial accounting’s allocations are arbitrary, and… this renders them useless for the general purposes which financial accounting attempts to serve.’ (Thomas, 1971, p472)

Discuss the above statement with reference to absorption costing and marginal costing.

Concerning the accounting information regularly is what the financial accounting mainly involved. All the accounting information will be generated into a form of statement which is acquired by the shareholders, government agencies and some of the other external parties. This kind of statement used to consist of past transactions and events. The financial statements also have to include a profit and loss account, a balance sheet and a cash flow statement.

With all these details, the statement will possibly be able to help the reader to understand the performance of an individual firm and the position of an enterprise. In 1971, the allocations of the financial accounting have been judged as arbitrary by L. Thomas. This argument has been disputed by many of the experienced accountants. Most of them believed that financial accounting can only serve some of the basic purposes.

If we try to integrate the financial information, by identifying, presenting and interpreting information so as to aid management in planning, controlling and decision making. It is concerned with the past, the present and the future. This is known as managerial accounting. And it could be divided into two different parts i.e. absorption cost and marginal costing. By computing the data with these two methods, it can help to judge whether financial accounting is actually arbitrary or not.

B. Absorption costing

The most common way of dealing with overheads is absorption costing. Absorption costing is a method of computing the costing which is trying to take in the total cost of a product an appropriate share of the organization‘s total overhead. An appropriate share is generally considered to be an amount which reflects the amount of time and the effect that has gone into producing a product.

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The use of absorption costing for product costing is mainly for inventory valuation and pricing decisions. Absorption costing should be used for the valuation of closing inventory and the determination of cost of sales during the accounting the accounting period for financial reporting purpose. Many enterprises adopt the cost plus pricing policy in that they attempt to fix the selling price by calculating the full cost of production of each product and then adding a margin for a profit.

Product costs are accumulated by using absorption costing by a process of allocation, apportionment and absorption.

In order to reach the integration, it was essential to allocate costs to products completely. This would lead to a result of arbitrary allocations that made the costs of particular products to be unclear. ‘... perhaps the most obvious example of external reporting's overriding and distorting influence on the internal accounting system is the arbitrary allocation of joint production costs ... Decisions are made on the basis of opportunities taken and rejected but the system does not record opportunity costs ... there appears to be sufficient evidence to suggest that financial accounting practices destroy or limit the usefulness of much accounting data’ [Burrows, 1974]. This gives support to the idea of the arbitrary allocations.

Another important method of managerial accounting is the marginal costing. With this method, there would be only either the variable cost or the direct cost being concerned in the cost unit produced. It can reflect the impacts on the profit of the changes in volume divided by the different types of output. In marginal costing, fixed costs cannot be charge to the production.

They are seen as a period charge and it is written to the profit and loss account in a period. Marginal cost is a contribution can be computed. Contribution is the surplus of revenue over marginal costing. As the marginal costs is the direct cost. So marginal costing is a way to report the profits and record the costs.

Absorption costing and marginal costing are two entirely different techniques of cost accounting. Absorption costing is broadly used for cost control aims and the absorption costing is good for the long term use because all of the costs must be recovered for the organizations to make a profit. The concentration on recovering the variable cost per unit in terms of contribution may distort this fact.

There are some favorable points of absorption costing, for example, it is required for statutory valuations of inventories that require the enclosure of fixed production overheads in inventory unit and the enclosure of fixed production costs in inventory valuation allows the matching of the revenue with the cost when the inventory is sold, hence smoothing out profits between periods.

There are two vital points to show the disadvantages of the absorption costing. As absorption costing highlighted on the total cost are all variable and fixed, it cannot actually help for the management to make a good decision, planning and controlling the manager’s emphasis is on the total cost, the cost volume profit relationship will be ignored.

Marginal provide better information hence is a useful managerial decision making tool and marginal costing is used for managerial decision-making and control. Moreover, marginal costing operating statement are more useful for making short run decision because they provide better information about expected profit which is taken from the uses of contribution and variable costs.

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That is the same as the example in task 1 (managing director of XOX Ltd) who can use the marginal costing to expect profitability of each product and the total company profit for 20x7 and 20x8 because it can be used to help management make decisions among alternatives course of action. So the advantage of marginal costs is which it can show the relationship between cost, price and volume. Furthermore, the marginal costing is simple to operate because it does not require complex apportionments and calculation of overhead absorption rates .Accordingly, under or over absorption of overhead can be avoided.

Absorption costing is a costing system that includes both variable and fixed production costs in the cost units. Under absorption costing system, closing inventories and production cost of sales are valued at full production cost including a share of the fixed production overheads. When the fixed production overheads incurred differ from the fixed production overheads absorbed, there will be an under or over absorption of production overheads.

Alternatively, marginal cost is part of the cost of the goods or services which would be prevented if the unit is not produced and so as the variable cost of one unit of product or service. Marginal costing, also known as variable costing is a costing system that includes variable costs in the cost units and fixed cost is treated as period costs. Variable costs may include production variable cost and non-production variable costs.

Under a marginal costing system, closing inventories are valued at variable production cost only. Costs of sales are valued at variable cost only, which may include production and non-production costs. Since there is no absorption of fixed product overheads, there will not be any under or over absorption of product overheads. Contribution is obtained when cost of sales is deducted from sales. When there is no inventory or changes in inventory levels at the beginning and the end of a period, absorption and marginal costing will provide the same profit figures for the period.

Marginal costing and absorption costing do not have the same profit number because of different absorbed overheads. For absorption costing, it can never fully absorb the fixed overheads as we may find hard to predict the costs and the values of output. If these balances of different absorbed divided by the recovery were not including in the costing profit and loss account. Yet, for the marginal costing, the real fixed overhead involved is literally completely charged just against contribution. Therefore, differences are found in the net profits.

Conclusion

Managerial accounting is good information for the managers .Since managers need information to help decide which of the various possible course of action they should take. And managers also need information about the deviations from plans and help decide the appropriate corrective action they should take. It is the roles of the management accounting provide information of good qualities to facilitate managers to reach an informed decision.


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