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Implementing effective costing methods in business

Introduction

In today’s complex and changing business contexts, management requires day-to-day and accurate information about the business and costs incurred for taking the right decisions to avoid all possible wastages and losses and to increase the efficiency of the business. The management will be able to make proper appraisal of the productivity and performance of the employees only if it uses effective costing methods. Strict adherence to a particular costing method has been considered to be highly significant because costing methods that a business adopts can play vital roles in the growth of advanced manufacturing technologies and business philosophies. Marginal costing and absorption costing are the basic two methods of costing that are used for managerial decision making.

This research paper outlines comparison and contrasting of marginal costing with absorption costing to be presented to the manager of Ball Dolbear Ltd that I recently joined as an accountant. This paper describes the meaning and basic principles of both marginal costing and absorption costing. The managerial concepts and significance of both these methods are detailed in this paper.

Marginal Costing: Basic principles

Both absorption costing and marginal or variable costing are types of product costing systems. Absorption or full costing includes direct materials, direct labor and both variable and fixed manufacturing overhead in the product costs whereas variable costing doesn’t include manufacturing fixed costs along with direct material and direct labor (Weygandt, Keiso and Kimmel, 2005, p. 265),.

Marginal costing is the basic tool that helps management in taking most appropriate decisions and understands accurate cost structures. Marginal costing or variable costing considers direct materials, direct labor and variable manufacturing overhead costs as product costs. Under marginal costing, variable costs are charged to cost units for a fixed period and fixed costs are written off in full against the total contribution, which is the sales value less variable costs (Lucey and Lucey, 2002, p. 296).

Nigam, Nigam and Jain (2004) defined marginal costing as the costing technique that “charges only the variable costs to the cost units” (p. 398). According to CIMA terminology of marginal costing, “it is a principle whereby variable costs are charged to the cost units and fixed costs attributable to the relevant period is written off in full against the contribution of that period” (Bhattacharyya, 2005, p. 68). Cost of a unit consists only of out of pocket costs that are direct, variable or avoidable costs. These costs that are incurred if specific products are manufactured and sold. Marginal costing considers cost behavior. Costs may be variable or fixed, but, marginal costing takes in to account only variable costing (Bendrey, Hussey and West, 2003, p. 127)

Marginal cost is variable costs attributed to the production costs because it tends to vary in the direct proportion to the changes in the production and final output. When an extra unit of the output is manufactured and sold, the extra cost incurred for the manufacturing of that extra unit will be ultimately variable because the fixed costs are remaining constant.

Marginal costing is an invaluable management accounting technique that is used to provide managerial information about costs incurred in the business operation, profit and volume relationship in an easy form to understand. The basic elements of marginal costing is that it facilitates managerial decision making, profit planning and cost management etc (Glautier and Underdown, 2001, p. 441).

Absorption Costing

Absorption costing is a costing methods in which all manufacturing costs including both variable and fixed costs are attributed to the production costs. Absorption costing or full costing is a technique which absorbs or recovers both fixed and variable costs. The cost of a unit is taken as variable cost per unit plus an allocated share of the fixed overheads (Jawahar-Lal, 2008, p. 627, Nigam, Nigam and Jain, 2004, p. 398).

Direct costs are directly attributed to the cost units and it is therefore easily identifiable. Manufacturing overhead costs are charged to the product and other overheads. Variable costs like direct material cost and direct labor cost are directly attributed to the product whereas fixed costs are charged on a proportion basis over different products that the company manufactured over a certain period of time (Williams, Haka and Bettner, 2004, p. 923).

Under absorption costing method, prices are the functions of the costs and therefore demand of the product is never considered. It includes past costs that may not be relevant to the prevailing decision making and pricing processes. It is thus criticized that absorption costing may not be able to provide accurate information in order to help decision making especially in today’s highly dynamic and complex business environments (Boardguess, 2009).

Under absorption costing, all overhead costs are absorbed in to the product along with direct costs. According to SSAP 9, absorption costing technique is an essential requirement for the external reporting purposes. It is because costs of inventory must include all production overheads with both fixed and variable costs (Broadbent, Broadbent and Cullen, 2003, p. 92).

Marginal Costing and Absorption Costing: Comparison

Arguments for marginal costing

Marginal costing technique has long been applied by many businesses and it is more convenient and easy to adopt in the business.

As it is variable costing technique, there are no chances of over absorption or under absorption.

Marginal costing avoids apportionments that are made on arbitrary basis

It is more suitable for managerial decision-making and controlling processes.

Closing inventory is easily valued under marginal costing.

Absorption costing often encourages over production because there is a chance that the reported profit can be increased by the increase f inventory levels.

It is argued that fixed costs are never variable in the long term.

Davies and Pain (2002) argued that there are different alternative basis of overhead allocation that may represent different interpretation (p. 295).

Fixed costs are some time under absorbed if a particular activity is not equal or not greater than the budgeted level.

Arguments for Absorption Costing

Closing inventory values include a share of fixed production overhead and therefore absorption costing meets the international accounting standard. Stock valuation according to absorption costing complies with SSAP 9 as an element of fixed production cost is absorbed in to inventories.

Absorption costing is fair in the accounting view point because fixed manufacturing costs are incurred for making output

Absorption costing technique is considered as having more accuracy because a proportion of the production costs are matched against future sales

It is also more suitable for job costing and batch costing because it is helpful or taking decisions of pricing and therefore there is accuracy that profit markup is enough to meet fixed costs (Cost Accounting System, 2010, p. 7).

It ensures that all prices are covered. Absorption costing method avoids separation of total costs in to fixed and variable elements, as these are not easily identifiable (Davies and Pain, 2002, p. 295).

Major differences between absorption costing and Marginal Costing

1) Inventory Valuation

Absorption costing includes overheads, except marketing so that the inventory value represents all the costs of getting inventory to its current condition and location. But, marginal costing excludes fixed overheads for stock valuation and it thus doesn’t represent full costs of manufacturing the goods (Nigam, Nigam and Jain, 2004, p. 399). It shows that both absorption and marginal costing influence the valuation of inventory in different levels. In marginal costing, inventories are calculated in the basis of variable production costs and hence the inventory value is comparatively in a lower level. The absorption costing considers fixed factory overhead and hence value of inventory will be relatively higher than that in absorption costing (Jawahar-Lal, 2008, p. 628).

Cost Elements of Product Cost

The selling and administrative expenses, let it be fixed or variable nature, are considered as period costs and these are not considered as product costs in both absorption and marginal costing methods. But, fixed factory overhead is treated entirely different in both absorption and marginal costing methods. Fixed overheads are brought in to all calculations on the assumption that they are to be recovered. But in marginal costing, fixed overheads are considered irrelevant for short run decisions (Jawahar-Lal, 2008, p. 628, Nigam, Nigam and Jain, 2004, p. 399).

Jobs and Products

Marginal costing seems to be more realistic than absorption costing. It is because marginal costing considers only those costs that are easily identifiable and attributable to the job or product (Chadwick, 1993, p. 77). Marginal costing is more suitable, reliable and accurate with internal financial reporting, where as absorption costing is most appropriate for external financial reporting and analysis.

Net-income

Fixed overheads are treated differently in marginal costing and absorption costing and therefore it is obvious that the net income result in both of these costing tools will necessarily;y be different as well.

Appropriateness for Decision Making

Absorption costing cannot be used for managerial decision making because the costs that it takes in to account are imprecise in nature. Normally, marginal costing is widely recommended for managerial decision making as the costs that it considers are traceable to a particular product and hence it is useful for managerial decision making.

Absorption costing and Marginal Costing Contrasted

The following example can illustrate how profit calculation and stock valuation differ while using absorption costing and marginal costing methods.

Following are the information available from a company

Fixed manufacturing costs = $ 40, 000 per annum

Variable overheads = $2 per unit

Direct materials and direct labor costs= $3 per unit

Sales are constant at 1000 units per annum at $ 12 each

Production in the first year = 1200 uniots, in Second year= 1500 units, in the 3rd year= 1900 units

The results under the two methods are as follows:

Year 1 2 3

Marginal costing

(1) Sales 12, 000 12,000 12,000

Less variable cost: 6000 7500 4500

Add opening stock: - 1000 3500

Less valuation of closing stock 1000 3500 3000

= 5000 5000 5000

Fixed manufacturing costs 4000 4000 4000

(2) = 9000 9000 9000

Gross Profit = (1) - (2) = 3000 3000 3000

===============================================================

Absorption Costing

(1) Sales 12000 12000 12000

Less variable costs; 6000 7500 4500

Fixed manufacturing costs 4000 4000 4000

= 10000 11500 8500

Add opening stock - 1666 5366

Less closing stock 1666 5366 5666

(2) = 8334 7800 8200

Gross Profit (1)- (2) 3666 4200 3800

Gross profit differences calculated under absorption costing and marginal costing methods: Graphical representation

Conclusion

This research paper has highlighted the basic differences between marginal costing and absorption costing. Absorption and marginal costing are basically different in terms of treating the overheads, inventory valuation, appropriateness for decision-making, net income and methods of calculation. This paper has outlined how both these costing methods can influence net income results and thus delivers different profit figures when production or sales fluctuate or sales exceeds production figures.


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