Costing methods, variance analysis and continuous improvement

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Keywords: marginal costing, Absorption Costing,

Costing Methods

Assignment 1 – Cost Accounting

DBSM703 – Business Financial Principles and Techniques

13 November 2014

Marginal Costing and Absorption Costing (Questions 1&2)

Definition.Marginal Costing is a method for computing costs which takes into account only the varying costs involved in the manufacturing process. Absorption costing is a costing method which considers all costs involved in the production regardless of its nature whether it is variable or fixed cost. (Averkamp H. , 2014)

Differences. The two methods can be distinguished from each other through several notable differences. First is through its cost concentration. Marginal costing is mainly concerned about variable costs while absorption costing considers all fixed and variable costs incurred by the organization through all its activities.

Second, is through its use. Marginal costing is used by organizations to aid them in decision making and business planning. Through its detailed presentation of costs or expenses, companies will be able to carefully study its processes to help them identify areas for improvement and for total quality management. Absorption costing is used mainly for external financial and income tax reporting. It is also a tool for the organization in presenting the actual valuation concerning its overall operation (involves inventory, fixed and variable costs, etc.) to their investors. (Averkamp H. , 2014)

Similarities. Both accounting system are effective in presenting the actual valuation of an organization with regards to its operation by avoiding manipulation and misdeclaration of profit or loss by the company. The two system are also similar through its treatment of manufacturing and non-manufacturing costs.

3. Three Major Influences in Pricing Decision

Customer Demand. Demand is very important in all the major business activities of the company from the sourcing of raw materials, product design and manufacturing. For example, there is a very high demand from customers for high quality performance cars. For car manufacturing companies, this demand would entail sourcing high quality materials, and more comprehensive production and testing process to ensure product quality which would also lead to higher prices. However, it is very important that despite of the rise in production expenses, companies should work their best not to price their product above the market for them to remain competitive. To be able to do that, companies need to regularly conduct market research, surveys, marketing and advance business planning to help the company design its manufacturing process that will enable them to provide quality products at a reasonable price. (Hilton)

Costs. In most cases, companies price their product based on its production costs. For example, in the manufacturing of high-quality performance cars, the main determinant of price would be the amount of cost incurred in its production per unit. Again, to remain competitive and ensure profitability, the company should determine how much markup they are going to charge on top of the production cost and in consideration of other indirect costs involved (holding costs, marketing and other expenses). (Hilton)

Actions of Competitors. To remain competitive, the company should always be on the lookout on its competitors activities. In the example given above, if a competitor lowers down the price of its high-quality performance car, it is very important that the company do the same to avoid the risk of losing its share in the market. However, the company should exercise caution in following the actions initiated by its competitors. In this aspect, it is very important for the company to define its product and highlight its strong points (technology and materials used, technical specifications, safety features, etc.) to distinguish their product from that of their competitors thus providing them certain leverage to justify their pricing. (Hilton)

Political, legal and reputation. Legal factor affect the pricing of commodities because of the need for companies to submit to the requirements of the law. Some business laws were crafted to prevent companies from colluding among themselves to manipulate prices and take advantage of consumers. Examples are the Oil Deregulation Law to prevent forming of cartels by petroleum companies and the Anti-trust Law to regulate competition and prevent monopoly. Political landscape in a country where the business operates also directly affects the pricing of goods and services. For example, in New Zealand due to the pressure brought by the extensive lobbying of rights group, environmental and health activists the government was forced to legislate and pass a bill that would impose higher taxes on tobacco and alcohol products resulting to steeper prices of the said commodities. Reputation also affect product pricing especially to those companies who have already established a solid reputation for producing quality and high performance products. Companies like Apple normally set a higher price whenever they launch a new product to the market regardless of competition. (Hilton)

4. Cost Object

Cost object is an accounting term used to refer to any item or product that has a cost of its own. The term may be used for items whose cost can be calculated through estimates, direct measurement or market valuation. (Schmidt, 2014)

Examples of cost object includes:

  1. Services – Car maintenance or repair service that has a specific cost for every service done.
  2. Product – A bicycle. The cost for its development, design and production can be measured directly.
  3. Projects – A construction project with a specified cost for infrastructure design and implementation.
  4. Departments – Marketing Department for which the cost of all its activities like promos and advertisement is specified.

(Schmidt, 2014)

5. Direct and Indirect Cost

Definition. Direct Cost are costs that can be easily linked to a cost object. Indirect Cost are costs that are related but cannot be easily and accurately linked to the cost object eventhough the cost is incurred in producing the product. (Jan, 2013)

There are several factors affecting the classification of costs. They are Materiality, Function and Information Gathering Technology.

Materiality. The classification of costs as direct or indirect depends on the contribution, relevance, impact and actual value of the cost to the end product. The greater the cost, the easier it is to establish the link to the final product. (, 2014)

Function. Another factor that affects the classification of costs is on how the cost was used in relation to the major business activities of the company like in research and development, production, distribution, selling and administration. (Vivekanand, 2014)

Information gathering technology. The continuous advancement in information technology paved the way for the development of software application that helps company easily trace costs. Nowadays, big companies emphasize the importance of information management and reporting system as an effective method that enables them to properly trace the smallest of costs. (, 2014)

  1. Opportunity Cost

Opportunity cost is the income or value that a company or person gives up in favor of one particular decision. (, 2014) For example, in the morning you have two choices to help you kickstart your day. One is to drink cup of coffee or to eat an apple. For you both has its benefits, coffee for your caffeine needs and apple as a healthy alternative. You choose coffee over apple. By choosing coffee, the benefit to your health that you can get by eating the apple becomes your opportunity cost.

To avoid what economists says as “decision making pitfalls”, it is very important for managers to take into consideration opportunity cost or do a simple cost-benefit analysis in order for them to arrive at an intelligent decision. (, 2014) Opportunity cost is also very important in helping companies evaluate their decisions for future considerations especially when the alternative decision they give up turns out to be the better option. (, 2014)

  1. Management By Exception And Variance Analysis

Management by exception is a management style that focuses on the areas of the organization whose plans are not working according to expectation. The goal is to provide immediate attention to the problem by concentrating company resources like time, money and effort to help them strategically address the issue or problem. ( Most companies were able to identify specific areas in their business that are not working according to plan with the help of variance analysis. Variance analysis is a method used by organizations in determining the difference between the standard cost and the actual cost. The higher the variance between the standard and actual cost means that an area in an organization is not performing as planned. (Ahmed, 2014)

  1. Standard Costing and Its Importance in Planning and Control

Standard Cost refers to the cost determined by the management based on available information concerning direct labor, materials and manufacturing overhead. This cost would serve as the benchmark for the company’s spending in relation to its actual business operation. Standard costing is very important because it helps management in setting their budget, better understand the expenses that would concern their operation, and most of all for determining its projected income. During actual operation, standard costing provides an avenue for feedback to the management in cases where variances arise between the standard and actual cost. It allows them to immediately focus their attention in areas where there are large deviations in actual cost against the standard cost to help keep the operation on track and as planned. (Averkamp H. , 2014)

  1. Variance Analysis and Continuous Improvement

Variance analysis provides information that helps management measure the actual performance of different areas in their organization against expectation. (AC >SC = Unfavorable Variance; AC<SC = Favorable Variance). Unfavorable variance means that if left unchecked the company is most likely not to achieve its target. It is very important for management to be able to identify the underlying causes of negative variances and immediately implement corresponding solutions or action to address the issue. Through informed decision making and learning from the mistakes that gives rise to unfavorable variances, the management will be able to avoid/prevent the same problem in the future. Favorable variance normally means that everything is going according to plan and if the operation remains on track, the company is well on its way to achieving or even exceeding its expectation. However, positive variances still need to be investigated to help the management understand the reasons that led to favorable variances and to put in place some measures that will allow them to further improve and replicate their success as often as possible. (

  1. Job Costing vs. Process Costing

Job Costing is a costing method being used by companies producing unique products where the cost is measured depending on the production requirements (Materials, Labor, etc.) of each product or unit produced. Process Costing is an accounting method used by companies involved in mass production of identical products and using an established or fixed manufacturing process where unit cost can be calculated by dividing the total cost with the total quantity produced. (Heisinger & Hoyle, 2014)

The following are the differences between process costing and job costing:

  1. Application. Process costing determines the cost of the total number of units produced by batch. Job costing is used to determine the cost of every product or unit produced.
  2. Product Cost. In process costing costs are assigned to the process while in job costing costs are assigned to jobs.
  3. Time Frame. Process costing has a period for which costs are accumulated while job costing has no time frame. In job costing, costs are computed after each job is completed.
  4. Unit Cost Information. In process costing, units cost is derived based on the production cost report (Total Cost (Variable&Fixed)/ Total No. of Units Produced = Unit Cost). In job costing, unit cost is determined based on the total cost of the job per unit.

(, 2014) (Heisinger & Hoyle, 2014)

  1. Job Cost Sheet

ABC Toys Pty Ltd

Job Cost Sheet

Job Number

GB 45

Date Initiated



Production Department

Date Completed



Barbie Doll Boxes

Units Completed


Direct Material

Direct Labor

Manufacturing Overhead

Req. No.


Time Sheet No.



















Cost Summary

Units Shipped

Direct Materials





Direct Labor





Manufacturing Overhead


Total Cost


Unit Product Cost


*$978.00/200 Units = $4.89 per unit

  1. Process Costing

Mixing Department

Bottling Department

Total Cost

Direct Materials




Direct Labor








Total Production Cost




Units produced

1,250 Liters

5,000 Bottles

Cost per bottle


40,000/5000bottles = $8.00 / bottle

  1. SMK Pharmaceutical production cost for April



Inventory- Mixing Dept

Raw Materials



Inventory- Bottling Dept

Raw Materials



Inventory-Finished goods












13. Responsibility Centre

A responsibility centre is a unit in an organization tasked with a specific set of duties to help the organization effectively exercise control over their business and to help them achieve both their long term and short term goal. Usually there are four responsibility center in every organization (Cost Center, Profit Center, Revenue Center and Investment Center). Each center is headed by a manager. (Barnat, 2014)

Cost Center. A cost centre is responsible for managing costs. There are two type of cost under cost centre. They are Engineered Cost and Discretionary Cost Centre. Engineered costs are those cost that can easily be linked with the cost centre (direct labor, direct materials and manufacturing overhead). Discretionary costs are costs that are allocated by the management on a discretionary basis (administrative cost, research and development, allowances, etc.). (Barnat, 2014)

Profit Centre. The profit centres are like independent businesses within the organization. They are given autonomy in managing their own affairs from the strategic balancing of sales and expenses up to performing a more detailed management function like helping maintain quality, measuring employee’s productivity against wage, managing overhead expenses and everything that they can control within their unit. (Barnat, 2014)

Revenue Centre. The sole responsibility of revenue centre is to generate revenue for the company through sales of goods or services. Most organizations set periodic sales target (daily, weekly, monthly, etc.) that whether surpassed or missed serve as an indicator of the performance of the unit manager or the revenue centre. An example of revenue centres are the outlet shops by manufacturing companies. The main focus of these shops is to sell company products with little or no consideration at all on costs and marketing. (, 2014)

Investment Centre. The responsibility of Investment centre is to generate returns of investment through effective asset management, increased sales performance and the proper management of cost and expenses.

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Vivekanand. (2014). Retrieved November 9, 2014, from

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