Absorption Costing is a method, which endeavours to apportion the entire cost of production; including the overhead expenses incurred to the finished product or the services rendered. It is also known as Full Absorption Costing or Full Costing. In order to fully gauge the extend of the costs covered by the sales revenue; the firms may adopt Absorption Costing method.
The companies while trying to arrive at the profit of their products, they should consider all their overhead costs rather than just taking into account the direct costs involved to produce their products. Some of the overhead costs, which companies may ignore while computing the profits are the depreciation of plant and machinery, the salary paid to administrative staff, cost of power for running the factory, lighting, heating, air-conditioning etc. and some general office overheads such as printing and stationery, telephone expenses etc. These general expenses will all be allocated to the products in addition to the direct costs, such as the cost of materials and of direct labour.
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Full cost can be described as the entire sum of resources used up to accomplish a targeted objective.Â This utilisation of resources is normally calculated in terms of money.Â This measuring process would consider all wealth sacrificed to realize that goal. Therefore, if the target is to deliver a customer with a product or service, the cost of all aspects for producing that particular product or making that service possible would becomeÂ part of the full cost. In order to arrive at the full cost figure, all the elements of cost incurred are to be added up and then allocate them to the particular product or service accordingly. The simple logic of having full costing is to ensure that the entire cost of operating a particular facility is duly taken into account as part of the cost of the output from the said facility. The office rent is a case in point which does not vary due to the change in the quantity produced or service provided.Â However, if no office is rented, staff will not have a place to work or to extend their services.Â Therefore, rent is a vital component of the cost of each unit produced or service provided.
Activity-based costing (ABC) is based on the assumption that the overhead costs incurred for a product is determined by the procedures and steps adopted to produce that particular product. Under this method, each overhead cost, irrespective of it being fixed or variable cost is designated to a category of costs. Such cost categories are normally known as Activity Cost Pools. The activities that boost the total cost in an activity cost pool are called Cost drivers. Any action undertaken by a company such as ordering raw materials, the number of production lines, the shipments made to the customers etc. all add up to the costs incurred by the company. The cost per unit is calculated in ABC by dividing the total cost of each activity pool with the total number of units produced. The benefit of ABC is mainly enjoyed by the companies who incurs considerable amount of overheads for providing various goods or services. The manufacturing industry being a good example, compelled to engage in scores of different activities to meet the changing demands of the customers.
A company can take full advantage of the Activity-based costing by using computers regardless of the number of the activities they are involved in the course of their business. One of the most prominent limitations of Activity Based Costing is that it is too complex to implement. This draw back prevents it being applied extensively. For example, apportioning some overheads like supervisor salaries to activities is extremely expensive to implement and maintain; both in terms of time and money.
Definition of Marginal Cost Pricing
Marginal cost pricing can be defined as the practice of fixing the price of a product at par or little bit more than the variable cost which is required to produce the same.
There are two circumstances which normally warrant the situation indicated above. Firstly, A company desires to fully utilize the unused production capacity remaining at its disposal regardless of the size of the residual capacity. On the other hand, a company could be experiencing lack of sale when it increases the price of its products.
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When a company is financially sound; there are more chances to occur the first scenario. In such a situation, the company wants to propel its profitability by increasing the quantum of its production. The second situation arises out of nervousness and here the company finds it hard to achieve its sales targets through any other methods. The intention in both cases is to enhance the sales in short term without resorting to a long-term pricing strategy.
The variable cost of a product is largely based on the material required to produce it whereas the direct labour required to manufacture the product hardly vary. This is because a production line normally requires a certain number of workers regardless of the quantity produced.
The Variable-costing method is extremely helpful to make short-term decision as it differentiates between fixed and variable costs. In this approach, the cost of the goods or service includes variable cost and any variable indirect elements only. Both direct and indirect cost elements will be absorbed as a cost of the period in which it has actually been incurred. The Variable Cost philosophy does not link fixed cost to units' cost as is in the practice with Absorption (full) costing. Consequently, only the variable cost of the inventories of finished products and work in progress carried from one accounting period to the next would be valued.
Product development time might be lengthened as product is repeatedly designed to bring cost below that of target.
Target costing is the process through which a maximum cost that can be allowed for a new product is determined. The next step under this process is to develop a prototype of the product which can be produced profitably duly allowing the maximum target cost already determined. The target costing for a product is arrived at appropriately deducting the desired profit from the product's anticipated selling price.
In many instances, 'current cost' could be higher than the target cost, which makes a 'cost gap'. All attention should then be divertedÂ as how to bridge this gap so that the product is made and the services are provided duly meeting the target cost. This can be achieved through different means such as revising the design, introducing more innovative and efficient means of production or finding out the most economical source of supply for goods and services. As the companies are too keen to make some cost savings at the beginning stages of the life cycle; i.e.Â During the per-production phase, Target costing is considered as part and parcel of a total life-cycle costing approach. However, this method can lead to extend the Product's development time as the product is constantly re-designed to bring the cost below that of the target.
Environmental Management Accounting can be described as one of the branches of Management Accounts which concentrates on the cost of energy, water, effluent and waste management. It is pertinent to mention here that Environmental Management Accounting is not simply focussing on financial costs involved; but it involves other aspects such as costs vs. benefits of procuring supplies from sources / suppliers who are more environmentally conscious. This approach and policy would boost the image of the company in the eyes of general public. It is obvious those companies who do not comply with environmental regulations will have a tarnished reputation before the people and the society. There are however some issues with using the environmental accounting method such as there is no definite pattern of accounting method can be established with Environmental Accounting. It is also quite apparent that no proper evaluation between two companies or nations is feasible if the method of accounting applied is different. In addition, since the costs and benefits relating to the environment are not easily assessable, it is hard to obtain the inputs for Environmental Accounting.
An apt example for an organisation which applies the environmental costing method is the State of Florida with regards to their solid waste management. They rely on environmental costing for a systematic approach to identify, sum up and to report the actual costs of waste management. It considers past and future outlays, overhead costs and operating costs. This enables the state to make decisions such as whether to provide the services by itself or to assign the job to contractors.
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During the decision making process relating to the future, instead of pondering over Past Costs or historic costs, we should focus on future opportunity costs and future outlay costs that are of great concern.Â An opportunity cost can be described as the value in monetary terms of being deprived of the next best available opportunity to chase a particular objective. The amount of money spent to achieve that objective is called Outlay Cost. A future Outlay Cost or an Opportunity Cost can be considered appropriate to a decision if it can meet the two conditions.
The first is that the Cost must have a direct relationship with the objectives of the business. The pivotal strategic objective of majority of businesses is to boost the owners' wealth. In other words, they try to make the shareholders prosperous and richer. Hence, any decision taken to be relevant, the cost should have a direct impact to increase the wealth of the business. Secondly, it must differ from one possible decision outcome to the next. Only costs and revenues that are different between outcomes can be used to distinguish between them.
Relevant costing is the best option for certain specific situations such as Limiting factor due to scarce resources, Make or Buy decision, Accept or Reject special order, to continue or discontinue or shut down decisions.
This method of costing is based on the hypothetical argument that any given product orÂ service will have three phases of life cycle. These are:
1 The pre-production phase: This stage refers to the period before the production of aÂ product or service ready for sale. The companies undertake research and development on the products they are intending to produce or the service they aim to render and of the market they seek to focus. The end result of the R&D is the invention or designing of the product and putting the production plan in place. By the conclusion of this phase,Â the company would procured the necessary production facilities and infrastructure.Â The end of this period would also see the completion of all advertising and other promotional activities.
2 The production phase: This is the stage where the product is manufactured and the service is provided to the end-user.
3 The post-production phase: This is the last phase of the life cycle where the customers are taken care off by the manufacturer / service provider through after-sales service.Â The necessary follow-up actions like rectifying the faults etc. after the sales or service is carried out during this phase duly incurring costs, if needed.Â There are other additional costs involved during this stage like the cost of decommissioning production facilities at the end of the product's or service's life cycle.Â It is pertinent to highlight that an overlapping of after-sales service and manufacturing process/service rendering can occur at this stage.Â This is due to the fact that after-sales service can commence any time after the first unit of the product or service being sold and could be well before the last piece is sold.Â Thus, the after-sales service and the manufacturing/service-rendering process could happen simultaneously at this phase.
It is an established fact that as high as 80 per cent of the total cost incurred over the entire life of a particular product is required to spend during the pre-production phase in some technically advanced manufacturing sectors.Â The vehicle manufacturing industry is an ample example for it.Â A vehicle manufacturer deploys a significant portion of the total cost; which may incur during the whole length of life of a particular model; for designing, developing and setting up production of a new model; i.e. during the pre-production phase.Â (Not only are pre-production costs specifically incurred during this phase, but the need to incur particular costs during the production phase is also established. This is because the design will incorporate features that will lead to particular manufacturing costs. Once the design of the car has been finalised and the manufacturing plant set up, it may be too late to 'design out' a costly feature without incurring another large cost.)