Identifying measuring and communicating financial information

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Accounting is the process of identifying, measuring and communicating financial information about an entity to permit informed judgments and decisions by users of the information. Management accounting is a specialist branch of accounting which has developed to serve the particular needs of management. {Pauline Weetman, 2009, Management Accounting, p.4}

The costs that vary within a process should only be included in decision analysis. For many decisions that of a short time span, fixed costs are not relevant to the decision. This is because either fixed costs tend to be impossible to alter in the short term or managers are reluctant to alter them in the short term.

What is the marginal costing?

Marginal cost (variable cost) is a cost of a product that includes direct labor, direct materials, and the variable manufacturing over head costs.

Marginal costing is a costing technique which includes only variable manufacturing costs when calculating the cost of products, it treats fixed manufacturing overheads as period costs. Marginal costing is useful for short-term planning, control and decision-making, particularly in a business producing multi-products.

Theory of Marginal Costing

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"In relation to a given volume of output, additional output can normally be obtained at less than proportionate cost because within limits, the aggregate of certain items of cost will tend to remain fixed and only the aggregate of the remainder will tend to rise proportionately with an increase in output. Conversely, a decrease in the volume of output will normally be accompanied by less than proportionate fall in the aggregate cost." { A report on Marginal Costing, CIMA, London}.

Marginal Costing principles:

Fixed costs will stay the same as long as production is in a certain range

Selling more of the products results in:

Revenue will increase by the sales value of the item sold

Costs will increase by the variable cost per unit

Profit will increase by the amount of contribution earned from the extra item

If sales fall down, the profit will fall by the units contribution

When a unit is produced, costs incurred in its manufacture are variable costs, fixed costs are not affected.

Advantages:

Simple to understand

Varying charges of a unit is avoided, because fixed cost are not charged to the production cost

It helps in short-term profit planning by breakeven and profitability analysis

Disadvantages:

Separation of cost is misleading and sometimes yields wrong results

Stocks and work in progress are understated, which affect the profit level.

What is the absorption costing?

Absorption costing assigns direct cost and all overhead costs to the cost units, using a predetermined absorption rate, Absorption costing is a costing technique that includes all manufacturing costs (variable & fixed ), while determining the cost per unit of a product. Absorption costing considers a share of all costs incurred by a business to each of its products/services. Absorption costing gives better information for pricing products as it includes both variable and fixed costs, these costs are absorbed into the cost of goods produced and are only charged against profit in the period in which those goods are sold.

Absorption Costing argues that fixed costs are an integral part of the production cost and should be absorbed by the products produced in the time it's incurred. From that we can notice that absorption costing encourages over production so that each unit will take a lower rate of the fixed costs.

Absorption Costing Limitations:

In absorption costing, some of the fixed cost is differed into the next accounting cycle in form of closing stock, which is not accepted because costs of certain time can't be included in later cost.

Absorption costing depends on the output, which is not fixed, affecting by that the cost of the unit.

Marginal Costing versus Absorption Costing

Over and Under Absorbed Overheads: costs and the quantity of outcomes can't be forecasted due to different factors, so it will be hard on absorbing the fixed costs, but in marginal costing, the actual fixed overhead incurred is wholly charged against contribution. Creating by that differences in the net profit/loss.

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Difference in Stock Valuation: work in progress and finished goods are valued by marginal costing, but in absorption costing, they are valued at total production cost. Therefore difference in profit will occur between the two methods. The differences in profit are based to:

When there is no opening and closing stocks, there will be no difference in profit

When opening and closing stocks are same, there will be no difference in profit

When closing stock is more than opening stock, the profit under absorption costing will be higher as comparatively a greater portion of fixed cost is included in closing stock and carried over to next period

When closing stock is less than opening stock, the profit under absorption costing will be less as comparatively a higher amount of fixed cost contained in opening stock is debited during the current period.

What to use?

The valuation of stock in absorption is higher than marginal costing because, in absorption stock is taking a fair rate of fixed cost while in marginal costing the cost is only the variable cost.

Cost of sales used to determine profit in absorption costing will have, included some fixed production overhead costs incurred in a previous period but carried forward into opening stock values of the current period, while excluding some fixed overhead costs incurred in the current period by including them in closing stock values.

In marginal costing, the identification of variable costs and of contribution enables management to use cost information more easily for decision-making purposes

In absorption costing, 'actual' fully absorbed unit costs are reduced by producing in greater quantities, whereas in marginal costing, unit variable costs are unaffected by the volume of production.

In King Plc. Case, comparing both first calendar quarters, using absorption and marginal costing we conclude that:

Absorption costing production costs includes the variable cost of the product, added to it the fixed cost.

Production = (Units produced * Variable cost) + Fixed costs.

So, if production was lower than expected that will result in higher variable cost for the products produced, which leads to less profit.

Closing stock cost in absorption costing calculates the variable cost of the unit plus the rate of absorption by the unit multiplied by the inventory level.

Closing Stock = (Variable cost + absorption rate of a unit) * Ending Inventory

As for marginal costing, the production only includes the variable cost of the product. Fixed costs are treated as a normal cost.

Production = Units produced * Variable cost

Closing stock cost using the marginal cost differs, because it only takes the variable cost of the unit into calculating the cost.

Closing Stock = Variable cost * Ending Inventory