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â€¢ Marginal cost is 'Part of the cost of one unit of product or service that would be avoided if the unit
were not produced, or that would increase if one extra unit were produced'.
â€¢ Absorption costing 'Assigns direct costs, and all or part of overhead to cost units using one or
more overhead absorption rates'.
The Influence of marginal costing on pricing policy
a)For any given period of time, fixed costs will be the same, for any volume of sales and production (provided that the level of activity is within the 'relevant range'). Therefore, by selling an extra item of product or service the following will happen.
b)Revenue will increase by the sales value of the item sold.
c)Costs will increase by the variable cost per unit.
d)Profit will increase by the amount of contribution earned from the extra item.
The Influence of absorption costing on pricing policy
(a) Fixed production costs are an integral part of the production cost of an item and so should be absorbed into product costs With absorption costing, fixed production costs are absorbed into product unit costs using a
predetermined overhead absorption rate, based on the normal level of production for the period.
(b) Inventories are valued at their full production cost including absorbed fixed production costs.
If the actual production is different from the normal level, or actual expenditure on fixed production costs
is different from that budgeted, there may be an under or over absorption of fixed production costs for the
NATURE AND SIMILARIES BETWEEN MARGINAL COST AND ABSORPTION COST
*Marginal costing is a method of inventory costing in which all variable manufacturing costs are included as inventoriable costs. All fixed manufacturing costs are excluded from inventoriable costs. They are instead treated as costs of the period in which they are incurred. Inventoriable costs are all costs of a product that are regarded as an asset when they are incurred and then become costs of goods sold when the product is sold.Â
In product/service costing, a marginal costing system emphasises the behavioural, rather than the functional, characteristics of cost. The focus is on separating costs into variable elements (where the cost per unit remains the same with total cost varying in proportion to activity) and fixed elements (where the total cost remains the same in each period regardless of the level of activity
In a marginal costing system, sales less variable costs measures the contribution that individual products/services make towards the total fixed costs incurred by the business. The fixed costs are treated as period costs and, as such, are simply deducted from contribution in the period incurred to arrive at net profit.Â
*Absorption costing is a method of inventory costing in which all variable manufacturing costs and all fixed manufacturing costs are included as inventoriable costs.Â
In product/service costing an absorption costing system allocates or apportions a share of all costs incurred by a business to each of its products/services. In this way, it can be established whether, in the long run, each product/service makes a profit.
An absorption costing system traditionally classifies costs by function. Sales less production costs (of sales) measures the gross profit (manufacturing profit) earned. Gross profit less costs incurred in other business functions establishes the net profit (operating profit) earned.Â
Marginal Costing versus Absorption Costing
After knowing the two techniques of marginal costing and absorption costing, we have seen that the net profits are not the same because of the following reasons:
1. Over and Under Absorbed Overheads
In absorption costing, fixed overheads can never be absorbed exactly because of difficulty in forecasting costs and volume of output. If these balances of under or over absorbed/recovery are not written off to costing profit and loss account, the actual amount incurred is not shown in it. In marginal costing, however, the actual fixed overhead incurred is wholly charged against contribution and hence, there will be some difference in net profits.
2. Difference in Stock Valuation
In marginal costing, work in progress and finished stocks are valued at marginal cost, but in absorption costing, they are valued at total production cost. Hence, profit will differ as different amounts of fixed overheads are considered in two accounts.
The profit difference due to difference in stock valuation is summarized as follows:
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, provided the fixed cost element in opening and closing stocks are of the same amount.
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.
There are arguments in favour of each costing method.
1) Arguments in favour of absorption costing
(a) Fixed production costs are incurred in order to make output; it is therefore 'fair' to charge all
output with a share of these costs.
(b) Closing inventory values, include a share of fixed production overhead, and therefore follow
the requirements of the international accounting standard on inventory valuation (IAS 2).
2) Arguments in favour of marginal costing
(a) It is simple to operate.
(b) There are no apportionments, which are frequently done on an arbitrary basis, of fixed costs.
(c) Fixed costs will be the same regardless of the volume of output, because they are period costs. It
makes sense, therefore, to charge them in full as a cost to the period.
(d) Under or over absorption of overheads is avoided.
(e) Absorption costing may encourage over-production since reported profits can be increased
by increasing inventory levels.
Marginal cost is the cost management technique for the analysis of cost and revenue information and for the guidance of management. The presentation of information through marginal costing statement is easily understood by all mangers, even those who do not have preliminary knowledge and implications of the subjects of cost and management accounting.
Absorption costing and marginal costing are two different techniques of cost accounting. Absorption costing is widely used for cost control purpose whereas marginal costing is used for managerial decision-making and control.
QUESTION : 2
Classifications of cost system in terms of object, functions, product(service) and behavior, analyzing probable causes of cost variances and offer directions the needed advice to improve performance.
Definition of a Cost Â :
Cost is a measurement, in monetary terms, of the amount of Resources used for the purpose of production of goods or rendering services.
Cost Object is the logical sub-unit for collection of cost.
Cost Centre may be of two types - personal and impersonal cost centers. Personal cost centre consists of a person or a group of persons
Basic Rules for Classification of Costs
1. Classification of cost is the arrangement of items of costs in logical groups having regard to their nature (subjective classification) or purpose(objective classification).
1)Relation to object - traceability
2) Functions / activities
3) Behaviour fixed, semi-variable or variable
4) Production Process
By Relation to Cost Centre or object
*If an expenditure can be allocated to a cost centre or cost object in an economically feasible way then it is called direct otherwise the cost component will be termed as indirect.Material cost is divided into direct material cost and indirect material cost, labour cost into direct labour cost and indirect labour cost and expenses into direct expenses and indirect expenses. Indirect cost is also known as overhead.
*Direct cost has three components - direct material cost, direct labourcost and direct expenses and indirect cost has three components- indirect material, indirect labour cost and indirect expenses. Sum of all direct costs is called prime cost .
A) Direct material Cost is the cost of material which can be directly allocated to a cost centre or a cost object in a economically feasible way.Direct Expenses are the expenses other than direct material or direct labour which can be identified or linked with the cost centre or cost object.
B) Indirect labour cost is the wages of the employees which are not
directly allocable to a particular cost centre.Indirect expenses are the expenses other than of the nature of material or labour and can not be directly allocable to a particular cost centres
*Costs should be classified according to the major functions for which the elements are used into the following
four major functions :
Research & Development Expenditure.
*Costs are classified based on behaviour as fixed cost,variable cost and semi-variable costdepending upon response to the changes in the activity levels
Fixed Cost is the cost which does notvary with the change in thevolume of activity in the short run.These costs are not affected bytemporary fluctuation in activity of an enterprise. These are also known asperiod costs.
Variable Cost is the cost ofelementswhich tends to directly vary withthe volume of activity. Variable cost has two parts - (a) Variable direct cost;and (b) Variable indirect costs. Variable indirect costs are termed as variable overhead.
Semi Variable Costscontain both fixed and variable elements. They are partly affectedby fluctuation in the level of activity
*When the production process is such that goods are produced from a sequence of continuous or repetitive operations or processes, the cost incurred during a period is considered as process cost.
The process cost per unit is derived by dividing the process cost by number of units produced in the process during the period
Corrective action are applied to the causes of varience by observing the risk factor, both te highest and lowest risk factor, in effort to prevent deviation in material managemen.Comprehennsive understanding of field issues and problems are required before giving corrective action recommendation.
QUESTION : 3
Responsibility accounting as a system of planning and control of An organization.
Â *Responsibility accounting is an underlying concept of accounting performance measurement systems. The basic idea is that large diversified organizations are difficult, if not impossible to manage as a single segment, thus they must be decentralized or separated into manageable parts. it could be described as a system of collecting and reporting accounting data on the basis of managerial level
*Responsibility accounting considers both historical and future costs.Â Â For some purposes, the activity of responsibilityÂ centresÂ is expressed in historical amounts.Â Â For others, these are expressed in estimated future amounts.
These parts, or segments are referred to as responsibility centers that include:
revenue centers, 2) cost centers, 3) profit centers and 4) investment centers.
*An example of how an organization structure is generally depicted appears as Figure 1. This extract of an organizational chart has been prepared from the perspective of the F&B department. Each of the responsibility centres identified in the chart is focused on a particular activity.
Most responsibility centers consume inputs (e.g. labour and materials). Some will produce outputs that can be measured monetarily and some will have an identifiable asset base that represents invested capital. The relationship of inputs, outputs and assets to a responsibility centre is depicted in Figure 1.
The distinction between inputs, outputs and assets is important. These three
aspects of accountability provide a checklist when determining a manager's scope of
influence. If we can identify which of these three areas can be affected by a
responsibility centre's manager (in many cases it is more than one), we can
determine what he or she should be held accountable for.
*Applying this approach to determining scope of accountability results in four main types of responsibility centre:
1 Cost centers
2 Revenue centers
3 Profit centers
4 Investment centers.
A cost centre refers to a responsibility centre where the scope of the manager's influence is limited to inputs. A revenue centre is the term used for a responsibility centre where the scope of the manager's influence is limited to outputs that can be monetarily measured. A profit centre is the term used to describe a responsibility centre where the manager's influence spans both costs and revenues.Finally, an investment centre is the term used for a responsibility centre where the manager's influence includes costs and revenues as well as the asset base employed to generate profit
In order to highlight their differing scope and degree of accountability, these four generic types of responsibility centre are presented hierarchically in Figure 3. In this figure, cost centres and revenue centres appear at the lowest level, as each is accountable for only one of the three dimensions of accountability depicted in Figure 2. A profit centre appears at the intermediary level as it is accountable for two of the circles in Figure 2. Investment centres appear at the top of Figure 3 as managers of investment centres are accountable for all three dimensions of accountability.
There are two main types of cost centre: engineered cost centers and discretionary cost centers. An engineered cost ceâ‚¬ntre is a centre where an output can be quantitatively measured and there is a reasonably good understanding of the input/output relationship, i.e. the level of costs that should be incurred to achieve a specified level of output is known. Examples of engineered cost centers in hotels include housekeeping.
Revenue centers are not widely found in the hotel industry. They generally arise in sales departments where sales quotas are set for staff (e.g. in real estate and car retail operations). Unlike the case for inputs, it is often quite hard to measure outputs in terms of money. For example, we generally do not attempt to attach a dollar value to the outputs of departments such as accounting, training or public relations simply because these outputs do not lend themselves to financial measurement.
Profit is clearly an important performance indicator as it is widely used by investors when monitoring company performance. It is a broader measure of performance than the indicators used in revenue and cost centres as it encompasses both revenue and cost. Despite its considerable appeal, it is a less than perfect measure because:
(a) Monetary measures do not exactly measure all aspects of input or output.
(b) Standards used as a basis of performance evaluation can only be estimates.
(c) Profit measures are used predominately in the context of one year or less, i.e.
they tend to have a short-run achievement bias.
(d) Rarely are all factors that determine profitability controllable by the profit centre
Several particular issues arise in connection with investment centre accountability. In this section, the issues surrounding the scope of an investment centre's accountability are initially outlined.
Advantages and Disadvantages
Responsibility accounting has been an accepted part of traditional accounting control systems for many years because it provides an organization with a number of advantages.The most compelling argument for the responsibility accounting approach is that it provides a way to manage an organization that would otherwise be unmanageable. Assigning responsibility to lower level managers allows higher level managers to pursue other activities such as long term planning and policy making. It also provides a way to motivate lower level managers and workers. Managers and workers in an individualistic system tend to be motivated by measurements that emphasize their individual performances.
An implicit assumption of responsibility accounting is that separating a company into responsibility centers that are controlled in a top down manner is the way to optimize the system. However, this separation inevitably fails to consider many of the interdependencies within the organization. Of course, a system that prevents teamwork and creates excess is inconsistent with the lean enterprise concepts of just-in-time and the theory of constraints. For this reason, critics of traditional accounting control systems advocate managing the system as a whole to eliminate the need for buffers and excess. The information system needs to reveal the company's problems and constraints in a timely manner and at a disaggregated level so that empowered users can identify how to correct problems, remove constraints and improve the process. According to these critics, accounting control information does not qualify in any of these categories because it is not timely, disaggregated, or user friendly.