Most organisations and firms provide a service or manufacture products that result in multiple costs due to either the production or provision of a service or good. There are numerous methods of costing however in this assignment I will be looking at two types of costing methods which are widely used by different organisations. I will be comparing both of the methods and noting their key differences and I will also be looking at the advantages and disadvantages of each method. During the comparison of both methods of costing I will look at the effectiveness of both in terms of real world scenarios such as Decisions making within an organisation, to try and identify where one may be more useful than the other.
When an organisation is providing a service or mainly manufacturing products there are multiple costs which are incurred, these costs can be ranging from things like electricity bills to the wages of workers which are all parts of the production process. The costs can usually be differentiated and put into groups such as fixed and variable costs. Weetman (2010, p.36) states that "A fixed cost is one which is not affected by changes in the level of activity, over a defined period of time." An example of this could like renting a factory for a year which costs £10,000 so regardless of how much production takes place over that period of a year the rent will not change. Weetman (2010, p.35) also states that "A variable cost is one which varies directly with changes in the level of activity, over a defined period of time." So an example of a variable cost would be if say this week I am producing 1000 units of a certain product, and last week I only produced 800 units of it, this would vary my cost of materials for this week as I would have had to buy in more materials to create the extra units.
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Absorption costing is a method which does not look at the costs separately and treats them as one whole cost which is then "absorbed" so to say into the cost per unit. So it accumulates all of the costs such as variable, fixed and variable overheads and then combines them before the price per unit of the product is determined. This is the main method which organisations use when it comes to external financial reporting, as it tends to give a much more in depth view of all the costs which were incurred, also because it follows all of the standards required for external reporting which makes it easier to understand. Organisations must also use this method for external reporting so that they do not under value their closing stock at the end of a period using other methods such as marginal costing. This is what the FRC (Financial Reporting Council) had to say about stock valuation
"In order to match costs and revenue, 'costs' of stocks should comprise that expenditure which has been incurred in the normal course of business in bringing the product or service to its present location and condition. Such costs will include all related production overheads, even though these may accrue on a time basis."
This means that methods such as marginal costing cannot be used in order to value stock for external reporting, as marginal costing does not take into account the fixed overheads.
Marginal costing works largely by using the same information that absorption costing makes use of, however the difference is that this costing method uses the same information but looks at it from a different perspective, which in turn gives a slightly different outcome when it comes to pricing products etc. Marginal costing ignores any fixed costs and simply looks at the costs which are directly related to the units being produced, so such costs as material, direct labour costs and also any other variable costs. This method considers fixed manufacturing overheads to be period costs rather than product costs, so any contribution at the end of the period will need to have the fixed costs deducted from it in order to get the profit. By ignoring all fixed costs it makes things much simpler and easier to understand, however this can sometimes cause problems like misinformed decision making. The marginal costing method is used much more internally by managers etc. and it usually helps in order to make much better short term decisions.
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Both of the Methods mentioned above have advantages and disadvantages when it comes to using them within an organisation. Take absorption costing for example, one of the big advantages of using this method to cost products up is that when you determine the price per unit at the end of costing things up, you will know how much you need to price the product in order to cover all of the costs that were incurred in order to manufacture it, Davies and Crawford (2011, p374) said that "cost price or full cost pricing ensures that all costs are covered." This is one way it gets an upper hand on marginal costing, because marginal costing does not take into account the fixed costs incurred when determining the price per unit. This can mean that if careful attention is not given to pricing, even though each unit sold might be generating contribution, it may not be getting enough contribution per unit in order to make up for the fixed costs at the end of the period, which could result in a loss for the company. Davies and Crawford (2011, p375) stated this as a disadvantage for marginal costing "pricing at the margin may lead to under-pricing with too little contribution and non-recovery of fixed costs, particularly in periods of economic downturn."
In order for managers to be able to make decisions which matter now marginal costing is very likely the best method, because regardless of production the fix overheads are going to be charged, so the manager can make decisions regarding products from looking at marginal costing to see how much of a contribution each product may be making and whether it is worth it to keep that product or not. A CVP analysis can be of huge help when it comes to aiding decision making within an organisation, it can help managers to asses and recognise risks. In order to product a CVP analysis it is very important that all fixed and variable costs can be seen separately, and because marginal costing does not combine the two costs, the data from it can be used in order to create a CVP analysis unlike with absorption costing. It was stated by Atkinson et al (2011, p66) that "Cost-volume-profit (CVP) analysis uses the concepts of variable and fixed costs to identify the profit associated with various levels of activity"
As Stated by Davies and Crawford (2011, p.374) One of the disadvantages of using absorption costing it that is may lead managers to believe that the more units that they produce, the lower the amount of cost will be per unit as the fixed costs will be spread over a much larger number of units. This can cause a build-up of inventory, so at the end of the period it will give the appearance of increased earning even though this may be false.
After comparing both methods I feel that each has its own uses in different situations, it is not easy to determine which is better than the other. I think that both methods are useful if used appropriately and in the right situations. However overall I would have to say that the marginal costing method is much better when it comes aiding in decisions regarding things like the shutdown or continuation of a product or service. I also feel marginal costing is better in decision making as data can be directly taken from it in order to help create a CVP analysis which is also a great tool in aiding decision making. Overall I do not feel that marginal costing beats absorption costing; I think both can be applied in different scenarios in order to obtain different results.