Variable costing - Assignment Example

?TABLE OF CONTENTS Executive summary 2 Assumptions of marginal costing 3 Uses of marginal costing in short term decision making 3 Types of costing methods 4 Marginal costing absorption method 5 Advantages of Marginal Costing over Absorption Costing 6 Recommendation 7 Conclusion 7 Costing is one of the managerial accounting functions which needs a careful selection and evaluation of the effectiveness of every technique used by a firm. Despite the various methods of pricing a firm based on its industry should select the most effective method to the firm. Costing is the main function in every firm, the rational being every firm exists in its industry with the main aim as profit making. References 8 VARIABLE COSTING Executive summary This is a report about a review of marginal costing as used in the managerial accounting system. Certain terminologies associated with the concept of marginal costing are identified in the report. The report also defines logically certain terms like variable costs, fixed costs, CVP and breakeven analysis as the key concepts. It goes ahead to prove the rational and marginal costing concepts as used in short term decision making. Being a costing technique, several assumptions such as division of cost element into fixed costs and variable costs, variable cost being considered directly proportional to the production volume, fixed costs being constant throughout the production levels and is being shared according to the volume of production per unit, cost is only influenced by the volume output, and at all levels, the selling price would remain unchanged, are associated with it. The report analysis gives logical evidences in manufacturing, hospitality and airline industries, as where the technique is used. Through appraisal and evaluation, it has been found to be the basis for product and service costing; hence, it is critical to identify its strengths and weaknesses (Maher, Lanen & Rehan, 2005). A recommendation has been made in this report for the marginal costing to be used in the three industries for a short term after its comparison with other alternative methods. Reconciliation of absorption and marginal costing methods has been recommended in order to cater for both short term and long term decisions. In summary, every firm is advised to use a costing method which is relevant to the firm’s decision. Introduction Variable costing is a managerial accounting concept, which according to Managerial Accounting by Ray H. Garrison, Eric W. Noreen, and Peter C. Brewer, is a costing method which has only a variable cost in the unit product cost. From its definition, Variable costs are the costs that vary with corresponding changes in the level of production. Thus, we can say variable costs are directly proportional to the volume of production. The technique is majorly for short term decision making instances rather than for outside purposes. Other methods of costing may include manufacturing cost that does not consider differentiating the costs into either fixed or variable costs (Drucker, 1999). In manufacturing cost, we consider the direct materials, direct labor and manufacturing overhead. Under this managerial accounting concept, a logical relationship between direct materials inventory and the expenses (direct labor and manufacturing overhead) incurred in the production of the end product which is delivered to the market for sale. In this case, the inventory does not fully absorb the firm’s costs. The method considers cost of goods sold to be made solely as a variable cost because it does not include fixed manufacturing overhead from the cost of inventory. Since fixed inventory is always expensed in the current period, it is normally treated as a periodic cost as the capitalizing cost which forms part of the inventory cost is often referred to as product cost (Maskell & Bargerly, 2003). When marginal costing is used to mean the cost of goods which only includes variable in its unit product cost, then variable costing may also be linked to this meaning. Variable costing is described by the CIMA as an accounting system where variable costs are charged to unit costs and fixed cost for the period are written off in full against the aggregate contribution margin. In this case, contribution margin is the difference between the total sales and the marginal cost. When we subtract the contribution margin from the fixed cost, the resulting is the profit. Therefore, contribution margin can be said to be contributing to fixed costs. At the breakeven point, the fixed cost is considered equal to the contribution margin. Assumptions of marginal costing One assumption of the marginal cost is that, the cost is assumed to be divided into both fixed and variable costs. The second assumption considers variable cost/marginal cost to be directly proportional to the production volume and the third assumption considers that fixed cost to remain constant throughout the production period. The fixed cost is said to be divided according to the volume of production per unit of output. When fixed cost per unit output is shared, there is a variation according to the production volume. The selling price of every unit remains constant at all levels of activities while the volume of output changes to influence the cost. Uses of marginal costing in short term decision making One of the short term analyses which are considered when making short term decisions is the breakeven analysis. This analysis is fundamental in determining whether the firm is making a profit or a loss (Kaplan, Robert & Bruns, 1987). This is a short term decision of the firm. When the breakeven is zero, then the fixed cost is equal to the contribution margin since breakeven analysis involves subtracting the contribution margin from the fixed cost. Apart from breakeven analysis, the firm can also use marginal costing in the following ways: For Pricing For checking the effect reducing current price has on profits, For choosing good Product Mix For calculating the Margin of Safety, It helps the managers introduce discounts without affecting the firm profits. Marginal costing, as used in a number of industries such as the hospitality industry, has the prices derived from the cost of sales mainly by using the bottom up pricing approach. For a firm to remain competitive in the market, cost competitiveness needs to be adopted for the competition segment. Similarly, the airline industry uses the same principle as the hospitality sector hence the same methods can be used. In the manufacturing industry, the same method is used for inventory control and control of prices of every commodity and determines its selling price after calculating the breakeven point. Various types of costing approaches are used by firms in the world as discussed below. Types of costing methods Uniform Costing: This is a type of costing which involve an agreement of two or many firms to use the same technique Marginal Costing: This is a type of costing approach, where the variable cost and fixed costs are treated differently. This method includes variable costs in the unit product cost while the fixed costs arrived at through contribution margin. Standard Costing and variance analysis: This method is used in the manufacturing industry where there is standardization of goods produced. The standard costs are estimated and then compared with the actual costs recorded thus important for arriving at costs and cost control. Historical Costing: this is the method that does not focus on the future, but is used to arrive at the costs when they have been incurred. It is a rarely used method. Direct Costing: Direct costing method is a technique which charges all the direct costs in the product cost while fixed costs (indirect costs) are written off from profits. Absorption Costing: this is a method of charging all the costs, both the fixed and the variable operations, products or processes. The difference between this method and the marginal costing comes about where fixed costs are being excluded The main methods of costing where one can have a distinct comparison of advantages and disadvantages are marginal costing and variable costing where the other typologies can fit. Marginal costing absorption method In the marginal costing, fixed costs is treated in the current period while in real sense, they are current periodic costs Whereas absorption costing may differ fixed overhead costs for the next period when inventories increase and Variable costs are included in the ending inventory in the variable or marginal costing Both the variable and fixed manufacturing overhead costs are included in the ending inventory Marginal costing net operating income is not affected by the increase in production volume Increase in production volume under absorption net operating income will increase with an increase in output level thus increase inventories They are used for short term decision making for price control and inventory control Absorption method is used for the external purpose of the firm and mainly long term decision making Advantages of Marginal Costing over Absorption Costing Easy identification of fixed costs: This method treats fixed cost in the current period which it really is unlike absorption which may carry forward fixed cost and include it in the next period (Edward, 2013). No effect on income from changes in the volume of production: The volume of production affects the net operating income in absorption since fixed costs are distributed among the units of production. It avoids misunderstandings concerning unit product cost: Under the absorption method, one can actually mistake product cost as a variable cost. In the case of marginal costing, it is hard for that to happen since it includes only variable cost in the unit cost. Cost control is possible. This is because under this method one can fully ascertain costs and ensure control. It’s easier to understand than other techniques. Being that variable costs are closely related to cash flow and data are organized by behavior, it becomes very easy for managers make out meanings from the variable costing reports. Used in the CVP analysis. Variable costing statements are useful in the CVP analysis, it gives the relationship between the three elements which are important to every manager to make decision in the short run. Limitation of Marginal Costing 1) It is difficult to separate variable costs from fixed 2) The assumption of these costing techniques is often not very realistic. 3) Several other factors other than contribution are taken into account during pricing. For instance, whenever a selling price is high, the selling price cannot remain fixed on the basis of contribution margin alone, other key factors such as capital employed are also considered. 4) Due to its treatment separately or its direct deduction of sales, simple confusion of it as sales may lead to major problems. 5) Given the fact that the inventory valuation under this method understates the profit, the tax authority will not be able to accept the method. Recommendation From the critical analysis of marginal costing and other alternative methods, there exists a rational for every firm in the mentioned industries (hospitality airline and manufacturing) to adopt marginal costing. This technique allows for easier cost volume analysis (CVP) which is used by managers for short term decision making on the appropriate adjustments to make to sales, production or even variable cost to achieve the desired profit. In marginal costing technique a firm is able to adjust the sales to the required level and reduce the marginal cost so as the contribution is able to meet the fixed costs and thus achieving the desired profit. For proper pricing per item variable costs or marginal costs have to be determined separately and included in the unit product cost and ending inventory (Velmurugan, 2010). Generally it is important to use the two methods concurrently for both short term and long term decisions. Reconciliation should be made between the two methods so as counter the disadvantage of using one method which on the other hand is an advantage of the other Conclusion Costing is one of the managerial accounting functions which needs a careful selection and evaluation of the effectiveness of every technique used by a firm. Despite the various methods of pricing a firm based on its industry should select the most effective method to the firm. Costing is the main function in every firm, the rational being every firm exists in its industry with the main aim as profit making. References 1. Cost and Management Accounting. Intermediate. ICA. p. 15.  2. Performance management, Paper f5. Kapalan publishing UK. Pg 17 3. Maher, Lanen and Rahan, Fundamentals of Cost Accounting, 1st Edition (McGraw-Hill 2005). 4. Performance management, Paper f5. Kaplan publishing UK. Pg 6 5. Mocciaro Li Destri A., Picone P. M. & Mina A. (2012), Bringing Strategy Back into Financial Systems of Performance Measurement: Integrating EVA and PBC, Business System Review, Vol 1. Issue 1. pp. 85-102. 6. Maskell & Baggaley (December 19, 2003). "Practical Lean Accounting". Productivity Press, New York, NY.  7. Horngren, Datar and Foster, Cost Accounting - A Managerial Emphasis, 11th edition (Prentice Hall 2003). 8. Consortium for Advanced Manufacturing-International 9. Kaplan, Robert S. and Bruns, W. Accounting and Management: A Field Study Perspective (Harvard Business School Press, 1987) ISBN 0-87584-186-4 10. Sapp, Richard, David Crawford and Steven Rebishcke "Article title?" Journal of Bank Cost and Management Accounting (Volume 3, Number 2), 1990. 11. Journal of Bank Cost and Management Accounting (Volume 4, Number 1), 1991. 12. Edward J. Vanderbeck, Principles of Cost Accounting - - Google Books. Books.google.co.uk.Retrieved 2013-03-01.  13. Drucker, Peter F. Management Challenges of the 21st Century. New York:Harper Business, 1999. 14. The design and implementation of Activity Based Costing (ABC): a South African survey 15. Velmurugan, Manivannan Senthil. "The Success And Failure of Activity-Based Costing Systems." Journal of Performance Management 23.2 (2010): 3-33. Business Source Complete. Read More