The Common Costing Methods - Essay Example

?Cost Accounting Cost Accounting Absorption and Marginal costing This paper will critically evaluate the costing method used by different management systems by assessing their convenience in terms of advantages and their shortfalls. The common costing methods used in cost accounting include absorption costing and marginal costing. Absorption cost (also known as full costing) is costing systems which includes direct materials, direct labour and variable and fixed manufacturing overhead as product cost (Duruy, 2011).This costing method is normally required for external reporting purposes under GAAP since accountants believe that fixed overhead is a crucial component in the manufacturing process (Deo, 2009).. A reason for this is that stock valuation include all production cost under UK SAAP9 so that when profit increases the stock also increase (Pong, & Mitchell, 2004) On the other hand, Marginal or variable costing is costing system which includes all manufacturing cost that vary according to the number of units produced, which includes direct materials, direct labour and variable manufacturing overhead (Bhimani, 2011). Economists favour the use of marginal costing since it enhances profit maximisation (Deo, 2009) since stock increases lower the profit (Pong, & Mitchell, 2004). Theoretically, it is easy to identify the effects of the costing method used by an organization on profit. The costing method used in stock valuation therefore has an implication on profit as shown in the table below: Movement increase decrease Valuation method used Full costing Variable costing High profit Low profit Lower profit Higher profit Several principles were put forward in attempts of supporting either of these costing methods. For instance, the matching principle, which holds that during profit calculation, revenues, must be matched with the costs incurred in generating the revenue (Pong and Mitchell, 2004). Assuming prices are constant, the variable costing method results in a time series of profits that is in synch with the sales. This is considered an advantage of variable costing. The profit generated in this case is not subjected to any movements influence by changes in the stock level as the fixed costs are written off. This is found to concur with the realization principle that recognises profits as they occur (Pong and Mitchell, 2004). On the other hand, carrying forward fixed costs in the full costing method can boost profits in the case of rising stock. It is acknowledged that production activities can affect profitability via the levels of stock. However, this claim has been on the spotlight as it encourages managers to increase profitability by increasing stock which may be dysfunctional to the firm (Pong and Mitchell, 2004). The main difference between absorption costing and managerial costing is the treatment of the fixed manufacturing overhead cost, which are treated as a period cost in variable costing (Durury, 2011, p.195). The two costing methods will be compared using the given data below. Year 1 Year 2 Sales Price 50 52 Direct Materials 10 10 Direct Labour 7 8 Variable Production overhead 5 5 Fixed Production overheads 4800 5700 Administration costs 4000 5000 Sales Volume 900 1400 Production 1100 1300 The unit cost for the absorption costing method was higher at ?26.36 than the ?22.00 for the marginal costing due to the addition of ?4.36 per unit in the first year. The unit cost for the second year was also high for the absorption costing at ?27.38 when compared to the ?23.00 for the marginal costing. This comparison discovered that the unit cost for absorption costing was higher than the marginal costing because of the addition of the fixed manufacturing cost. The benefit of a two year comparisons is that it reveals how manufacturing cost are transferred in the absorption and managerial costing (Lere, 2000, p.29). The benefit of marginal costing is that fixed manufacturing overhead is already incurred even if there is no production for the period. (Durury, 2011, p.169). This encourages management to venture into manufacturing additional units to utilize the unused capacity (Lere, 2000, p.29). Using the same set of data, the comparison will be done to determine the net income for two years for both costing methods. Absorption Year 1 Year 2 Selling Price ?45,000 ?72,800 Less: Cost of sales Opening Stock 0 ?5,273 Add: Direct Materials ?11,000 ?13,000 Direct Labour 7,700 10,400 Variable manufacturing overhead 5,500 6,500 Fixed manufacturing overhead 4,800 29,000 5,700 35,600 Manufacturing Cost (Product Cost) 29,000 40,873 Less: Closing Stock 5,273 23,727 27,38 38,134 Gross Profit ?21,273 ?34,666 Less: Administration Costs 4,000 ?5,000 Fixed manufacturing overhead Total Operating Expense (Period Cost) 4000 5,000 Net Income ?17,273 ?29,666 The net income for the first year was higher under the absorption costing at ?17,273 since the fixed manufacturing overhead was allocated based on the number of production units, which is transferred to the inventory account in the balance sheet. The net income for marginal costing at ?16,400 was lower since all the fixed manufacturing costs were expensed during the year. But on the second year the marginal costing method was better at ?30,100 since it was higher than absorption costing at ?29,666. Marginal Year 1 Year 2 Selling Price ?45,000 ?72,800 Less: Cost of sales Opening Stock ?0 ?4,400 Add: Direct Materials ?11,000 ?13,000 Direct Labour 7,700 10,400 Variable manufacturing overhead 5,500 6,500 Fixed manufacturing overhead 0 24,200 0 29,900 Manufacturing Cost (Product Cost) 24,200 34,300 Less: Closing Stock 4,400 19,800 2,300 32,000 Gross Profit 25,200 ?40,800 Less: Administration Costs 4000 5,000 Fixed manufacturing overhead 4,800 5,700 Total Operating Expense (Period Cost) 8,800 10,700 Net Income ?16,400 ?30,100 But when the net income for two years were added absorption costing was better at ?46,933, which has difference of ?433.This shows that absorption costing is considered to maximize the profit of the company. 2. Activity Based Costing and Traditional Costing The activity based costing is considered a better costing method since it allocates the manufacturing overhead using a cause and effect criteria based on multiple cost drivers (Blocher, Stout & Cokins, 2010, p.93). This is because the ABC uses cost drivers that are both volume-based and non-volume-based so that the resources consumed are more accurately allocated to products (Blocher et al., 2010, p.93). The advantage of the costing method is that it provides a more accurate estimate of the unit cost since it assigns resource costs to products and services depending on the performed activities (Rundora et al., 2013, p.487). An additional benefit is that is enhances decisions making by improving the profit and contribution by removing price distortions incurred in the traditional costing method (Rundora et al., 2013, p.488). The first step is to allocate the manufacturing overhead using cost drivers and based on various levels of activity. The second step is to assign the activity cost pools on the product or service using the activity in the cost drivers. Under the ABC method non-value adding activities are eliminated so that the manufacturing process is enhanced (Rundora et al., 2013, p.487). But there are significant limitations in its use, which is costly and problematic to implement (Innes, Mitchell, & Sinclair, 2000, p.349). ABC costing is considered as a support costing method due to its accuracy. Unfortunately traditional costing decreases the incentive for a production manager to control costs since overhead costs that are not directly included in the production process are also allocated to its products. The reason is that the costing method uses the number of production units as its basis (Blocher et al., 2010, p.128). Using the given data below there will be a comparison of absorption costing and ABC. The assumed total fixed overhead of 210,000 was divided by the total number of budgeted production units of 7,000 to get the fixed overhead rate of 30 per unit. The direct labour cost per unit was determined by multiplying the direct labour hours per unit with the assumed labour rate per hour. The material cost, labour cost and fixed overhead cost per unit was added to get the product cost per unit which is 135 for sauce, 100 for can and 95 for juice. The assumed fixed overhead cost was further divided into activity cost pools which are mixing, processing, and testing. These activity costs are further divided by the total activity consumed to get the activity consumption rate. The total overhead cost per activity was computed by multiplying the activity consumption with the activity consumption rate. The total overhead cost per activity is divided by the budgeted production units per product which is 1,000 for sauce, 2,000 for can and 4,000 for juice. The direct material, direct labour, and activity pool per unit is added below to determine the per unit value under the ABC method. These unit costs are then compared to the absorption costing unit cost in order to determine the difference. The difference revealed that the actual cost to produce each unit of sauce was more expensive by 5.46 under the absorption costing method. The juice was however more expensive to produce under the ABC at 98.70 revealing that if the company sold the product lower than 98.70 then it has been incurring losses of 3.70 per unit. As seen from the comparison above, the ABC is more appropriate for a service industry since it has no inventory and results in the same net income as with the traditional costing method (Deo, 2009, p.97). Since the ABC is considered to be more a support method then it can be more easily implemented in the service industry since it uses activity cost pools rather than the materials, labour, and overhead as its basis of computation which is seen in the traditional costing method. 3. Target Costing and Cost-Plus Approach Target costing is defined as a pricing method that determines a competitive selling price before the desired profit is decided and results to a target cost. The formula to determine the target cost is target price less the desired profit (Blocher et al., 2010, p.547). The target cost therefore is the maximum allowable cost to develop a product (Noreen et al., 2011, p.599), which can still be lowered in order to improve the desired profit. The reason for this approach is that manufacturing companies have actually less control on determining the selling price due to the rule of supply and demand in the market (Garrison et al., 2008, p.761). This can be mitigated in the design phase of the product since cost reductions can be implemented before the production starts, which can be done by simplifying the production process or decreasing the material costs. This approach reveals that the crucial portion of the production process is in the design and development (Noreen et al., 2011, p.599; Chen, & Chung, 2002, p.1). This costing approach is better in competitive environments since a successful implementation means the continued survival of the company. The difficulty in this approach is the redesigning of the product or service to become more cost effective or to improve the manufacturing technology to increase the productivity (Blocher et al., 2010, p.547). This may imply a better and more efficient product design but the use of target costing reveals a number of problems. One of the most significant problem in using target costing are conflicts in the supply chain since the company may request a lower price from the supplier, which is seen to be non-profitable. Another limitation to the method is that it increases the stress levels of the employees who are tasked to meet the desired cost. The reason for this is that it may be difficult to achieve especially when there are limitations with regards to material, labor and overhead costs. The most problematic is the operating cost to implement a desired product cost due to product redesigns and negotiating new contract prices with suppliers (McLaney & Atrill, 2008, p.388). The cost-plus pricing approach on the other hand is the more traditional pricing method since the selling price is decided after the production cost and product development costs are determined (Crosson & Needles, 2011, p.486). This approach however is more difficult to control since the planning stage is already completed along with its inherent costs such as research and development (Crosson & Needles, 2011, p.486). Therefore any plans and strategies to reduce the unit costs after the product has already started production will be considered as temporary in nature (Crosson & Needles, 2011, p.486). Unfortunately these strategies or alternative courses of action may result in a worsening product quality and eventually decrease the existing customer base (Crosson & Needles, 2011, p.486). This problem is seen under a costing quality control where the decrease in product quality will result in customers shifting to another supplier (McLaney & Atrill, 2008, p.42). Target Absorption Projected Sales 140.00 Cost 135.00 Less: Desired Profit 30.00 Add: Desired Profit 30.00 Target Cost 110.00 Estimated Selling Price 165.00 When the two costing methods are used to compute for the selling price, there is a significant difference in the cost value which is at a 25.00. The unit production is not going to be a problem to the company since the difficulty portion will be the selling volume. This is because in case of a decreasing disposal income, consumers may purchase the cheaper priced product resulting in improved volume sales. In case of a more expensive selling price, the volume sales may decrease significantly, which may eventually result to a decreased selling price in order to decrease the inventory levels. Target Absorption Desired Profit 30 30 X Volume Sales 1,000 600 Total Profit 30,000 18,000 This is seen in the table above where the lower priced product at a targeted selling price of 140 was able to sell at 1,000 units resulting to a total profit of 30,000. When compared to the more expensive product at 165 a selling volume of 600 units will only result to a total profit of 18,000. This reveals the value of using the target pricing approach in order for the company to retain its profitability while improving the sales volume. 4. Budgeting as a Performance Evaluation Method Performance management system works to ensure that whenever targets are set, all the individuals in the organization work to ensure the targets are me. Personal and organizational targets are set to enable the organization achieve its overall objectives. When well-coordinated, the individual targets combine to form the organizational goal. A performance evaluation is a management tool that functions to check if each individual in an organization is working according to schedule. Performance management is not to be confused with performance appraisal. Effective performance management systems are characterized by factors: Clear job description with differentiation of duties and authority The objectives of performance management should be well stated and be understood by both supervisors and employees Employees evaluation should be timely Supervisors that undertake employee evaluation should undergo proper training Management control systems there become a crucial business tool that provides information to management for the purpose of decision making. A budget is a planning tool that is used to estimate the required resource and the associated cost over a given period of time. The main benefit of developing a budget is that actual performances can be compared to check for compliance (Garrison et al., 2008, p.372). But the most problematic for the company is if it is used as a benchmark for evaluating the performance of a manager (Garrison et al., 2008, p.372). This means that the manager is responsible for the inability to achieve targeted revenues and costs since the absence of budget compliance will result in control breakdowns (Garrison et al., 2008, p.373). A budget is prepared with consideration of past and present conditions such as prices and external economic conditions. After the budget is implemented, circumstances may change making it hard for budget implementation. If it is a fixed budget, the implementing agents will find it difficult to operate according to the budget. If such budget is used as a performance evaluation tool, then those involved will all have underperformed according to the expected outcome. This makes a budget a non-suitable performance analysis tool. Budgets can be too involving for both management and the employees. Since they have to be achieved, all the organizational efforts are focused on implementing and sustaining the budget such that the other business operations such as customer attention are forgotten. Budgets can be a demotivating factor to employees. When budgets are prepared by top-level management and implemented downward, it become difficult for lower level employees to understand the reasons why the budget was prepared. Some employees may perceive the budgets as unfair hence develop a negative work attitude (Amin & Wahba, 2010. Therefore, they will be reluctant to implement it. When used as a performance evaluation tool, the budget may fail to capture some of these fundamental issues that affect performance of employees. The assumptions used in preparing the budget may not hold. This will distort the whole budget. For instance, assumptions about availability of resource and prices are likely to change. If changes are not made to the budget, evaluation will not be effective as the whole budget may seem unrealistic or distorted (Amin & Wahba, 2010). References Alnoor Bhimani, 2011. Management and Cost Accounting. 5th Revised Edition. Pearson Education. Amin, H., & Wahba, K. (2010). Healthcare Performance Management Model: System Dynamics Approach. Pdfcast. Retrieved November 22, 2013, from http://pdfcast.org/pdf/healthcare-performance-management-model-system-dynamics-approach Blocher, E. J., Stout, D. E., & Cokins, G. (2010). Cost Management: A Strategic Emphasis. (5th ed.). New York, NY: McGraw Hill Irwin. Chen, R. C., & Chung, C. H. (2002). Cause-Effect Analysis for Target Costing. Management Accounting Quarterly, 1-9. Colin Drury, 2011. Cost and Management Accounting. 7 Edition. Cengage Learning EMEA. Crosson, S. V., & Needles, B. E. (2011). Managerial Accounting. (9th ed.). United Kingdom: South-Western. Deo, P. (2009). Cost Allocation in a Service Industry. Journal of Applied Business and Economics, 9(4), 94-102. Garrison, R. H., Noreen, E. W., & Brewer, P. C. (2008). Managerial Accounting. (12th ed.). London, UK: McGraw-Hill. Innes, J., Mitchell, F., & Sinclair, D. (2000). Activity-based Costing in the U.K.’s Largest Companies: A comparison of 1994 and 1999 Survey Results. Management Accounting Research, 11, 349-362. John C. Lere, (2000) "Activity-Based Costing: A Powerful Tool for Pricing", Journal Of Business & Industrial Marketing, Vol. 15 Iss: 1, pp.23 – 33. McLaney, E. & Atril, P. (2008). Accounting: An introduction (4th ed.). New York: Prentice Hall. Noreen, E. W., Brewer, P. C., & Garrison, R. H. (2011). Managerial Accounting for Managers. (2nd ed.). New York, New York: McGraw-Hill. Performance Management System – A Conceptual Model. (n.d.). Hraadi. Retrieved November 22, 2013, from http://hraadi.mst.edu/media/administrative/hraadi/documents/hr/PERFORMANCE_MANAGEMENT_SYSTEM-_Conceptual_Model_AND_Flowchart.pdf Pong, C., & Mitchell, F. (2006). Full Costing Versus Variable Costing: Does The Choice Still Matter? An Empirical Exploration of UK Manufacturing Companies 1988-2002. The British Accounting Review, 38, 131-148. Rundora, R., Ziemerink, T., & Oberholzer, M. (2013). Activity-Based Costing in Small Manufacturing Firms: South African Study. The Journal of Applied Business Research, 29(2), 485-498. Read More