Management Accounting: Absorption vs Marginal Costing - Essay Example

Management Accounting: Absorption vs. Marginal Costing Introduction Costing is the technique used for ascertainment of the cost of the products and services. The adoption of cost accounting will be useful in controlling the costs and for taking strategic management decisions. The main objectives of cost accounting are ascertainment of cost, determination of selling prices, control of costs, ascertaining profitability of the various activities of the business and management decision making. According to Hilton, Maher & Selto (2008, p. 5), “Cost management is a philosophy, an attitude, and a set of techniques to create more value at lower cost.” In absorption costing apart from the direct costs which are allocated to the cost centers and the units produced, indirect costs are apportioned to the cost centers and the units produced on equitable basis. In the marginal costing system, the fixed and variable costs are segregated for ascertaining the effect of changes in volume on profit. The marginal cost will be very useful in taking management decisions. There are advantages as well as disadvantages in both the types of costing techniques. But, it is important to note that a good cost accounting system will be useful in identifying the unprofitable activities in an organization and inefficiencies in the system in any form. Variance analysis made by using cost accounting will be useful in highlighting the deviations from the planned performance for taking suitable management action. Absorption costing or marginal costing is used depending upon the purpose of the management activities. Absorption Costing Absorption costing is used in job order costing as well as process costing. There are several elements of cost. These elements of cost can be broadly classified as shown in the diagram: Wherever material, labor and expenses could be identified with the cost centers they are directly allocated to them. Indirect materials, labor and expenses which could not be directly allocated to the cost centers are apportioned to the cost centers on equitable basis. “Full absorption costing is a costing method that accounts for all costs to the units produced by the activities of an organization through cost drivers.” (Galang-Manalo & Valenzuela-Manalo, 2011, 1.8.4) Apportionment of indirect costs Materials, labor and expenses which do not form part of the finished products are known as indirect material, labor or expenses as the case may be. These are collectively called as overheads. The overheads are subdivided into production overheads, administration overheads, selling overheads and distribution overheads. Cost apportionment involves apportionment of the indirect costs to various cost centers on an equitable basis. For example, Works Managers salary needs to be apportioned to various departments such as Production (with divisions 1, 2 and so on), Maintenance, Quality Control, Stores and Assembly. This could be done based on the number of employees in various cost centers. Similarly all the overheads which are common to the these cost centers should be apportioned on suitable basis. Some of the bases and the related expense items are given below. Basis Overheads Number of employees Supervisors’ salary Area Rent, rates, building maintenance, etc. Cost of material Material handling charges Value of fixed assets Insurance, depreciation, etc The unallocated indirect costs are spread over the various cost centers. The bases adopted should be logical taking into account various factors involved to avoid discontent on this account by the departmental heads. Re-apportionment Now the overhead costs of the service departments such as maintenance, canteen, quality control and stores need to be reapportioned to the production department for further apportionment on equitable basis to the output or units produced. All the works overheads should be apportioned to the production departments in this re-apportionment process. The basis adopted will vary for re-apportionment depending upon the services used by the production departments from these service departments. The application of overheads in this process is called as distribution of overheads. Absorption The production department overheads including the overheads apportioned and reapportioned are again apportioned to the products manufactured and this process is called absorption. When the overheads are estimated in advance, this absorption takes place on pre-determined overhead absorption rates, and it is called as total absorption. Methods of absorbing overheads to products manufactured Collection of various components of cost under various departments of production is followed by absorption of cost over the products. There are various jobs or processes involved in manufacturing. If there is only one type of work is carried out, the total actual or estimated overheads collected could be absorbed by dividing the same with the actual or estimated output as the case may be. If there are different products involved, then the overheads need to be applied on equitable basis to the products. Since the overheads or output are likely to vary on monthly basis due to several factors, and there is need for computing the total cost immediately on completion of the production, it is necessary to apply the overheads at the predetermined rates to the products. For this purpose, the overheads and the output for the previous year adjusted for changes in the level of production during the current year could be considered. It could also be based on the estimates considering the normal level of production planned for the year as a whole. There are several methods used for applying appropriate overhead rates to the production. It could be based on the consumption of raw materials, prime cost, labor cost, labor hour rate or machine hour rate. This method enables charging of overheads immediately after production without waiting for the actual figures relating to the factory overheads. Over and under absorption At the end of the year there will be difference between the actual overheads incurred and the total overheads absorbed to the units produced by the various production departments. This absorption will result in over absorption or under absorption based on the actual overheads and the total overheads absorbed. This difference calls for analysis of reasons for the over or under absorption. Treatment of under or over absorbed overheads, being the overhead variance could differ depending upon the size of the overhead variance. If the amount is small it could be transferred to costing profit and loss account. If it is significant, it is charged as supplementary rates, otherwise cost figures would be misleading. Apportioning administration, selling and distribution overheads The administration overheads may be apportioned to production and selling on suitable basis. It could be charged to profit and loss account or charged separately to cost of production or cost of sales. Marginal Costing Marginal costing is a technique used for taking management decisions and not a different method of costing like job costing or process costing, but can be applied to all methods of costing effectively. All direct costs related to the operations are taken into account in marginal costing. The difference lies in treatment of fixed costs, and the ascertainment of cost is based on the nature of costs involved. The overheads could be classified by variability of the incidence of cost into fixed overheads, variable overheads and semi-variable overheads. Semi-variable or semi-fixed expenses do not vary due to small variations in output. But, it will vary beyond certain level of production. For example, depreciation in the case of plant and machinery depends partly upon passage of time and partly upon wear and tear due to usage. When the depreciation due to passage of time could be considered as fixed, wear and tear is semi-fixed. Suppose a company manufactures and sells Cell Phones. The cost will work out as below in marginal costing method at various volumes of sales. Cost 500 Units 1000 Units 1500 Units Selling Price @ 17.5 8750 17500 26250 Direct Material 5000 10000 15000 Direct Labor 1000 2000 3000 Direct Expenses 500 1000 1500 Direct Cost 6500 13000 19500 Contribution 2250 4500 6750 Overheads 2000 2000 2000 –Include Admin., Selling and Distribution Overheads Net Profit 250 2500 4750 Contribution per Unit 4.5 4.5 4.5 Contribution per unit remains the same at all levels of production. This is because only prime cost or direct cost has been considered. Distinction between marginal costing and absorption costing: In marginal costing, only variable costs are taken into account for all purposes including valuation of inventory. Product costing is based on fixed and variable costs in absorption costing. Fixed costs are treated as period costs, and the profitability depends upon volume i.e. profit volume ratio. Each product is loaded with reasonable portion of fixed cost in absorption costing. In marginal costing contribution of each product forms the basis for analysis. Both fixed and variable costs are considered for working out net profit in absorption costing. Unlike marginal costing, the difference in opening and closing stocks will affect the unit cost of production due to the impact of fixed costs involved in absorption costing. Reconciliation between Absorption costing and Marginal costing The cost as worked out for the purpose marginal costing could be reconciled with the cost arrived at in absorption costing. Sales @ 17.5 per unit 8750 17500 26250 Cost 500 Units 1000 Units 1500 Units Direct Material 5000 10000 15000 Direct Labor 1000 2000 3000 Direct Expenses 500 1000 1500 Overheads 2000 2000 2000 - Incl. admin Sales & dist OH Total Cost 8500 15000 21500 Net profit 250 2500 4750 - Absorption costing Prime cost 6500 13000 19500 Contribution 2250 4500 6750 Overheads 2000 2000 2000 Net profit 250 2500 4750 – Marginal costing Going by the above statement, equation for marginal cost can be given as below: Sale price per unit x Number of units – Variable cost per unit x Number of units = Fixed Expenses + Profit. Advantages and disadvantages of absorption costing Advantages: The advantage in absorption cost is that all costs are taken into account. The overheads are applied to the units produced on a scientific basis. “Full absorption costing uses direct costing methods, which are relatively easy to apply, and supplements the reporting with activity-based costing techniques for the indirect and shared expenses…” (Cokins et al, 2012, p. 38) Introduction of standard costing is easy since application of overheads is mostly based on predetermined production or sales and overheads. Variance analysis can be undertaken to identify the causes of inefficiency. Disadvantages: Disadvantages arising out of capacity utilization could be explained by way of illustration. Suppose a company manufactures and sells Cell Phones. The cost will work out as below in absorption costing method at various volumes of sales. Cost 500 Units 1000 Units 1500 Units Direct Material 5000 10000 15000 Direct Labor 1000 2000 3000 Direct Expenses 500 1000 1500 Overheads 2000 2000 2000 Total Cost 8500 15000 21500 Cost per Unit 17 15 14.33 It could be observed that the cost of sales per unit varies according to the scale of production. The problems arising out of variation in capacity utilization is a shortcoming of the system. The overheads of idle capacity will be unreasonably loaded into the cost. Absorption, re-absorption and application of overhead costs to the cost centers and products are complicated. Adjustment of over and under absorption is tedious. Advantages and disadvantages of marginal costing Advantages Marginal costing forms the basis for Cost-Volume-Profit Analysis. Break-even point can be calculated as below. Fixed Costs Break-even point in units = ---------------- Contribution per unit CVP analysis is very useful in taking managerial decisions. It is useful for working out Economic value addition “...it is a simple analysis which directs towards the factors of value;” (Ilic, 2010, p. 94). If fixed costs are included in costing at predetermined rates it results into under or over recovery causing problems in its treatment if it is significant. Since the finished goods and work in progress are valued on marginal cost, the period costs are excluded giving true profit for the period. “Cost and management accounting concepts and techniques are used in manufacturing sectors to provide cost information for decision-making.” (Shil & Pramanik, 2012, p. 170) Marginal costing will be useful in taking strategic management decisions in areas like pricing, make or buy decisions, sub-contracting and replacement of machineries and equipments. Limitations of marginal costing There is difficulty in classifying the expenses into fixed and variable, because some of the expenses will be semi-variable. In larger contracts exclusion of overheads completely will result into wrong management decisions. Fixed costs may not remain fixed at all times, for example salaries will go up. Marginal costing ignores time factor. A job taking more machine hours compared to another similar job, for example, is not considered. When Marginal costing is more applicable Viljoen states (2005, p. 58) states, “Management accounting is concerned with the future of an organisation whereas financial accounting is a record of the past. The data for management accounting are estimates of an unknown future while financial accounting records transactions that have actually taken place.” The marginal costing will be more applicable in taking several management decisions which includes the following situations: In the case of local markets prices are fixed by market forces. “Pricing decisions are complex and many interacting factors need to be considered…” (Lucey, 2002, p. 3) In the case of exports, pricing could be based on marginal costing, because anything recoverable over and above prime cost by way of contribution would be profitable. In case a product’s contribution is very limited, decision for outsourcing could be considered. In a competitive bidding process, the pricing may cut into the margins but still its contribution towards fixed overheads would be appealing for quoting competitive prices. Cost-volume-profit analysis enables the management to scale up the volumes subject to the other constraints. Banerjee (2006, p. 535)states, “Break-even analysis is one of the important tools under CVP analysis or marginal costing and is used by managers for decision making.” Learning outcomes 1. A good cost accounting system will increase the efficiency in an organization by identifying the unprofitable activities. 2. When there is significant variance between the absorptions based on estimates and actual costs, analyzing the causes would point out the problem areas for focusing management’s attention. 3. It aids management in decision making process with reference to the important activities such as pricing, especially pricing for exports, make or buy decisions and other decisions related to the products and the market. 4. Comparison of cost data of the different periods will improve the skills of the people in making estimations. 5. The data could be useful in case the contracts provide for escalation clauses, and the company needs to furnish justifications for the increase in prices. 6. The data provides adequate protection to the company in the case of government controlled products, wages negotiations, tariff protection and so on. 7. The marginal costing principles are useful in cost-price-volume analysis in connection with the studies on economies of scale. The study has been useful in understanding the techniques, its application in real life situations, and its usefulness to business for sustainable long term growth and development. References Banerjee, B, 2006, Cost Accounting Theory And Practice, 12th Edition, PHI Learning, Eastern Economy Editions. Cokins, G, Căpuşneanu, S & Briciu, S, 2012, Accounting’s shift to decision-based costing, Theoretical and Applied Economics, Volume XIX (2012), No. 11(576), pp. 31-44. Hilton, R., Maher, M. & Selto, F. (2008) Cost Management: Strategies for Business Decisions, McGraw-Hill Higher Education, 4th Ed. Ilic, M. (2008) Economic value added as a modern performance indicator, Perspectives of Innovations, Economics & Business, Volume 6, Issue 3, 2010, pp. 94-97 Lucey, T, 2002, Costing, 6th Edition, Thomson, London. Shil, NC & Pramanik, AK (2012) The USV Annals of Economics and Public Administration, Volume 12, Issue 1(15). Viljoen, PJ, 2005, MANAGEMENT ACCOUNTING FOR A PORTFOLIO OF PROJECTS TO SUPPORT ORGANISATIONAL VALUE MAXIMISATION, SA Journal of Industrial Engineering 2005 Vol 16(2): 57 – 67. Galang-Manalo, R & Valenzuela-Manalo, M, 2011, Modern Product Costing Technique in the Age of Competition, eBookIt! Read More