The Two Main Costing Techniques - Coursework Example

Mr. Farquaharson, Sales Director, XYZ Company Ltd. Dear Sir, An Explanation Of Marginal And Absorption Costing Techniques And The Process OfPrice Setting In A Manufacturing Organization This report seeks to give you an understanding about the two main costing techniques used in our organization, namely marginal and absorption costing. It further goes on to explain how product costs are build up and how such information is essentially used in determining the final price of products. Marginal Costing And Build Up Of Product Costs The marginal costing system can be referred to as the direct system of costing. Direct because it simply adds up all the directly associated costs with the products and gives the total cost. Generally direct costs consist of direct labor wages, raw material consumed in production, direct electricity used etc. The principles of marginal costing are often used to determine how changes in the volume of output effects the overall profit by separating fixed and variable costs and considering them as two separate elements of the overall product cost. An important point to know about marginal costing process is that fixed costs are never charged to in determining the final product cost. Fixed costs are in such a case are considered to be a period specific cost. They are not added while determining the price of the product and consequently expensed in the profit and loss account in the period of use. Contribution is a term that is very widely every time marginal costing is used. Contribution can be defined as the excess of sales price or revenue above the marginal costs. Another way of explaining contribution is the amount of profit made be any fixed costs have been accounted for. In very competitive market environments firms often make sales on marginal costs in the short term. As long as marginal costs are recovered, firms continue production as marginal costs cover all variable costs of production. Any excess of marginal cost to the sales price in such a situation contributes to the fixed costs and ultimately the firms break even. Monopolists often price their products on marginal costing basis whenever they see a market threat. Making sales at marginal cost in the short term would allow them to lower their prices temporarily until their competitors are driven out of the market. Consequently they can price their products at marginal cost plus profit formula and continue to exploit customers from their position as the sole supplier. There are some criticisms of the marginal costing process which must be discussed. Decisions taken on marginal costing are based on data derived from historical information. However, decisions made by management accountants relate to the future events and it is not clear whether the past data would adequately representation of future production related details. Secondly, marginal costing tends to ignore fixed costs in the decision making process. In such a case even though a firm might have a very high contribution margin, its profitability might actually be very low (there might even be a loss) if it has high fixed costs. Hence, the contribution margin here would somewhat deceive decision makers if they were to make a decision of the contribution margin without considering the effect of fixed costs. Another very important setback of the marginal costing technique is that it completely fails to take the possibility of fixed costs becoming variable in the long run into account. When such a thing happens then obviously marginal costs would rise and if the increase in variable costs is not accounted for (due to increase in marginal cost as fixed costs turn variable) then then the contribution margin would actually give an inflated view of the situation. Absorption Costing And Build Up Of Product Costs Under the absorption costing system, all costs whether they are fixed, variable or semi variable, are added to make up the total cost. This is very different from marginal costing as there fixed costs were considered to be a periodical expense whereas here they are added to make up the cost of the product. Supporters of absorption often refer absorption costing as full costing system. Full since all costs, whether they’re fixed or variable, are added to make up the overall cost. Fixed costs here are treated as product costs since it is believed that no product could be produced without the supported that is provided by fixed overheads. Absorption costing is widely used by management accounts throughout the world and in most financial accounts, stock is valued on the basis of absorption costing. The absorption costing technique also complies with the generally accepted accounting priciples. Also in absorption costing, the unit cost goes down as the level of production increases. This is somewhat different from what happened in marginal costing where unit cost remained same irrespective of the level of production. Just like marginal costing, absorption costing has its own limitations which need to be discussed. It has been observed by critics of the absorption costing system that the absorption costing system is dependent on the level of production and therefore the cost per unit of product might vary from period to period. Until and unless the fixed overhead absorption rate of FOAR is based on the normal production capacity, there is no point of such changed costs as they cannot be used in making comparisons and initiating control actions. Another disadvantage of the absorption costing system is that as it includes elements of both fixed and variable texts, it cannot be used by management accountants to make decisions and exercise planning and control upon the production activities. Also, it is not really possible to properly calculate the profit volume relationship when the absorption costing system is used. The main justification behind this point is that when an absorption costing system is in place, decision makers often tend to concentrate on the total product cost then on the P-V relationship. Such cases then often cause a problem for management accountants and they then resort to guess work while making final production related decisions. The Process Of Setting Prices In A Manufacturing Organization There are many different ways how organizations set up the prices of their products. A very simple strategy that many firms follow is to add a particular profit margin to the total cost of production per unit (based on either marginal costing or absorption costing) to arrive at the selling price. Such a procedure ensures that a profit it made on each unit of output that is sold in the market. Manufacturers also need to consider the prevailing supply side market conditions when taking decisions regarding the selling price of their products. For instance if there is cut throat competition in the market and loads of new suppliers are coming in, then a low price is likely to be set to ensure that the customers stick by and don’t switch purchasers. Manufacturers in such a case often sell their products on their marginal costs to make sure they catch as much of purchase market as they possibly can alongside covering all their variable costs. On the other hand when monopolist manufacturers foresee new entrants into their market, they often cut their prices to even below their marginal costs. Even though such is a loss generating strategy, they still do it to ensure all the purchasers come to them and the new entrant remains unable to find any market opportunity. Yet another factor that manufacturers consider while setting prices is considering the elasticity of demand. The elasticity of demand refers to the changed in the demand of product caused by change in another variable like price, substitute’s price etc. Manufacturers often tend to charge high prices when the products they supply are price inelastic. Such products include medicines, drugs and essential commodities. However, with items that are price elastic, manufacturers often set low prices and think a thousand times before they take decisions to change prices. Other concepts that manufacturers consider while deciding how to price their products include cross elasticity of demand and income elasticity, income elasticity of demand and the demand supply situation. If you would like like to know anything else regarding the above mentioned information, please don’t hesitate askimg me. Regards, Production Manager. Bibliography Top of Form CRAWFORD, J. V. A., & GOUGH, G. R. (1970). Marginal costing. Hove (169 Dyke Rd, Hove, Sussex BN3 1TX), Editype Ltd. Bottom of Form Top of Form INSTITUTE OF COST AND WORKS ACCOUNTANTS (GREAT BRITAIN). (1961). A report on marginal costing. London, The Institute. Bottom of Form Top of Form LUCEY, T. (2002). Costing. London, Continuum International Publishing Group. Bottom of Form Top of Form LERE, J. C. (1976). Firm characteristics associated with use of variable and absorption costing in periodic reporting. Thesis--University of Wisconsin - Madison. Bottom of Form Top of Form GÖX, R. F. (1998). Strategic transfer pricing, absorption costing and vertical integration. Magdeburg, Univ., Fak. für Wirtschaftswiss. Bottom of Form Top of Form GIETZMANN, M. B., & MONAHAN, G. E. (1993).Absorption versus direct costing: the relevance of opportunity costs in the management of congested stochastic production systems. Champaign, University of Illinois at Urbana-Champaign. Top of Form OXENFELDT, A. R. (1975). Pricing strategies. New York, Amacom. Bottom of Form Top of Form LIVESEY, F. (1976). Pricing. London, Macmillan. Bottom of Form Bottom of Form Read More