Absorption Costing vs Marginal Costing - Essay Example

? Contrast and Compare Absorption Costing With Marginal Costing ……………………… College …………………………. ……………. Words-count: 2142 Table of Contents Table of Contents 2 Introduction 3 Full Costing: Conceptual Framework and key assumptions 3 Variable Costing: Conceptual Framework and key assumptions 4 Full and Variable Costing: Compared and Contrasted to Product and Service Cost 7 Product Costing and Service Costing 7 Strengths of Variable Costing 9 Weaknesses 9 Strengths of Full Costing 10 Weaknesses 11 Full Costing or Variable Costing: Does the Choice matters? 11 Conclusion 12 References 12 Introduction In today’s complex business environment, the management not only requires day-to-day and accurate information about the costs incurred in the business functioning, but also needs to understand which specific costing method will be more suitable to the financial system it follows. The Strict adherence to a particular costing method is critically important to effectively managing the finance in a firm since its management will be bale to make proper appraisal of the productivity as well as performance of various costs units in the firm. This piece of research reviews full costing and variable costing and outlines the conceptual framework and key assumptions of these cost methods. This paper compares and contrasts these approaches to product and services costing with a view to explain whether the choice of full costing or variable costing still matter or not. Full Costing: Conceptual Framework and key assumptions Full costing, also commonly termed as Absorption Costing, refers to a costing method in which all manufacturing costs, including variable as well as fixed costs, are attributed to the production costs. Hilton, Maher and Selto (200, p. 58) stated that full costing applies all manufacturing-overheads to manufactured goods along with direct materials and direct labor costs. Full costing is also termed as absorption costing because it absorbs and recovers both fixed and variable costs (Heisinger, 2009, p. 276). The cost incurred for the production of a unit is considered as variable cost per unit plus an allocated share of the fixed overheads (Jawahar-Lal, 2008, p. 627, Nigam, Nigam and Jain, 2004, p. 398). In full costing, direct costs are directly allocated to the cost units and manufacturing overhead-costs are taken to the product and other overheads. Direct material costs and direct labor costs are variable costs and these are directly attributed to the product. But, fixed costs are charged over different products that the firm manufactures over a given period of time (Williams, Haka and Bettner, 2004, p. 923, Jiambalvo, 2009, p. 181). Inventory costs should include all production overheads with fixed as well as variable costs and therefore SSAP 9 considers Full Costing as an essential requirement for the external reporting purposes if the firm has to undergo it (Broadbent, Broadbent and Cullen, 2003, p. 92). In Full Costing method, the demand of the product is never considered, but prices are considered as the functions of the costs. Full costing includes pasts costs that may not always be relevant to the present decision making purposes and pricing determinants (Jackson, Sawyers and Jenkins, 2008, p. 228, Drury. 2006, p. 227) In Full Costing method, the demand of the product is never considered, but prices are considered as the functions of the costs. Full costing includes pasts costs that may not always be relevant to the present decision making purposes and pricing determinants. It is therefore criticized that Full costing may not be able to provide reliable and accurate information in order to make decision making be effective (Boardguess, 2009). Variable Costing: Conceptual Framework and key assumptions As detailed above, Full costing includes direct materials, direct labors and both variable and fixed manufacturing overheads that are incurred in manufacturing a product. In contrast, variable costing doesn’t consider manufacturing fixed costs, but it includes only direct materials and direct labor (Weygandt, Keiso and Kimmel, 2005, p. 265). According to the definition of Nigam, Nigam and Jain (2004), variable costing is “a costing technique that charges only the variable costs to the cost units” (p. 398). As CIMA denoted, variable costing is a costing principle whereby variable costs are charged to the cost units and fixed costs that are attributable to the relevant cost period is fully written off against that period’s contribution (Bhattacharyya, 2005, p. 68). Variable costing, also termed as Marginal Costing, applies only variable manufacturing overheads to manufactured goods as product cost along with direct materials and labor. It considers fixed overhead as period cost and expenses it immediately (Hilton, Maher and Selto 2000, p. 58). Marginal or variable costing is considered to be most appropriate tool for management to be used in decision making and identifying accurate cost structures. In this methods, variable costs are attributed to the concerned cost units for a specific period, but fixed costs are written off in full against the total contribution (Lucey and Lucey, 2002, p. 296). Variable costing considers cost behavior, because costs are variable and fixed, but variable costs take in to account only variable costs such as material and labor costs (Bendrey, Hussey and West, 2003, p. 127). Variable costs are those that vary according to the changes in the production and final output. When an additional unit of the product is manufactured, the extra expenses incurred for its manufacturing will be variable because fixed costs always remain constant (Kinney and Raiborn, 2008, p. 73). According to the cost and management accounting concepts, variable costing or marginal costing is an invaluable management accounting technique that provides managerial information about profit and volume relationship and various costs incurred in the business. Variable costing method is widely considered to be an effective managerial tool for decision making, costs and financial valuation, cost control and monitoring as well as profit planning (Glautier and Underdown, 2001, p. 441). Full and Variable Costing: Compared and Contrasted to Product and Service Cost Product Costing and Service Costing A product costing system accumulates the costs incurred in a production process and assigns those costs to the final products of the firm. Product costing is not only required for manufacturing firms, but other firms such as merchandising companies need to include the costs of buying and transporting merchandise in their products costs. The typical product costing applies manufacturing overheads, direct materials and direct labor to work in progress inventory as product costs. One type of product costing method includes direct material, direct labor and both the fixed and variable manufacturing overheads that flow through the manufacturing accounts. This approach to product costing is absorption costing or full costing (Hilton, Maher and Selto, 2000, p. 58). All costs including manufacturing and non-manufacturing costs are classified as either product costs or period costs. Product costs are assigned to Work in Progress as and when the production is carried out and subsequently they will be transferred to Finished Goods being products completed. When the inventory is sold out, product costs are recognized as an expense and matched with revenues from selling of the products. Period costs are not normally assigned to the product but they are considered to be expenses in the period the costs incurred (Vanderbeck, 2009, p. 482) Service costing is the cost of specific services and functions such as maintenance, personnel, canteen, etc. Service costing involves the method of determination of the cost of services. In the end of the specific period, operating costs will be collected and the aggregate of these costs will be divided by the quantity of services being provided in that specific period. Service firms do possess various features that make them different from others. Service firms provide variety of services such as catering, transportation, public utility services etc. These firms employ a large number of employees for running their business as they are labour intensive firms. Services that these types of firms provide cannot be stored and these services are kind of perishable commodities. Major inputs used in these firms cannot also be stores because major inputs are labors. Apart from these features, services firms do not produce tangible goods, but services are intangible goods. Both full costing and variable costing are two different types of product costing, but the difference is that full costing or absorption costing takes in to account all different types of costs to the product costs, but variable costs considers only the variable costs. Full costing takes both fixed and variable costs in to account for assessing the product costs, but variable costs ignores fixed costs and only variable costs are charged to the product costs. But, as far service costing is considered, service firms do not have inventories and they therefore do not use full costing, but mostly depend on variable costing. Variable costing will be more appropriate for them. Warren, Reeve and Duchac (2011, p. 196) stressed that service companies mostly use variable costing for reporting income from operations. A service company, in contrast to manufacturing company, doesn’t make or sell products and therefore these firms do not have inventories. Since they don’t have inventories, they do not use full costing to allocate fixed costs. Strengths of Variable Costing Variable costing technique has for several years been applied by large numbers of businesses as it has been considered to be greater convenient and easier to be adapted to the business. In variable costing technique, chances of over absorption and under absorption are relatively less, since variable costing doesn’t absorb full costs. Variable costing method avoids apportionments that are usually made on arbitrary basis. Variable costing method has been widely considered to be more suitable for managerial decision making since it provides more reliable and accurate information than that of absorption costing. In variable costing, closing stock can easily be valued and assessed. Variable costing some times encourages over production. It is because, while using marginal costing, there may be a chance that the reported profits may be shown increased by the increase in the stock levels. According some arguments, fixed costs are always fixed, and not variable even in the long run. There are many different basis for overhead allocation and attribution that may represent different interpretations as well (Davies and Pain, 2002, p. 295). Weaknesses Variable costing doesn’t meet the international standard requirements as specified in SSAP 9 In marginal costing, fixed overheads are considered irrelevant for short run decisions (Jawahar-Lal, 2008, p. 628 Full costing is fair according to the view of accounting, No special proportion of the production costs are proportioned for future costs, It is not much suitable for job-costing and batch costing Strengths of Full Costing Full costing is regarded as fair in the view of accounting since fixed manufacturing costs are incurred for manufacturing the products. Full costing is consistent with GAAP- generally accepted accounting principles (Weygandt, Keiso and Kimmel, 2005, p. 326) The closing inventory values normally consist of a specific proportion of fixed production overheads and therefore the full costing technique meets the international accounting standard according to the SSAP 9 view point. Full costing is some time more accurate as it apportions a specific share of the production costs. For job as well batch costing, full costing will be more suitable because it is helpful in decision making in relation to pricing. There is also accuracy in valuing profit mark up to meet foxed costs (Cost Accounting System, 2010, p. 7). Weaknesses There are chances of over or under absorption in full or absorption costing method. Valuing closing stock is relatively difficult in full costing method. Full costing doesn’t encourage over production. Full costing is not suitable for service firms since they don’t have inventories. Full Costing or Variable Costing: Does the Choice matters? In a comparison of the advantages and disadvantages of using both full costing and variable costing, especially in relation to their use for service and production costing, it is more clear that choice is matter of concern for any firm that wants to choose a specific method for costing. To be very simple and more specific, a service firm may better choose full costing where as a manufacturing firm may choose variable costing. Variable costing will be more appropriate for a manufacturing firm as the management will be able to take proper decisions regarding the costs and profit relations and other critical managerial activities. Full costing will be more suitable for a service firm, because a service firm doesn’t manufacture or sell products and they don’t have inventories. If the management requires greater accuracy in managerial decision making, marginal costing will be better option since it considers only variable costs and thus management can get accurate information. Variable costing is seen more realistic than full costing and is therefore the choice is critically importnat because variable costing takes in to account only those that are easily attributable to the job or product (Chadwick, 1993, p. 77). Conclusion This piece of research paper has explained the conceptual framework and basic assumptions of full costing and variable costing in relation to how they will be effective to product as well as service costing. This paper has contrasted and compared the strengths and weaknesses of both the techniques and concluded that variable costing will be better choice for manufacturing firm and full costing for service firms. References Bendrey M, Hussey R and West C (2003), Essentials of management accounting in business, Illustrated edition, Cengage Learning EMEA Bhattacharyya A K, 2005, Principles And Practice Of Cost Accounting, Third Edition, PHI Learning Pvt. 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