Analysis of Various Costing Techniques and Assessment of Their Applicability - Research Paper Example

Analysis of Various Costing Techniques and Assessment of Their Applicability Registration Number: Word Count: APC309 Workshop Tutor Name: Contents Contents 2 Introduction 3 Research Objective 3 Research Background 3 Research Objectives 3 Research Methodology 3 Limitation of the Study 3 Part A 5 1.Marginal or Variable Costing 5 2.Full or Absorption Costing 6 3.Activity based costing (ABC) 7 Part B 9 Standard Costing 9 Variance Analysis 9 Suitability of standard costing and variance analysis 10 Standard costing and variance analysis applicability in modern manufacturing background 10 Conclusion 12 Reference List 13 Introduction Cost measurement and analysis is an important decision making process in any company as it forms the central part of any financial decision. Cost measurement is essential to determine company profits and rewards for cost bearing. Measuring cost of different products and services is also essential to determine the breakeven point and level of profits that a company makes. Such analysis helps in fine-tuning areas where cost can be minimised by increasing efficiency and hence, increase profit margins. Such methods which help in analysing costs are known as costing measures. Variance analysis helps to determine variation from standards and in turn enhances productivity (Thukkaram, 2007). Research Objective The purpose of research is to analyse various costing methods and acknowledge the suitability of these methods in organizational settings where they fit the best. Research Background Any standard setting is a double edged sword, which has its plus points but is not free from certain drawbacks. The paper is an analysis of traditional and modern methods of costing and also, lays down an explanation for each one of these methods, besides recognising the importance of each one in specific industries. Research Objectives The prime objective of the paper is to understand the different methods of costing and analyse and establish the method of costing which is indispensable as per the kind of organizational setting and organizational needs in context. Research Methodology Information pertaining to costing methods and procedures was read from books, online journals and web pages dedicated to financial analysis and costing techniques. Limitation of the Study The study was aimed at analysis of various cost measures and their individual suitability to different organizational needs. The scope to fully gauge the benefits of using each one of them was unavailable. Real life case analysis was also not possible for establishment of research findings. Part A 1. Marginal or Variable Costing Marginal costing can be referred to as a variation of flexible standard costing that helps to distinguish between the fixed costs and variable costs, which depend on per unit of output produced. Marginal costing is helpful in monitoring costs based on resources that drive it. These resources help in segregating costs into fixed and variable elements. Any cost fluctuations observed as a result of operational changes can be accurately predicted and checked with the use of marginal costing. Marginal costing is one method of costing for inventory where all the different variables of manufacturing costs are included as inventory costs. Such costs are incurred and become a part of the cost of goods sold when the product gets sold, while other elements of cost, which is the fixed cost, is taken to be costs for the period within which it is incurred (Kaplan Financial Knowledge Bank, n.d.). Marginal costing tries to capture the behavioural aspects of cost calculation, rather than functional traits of cost. The focus is on segregating the costs into per unit cost and fixed element of cost, regardless of level of production activity. Contribution is calculated as total cost of sales minus variable costs. Fixed costs are kept specific to one period only and deducted from contribution for the period to get net profit. This method is often criticised on grounds of being too simple and unreal, in terms achieving accuracy in splitting the fixed and variable elements of cost. Marginal costing can be viewed useful for short run plans, decision making and control and for firms that are characterised by multiple products (Khan and Jain, 2006). While calculating the PV Ratio, managers would prefer to use marginal costing over other methods of costing. PV ratio establishes the relationship between Sales value and Contribution. PV Ratio = (Contribution/Sales) * 100 This PV ratio calculation is essential for management decision making because it is an important indicator of business profitability. With higher profit, better shall be the PV ratio. However, if a manager wants to improve the PV ratio, it can do so, whether by increasing the sales price or reducing the variable costs. PV ratio can also be improved by altering the sales mix and increasing the quantum of sales for those products which have a higher PV ratio. Here the main assumption is that the firm produces multiple products (Jain, 2000). Marginal costing helps in determining the variable cost components as separate from the fixed cost elements and hence, it becomes easy to detect the part of the cost which needs to be reduced in order to improve the PV ratio. Again, when the PV of each product is derived for a multiproduct firm, the cost mix for each product determines the PV ratio and therefore, the sales mix can be altered to get a better overall firm PV ratio (Weygandt, Kimmel and Kieso, 2009). Under absorption costing, profit figures might get altered as the fixed cost is carried over to the next period. This is not a sound practice as costs incurred within a period should not be carried on to the next period. Hence, managers would prefer marginal costing while calculating PV ratio. 2. Full or Absorption Costing Absorption costing is another method for costing of inventory, where all fixed and variable costs of manufacturing are added together to form a part of inventory cost. The absorption costing system of product costing takes all forms of cost incurred by a business and each type of product or service and apportions a share of cost to each one of them. There is some sort of ambiguity in terms of arbitration of apportionments of cost made to each product. It is to be noted that certain costs remain fixed for a production period, while they might also remain dependent on the level of production. The absorption form of inventory costing is helpful in determining the long run profitability of a business (Wikinson, 2013). The methodology of absorption costing is such that it classifies each cost by function. Sales minus production cost reports gross profit. Gross profit minus costs incurred in other functions of a business gives the net profit. However, in the absorption costing system, the profits of a manufacturing period shall be impacted by the production level and sales volume. This means that along with manufacturing overheads and expenses that are fixed, absorption costing also considers the value of unsold finished goods and work in progress for the next period as well (Hansen, Mowen and Guan, 2009). Absorption costing helps to determine per unit reduction in fixed cost as a result of increase in production activity and thus, encompass the benefits of economies of scale in terms of reduced per unit costs. The fully absorbed per unit cost has a fixed proportion that captures the fixed costs of production. Due to large scale production, such fixed costs, unaffected by degree of production, get distributed to larger per unit share and reduce per unit costs. So, absorption costing becomes indispensable while calculating the benefits arising out of economies of scale while calculating per unit cost of production. Marginal costing is unable to capture this because per unit fixed cost remains fixed to a specific period alone. Absorption costing captures the fixed cost for any period, thereby helping to determine profits added for any period caused by any change in scale of production. Absorption costing encompasses an advantage that while accounting for a period, if manufactured products are sold in that period, it gets carried onto the next period as costs for the future period and does not get added to the costs of present period, thereby inflating profit figures. Inventory of finished goods has per unit fixed expense overhead assigned to it. This figure of fixed overheads does not get added to cost of goods sold, unless they actually get sold. This in turn improves profit figures for the period. Disadvantage associated with absorption costing is that fixed element of cost changes from period to period. This cost is dependent on the level of output produced. Unless such costs are aligned to some normal capacity base, the fixed cost reflection becomes ambiguous for purposes of comparisons and control. 3. Activity based costing (ABC) Activity based costing differs from the traditional methods of costing as the former indicates costs for each specific activity, rather than product. This provides a more accurate method of costing but managers prefer to use this method only when they have to supplement system of costing. The method first identifies all kinds of activities associated with production of a product and then, assigns specific costs to each activity of the production process. Such activity costs are then cumulated to calculate the product cost using up the activity (Marx, n.d.; Cokins, 2006). The fundamental assumption behind activity based costing is that activity is seen as the underlying cost object as opposed to products in traditional methods. It also assumes that whilst activities cause costs to occur, activities also contribute to the creation of demand for other activities (Johnson, n.d.). The benefit of using the activity based costing system is primarily higher accuracy of measuring costs. The costs are assigned to only activities that are associated with production of the specific product. All other expenses incurred, which do not contribute to the production activity in any way, are eliminated from the calculation process. This method eliminates allocation of any irrelevant costs. Additionally, it also helps to understand cost interpretations in a simpler manner for internal management, enables simplification of benchmarking as well as a better understanding of overheads (Lucey, 2002). Disadvantages associated with ABC costing method include the need for immense resources to calculate costs associated with each activity. This makes it difficult for smaller firms to derive the benefits of ABC costing method. This costing system can also become an easy prey to misinterpretation by different stakeholders (Rojas, n.d.). Improvement in product costing derived from activity based costing comes from collation of all kinds of activities and then isolation of cost specific to each activity that goes in the manufacturing process. This basis completely eliminates the need for period and product costing ambiguities that arise in the traditional costing methods. In terms of managerial scope, absorption costing scores over activity based costing because it helps management to take strategic decisions by mirroring the functioning of the enterprise. It helps to establish real costs associated with each product, thereby making decisions regarding elimination of non-profitable and inefficient products and also, benefit from highly profitable products. The ABC system of costing improves upon management accounting quality, especially for firms associated in producing multiple products. In such firms, traditional costing methods like, absorption costing, produce misleading results about overhead costs (Nayab and Scheid, 2010). Absorption costing helps to determine the comprehensive efficiency and profitability of firm. It also assists in pricing of products in an equitable fashion by breaking costs into activities and adding cost of each activity, based on customisation requirements of customers. Absorption costing and marginal costing, on the other hand, help to determine the cost of individual products. Such system of costing is well-suited to the needs of small companies that are engaged in the production of similar products. Part B Standard Costing Standard costing allows a firm to assign expected cost figures to all activities of the production process and use actual cost figures to arrive at variance records for each period of analysis. The variance here is the difference between the expected cost and actual costs incurred. This method of costing estimates costs for each activity within the company’s production perspective. Such estimates are formulated as approximations that are set close enough to the actual costs that are incurred. This method of costing is suitable for almost all organizations that are engaged in producing homogenous products and have an assembly line that is repetitive in nature. Standard costing is not suitable for organizations that produce products that are heterogeneous and customised as per the needs of the customer. It is also unsuited to the needs of an organization which has a lot of human element involved in the production process. Variance Analysis Variance is the difference that arises out of a difference between the actual costs incurred and standard costs set for a production unit. Such variances can also be calculated in terms of sales incurred. Therefore, variance analysis can be from both revenue and cost points of view (Dandago and Adah, 2013). Variances can be calculated for two major types, rate variance and volume variance. Rate variance: This is the difference between the actual price paid for a product and the expected price multiplied by the quantity of product produced. This variance calculation can be applied as purchase price of inputs or sales price of products sold (Accounting Coach, n.d.; CMA, n.d.). Volume variance: This is the difference between the actual volume sold and the expected sales volume multiplied by the actual cost or price per unit of the product or input. Such variance calculation can be applied to materials, goods sold or even overheads (Berger, 2011). Such setting allows one to believe that variance analysis is suitable for any type of organizational activity that is involved in business. However, this is not true. This is because each organization has a different pattern of setting standards. Also, not all organizations produce standardised products with a standardised production activity which can be said to be homogenous. Heterogeneity in production process causes variations in costs for each customised product. Such variations are not suited for making comparisons (Accounting Tools, n.d.). Suitability of standard costing and variance analysis The idea behind standard costing is: To control by comparison of standard costs to the actual cost and investigate differences. To measure performance by the difference that arises out of difference in standard and actual costs. To prepare budgets based on standard costs and evaluate variances of actual costs incurred, thereby giving feedback to managers through variance analysis (Jamal, et al., 2007; The Society of Management Accountants of Canada, 2007). Standard costing and variance analysis applicability in modern manufacturing background The modern manufacturing situation is quite different from that promised by traditional manufacturing. Variance analysis in such an environment is found unsuitable owing to many reasons (Edwards-Nutton and Technical Information Service, 2008). Non-standard commodities Standard commodity cost applies in a manufacturing setting where the company produces huge quantities of exact copies of products in their production systems. Standard costing cannot be applicable in places where production is not standardised and every produce is customised as per the needs and want of the customer. The modern manufacturing segment has more inclination towards customisation, rather than standardization of products (Izhar, 2001). Swift outdates of Standard Costs The modern manufacturing system has products that are characterised by extremely short life cycle because of the ever-changing demand of consumers and intense competition for innovation in the industry. One such example of swift outdates in products is the mobile phone market where one sees a new product launch every month. This pattern of product life cycle requires regular updates of standard costs, which in turn raises the cost of estimating such standard costs. In case standard costs are not kept updated, planning and control activities tend to suffer. This limits the usefulness of standard costing measure and relevance of variance analysis (Banjerjee, 2005). Automated Production Systems The fundamental assumption behind standard costing measures is that cost controls can come about by tweaking workforce efficiency. In today’s manufacturing concerns, production is getting highly automated. In such manufacturing concerns, high automation of production systems control material consumption and product output. Under standard costing, management control can be exercised by setting efficiency standards for direct labour, not machines. Hence, it is uncertain whether standard costing is of much use in the highly automated production concerns of today (Bhattacharyya, 2011). Use of Ideal Standard Variance is calculated as a difference between standard and actual performance measures in terms of cost. Current businesses try to continuously improve in their production standards by use of TQM and JIT that set ideal standards for production processes and quality. Variance analysis and adverse variance calculations done with current standard and compared to ideal standard shall have a completely different implication that what it actually serves (Kinney and Raiborn, 2012). Focus on Constant Improvement Standard costing techniques almost eliminate the concepts of constant improved that lay the foundation of TQM and JIT methods. Standard costing needs improvements in predetermined standards (Lal, 2009). Requirement of Details Variance analysis is performed by considering the aggregates like total labour, total material etc. The business environment today is extremely complex and dynamic and this calls for requirement of detailed information regarding various management control decisions (Clarke, 2002). Importance of Performance Monitoring The reports of results of variance analysis are made available to different segments of the society only after the conclusion of the reporting period. The competitive industry setting today calls for a more real time reporting system and analysis (Dutta, 2004). Conclusion The report explains various methods of costing. It was observed that marginal costing was essential for making variable cost and contribution analysis and in order to facilitate short-term decision making and control. Absorption costing is useful for deriving the benefits of economies of scale, thereby assisting the determination of long run business profitability. Activity based costing is a modern approach that allows scientific calculation of costs and helps management to make strategic business decisions by analysis of different production activities (Drury, 2008). Standard costing and variance analysis was found suited to most organizations that produced homogenous products and high degree of mechanism in the production process. Modern day manufacturing systems focus on customisation of products that get outdated very quickly. Hence, standard costing is increasingly becoming unsuited to modern day organizational needs (Rajasekaran, 2010). Reference List Accounting Coach, n.d. Standard Costing: Explanation. [online] Available at: [Accessed 3 January 2014]. Accounting Tools, n.d. Standard Costing. [online] Available at: [Accessed 3 January 2014]. Banjerjee, B., 2005. Financial Policy and Management Accounting 7Th Ed. New Delhi: PHI Learning Pvt. Ltd. Berger, A., 2011. Standard Costing, Variance Analysis and Decision-Making. Munich: GRIN Verlag. Bhattacharyya, D., 2011. Management Accounting. New Delhi: Pearson Education India. Clarke, P. J. 2002. Accounting Information for Managers. Connecticut: Cengage Learning EMEA. CMA, n.d. 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