Absorption Coasting versus Marginal Costing - Term Paper Example

 Absorption and Cost Accounting Introduction In a manufacturing plant, directors use different approaches for allocating expenses incurred in the process and calculating profit realized (Daems, 2005.p.47). These approaches also influence planning activities of the firm. The commonly used approaches are marginal and absorption. They are different in application hence are both relevant in a production firm. Absorption and Marginal Costing Absorption costing refers to the process of calculating all expenses incurred in the process of creating a product (Kaye & Hawkridge, 2003,p.187). This method includes expenses involved in acquisition of resources, manufacturing procedure and other operating expenses as a result of support services and other relevant activities (Gilligan, & Wilson, 2003, p.45). In situations where outflows are sustained for a group of commodities, absorption expenses are shared among the number of items produced or other factors specific to a particular category of commodities. This process of determining cost of the commodities is useful to directors because it helps them to inform outside parties of the performance of the organization (Leuz, Pfaff, & Hopwood, 2004.p.135). When using his approach, the entire cost incurred is included to reflect a certain proportion of products completed. This method records only the value of finished commodities. The total expenses sustained from the time of acquiring resources to conversion procedure until the final commodity is obtained are included and then converted into actual cost for completed products. There is no value attached to unfinished commodities but only recognizes entire production cost the completed goods (Upshaw, 2007, p.118). When working out for the profit earned using this process, the total expenses of the finished products is similar to the value of goods sold. Therefore, the gain from the sales is the value above that of finished goods. When using this procedure, expenses may be allotted according to specific class of commodities where that class can be linked to those expenses (Daems, 2005.p.63). For example, if 100 chairs were manufactured at a value of US$-5000, each chair will have a production value of $5000/100 to get $500 per chair. Cost may also be allotted according to development or procedure so far attained if the product cannot be broken down into specific completed units. This may be the case in firm processing things like petroleum or juice, where the product is not separable into specific completed units (Leuz, Pfaff, & Hopwood, 2004.p.242). Other criteria can be used to disperse the cost where the manufacturer is dealing with more than one product. In this case, the total expenditure incurred for different commodities being processed is divided according to certain characteristics such as the area occupied by each product, the number of workers engaged its production and so on. When working out for the expenditure associated who each item, all the expenses involved at every stage of manufacturing procedure is established and added to the particular item before it is passed to the next phase (Kaye & Hawkridge, 2003,p.134). The manufacturing process involves different phases and at each phase, additional value incurred is collated and then added to the initial expenditure. For example, when a company acquires raw materials for creation of goods, the amount spent in obtaining materials is accounted as asset. An expense sustained during changing of resources into completed products is known as “work in progress.” After a product has been created, it is moved to the sales department at a value equivalent or higher than the total expenses sustained in the creation process (Daems, 2005.p.81). The expenses included in the value of the finished products also include operation expenses. Sometimes, the market value of the goods produced may reflect a higher or a lower value than operation expenditure allotted to the product. In such a situation, expenditure allotted may either be less or greater than the actual expenditure sustained in the manufacturing procedure (Porntip, 2011). If the estimated operating expenses are greater than the actual expenses sustained, it means the unrealized profit included overhead expenditure (Upshaw, 2007, P.132). If the actual operating expenses allotted in the completed products are higher than the expenditure allotted, it means the total expenses of the final products were not fully covered. Variation in allotting the overhead expenses arises in situations where the estimated cost goes below or above the normal expenses incurred. It may also result in the situation where the amount of output actually attained is below or above the estimated units of outputs (Leuz, Pfaff, & Hopwood, 2004.p.322). Finally, this may be caused by the difference between the estimated and the real operating expenses and output level. The expenses incurred during manufacturing process are recorded in the assets accounts and only shifted to the expenditure accounts after the products have been sold Allocation of expenses in absorption costing is done in three different approaches. The first one is job order costing whereby expenditures are allotted for the goods produced in sets. Each set has different cost from other sets (Upshaw, 2007, p.67). Another method used is called “process costing” which is applied where the company if producing goods which are alike. In this case, every item has similar cost like the rest of the items. This makes it possible to work out the expenses associated with each item in the group (Gilligan, & Wilson, 2003, p.435). The final method is ABC costing whereby the expenditure is allotted from a central location in the organization. This occurs when good produced are of different capacity When using absorption approach in estimating the value of expenses incurred, production income can be magnified by increasing the stock without changing the level of goods sold (Kaye & Hawkridge, 2003,p.128). The level of current period income will appear higher due to the greater proportion of absorbed invariable expenses being transferred to the next period. When the actual goods are sold later, the level of profit earned will decrease because the greater proportion of absorbed invariable expenses will be realized hence decreasing the actual income for that period. This process of maintain high level of unsold stock will create unreal income thus creating false hope for the administrators (Upshaw, 2007, p.122). However, administrator can reduce this observation by maintaining the level of unsold stock as low as possible to ensure the absorbed invariable expenditure is reflected in the period to which it belongs. Advantages of Absorption Costing This approach accounts for the indirect cost of a product during manufacturing process. Therefore, directors can assess the actual expenditure sustained by each unit of goods manufactured and set selling price and quantity to be produced in order to make profit (Gilligan, & Wilson, 2003, p.435). It is also useful since it can help the management to avoid conflict with the tax department because they commodities reflect the true value of what company paid to obtain them. In addition, the values obtained using this method is useful in deciding the financial position of the business (Upshaw, 2007, p.29). Furthermore, it reflects the true value by which the market price has increased or decreased in a volatile market. Disadvantages of Absorption Costing This approach is not useful to the directors of the company in making short-term operating decisions. This is because it includes both direct and indirect cost in the production activity of the product (Gilligan, & Wilson, 2003, p.435). It lacks basis of decision making by the management because some of the direct costs is only useful on a day to day operation of the business rather than for long term decisions. Furthermore, managers are only interested in overall manufacturing for decision making costs rather than the expenses of an individual item manufactured. It is important to note that absorption valuation method is very useful to the directors when making strategic plans for the company (Daems, 2005.p.28). This is because, in the long run all expenses are direct and therefore, all expenditures incurred in the manufacturing processes will become relevant in the long run. These plans may include expansion of manufacturing capacity of the company, expansion of market or additional of more workforces. Marginal system is only important for short term plans such pricing commodities and planning for taxation. Marginal Costing This method is uneven in the sense that, only those expenses which vary with number unit manufactured allotted allotted to the products value (Leuz, Pfaff, & Hopwood, 2004.p.112).. Therefore, every additional output produced adds expenses which are specific to that specific unit. The rest of the cost is maintained in the department until the end of accounting period when it is charged directly from to the revenue account. The process also recognizes the share of each unit produced in clearing the invariable expenditure (Upshaw, 2007, p.64). Producers can effectively determine the number of units of each commodity they need to produce in order to make profit. This is achieved by calculating the amount each product adds towards compensating invariable expenses. When using this procedure for allotting cost to various products, finished goods which are unsold are priced according to the express expenses attributable to a particular unit only (Gilligan, & Wilson, 2003, p.265).. This means that cost shared with other processes are not included in the finished product. The value of goods is inclusive of the direct expenditure attributable to an individual product. The invariable expenses which were incurred in the production activities are recognized after the commodity has been sold. The sales income obtained above the manufacturing value of the finished product represents shared expenses among the goods produced (Gilligan, & Wilson, 2003, p.343). Invariable operating expenses are discarded when calculating the value of completed goods but are recorded as expenditure in income statement (Leuz, Pfaff, & Hopwood, 2004.p.336). Since there is inclusion of operating expenses when using marginal valuation procedure, there is no variation in estimating the amount of operating expenditure incurred. Advantages of Marginal Cost The theory of accounting for direct and indirect cost is easy to understand and apply. This is so because producers can consider rate at which expenses have increased in manufacturing an extra unit (Daems, 2005.p.28). It can help business to thrive in a highly competitive market because manufacturers can decide to sell their products at a value which is just enough to pay for the indirect expense only. After all, this method establishes a connection between expenses, selling price and amount of goods produced (Leuz, Pfaff, & Hopwood, 2004.p.336). Furthermore, manufactures can be able to value their inventories adequately without any distortion of price. Disadvantages of Marginal Costing It is not useful for making decision by the directors because it relies on past information while decisions made are for the time to come. It fails to recognize indirect cost as an important part of production expenses (Gilligan, & Wilson, 2003 p.385). This is not realistic because all expenses should be determined in order to reflect true cost of manufacturing process. It also fails to recognize that all expenses are variable in the long run. Therefore, this requires directors to consider entire cost in making decisions rather than direct cost only. Numerical Example ABC Limited manufactures and distributes products with the following expenditure structure. , (The manufacturing expenditure per item is non-fixed) Direct input expenses valued at $100 Direct wages valued at $240 Non-fixed manufacturing operation expenditure $60 The estimated market value per component is $1600 for the next two years. The manufacturing and marketing financial plan for the coming two years are: 2010 2011 Units manufactured 50,000 60,000 Traded units 40,000 70,000 Opening stock for the year: 2010. Estimated invariable manufacturing operation expenses, $20 per unit and the estimated annual production capacity is 54, 000 During the ear, the following items were not included in the annual estimates: Direct non-manufacturing operation expenses: $10 per unit traded. Annual indirect non-manufacturing operating expense: $2,000,000 Essential: Using marginal and absorption expense valuation procedure, prepare an annual estimates for the next two years. Estimated working report for the year ended 31 December (Absorption costing system) 2010 2011 ($’000) ($’000) Sales 16,000 28,000 Less: Manufacturing expenses of trade Opening stock: - 2,200 Add: Direct manufacturing operating expenses: 10,000 12,000 Indirect manufacturing operating expenses: 1,000 1,200 11,000 15,400 Less: Closing stock 2,200 8,800 15,400 Variation in absorbed non-variable manufacturing expenses: 8,880 15,280 Gross profit 7,120 12,720 Less: Direct nonmanufacturing operating expenses: 400 700 Invariable nonmanufacturing operating expenses: 2,000 2,000 2,400 2,700 Net profit 4,720 10,020 Estimated operating report for the year ended 31 December (marginal costing System) 2010 2011 $’000 $’000 Sales 16,000 28,000 Less: direct manufacturing expenses of sales Opening stock 2,000 Add: direct manufacturing operating expenses 10,000 12,000 10,000 14,000 Less: Closing stock 2,000 8,000 14,000 Direct non-manufacturing operating expenses: 400 700 8,400 14,700 Contribution: 7,600 13,300 Less: Indirect manufacturing operating expenses: 1,080 1,080 Indirect nonmanufacturing operating expenses: 2,000 2,000 3,080 3,080 Net profit 4,520 10,220 Source; Porntip, 2011. Advantage of Contribution The mangers can easily predict the amount of revenue which may be realized from a particular volume of goods sold. Reconciliation In the event all units of the goods produced are equivalents to the units of the goods sold, the level of income obtained whether marginal valuation method or absorption method used is equivalent (Daems, 2005.p.136). When the two methods are used, any variation will result into dissimilar income values. This variation may be caused by the facts that the estimation of operation cost was done at varying time period. If for example the amount of unsold goods is greater than the value of goods sold, this will result into higher income being reported during that trading period for absorption procedure than for marginal valuation method (Leuz, Pfaff, & Hopwood, 2004.p.312). This will be the case because most of the invariable operating expenses are calculated in the unsold goods while low invariable operating cost will be recognized in the value of goods sold. In case the value of unsold stock is declining due more sales of goods as compared to unsold goods, the revenue realized under marginal procedure will be higher than one realized from absorption valuation process (Gilligan, & Wilson, 2003, p.435). Bibliography Daems, H. 2005. Business Planning and Financing: The Nuts and Bolts of a Strategic Plan. House Bloomington, IN. PP. 185 Gilligan, C. & Wilson, R. M. S., 2003. Strategic Marketing Planning. Butterworth-Heinemann, Boston. PP. 643 Kaye. R. & Hawkridge, D., 2003. Learning & Teaching for Business: Case Studies of Successful Innovation. Kogan Page, London. PP. 240 Leuz, C., Pfaff, D. & Hopwood, A., 2004. The Economics and Politics of Accounting: International Perspectives on Research Trends, Policy, and Practice. Oxford University Press, Oxford. PP.434 Porntip, S., 2011. Effectiveness of Management Accounting Implementation, Decision Making Quality and Performance: An Empirical Study of Thai-Listed Firms: Academic journal article from International Journal of Business Strategy, Vol. 11, No. 1 Upshaw, L., 2007. Truth: New Rules for Marketing in a Skeptical World. AMACOM, New York. PP. 288. Read More