Cost Control and Performance Management - Case Study Example

Full costing vs. variable costing The main reason for costing is to help in decision making for the production of a company. The costs which vary help determine the effect of different decisions. In costing, small differences and changes bring about a marked difference in costs and revenue. Usually, the variable costs, or the costs which change as the productions level changes make a difference on the end result. The fixed costs only change slightly and don’t make such a difference on the end profit. There are two method of costing: fixed costing and variable costing. (Carter, 2005) The first is full costing method. This is also known as absorption method. When costing is done in this method then, all costs are treated as the cost of production. This is done regardless of whether they are variable of fixed costs. The costing method allocates part of the fixed manufacturing overhead cost to each single unit of production. The same is done with the variable manufacturing costs. (Wolk, Porter, Gerber, 1988) When it comes to the variable costing it is a bit different from fixed costing. When the variable costing method is used, then all the costs which change according to production are treated as product costs. All this includes direct costs of labor, material and cost of manufacturing overhead. While the fixed costs, which stay the same no matter what the production level is, are treated as the period costs. These costs are marked off against the revenue earned from the production. (Carter, 2005) Variable costing The basic aim of variable costing is to distinguish between the fixed costs incurred during production and the variable costs incurred during production. Profit = Contribution Sales – Marginal Cost Marginal Cost = Direct Material + Variable overheads + Direct expense + Variable Cost + Direct Labor Definition: It is the system of accounting where the variable costs are put under units produced, while the fixed costs are put under the period they have been incurred in. they are written off against the aggregate contribution. (Brown, 1999) In simpler words, marginal costing is based on the following two things: 1. When the output of production increases, it leads to the decrease in the cost per unit. However when the output decreases, it leads to the increase in the cost per unit. 2. When the increase in output is higher than one, the average marginal cost per unit can be found. This is done through dividing the increase in expenditure by the increase in number of units. When talking about marginal costs, we basically mean the last unit produced. This is known as the marginal unit produced. So in terms of marginal costing, we calculate the cost of producing a marginal or additional unit, along with the present level of production. Marginal costing is a method of displaying data in terms of variable costs and fixed costs. This is done to help with the process of making managerial decisions. It is done purely for analyzing the information available of the costs of production. It helps the managers find the changes in the profit due to the changes in the output of production. (Nicholson, 2007) Variable costing has given rise to the concept of contribution. The equation for which is: Sales Revenue – Variable Cost In other words it is also known as the profit which we get before the recovery of fixed costs. The equation for which is: Fixed Costs + Profit When a company makes neither profit nor loss, it is said to have reached the breakeven point. This point is where the contribution is equal to the fixed costs of production. Contribution = Fixed Costs When talking about the marginal costing, a few principles are constant. They are as follows: For the any one accounting period of a given firm, the fixed costs stay the same. They do not change with the change of production levels and sales. The change in production level and sales only affects the variable costs. When change in the above two takes place, the following happens: The revenue increases due to the sales value of the product sold. The costs will increase due to the marginal cost per unit. The profits will increase due to the amount of contribution from the marginal unit. When the sales of the products fall, it will lead to a fall in the profit in the proportion of the contribution which is earned from the product. (Horngren, 2008) The profits should be measured on the analysis of the total contribution. As the fixed costs are the same throughout the whole of the accounting period, it is false presentation if the units of sales are charged against the fixed costs. (Horngren, 2008) When marginal units are produced, they incur variable costs only. They have no link to the fixed costs of production. They remain completely unchanged throughout the accounting period. (Horngren, 2008) Period costs Product Costs (Vanderbeck, 2008, pg. 483) Fixed/absorption costing In this type of accounting, the costs are not classified into fixed and variable costs. They are all classified as production costs. There is no importance given to the costs classification. As per the absorption method of costing, the fixed variable overhead costs are classified as product costs. While in the method of variable costing, they are classified as period costs. (Vanderbeck, 2008, pg. 482) Product costs Period Cost (Vanderbeck, 2008, pg. 483) ABSORPTION COSTING SCHEDULE Sales Revenue  xxxx Less Absorption Cost of Sales   Opening Stock xxx  Add Production Cost xxx  Total Production Cost xxx  Less Closing Stock (xx)   Absorption Cost of Production xxx  Add Selling, Admin & Distribution Cost xxx   Absorption Cost of Sales  (xxx) Un-Adjusted Profit  xxxx Fixed Production O/H absorbed xxx  Fixed Production O/H incurred (xxx)  (Under)/Over Absorption  xxxx Adjusted Profit  xxxx The above shown schedule is for the method of absorption. As can be seen from the schedule, the costs are all distributed at the cost of absorption. This means that the costs are divided among the units produced. (Meigs, 1990) Strength and weaknesses Marginal costing Advantages It is simple to understand The carrying forward of stock valuation in proportion to current years fixed overhead is prevented. The assessment of different decisions can be made easily. The huge balances left behind in the overhead controlling accounts are eliminated. This will help with determining a more accurate recovery rate. When the allocation of fixed costs is removed, then management can concentrate on maintaining the managerial cost. The short term profit planning is helped by the break even analysis and the profitability analysis. Comparisons can be made between the two products in terms of cost and revenue. Disadvantages The classification of costs into variable and fixed cost causes problems. It sometimes results in misguiding figures. The regular costing method also uses overhead as per the regular operating levels, this tells us that there is no true advantage by using marginal costing. This method does not allow for transparency of accounts. This affects the financial affairs of the firm. This is because in this method, the stocks and work in progress are undervalued. The changes in volume are shown when standard costing is used. Marginal costing just brings to hand an unrealistic picture of the levels of production. The fixed overhead is based on estimates. They have little basis in the actual figures. This could lead to the over and under absorption. Net profit of company is affected when the fixed overheads are not taken into account. A huge portion of fixed overheads are ignored. For long term planning the variations in sales price, fixed costs and variable costs should not be ignored. As they all do change whether majorly or in a minor. Advantages of Absorption Costing: Fixed costs are accounted for in this method The stock is not undervalued when this method is used. The absorption method is used to prepare financial accounts. The absorption costing method shows minor fluctuation in the net profit in result of sales fluctuation. The stock valuation is changed due to the change of fixed costs into variable costs. Disadvantages of Absorption Costing: It cannot be used for making decisions by the management. The relationship between cost volume and profit are largely ignored. As the focus is on the total costs of production. Over and Under Absorbed Overheads In the method absorption costing, the fixed costs are never absorbed properly. This is because of difficulty in forecasting costs and the output levels. The recovery will not be written off to the profit and loss account. This is because the balances may come out to be either over or under absorbed. In reality the actual cost which was incurred was not shown (Bragg, 2001). In marginal costing it is completely different. There are no such problems of over valuation or under valuation. This is because both the fixed costs and the variable costs are separately shown. And the fixed costs are shown against the contribution. This will show a more accurate picture of the net profit (Bragg, 2001). Difference in Stock Valuation There is a difference which comes up in the stock valuation when absorption method is used, and the marginal method is used. For marginal costing, the finished stocks and the work in progress are valued at the marginal cost. While in the absorption method, it is valued at the cost of total production. Let us now see a brief summary of how the profit differs due to this difference: a. There is no variation in profits when the opening and closing stock are not changed. b. Taking into account the element of fixed costs, the opening stock and closing stock will be the same. This is provided that the level of fixed costs remains constant in to values. This will then show no change in profits. c. If the valuation of closing stock is higher than the opening stock, then the profit as per absorption method will be higher in comparison. The bigger part of the fixed costs is carried to the next accounting period as it is a part of the closing stock. d. If the closing stock is lower than the opening stock, then the profit as per absorption method will be lower in comparison. A larger part of the fixed costs will be debited during the current period. (Brown, 1999) Management decisions Such accounts are made for management decisions. They help managers do the following. View the various alternatives to a taken decision. Get the data which is necessary for the alternatives which are being evaluated. Evaluate and analyze each alternative’s results on the profit of the company. Choose the best alternative. This should help to gain the result which is being looked for. Apply the chosen alternative. At a set time, evaluate the result of the implemented alternative. When the management starts the process of making decisions using costing, they first have to categorize the decision into strategic and tactical decisions. This is because they are both forecasting and planning for a strategic change or a tactical change (Goosen, 2008). Strategic decision The aim is always to choose the best possible option for the company. It should always improve the revenue while keeping the costs at a lower percentage of the revenue. This is a very difficult thing to do. All factors are subject to change at any given time. This may throw all the calculations done off. Also the decisions are mainly subjective, they are not concrete. The goal which is to be achieved plays an important role in the nature of the decision. Strategic decisions are decisions pertaining to things such as changes in the product line, pricing strategy, level of risk to be taken. By definition strategic decisions are broad in nature, they are of qualitative nature. They are non-quantitative decisions. They are done by using the subjective thinking of the management (Rao, 2003). While on the other end, tactical decisions are quantitative in nature. They are made through practical calculation tools. They result from the strategic decisions. This means that when a strategic decision has been made, then the management turns towards the tactical side of the decision. They will then use tools such as management accounting which will help them achieve the overall strategic goal (Rao, 2003). So in the end we can conclude that the strategic decision is of qualitative nature, while the tactical decision is of quantitative nature. We use tools such as mathematical calculations to help us come to a decision regarding what option to choose (Rao, 2003). Summary It can be said that the answer to the question, does the choice matter, is yes. The choice really does matter. When you make a decision for the company, many things are at stake. The decision should be as fine-tuned as possible. The strategic decisions are the entire basis for decisions which are supposed to be well thought out. The tactical decisions should be taken by the best of the best. Even if a small thing changes the whole of production is affected. When it comes to costing, it is the tool used for making tactical decisions. They help in decide which cost to minimize and which they can relax on. The costing of production matters extremely when you are evaluating the profits off the company. Costs whether fixed or otherwise have to be paid out of the profits which are earned from the production. If the costing is done in a way where the costs have a higher percentage in the profit, then eventually, the profit will be lower than expected. While the costing in which the costs are distributed in a manner where the costs have a lower percentage in the profit. This will increase the profits marginally. Many companies may choose to do costing in manner where the profit is shown at a lower cost. This helps them at times of auditing. While at times costing is done in a manner to attract investors. In that case the costing is done in the manner which shows a higher value of profits. Either way, the method of costing chosen plays an important role in making a decision. References Dr. Glen Brown, 1999. Introduction to costs accounting: Methods and Techniques. 1st ed. New York: Globusz Publishing Edward J. Vanderbeck, 2008. Principles of cost accounting. 15th ed. South-Western Pub. Co. Kenneth R. Goosen, 2008. Management Accounting a Venture Into Decision Making. Micro Business Publications Robert F. Meigs, Walter B., 1990. Meigs Accounting: the basis for business decisions. 9th ed. McGraw-Hill Publishers. Adolph Matz, Milton F. Usry, 1980. Cost accounting: planning and control. 7th ed. South-Western Pub. Co. Jerome Lee Nicholson, 2007. Cost accounting, theory and practice: Ronald accounting series. Ronald Press Co. David Russell, Ashok Patel, G. J. Wilkinson-Riddle, 2001. Cost accounting: an essential guide. Financial Times Prentice Hall Steven M. Bragg, 2001. Cost accounting: a comprehensive guide. Wiley publishers. William K. Carter, 2005. 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