Calculation of Absorption Costing and Marginal Costing of Simpson Ltd - Assignment Example

Introduction: Simpson Ltd. Wanted to manufacture and sell 30,000 units of its product in the year 2007 for which, the marketers estimated that there would be a demand slow down in that year and as such 30,000 units could not be sold easily. However, the management wanted to increase the demand by increasing the production of the product and as such produced 45,000 units with a thought that by putting the pressure, the selling agents could push the products more than the estimated sales into the market. However, only 20,000 units could be sold for which the profit ascertainment under both the absorption costing and marginal costing is calculated below: Income Statement of Simpson Ltd. For the year 2007 under absorption costing: Particulars Amount in £ Amount in £ Sales (20,000 units @£35 per unit) 700,000 Less Cost of goods manufactured: Variable costs (45,000 Units @£15 per unit) 675,000 Fixed Manufacturing costs (45,000 units @ £10 per unit) 450,000 Cost of Goods Manufactured: 1,125,000 Less: Closing Stock: (Exp. 1) 625,000 500,000 Less: Fixed Manufacturing overheads, over absorbed: (Exp. 2) 150,000 350,000 Gross Profit: 350,000 Exp. Implies Explanation. Explanation – 1: Working notes for Closing Stock valuation: Closing stock in units: No. of units produced – No. of units sold = 45,000 – 20,000 = 25,000 units. Valuation for 25,000 units = (25,000/45,000) x Cost of Goods Manufactured: = (25,000/45,000) x 1,125,000 = £625,000 Explanation – 2: Working notes for Fixed Manufacturing overheads, over absorbed: Fixed manufacturing overheads calculated for 45,000 units – Fixed manufacturing units incurred. = 450,000 – 300,000 = 150,000. Income Statement for Simpson Ltd. For the year 2007 under marginal costing: Particulars Amount in £ Amount in £ Sales (20,000 units @ £35 per unit) 700,000 Variable Costs: (45,000 unit @£15 per unit) 675,000 Less: Closing Stock (25,000 units @£15 per unit) 375,000 300,000 Contribution: 400,000 Less: Fixed Costs (given) 300,000 Net Profit: 100,000 (Shim. J. & Siegel. K., 1999). Comments on the effect of using absorption costing: Simpson Ltd has produced more than its estimated sales volume. Hence closing stock got piled up which could be avoided if they would have followed methods like just in time inventory system, regular delivery system etc to reduce the stock holding costs (Chadwick. L., 1998). As of now, in this case, since the sales volume is lower than the production volume, the profit is higher in absorption costing than in marginal costing. This is because of higher valuation for the closing stock in absorption costing than what is valued in the marginal costing. The difference of increase in closing stock valuation is attributable to the fixed expenses charged to the cost of goods manufactured in the absorption costing while in marginal costing, the same are not being charged as it is guided by the contribution principal of sales less variable costs. Hence, as the costs of goods manufactured is more in absorption costing, naturally, its closing stock valuation would also be higher which is deducted from the actual sales (through deduction in the cost of goods manufactured) indirectly thereby increasing the profit figure. In this way, the profit figure gets inflated in the case of absorption costing than in marginal costing thereby misleading the management about the higher profit figures than what is really earned if we observe the data for only one term. However, as this closing stock gets utilized in the next period, if the production is lesser in that period, the absorption costing would record lesser profits than that of the variable costing thus nullifying the differences arising in this term. In this way, there is no difference in the reporting of the profit figures if taken on a long term basis in both the systems. (Walker.J. & Burke. L., 2003). Explanation of the two costing methods: Absorption costing is used for external reporting purposes as mandated by the financial statements under the guidelines of the generally accepted accounting principles (GAAP). For internal purposes, managements usually take the help of the marginal costing for making crucial decisions regarding their businesses. Though both the methods are used interchangeably, an explanation of both these methods will throw light upon their utility. Basically, costs are divided into manufacturing or the direct costs which are directly incurred during the production process like the raw material, labor cost etc. and non-manufacturing costs which are indirectly related to the production process like the selling and administrative costs. In both the cases, some costs increase with every increase in the unit of output and such costs are called the variable costs, while some costs stay constant for a relevant range of the production, called the fixed costs. The graph below shows the behavior of variable and fixed costs: In absorption costing, both variable and fixed costs which are directly related to the manufacturing process form the basis for the determination of the unit cost and are deducted from the total sales to arrive at the net income. On the other hand, only variable costs whether manufacturing or non-manufacturing are deducted from the sales to arrive at the unit cost and contribution margin. Fixed expenses are later deducted to get the net income. An example would explain this more clearly: Absorption costing Amount Unit Cost Variable Costing Amount Unit Cost Sales (1000 units) 800,000 $800 Sales (1000 units) $800,000 $800 Less: Cost of goods 550,000 $550 Less: Variable _________ ________ manufacturing costs $325,000 $325 Gross Profit $250,000 $250 Less: Variable Less: selling & Selling & Admn. Distribution exp. costs: $100,000 $100 Variable $100,000 $100 _________ _________ Fixed $50,000 $50 Contribution: $375,000 $375 _________ ________ Less: Net Income $100,000 $100 Fixed Manufacturing costs: $225,000 Fixed Selling & Administration costs $50,000 _________ (Myers. G., 2009) Net Income 100,000 In the above illustration, both the net incomes are the same because there is no closing stock adjustment in the problem. If closing stock adjustment is given, then naturally, as some of the unit cost under absorption costing includes fixed costs, the closing stock also carries certain amount of the fixed cost of this year into the next reporting period thereby causing a mismatch with the marginal costing figures. For instance, in the above example, if we take that 200 units were left as closing stock, the income statements would differ as follows: Absorption costing Amount Unit Cost Variable costing Amount Unit Cost Sales (1000 units) $800,000 $800 Sales (1000 Units) $800,000 $800 Less: COGS: Less: Mfg. Costs $550,000 Variable costs $425,000 $425 _________ ________ _________________ Gross Profit $250,000 $250 $375,000 $375 Less: Add: Closing Stk. $75,000 $75 Selling & Dist. Exp. $150,000 $150 (200 Units) _________________ _________ _________ Contribution: $450,000 $450 Net Profit $100,000 $210 Less: Fixed Costs: $275,000 $275 Add: Clg. Stk. $140,000 $140 _________________ (200 Units) _________________ Net Income $175,000 $175 Net Income $240,000 $240 In the above example, it is noted that because valuation of the closing stock includes the fixed manufacturing costs also in the case of absorption costing, the profit reported has been inflated in comparison to the net income reported in the case of marginal costing, the reason being the non-inclusion of fixed expenses. The fixed expenses are apportioned based on some apportionment basis like the machine hours, output units etc. (Harper. W.M. 1995). In case of such apportionment, sometimes, the fixed overheads incurred may be more or less than what is apportioned for and the variance between the overhead incurred and apportioned shows the efficiency of the management thus making absorption costing more meaningful. But, at the same time, under absorption costing, if more closing stock is held up, more will be the inflated profit in comparison to the reported figures according to the marginal costing and vice versa. However, in the long run, all these discrepancies get settled as the reported closing stock values of this year become the opening stock for the next year implying a disadvantage for the absorption costing as the fixed costs of this period get carried into the next period thereby deflating the profits in that period. The time taken for the equalization of profit figures of both the methods will depend more on the volume variances in the production and sale processes. If more products are sold, faster can the reconciliation be done and if the sales are slow with increased production volumes, the reconciliation would be rather difficult. (Anonymous, 2009). Analysis of the strengths and weaknesses of the two costing methods: Strengths of absorption costing in the financial accounting aspect: It helps in the suitable determination of a pricing policy depending on the production costs and ensures that all costs (variable and fixed) are covered while taking a pricing decision. For seasonal and future sales cases, absorption costing is more suitable as it covers the right period costs of production also thereby confirming to the accrual and matching concepts. It is recognized by all the accounting bodies of the entire world and is also in line with the GAAP. Weaknesses of absorption costing in the financial accounting aspect: As the fixed costs are also included in the unit cost calculation, the unit cost differs with the different levels of output thereby making it difficult to ascertain a particular per unit cost for the product. Hence, comparison of unit costs within two periods and controlling of the costs becomes quite tedious. Flexible budgets cannot be prepared without the distinction between the variable and fixed costs clearly outlined which is not done in absorption costing. The fixed costs of one period get carried into the income statements of the other period as the closing stock represents the fixed costs of the period in which it has emerged. Hence, accounting statements would realize the expenditure already incurred in the previous period in this period which is against the principle of conservatism which professes that all expenditure should be recorded as and when they are incurred. (Fitzgerald. R., 1999). Strengths of absorption costing in the managerial accounting aspect: It does not go in for separation of costs on the basis of their behavior of fixed and variable thus making the accounting quite simple. The underutilization and overutilization of the fixed overheads depict the standard of efficiency of the particular organization. It ascertains the costs in the department or cost centre perspective thus making the managers responsible enough for the performance of their particular department. Weaknesses of absorption costing in the managerial accounting aspect: Apportionment of costs has to be done on arbitrary methods which sometimes may lead to wrong calculation of unit costs depending on which the pricing policies would be determined. Due to the inclusion of the fixed costs in the per unit cost calculation, the closing stock prevalence inflates the profit figures which may be misleading to the management. They also cannot take any decisions in situations like make or buy, product mix selection, accurate pricing decision processes etc. Fixed costs are almost dead costs unless there is an opportunity cost attached to them as they are incurred irrespective of the volume of production and sales. In fact, instead of fixed costs, if the opportunity cost is measured as in the case of valuing economic profit, the profit figures would be more realistic. (Anonymous, 2004). Strengths of marginal accounting in the financial accounting aspect: The closing stock valuation is based only on the variable costs incurred and hence, do not represent carry forward of period costs into the next period. The tedious calculations of recovery rates for fixed overheads can be done away with. It is very simple to calculate and understand and hence is liked by many accountants even though there is no statutory stipulation for following this method. Weaknesses of marginal accounting in the financial accounting aspect: Determination of a particular expense into fixed or variable may sometimes be cumbersome. Expenses which are semi-variable in nature are posing high difficulty in calculating the marginal profit. With the mechanization of the manufacturing concerns, fixed overheads account for more costs incurred than the variable costs. Hence, per unit cost may be very cheap while the reality is that the total expenses incurred are very huge which may not be covered if pricing decision is taken on the basis of variable overheads. In case of contingencies like, full loss cannot be recovered by the insurance agencies if per unit cost is calculated on the basis of marginal accounting. Sometimes, small orders are taken up by the organizations if they feel that the pricing of that product is enough to cover the variable costs. However, in the long run, there is every danger that their products could be low ranged permanently. Strengths of marginal costing from the management accounting aspect: Marginal costing emphasizes that per unit cost of a product is related to its sales volume rather than to its production volume. It controls the variable costs which if ignored can destroy the profitability of the firm. It is helpful in much managerial decision making like pricing of a product, choosing the right product mix, make or buy situations etc. It helps to achieve the break even analysis, P/V ratio and is also the base for standard costing and budgeting techniques. The dimension of time is achieved that the data of the past is easily used for the future decision making and even the frequency of such reporting could be increased due to simplicity of the accounting methodology. (Drury, 2008). Weaknesses of marginal costing from the management accounting aspect: Due attention is not given for the time factor while calculating the unit costs. Distinguishing and apportionment of variable costs is in itself very cumbersome. In contract accounts and heavy industries like ship building industry, applying the marginal costing concept is quite difficult. Work-in-progress cannot be accurately calculated due to the confusion in the apportionment of the variable and fixed costs. Conclusion: It is concluded that both the methods have their own advantages and disadvantages and absorption costing method is followed by the organization while the same organization also applies marginal costing technique to be sure about the results achieved. Along with accurate decision making, standardization of the income statement could be possible by following the two methods. Any discrepancies of over or under reporting profits or losses would always be curbed in the long run. References: Book Bibliography: Jain S.P. & Narang K.L. (2005). Cost Accounting Principles and Practice – Absorption costing and Marginal Costing. New Delhi. Kalyani Publishers. Pgs. V-3 – V – 21. Book References: Chadwick. L. (1998). The costs involved in holding the stocks. Management Accounting.-2nd edition. U.K. International Thomson Publishing Inc. Drury. C. (2008). Differences between financial accounting and management accounting. Management & Cost Accounting. U.K. Pat Bond. Pg. 7. Fitzgerald. R. (1999). Follow the best accounting Practice. You don’t need an accountant. Ireland. Black Hall Publishing. Pg. 72. Harper. W.M. (1995). Absorption Costing. Cost & Management Accounting. London. Pitman Publishing. Shim. J. & Siegel. J. (1999). Determinatin of Cost Behavior Patterns. Theory & Problems of Managerial Accounting. – 2nd edition. New Delhi. Mc. Graw Hill Co. Pg. 54. Walker. J & Burke. L. (2003). FMAF Final Level. Management Accounting fundamentals. New Delhi. Viva Books Private Ltd. Internet References: Anonymous. (2004). Economic Profit. Risk Glossary.com 26th April, 2009. Available: http://www.riskglossary.com/link/economic_profit.htm Anonymous. (2009). Reporting techniques in support of managerial decision making. Principles of accounting.com. 26th April, 2009. Available: http://www.principlesofaccounting.com/chapter%2023.htm Myer. G. (2009). Absorption vs. variable costing. School of Business. Pacific Lutheran University. 26th April, 2009. Available: http://www.plu.edu/~myersgm/absorption_vs__variable_costing.htm Read More