Managers as well as accountants need financial information to help them make managerial and accounting decision that are very crucial for both internal and external consumers of this information (Drury 2008). To be successful in this area both managers and accountants need to have full understanding on the different types of cost and their calculations. There are different ways of classifying cost for example, manufacturing costs verses Non-manufacturing costs, fixed costs versus variable cost and finally product cost versus period costs. The most important thing that managers and accountants need to know is how to treat variable costs and fixed costs. Valuation of stock is always and therefore difference in profit. Treating cost to variable and fixed cost require segregation (Burgstahler 2008). There are assumptions that managers must understand when considering segregating variable cost and fixed costs. The first assumption is that fixed cost is constant irrespective of volume of production. The second assumption is that variable costs vary with the volume of production and the cost per unit remains constant (Horngren 2009).
Product costs are those cost that can identify with the product such as direct material or direct labour. Product costs vary with production. On the other hand, period costs are those costs that associates with time not like product costing a good example is yearly insurance. In most cases, period costing of fixed cost in a given period (Horngren 2009). With proper understanding of these types of costing, managers are able to use both marginal costing and absorption costing (Ittner 2010). The two costing methods are different in various ways. Marginal costing which is also known as variable costing treats charge variable manufacturing costs to product costs. Marginal costing also treats fixed cost, regardless of whether they are manufacturing or they are non-manufacturing, as period costs (Drury 2008). Absorption also called Full costing treats manufacturing costs, regardless of whether they are variable or fixed, as product costs (Horngren 2009). On the other hand, non-manufacturing considered period costs in absorption costing method. The two costing methods have advantages and areas of their undoing. The most important advantages and disadvantages of marginal and absorption costing are as shown below:
Advantages of Marginal Costing
Marginal costing method is very easy to understand and use. Shareholders who do not have skills on accounting methods can comfortably understand. All users both skilled and unskilled find this method easy to use and interpret.
Marginal costing plays critical role in analysis of break-even, especially when looking for the unit cost and the number of possible units needed (Drury 2008).It incurs fixed cost after a period, they do not form part of stock valuation, and this gives a realistic calculation that can give objective analysis for decision-making.
Gives more calculation that is realistic on profit as costing done after a given period. It gives contribution a critical consideration (Zaman 2009). This is not as it is in the absorption costing method.
Decision on special orders is possible with marginal costing since it pricing method relates to variable costs and fixed costs subtracted from contribution. Marginal costing also helps solve problems that may arise from fixed costs as unit cost can be easily predetermined (Drury 2008).
It requires apportionment of overhead costs. This is more subjective basing on the relationship of fixed cost and departmental activity. Through marginal costing, managers are able to avoid over or under-absorption of the overhead costs. This normally happens when level of activity is different from the pre-planned level. Managers find it better when dealing with a specific decision and in panning.
Problems of Marginal Costing
There exists impracticability when it comes to segregating manufacturing overheads and other costs into fixed and variable costs. It makes it very difficult to
It excludes fixed manufacturing cost from production cost. This may give wrong impression to the users of this information.
Advantages of Absorption Costing/Total Costing
Absorption costing help managers and accountants calculate realistic profits. It considers fixed cost as intricate part of production. It comprise of all needed costs of production. This was not true in the case of marginal costing. Unlike in marginal costing, absorption-costing losses do not occur in losses especially when there are low sales and with the fixed cost written off when sales completes later (Horngren 2009). This does not lead to distortion in absorption costing.
Better information given by absorption costing with regard to product pricing since it incorporates both variable and fixed cost in its calculations. It solves the problem of marginal cost where the prices go low with reduction in operation capacity. This always led to a problem with customers as they may expect low prices even when the operations of the firm are improved. It follows matching concept by ensuring that manufacturing costs of goods sold can compared to the revenue from sales (Healy 2009). It is this reason that reporting standards, by financial users prefer absorption costing to marginal costing.
Absorption enables pricing strategy in cost-plus method of pricing. As a going concern of the business continues, there is an assurance of profitability of the business and survival. This can only be possible when the prices cover fixed costs.
Problems of Absorption Costing
Absorbing manufacturing overhead fixed cost to those of product units by way of absorption overhead rate may always lead to arbitrary calculations. This gives difficulties and stress to the management and accounting team when making decisions.
Management may decide to manipulate profits that needed by the public by simply making little adjustments in the stock level in the short period of operations. According to Choi (2010), the closing inventory is piled up at the year ending creating a wrong impression that the profit increased by 10%. This can also cause the business legal fee if the information is to help the business avoid taxes unlawfully.
Most managers and accountants find absorption costing method to be very difficult to understand and sometime make errors when using it. Those who do not have accounting knowledge, such as shareholders without accounting skills, find this method of costing very difficult to understand. Like in the case of CricSmart, the understanding of this costing method seems to be the genesis of all misunderstandings.
Absorption method the business made a profit of £ 6500 in the year ended 2012.In 2013, absorption method of costing shows that CricSmart business made a loss of £4562. However, the figures by marginal costing method show a different case. The business made a profit of £1000 in the year ending 2012 and profit dropping to £938 by the year ending 2013. In either cases the there is a decreasing trend in the performance in terms of the operating profit. The decline in profit prompted the ownership of CricSmart to look for Mr. Cook to help lift up the face of the business.
The decision by management team not to pay Cook was informed by the figures in the two accounting method (Lucey 2009). With absorption showing a negative profit (loss), and marginal showing a drop by £ 62, Cook deed not attain the agreed percentage that was set by management which was 10 percent increase on the profit of the business by the year ended in December 2012. In as much as this is true, there is need to consider the fact that the fixed cost that Mr. Cook has no control is so high that it may be difficult to make greater difference on the profitability of the business (Zaman 2009). There should be other things of concern other than the increase in profit figures. Mr. Cook worked hard to improve sales from 10000 units to 11000 units and rational owners should be able to consider this an improvement that to be rewarded. Increase in sales should be able to imply an increase in profit unless the fixed cost is too high.
There are a number of activities that managers are able to control and those that are very difficult or simply not within the power of managers (Latham 2010). When the managers are obliged to reward according to their performance, there is need to take into consideration of those that the managers are able to control and those that are within their powers. Managers need to be given reasonable and achievable goals for which when achieved they are suppose to be rewarded either financially or by use of non-financial rewards (Kaplan 2011). Proponents of non-financial performance argue that these rewards give managers chance to focus on impacts of their actions in the end. They believe that short-term incentives are to stimulate short-term performances. As in the case of Mr. Cook of CricSmart, the management promised a short-term incentive, inform of bonus. He therefore concentrated on the short term a performance, which was to increase sales, and did not check on how to reduce the level of fixed cost.
List of References
Banker, D, 2012, “A Field Study of the Impact of a Performance Based Incentive Plan.” Journal of Accounting and Economics vol. 21, pp. 195-226.
Burgstahler, D, 2008, Introduction to Management Accounting, Prentice Hall, Upper Saddle River.
Choi, S, 2010, International Accounting, Prentice Hall, New Jersey.
Drury, C. 2008, Management, and Cost Accounting, Cengage Learning London.
Healy, P, 2009, “The Effect of Bonus Schemes on Accounting Decisions.” Journal of
Accounting and Economics vol. 7: pp. 85-107.
Horngren, C, 2009, Cost Accounting: A Managerial Emphasis. Upper Saddle River: Prentice Hall.
Kaplan, R, 2011, The Balanced Scorecard – Measures that Drive Performance, Harvard.
Ittner, C, 2010, “Are Nonfinancial Measures Leading Indicators o Financial Performance? An Analysis of Customer Satisfaction.” Journal of Accounting Research vol. 36, pp. 1-35.
Lucey, T, 2009, Costing, South‐Western Cengage Learning, London.
Latham, 2010, A Theory of Goal Setting and Task Performance, Englewood-Cliffs: Prentice-Hall.
Zaman, M. 2009, Survey “The role of financial and non-financial performance evaluation measures for management control over foreign subsidiaries,” Faculty of Economics, Ljubljana.