Week 2 Everything Flashcards
the 2 cost accumulation systems
Marginal costing systems: Assigns only direct manufacturing costs to cost objects.
Absorption costing systems: Assigns both direct and indirect manufacturing costs to cost objects. Traditional costing system
Under the absorption costing method:
All manufacturing costs (material, labour, variable and fixed overheads) are allocated to products. Non-manufacturing costs are NOT allocated to the products, but charged directly to the income statement. So, under this method, stocks are valued at their total (fixed and variable) manufacturing cost.
Under the marginal costing method:
Only variable manufacturing costs (material, labour and variable overheads) are allocated to products, but fixed manufacturing costs are treated as period costs. Non-manufacturing costs are NOT allocated to the products, but charged directly to the income statement. So, under this method, stocks are valued on variable manufacturing costs.
Absorption costing
Traces all manufacturing costs to products. Treats non-manufacturing overheads as a period cost.
Marginal costing
Traces variable manufacturing costs to products. Treats fixed manufacturing overheads and non-manufacturing overheads as a period cost.
Absorption and marginal costing: Similarities
Similar in terms of treating non-manufacturing costs Both marginal and absorption costing treat non-manufacturing costs as period costs.
Absorption and marginal costing: Differences
Differ in terms of treating fixed manufacturing overhead costs.
Absorption costing includes fixed manufacturing costs to product cost and to inventory valuation. Marginal costing does not include fixed manufacturing costs to product costs and treat them as period costs.
Marginal Vs absorption costing diagram
14/3/19
Relevance of costs for short-term decision making: variable costs
Only variable costs are generally regarded as being relevant for short-term decision making, because they will be affected by a decision.
Relevance of costs for short-term decision making: fixed costs
Fixed overhead costs are generally regarded as irrelevant for short term decision making, because they will not be affected by a decision.
Fixed overhead costs are generally regarded as irrelevant for short term decision making, because they will not be affected by a decision.
Fixed costs:
Have been incurred or committed prior to a decision point and cannot be avoided (e.g., Sunk costs).
Are NOT considered to be the real costs of production.
Are considered as costs which provide facilities that enable production to take place.
Using absorption costing for short-term decision making
As both variable and fixed manufacturing costs are absorbed into products, absorption costing shows the full cost of a unit of product. However, absorption costing is generally not helpful in (short-term) decision making, because it uses information on past fixed overhead costs.
Using marginal costing for short-term decision making
Under marginal costing, fixed overhead costs are regarded as period costs and not part of the product costs. Therefore Product costs only include relevant costs (variable costs) that change by a decision. Product costs do not include irrelevant costs that do not change by a decision.
Profit under absorption and marginal costing
Absorption and marginal costing give different profit figures when inventory levels are changing.
Profit under absorption costing
In absorption costing, closing inventories include variable costs and their share of fixed costs. Share of fixed costs are carried forward to be treated as an expense of following periods, this is the main reason for the difference in profit figures.
Profit under marginal costing
In marginal costing, closing inventories include only variable costs. Whole fixed costs are written off as an expense of the current year, reported profit is not affected by the changes in inventory levels.
The main difference between variable costing and absorption costing is the way in which fixed manufacturing costs are accounted for:
Under variable costing, fixed manufacturing costs are treated as an expense of the period
Under absorption costing, fixed manufacturing costs are inventoriable costs. In our example, the fixed manufacturing cost is $1.20 per metre ($60,000/50,000 metres) produced.
Marginal vs Absorption costing: Effect of inventory changes on profit
14/3/19
Usefulness of absorption costing
Absorption costing is the required inventory method for external reporting in most countries. Absorption costing information may prove useful for long run decisions (such as pricing and product mix) as both variable and fixed manufacturing costs are included in product costs.
Weakness of absorption costing:
Under absorption costing system:
Profits can increase when sales volume declines.
Profits can decline when sales volume increases and costs remain unchanged.
Profits can increase when sales volume declines.
Profits can decline when sales volume increases and costs remain unchanged.
This enables managers to increase operating profit in a specific period by increasing production even if there is no customer demand for the additional production! By doing so managers may get higher bonuses based on absorption costing profit numbers. Higher operating profit may also increase manager’s share-based compensation.
Absorption costing and performance measures
Undesirable build-up of inventories
Managers may seek to manipulate income by producing too many units. Production beyond demand will increase the amount of inventory on hand.
Production beyond demand will increase the amount of inventory on hand.
Resulting in more fixed costs being capitalised as inventory. Leaving a smaller amount of fixed costs to be expensed during the period.
Resulting in more fixed costs being capitalised as inventory. Leaving a smaller amount of fixed costs to be expensed during the period.
Therefore
profit increases and so, potentially, does a manager’s bonus
Undesirable build-up of inventories
A manager may:
Decide to manufacture products that absorb the highest amount of fixed costs, regardless of demand (‘cherry-picking’). Accept an order to increase production, even though another plant in the same firm is better suited to handle that order or defer maintenance.
Absorption costing and performance measures
Proposals for revising performance evaluation
Focus on careful budgeting and inventory planning.
Incorporate a carrying charge for inventory.
Change the period used to evaluate performance.
Include non-financial as well as financial variables in the measures used to evaluate performance
Advantages of marginal costing
Shows consistent profit figures despite changes in inventory levels. Avoids fixed overheads being capitalised in unsaleable stocks. In a period with increasing stocks (when sales volumes are declining, but output is sustained), marginal costing shows lower profits than absorption costing does. Thus, in such periods, marginal costing gives the early profit warning more rapidly than does absorption costing. Provides more useful info for short term decisions.
How does marginal costing assist in short-term decision making?
Marginal costing is the basis for cost-volume-profit (CVP) analysis.
Using the contribution information, marginal costing can be used:
Using the contribution information, marginal costing can be used:
To establish the number of units required to break-even or to make a given profit.
To analyse the margin of safety (how much can the existing level of sales fall before the business starts to make losses).
Whether to make or to buy goods and so on.
The relation between marginal costing and CVP analysis
If the variable cost increases, then the . contribution per unit will decrease. This means that more items will have to be sold in order to reach the break-even point.
If it is possible to reduce costs, then the contribution per unit will increase. This means that the company will reach the break-even point at a lower level of activity and will then be earning profits at a faster rate.
Arguments against marginal costing
In the long rune, prices must cover all costs.
Fixed production costs are incurred in order to make output, it is therefore ‘fair’ to charge all output with a share of these costs.
If a product is only charged with variable costs, it may be difficult to see whether or not it is profitable.
Product pricing may be difficult.
Should we use absorption costing or marginal costing?
Financial reporting rules require that absorption costing is used for external reporting.But for internal reporting purposes, choice of method depends on the purpose of costing. Marginal costing is generally useful for performance evaluation and short-term decision making. Absorption costing is generally useful for longer-term decision making.
