Accounting for decision making

LECTURER-TRACY

SUBMITTED BY-BABITA KC

Table of contents Page no.

Task 1 Task 2 Task 3 Task4 Reference

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To: The Divisional Manager Fro : Manage ent !cco"ntant Date: 15th of March# 2$13. Ref: %ost Manage ent !cco"nting re&ort Task 1 Under absorption costing, cost of goods sold and ending inventory consist only of factory overhead. On the other hand in marginal costing there are no further cost to a central cost of goods sold on inventory is because there are no variable cost of production. However in July the absorption costing profit of 41 , various marginal costing result in profit of ! was # . On the other hand during the month of "ugust the profit for absorption costing . %he &ey to understanding the effect of findings in and marginal costing was $

inventories lies in the accounting for fi'ed factory overhead. Under marginal costing the income statement each period includes the fi'ed manufacturing overhead actually incurred that period. Under absorption costing the situation is more complicated than income statement (the fi'ed manufacturing cost which is part of standard cost of household . )n this stage the difference between profit reported under absorption costing and marginal costing is always e*ual to the difference in the amount of fi'ed manufacturing overhead charged in income statement. +hen the undoing the month of "ugust and the production staff s where in holiday. )n this stage due to lac& of wor&force there were production. )n addition it is also observed that no reduction in production staff resulted in production overhead being under absorbed and this is # under a result of overheads that result in additional fi'ed overhead compared with July been assigned as cost with the "ugust profit statement. ,ut as "ugust being a holiday period, there was short of the staff in production department which resulted in less production, this situation incurred to production overheads being under absorbed and resulted in additional fi'ed overheads. %his is shown in above calculation as the fi'ed overhead volume variance for "ugust is # 14 , which is under-absorption of overhead. "nd so the fi'ed production costs included in absorption costing profit statement reached to after adding the fi'ed production costs incorporated on cost of goods sold for the month of "ugust.

July . . /s0 3$$$ %ost of sales 'absor&tion costing(

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"ugust 33$$

%ost of sales 'variable) arginal costing(

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Fi*e+ &ro+"ction costs incor&orate+ in cost of goo+s sales Fi*e+ overhea+ vol" e variance

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Fi*e+ &ro+"ction costs incl"+e+ in absor&tion costing &rofit state ent Fi*e+ &ro+"ction costs incl"+e+ in &rofit state ent Difference bet,een costing fi*e+ costs arginal costing

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arginal costing an+ absor&tion

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Reconciliation of the +ifference bet,een absor&tion an+ Marginal costing &rofit !bsor&tion costing &rofit

arginal costing &rofits2 2$$ 41 !1 5$$ # !

-*hibit 1: Manage ent !cco"nting &rofitabilit. anal.sis.

Task T,o %o for ent on the vario"s state ent &rovi+e+ b. the anage ent acco"nting. anage ent an+ their i &lication

Statement One: He stated that surely if there is a significant increase in sales this should be reflected in an increase in profits. %he researcher strongly agrees with the mentioned statement. %o avoid mista&es when absorption costing is used for readers of financial statements it gives attention to both fi'ed and variable costs3 that is, all production costs are considered regardless of whether they are variable or fi'ed. "nd, this is very important when it comes to pricing decisions since the manufacturer can have a clear picture of the profit margin to be made on each sale, as all costs would have been incorporated into the product cost. Under absorption costing, if inventories increase, fi'ed manufacturing overhead costs are deferred in inventories, which in turn increases net operating income. )f inventories decrease, fi'ed manufacturing overhead costs are released from an inventory, which in turn decreases net operating income. Statement Two: He pointed out that the process was time consuming and many of these allocations were arbitrary and had the potential to distort the profit margin on individual products. %he researcher strongly agrees with the mentioned statement. %he marginal cost distinguishes between fi'ed and variable costs therefore providing relevant information about costs for decision ma&ing purposes. +hen fi'ed and variable costs are split, it becomes easier to manage costs as it gets clearer to management on how costs behave. 4o, by altering the activity level, for instance, management an choose an optimal production level.5emoves the effect of inventory changes on profit and reduces the danger of dysfunctional behaviour in employees. 6ysfunctional behaviour may occur in the case of absorption costing by encouraging managers to produce more inventory than can be sold. 7roducing for stoc& has the effect of absorbing more fi'ed production overheads, hence reducing the cost of sale. %he reduced cost of sale has the effect of improving the level of reported profits. However, it is possible for such stoc& to tie up capital and even become obsolete. %his is dysfunctional. Statement Three: She pointed out that with the marginal costing system that business would be under taken at margins that exceeded the variable cost but they may not provide a sufficient contribution to covering fixed cost or generating sufficient profit. %he researcher strongly agrees with the mentioned statement. %he marginal 8ost of product is its variable cost. )t includes direct materials, direct labour, direct e'penses and the variable
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part of over heads. %he term marginal costing has been defined as the ascertainment of marginal cost and the effect of profit or changes in volume or type of output by differentiating between fi'ed costs and variable costs. ()n the techni*ue of costing only variable cost and charges to cost units and fi'ed costs are to be written of against contribution for that period contribution is nothing but the e'cess of sale price over marginal cost.

Statement our: Therefore it would be necessary to operate both marginal and absorption costing systems!one for internal profit measurement and other for external profit measurement. %he researcher strongly agrees with the mentioned statement. Marginal costing for e*ternal &rofit 1. 8ost 8lassification2 %he marginal costing techni*ue ma&es a sharp distinction between variable costs and fi'ed costs. )t is the variable cost on the basis of which production and sales policies are designed by a firm following the marginal costing techni*ue. !. 4toc&9)nventory :aluation2 Under marginal costing, inventory9stoc& for profit measurement is valued at marginal cost. )t is in sharp contrast to the total unit cost under absorption costing method. #. ;arginal 8ontribution2 ;arginal costing techni*ue ma&es use of marginal contribution for mar&ing various decisions. ;arginal contribution is the difference between sales and marginal cost. )t forms the basis for <udging the profitability of different products or departments

!bsor&tion costing for e*ternal &rofit: "bsorption costing principles must be used when preparing financial statements for e'ternal purposes. One of the &ey principles of absorption costing is that inventory and units

produced must include a share of all production costs, both fi'ed and variable, incurred in getting them to their present condition .,arrett,! $0.

%he difference between the profit figures calculated under absorption and marginal costing principles is caused by the treatment of fi'ed production overheads. )n marginal costing the full amount of fi'ed production overheads is written off in the period that it occurs. )n absorption part of the fi'ed production overheads is carried between accounting periods as part of inventory valuations. Statement ive: She suggested an activity based costing system as an alternative method

for costing that could be considered. "ctivity based costing .",80 is a managerial accounting system that estimates the cost of products and services by assigning overhead costs to direct costs. %his costing method assigns the cost of each activity in an organi=ation to all products and services according to the actual consumption of the activity resource by the product or service. %his is a mar&ed departure from the practice of sharing overheads costs e*ually or overheads becoming part of the overall profit-loss estimate instead of component product pricing. )n contrast to traditional cost accounting systems, ",8 systems first accumulate overheads for each organisational activity. %hey then assign the costs of these activities to products, services or customers .referred to as cost ob<ects0 causing that activity. %he initial activity analysis is clearly the most difficult aspect of ",8. "ctivity analysis is the process of identifying appropriate output measures of activities and resources .cost drivers0 and their effects on the costs of ma&ing a product or providing a service. ",8 systems have the fle'ibility to provide special reports so that management can ta&e decisions about the costs of designing, selling and delivering a product or service. %he &ey aspect is that ",8 focuses on accumulating costs via activities, whereas traditional cost allocation focuses on accumulating costs within functional areas. %he main advantage of ",8 is that it minimises or avoids distortions on product costs that might occur from arbitrary allocation of overhead costs. %he ma<or advantage of activity based costing is the ability to estimate the cost of individual products and services precisely. ,y transferring overhead costs to individual units of products or services, ",8 helps identify inefficient or non-profitable products

Task 3 !bsor&tion costing2 )n absorption costing system the >'ed production costs for a period are shared across the output for that period. %herefore, a product/s costs will consist of its variable costs, .direct materials, direct labour, and variable .direct0 production overheads0 plus a share of >'ed production overheads. 8losing stoc&s and wor& in progress will
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therefore include a share of the current period/s overheads. "s a result, some of the current period/s >'ed costs will be carried into the ne't period/s production cost of sales . Marginal costing: )n marginal costing system a product/s production cost is its variable production cost. %herefore, any unsold production, i.e. closing stoc&s or wor& in progress, will also be valued at its variable production cost. 8ontribution will be revenue less the variable cost of sales. %he variable cost of sales is the variable production cost of the goods or services sold in a period plus any variable selling and distribution costs."ll the >'ed costs for a period will be charged to that period/s pro>t and loss account !rg" ents in favo"r of absor&tion costing .a0 ?i'ed production costs are incurred in order to ma&e output3 it is therefore @fair@ to charge all output with a share of these costs. .b0 8losing inventory values, include a share of fi'ed production overhead, and therefore follow the re*uirements of the international accounting standard on inventory valuation '/!01 /nternational !cco"nting stan+ar+s 2(. .c0 "bsorption costing is consistent with the accruals concept as a proportion of the costs of production are carried forward to be matched against future sales. .d0 " problem with calculating the contribution of various products made by an enterprise is that it may not be clear whether the contribution earned by each product is enough to cover fi'ed costs, whereas by charging fi'ed overhead to a product it is possible to ascertain whether it is profitable or not. %his is particularly important where fi'ed production overheads are a large proportion of total production costs. Aot absorbing production would mean that a large portion of e'penditure is not accounted for in unit costs. !rg" ents in favo"r of .a0 )t is simple to operate. .b0 %here are no apportionments, which are fre*uently done on an arbitrary basis, of fi'ed
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arginal costing

costs. ;any costs, such as the mar&eting director@s salary, are indivisible by nature. .c0 ?i'ed costs will be the same regardless of the volume of output, because they are period costs. )t ma&es sense, therefore, to charge them in full as a cost to the period. .d0 %he cost to produce an e'tra unit is the variable production cost. )t is realistic to value closing inventory items at this directly attributable cost. .e0 Under or over absorption of overheads is avoided. .f0 ;arginal costing provides the best information for decision ma&ing. .g0 ?i'ed costs .such as depreciation, rent and salaries0 relate to a period of time and should be charged against the revenues of the period in which they are incurred. .h0 "bsorption costing may encourage over-production since reported profits can be increased by increasing inventory levels. F2R3!RD )f there are changes in inventories during a period, marginal costing and absorption costing systems will report different profit figures. )f inventory levels increase, absorption costing will report a higher profit than marginal costing. %his is because some of the fi'ed production overhead incurred during the period will be carried forward in closing inventory .which reduces cost of sales0 to be set against sales revenue in the following period instead of being written off in full against profit in the period concerned. )f inventory levels decrease, absorption costing will report the lower profit. %his is because as well as the fi'ed overhead incurred, fi'ed production overhead which had been brought forward in opening inventory is released and is included in cost of sales. )f the opening and closing inventory volumes and values are the same, marginal costing and absorption costing will report the same profit figure. )t is important to appreciate that the differences in reported profits occur only in the short run, in this stage in reporting the profit of individual accounting periods. )n the long run, the total reported profit will be the same whether marginal or absorption costing is used. %his is because in the long run, total costs will be the same by either method of accounting. 4hort term differences are the result of changes in the level of inventory)."llot,! 40.

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Reco

en+ation

)n spite of the arguments in favour of marginal costing as a decision ma&ing tool, absorption costing is widely used for general accounting purposes and inventory valuation. ?i'ed production costs should ultimately be charged to cost units in a fair and meaningful way. " central problem in cost accounting is to identify the best method of attributing these costs. )n the following few chapters we shall loo& at new approaches developed to address the wea&nesses of both marginal and absorption costing.

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Task 4

!bsor&tion costing or full costing fi'es the cost of a finished unit in inventory as the sum of cost of direct materials, wages of direct labor, and both variable and fi'ed manufacturing overheads. 8ost of a product unit under absorption costing B cost of direct materials C direct labor C variable manufacturing overheads C .fi'ed manufacturing overhead costs9units produced0. !ctivit.1base+ costing .",80 identifies activity centres in an organi=ation and assigns costs to product units based on the number of activities used by each product unit. ",8 ascertains the purpose of each activity or service and assigns the cost of such activity or service to the product or service unit that demands such activity.

%he compare and contrast between absorption costing and activity based costing lies in the approach, methodology, and scope of these two cost accounting systems.

Difference in !&&roach %he ma<or difference between absorption costing vs. activity based costing is the approach. "bsorption costing allocates costs to product units, whereas activity based costing traces the costs of product units. "bsorption costing is the traditional cost accounting method that focuses on the product or service when fi'ing costs. )t wor&s under the simple approach of assigning resources to products or services directly. 6ifference in ;ethodology "bsorption costing divides e*ually the fi'ed overhead costs with the number of product units whereas activity based costing identifies the actual proportion of fi'ed overheads costs incurred by the product unit. 8omparing absorption costing vs. activity based costing, the latter follows a more scientific approach. 7rice fi'ation in absorption costing depends on the inventory. %he higher the inventory, the lower the product cost and lower the inventory3 or the higher per-product cost. 7rice fi'ation in activity based costing bases calculations to derive the actual overheads incurred on a unit, and does not vary with change in inventory levels .6rury,! D0.
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"ctivity based costing, however, faces serious challenges in practical application, for appropriating some of the fi'ed overheads such as the chief e'ecutive@s salary on a perproduct usage basis, is ne't to impossible. ;oreover, process of data collection, data entry, and data analysis re*uired to divide the fi'ed overhead costs among units based on usage, re*uires substantial resources and remains costly to maintain. "bsorption costing that divides all fi'ed overhead costs with the number of units produced is a simple and easy approach and free from such comple'ities. Eegal :alidity "bsorption costing complies with the generally accepted accounting principles .F""70 whereas the ?inancial "ccounting 4tandards ,oard .?"4,0 and )nternal 5evenue 4ervice .)540 do not accept ",8 for e'ternally published financial statements. ?irms that follow activity based costing, therefore, need to maintain two cost systems and accounting boo&s, one for internal use, and another for e'ternal reports, filings, and statutory compliance. Difference in 0co&e "bsorption costing helps ascertain the overall profitability or efficiency of the manufacturing system but fails to provide the real cost of individual product units. "ctivity based costing mirrors the functioning of the enterprise and contributes to strategic decision-ma&ing processes. ",8 provides the real cost of individual product units and, thereby, helps identify inefficient or non-profitable products that eat into the profitability of other highly profitable products. ",8 also helps price products e*uitably, allowing brea&ing down of product or service into sub-components or offering Gtop upsH based on customer needs.Hung,! 110. 8omparing absorption costing vs activity based costing, activity based costing improves the *uality of management accounting information, especially in large and multi-product operations where conventional overhead allocation methods such as absorption costing may produce misleading results. "bsorption costing, however, remains more suitable for small firms and enterprises with homogeneous products or services.

Reference
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"llott, ".!

40. "ctivity ,ased ;anagement can wor& for your company. 8);" )nsight,

"vailable from2 www.cimaglobal.com9insight I"ccessed 4th ;arch ! 1#J. ,arrett, 5..! $0 How ",8 can ma&e shared services wor&. 8);" )nsight,

"vailable from2 www.cimaglobal.com9insight I"ccessed !nd ;arch ! 1#J. 6rury,8..! D0 ;anagement and 8ost "ccounting, Kth Ldition, 4outh-+estern

Hung,8..! 110, ""% 7aper # ;anagement "ccounting, ?irst Ldition, 7rentice Hall

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