Sales of Bohemia Industries are more in the month of August as compared to July but the monthly report states a less profit in comparison. The company is considering an alternative system that represents the profit in a convinced manner. In this regard the management has three options, Marginal Costing, Absorption Costing and Activity Based Costing. The following report compare and contrast the three systems and recommend as to which system the company shall apply.
Marginal and Absorption costing systems results in the reporting of different Profits
Absorption costing comprises two types of costs variable and fixed production costs. In absorption costing, inventory at the end of the period and cost of sales are valued at complete production cost. Gross profit is achieved when the cost of sales is subtracted from sales. Hopper, T.; Major, M. (2007)
Marginal costing is also known as variable costing. It includes variable costs in the cost units and fixed costs are treated as period costs, which are written off in the profit statement of the period to which they relate (Lucey 2002). Under marginal costing, closing inventory is valued at variable production cost only. The contribution is obtained when the variable cost of sales is deducted from sales.
Reason for different profit under marginal and absorption costing
At times when there is no stock at the commencement and the end of a period or during the period, both of the systems will present the same figures of profit for the period. But when there are changes in the stock levels, result will be in different profits under the two systems. The differences are credited to the moment in time of when overheads of fixed production are expensed. If the stock level is increasing, then the earnings under absorption costing will be higher for the reason that a larger sum of overheads of fixed production in the stock at the period end is being subtracted from the expenses of the period than is being carried in the starting stock for the period. If stock level is lessening, at that time the earnings under marginal costing will be higher for the reason that a large sum of overheads of fixed production are carried forward as in the starting stock than is being subtracted in the final stock adjustment. The same has happened in the Exhibit 1 where the inventory valuation is decreasing i.e. from 6300,000 to 5700,000 (absorption costing) and 4200,000 to 3800,000 (Marginal costing).
Various Statements made by each of the manager and their Implications:
In the particular situation Vaughan's initial statement was regarding Absorption costing which comprises both fixed and variable production overheads in the cost units.
The opinion used in favor of absorption costing is as follows:
Fixed costs are for the production purpose and devoid of those amenities it would not be would not be possible to produce. As a result such expenses can be connected to production and should be incorporated in inventory assessment.
Absorption costing pursues the concept of matching by moving forward a sum of the production cost in the inventory estimation to match adjacent to the sales worth.
At the time when the items are sold. It is essential to take in fixed cost in inventory values for statements usual accounting, by means of absorption costing create inventory values which comprise a split of fixed costs.
Fixed cost allocation is the feasible way of finding job costs for approximation of prices and earnings scrutiny.
Analysis of under absorbed and over absorbed fixed cost is helpful to recognize incompetent use of production wherewithal.
As, in absorption costing, final stock at the period end and production cost of sales are appreciated at complete cost of production, because of under absorbed fixed cost profit decreases.
To delight his manager Owen about divisional performance, he gave point of view in the support of Marginal costing, as in marginal costing; stock at the yearend is appreciated at changeable cost of production only. Cost of sales, of sold cost units, is valued at variable cost, which possibly will comprise manufacturing and non manufacturing costs. The contribution is attained when the changeable cost of sales is subtracted from sales.
For this reason by using marginal costing approach sales volume discrepancy does not occur and earnings figures were enhanced.
By critical investigation of the particulars we came to know that here absorption costing is not showing the apparent image of Bohemia Industries earnings as, the fixed overheads do not alter as a consequence of a transform in the level of activity. For that reason such costs cannot be linked to production and should not be incorporated in the inventory estimation.
The addition of fixed costs in the inventory evaluation disagrees with the prudence concept, hence these costs are written off for that period. And since marginal costing give emphasis to per unit variable costs and fixed costs in total while absorption costing take in all production costs to work out unit cost. Marginal costing hence reproduces the performance of costs in relation to commotion. As most decision-making troubles engage changes to activity, marginal costing is more suitable for short run decision building preferable for interior management and decision making rationale than absorption costing.
Furthermore the financial director worries about formation of uncertainty is not that much convincing for the reason that companies do regularly uses separate accounting techniques for their earnings valuations. The simple need is they be supposed to have the personnel who know fine to run these accounting systems.
Director's proposal of using ABC is of substantial significance in comparison to the other costing techniques it is a more fundamental and novel approach to cost investigation and cost managing. Certainly, this technique can be well-organized and obliging depending upon its attempt and know-how that is put into the ABC plan and function.
By using ABC it can offer many paybacks for organizations as it provides more precise production line costs particularly when non-volume type costs are larger than the other costs; and a variety of dissimilar products are made. As in case of Bohemia industries by using ABC manager can with no trouble assess the two Products i.e. A51, A55 which is more cost-effective and how to handle the cost linking to both independently. In addition, ABC is more adaptable to decide costs by cost objectives to a certain extent than like the other techniques, which examine outlay by procedure, customers and many others. Also, ABC provides a additional dependable sign of how unstable production costs are in the extensive run so that executives can map in advance more productively. Furthermore, ABC provides vital monetary and non monetary information, which are advantageous events for cost supervision and performance evaluation at operational levels. Managers are in addition capable to recognize and appreciate how costs work and are then able to perk up cost inference.