Advantages Essay

Statements and obscure the effect Of increasing or decreasing sales. 3. Comparison between products can be misleading because of the effect of Arab tertiary apportionment of fixed costs. Where two or more products are manufactured in a factory and share all production facilities, the fixed overhead can only be apportioned on an arbitrary basis. 4. Marginal costing emphasizes variable costs per unit and fixed costs in total whereas absorption costing accounts for all production costs to calculate unit cost.

Marginal costing there fore reflects the behavior of costs in relation to activity. Since most decision- aging problems involve changes to activity, marginal costing is more appropriate for short-run decision-making than absorption costing. Advantages of Absorption Costing (Relative to marginal costing) Absorption costing is widely used and you must understand both principles. The only difference between using absorption costing and marginal costing as the basis of stock valuation is the treatment of fixed production costs.

The arguments used in favor of absorption costing are as follows: 1 . Fixed costs are incurred within the production function, and without those facilities production would not be possible. Consequently such costs can be related to production and should be included in stock valuation. 2. Absorption costing follows the matching concept by carrying forward a proportion of the production cost in the stock valuation to be matched against the sales value 3. When the items are sold. 4.

It is necessary to include fixed overhead in stock values for financial statements routine cost accounting using absorption costing produces stock values which include a share of fixed overhead. 5. Overhead allotment is the only practicable way of obtaining job costs for estimating prices and profit analysis. 6. Analysis of under-lover- absorbed overhead is useful to identify inefficient utilization of production resources. Arguments against absorption costing The fixed costs do not change as a result of a change in the level of activity.

Therefore such costs cannot be related to production and should not be included in the stock value Zion. The inclusion of fixed costs in the stock valuation conflicts with the prudence concept, therefore the fixed costs should be written off in the period in which they are incurred Absorption costing principles In product/service costing, an absorption costing system allocates or proportions a share of all costs incurred by a business to each of its products/ services. In this way, it can be established whether, in the long run, each product/service makes a profit.

This can only be a guide. Arbitrary assumptions have to be made about the apportionment of many of the costs which, given that some costs will tend to remain fixed during a period, will also be dependent on the level of activity. An absorption costing system traditionally classifies costs by function. Sales less production costs (of sales) measures the gross profit (manufacturing profit) earned. Gross profit less sots incurred in other business functions establishes the net profit (operating profit) earned.

Using an absorption costing system, the profit reported for a manufacturing business for a period will be influenced by the level of production as well as by the level of sales. This is because of the absorption of fixed manufacturing overheads into the value of work-in- progress and finished goods stocks. If stocks remain at the end of an accounting period, then the fixed manufacturing overhead costs included within the stock valuation will be transferred to the following period.

Absorption costing profit statement The first stage in the preparation of absorption costing profit statements is the measurement Of the gross profit (manufacturing profit) earned. This requires the calculation of unit production costs, including the establishment of absorption rates for manufacturing overheads. Referring to the example being used for illustration in this article (see earlier), variable manufacturing costs per units are given in the question (at E. 40 per unit).

Axed manufacturing overheads of EYE,OHO per period are to be absorbed at a unit rate (based on normal production activity of 20,000 units per period). The axed manufacturing overhead absorption rate is therefore E. 60 per unit (EYE,OHO 20,000 units) giving a total manufacturing cost of El 1. 00 per unit (E. 40 + E. 60). The use of normal activity as the basis for overhead absorption is similar to the use of budgeted activity. It is to be expected that actual activity (and indeed actual expenditure also) will be different to normal/budget thus giving rise to overhead over or under absorption.

It is important that this is highlighted in profit statements. The use of normal (or budgeted) activity and expenditure to establish the absorption rate not only alps to focus attention on overhead recovery but also has the effect of ‘normalizing’ per unit product/service costs. Referring again to the example, fixed manufacturing overheads will be over-absorbed in Period 2 because the actual production of 21 ,OHO units exceeds the normal activity, the basis used to establish the absorption rate, by 1 ,OHO units.

The extent of the over- absorption (the balance remaining in the fixed manufacturing overhead account) is, therefore, E,600 (1 ,OHO units at E. 60 per unit). This amount will be transferred to the profit and loss account in order to establish the manufacturing profit. It will have a positive effect (I. E. , it will be added to profit) because more manufacturing overhead has been absorbed into stock in the period than has been incurred (see the entries in the fixed manufacturing overhead account demonstrated later in examples).

The Examiners Report for the June 2000 paper 3 noted that the over-absorption of fixed manufacturing overhead caused problems for many candidates. It was frequently not identified. Where it was calculated, it was at times described as ‘under-absorbed’ or was at least treated as such in terms of its impact on the manufacturing profit. Other candidates wrongly calculated the ever/under- absorption based upon the difference be;en sales and production quantities, rather than upon the difference between actual production and normal production.