Absorption costing
Generally, absorption costing traces both the fixed and variable costs of production. The absorption costing method estimates the closing stock at full production cost and includes a share of fixed production. In using this approach, a share of the fixed cost of production is allocated to each product. This share is added together with the direct cost of production for each product to obtain the total cost of producing a unit of output. The fixed costs are assigned using the overhead absorption rates. One key assumption of the absorption costing approach is that it assumes that consumers and producers are insensitive to the price of the product, thus, the pricing of the firm does not affect the decision to purchase (Weetman 2013).
Strengths and weaknesses of absorption costing
One key advantage of absorption costing is that it makes use of the fixed cost of production when computing the cost per unit of output. Therefore, the management of a company can view the total cost associated with producing a product. Secondly, the method is consistent with the Generally Accepted Accounting Principles (GAAP). Therefore, the results of absorption costing helps the management to prepare financial reports.
Absorption costing helps management in the valuation of a stock. The International Accounting Standards (IAS) require that inventory should be valued at the lower of the costs of the net realizable value. Finally, the allocation of production overheads to cost centres help the management to control, be informed, and take charge of the services offered to another department in a company (Atrill & McLaney 2009).
A major drawback of this approach is that it does not give accurate results. It is for this reason that allocation, apportionment, and absorption of costs using this approach is based on budgeted values. These values are arrived at after taking into account operations of the previous years and plans of the company. However, the business environment does change. Therefore, there is a tendency that the budgeted values would not be the same as the actual values. This causes variance which calls for adjustments at the end of the year. Further, absorption costing ignores the cost-volume-profit relationship. This relationship is quite significant in decision making. Management has to seek other methods which can be useful in decision making, such as the marginal costing technique (Seal, Garrison, & Noreen 2011).
Marginal costing
Marginal costing is an accounting system used to assess the profitability of a business. It adopts a different approach to accounting for costs and profit. It rejects the principle of absorbing fixed overhead into unit costs. In marginal costing, only variable costs are included in the determination of the production cost. This means that fixed costs are treated as period costs (Drury 2012).
Advantages and disadvantages of marginal costing
Marginal costing has several advantages over the other methods. The first advantage is that marginal costing is easy to calculate. Secondly, in marginal costing, there is no apportionment of costs into various components such as fixed and variable costs because this method of costing is based on variable costs only. It is worth noting that the separation of fixed and variable costs cannot be done with accuracy because some costs comprise both fixed and variable cost elements such as electricity. Further, fixed costs are the same irrespective of the number of units produced (Atrill & McLaney 2009). Thus, these costs are irrelevant in marginal costing analysis.
Proponents of marginal costing argue that variable costs are the real costs of producing an extra unit of output thus, apportioning fixed costs and charging them to each unit of output is irrelevant and it only increases the unit price of a commodity. Another advantage of marginal costing is that there is no existence of over or under absorption of overheads as is evident in the other methods of cost accounting. This implies that values arising from marginal costing are accurate. Further, marginal cost is useful in decision making. Specifically, information arising from marginal costing can be used in the decision-making process in an organization when a series of variables interact (Whitman 2013).
The first drawback of this approach is that it gives incorrect results because it ignores other indirect costs that are incurred in the production process. Secondly, it ignores semi-variable costs. These costs are neither fixed nor variable and they should be included in the production process.
Profit statements
CricPitch Ltd/ Absorption cost-profit statement/For the year ended December 2013
CricPitch Ltd/Absorption cost-profit statement/For the year ended December 2014
CricPitch Ltd/Marginal cost-profit statement/For the year ended December 2013
CricPitch Ltd/Marginal cost-profit statement/For the year ended December 2014
Arguments in favour of and against the board’s decision
Arguments in favour of the board’s decision
The calculations above indicate that the number of Flexi-Pitches increased by 100 units. This resulted in an increase in the total amount of sales by ÂŁ100,000, an equivalent of 11.11%. On the other hand, Mr. Butler decided to reduce production by 400 Flexi-Piches. This amounted to ÂŁ329,000 when using absorption costing and ÂŁ240,000 when using marginal costing. Therefore, from the point of view of the board, the increase in sales could not offset the reduction in production when both methods of costing are used. This implies that the company needs to cut production to earn more profit.
The profit declined by 44.57% in the case of absorption costing. Profit increased by 43.01% under marginal costing. It can be noted that the two methods do not give consistent results when it comes to the changes in profit between 2013 and 2014. The CricPitch Limited uses the absorption costing system. Therefore, the board relied on the results of the absorption cost-profit statement. The board believes that Mr. Buttler succeeded in increasing the sales value, but not profit (Atrill & McLaney 2009). The bonus was supposed to be awarded if the manager had achieved both. Therefore, the threshold for the bonus was not attained.
Further, the board believes that this strategy is not sustainable in the long term because the company will not be in a position to meet the demand. After all, the units sold are more than the units produced. The strategy requires the company to have adequate units of Flexi-Pitches in stock to be effective. This may not be feasible because production needs to take place. Besides, it results in a reduction of profit. It is one of the effective turnaround strategies if the company’s focus is growth in sales (Atrill & McLaney 2009).
Arguments against the board’s decision
The sales manager based his argument for a bonus on the results achieved by the marginal cost profit statement. As mentioned above, the results of the marginal costing system show that sales increased by 11.11% while profit increased by 43.01%. Therefore, Mr. Buttler argued that he surpassed the target for the bonus in all aspects and he deserves to receive the bonus. The sales manager argues that the method of estimating profit does not matter. Besides, the absorption costing system includes costs that are not directly related to the production of the commodity. Therefore, Mr. Buttler believes that such costs should be excluded in the estimation of the per-unit cost of the product.
The manager also argues that the board did not talk about whether they wanted a short-term or a long-term increase in sales and profit. The board wanted to experience a change in the reports of the year 2014. Further, the manager believes that different strategies can be used from time to time to improve the financial performance of an entity (Lau & Sholihin 2005). Both long-term and short-term strategies can be employed to improve the overall performance of a company. Therefore, the sales manager thinks that he deserves the bonus of $10,000.
The concept of controllability
The idea of controllability is seen as an integral part of performance management. Controllability can be seen in very many perspectives. For instance, it connects responsibility to authority. The principle of controllability suggests that managers should be answerable only for the results that they can meaningfully sway. The principle further suggests that it is important to separate between the factors that can be controlled and those that cannot be controlled (Lau & Sholihin 2005).
Some of the costs that cannot be controlled are competitive factors, acts of nature, economic factors, general, and administrative expenses among others. Therefore, based on this principle, if a manager has control over quantity and price, he/she will be held accountable over attributes that are related to these variables. Further, it is worth mentioning that different types of performance measures, financial and non-financial measures, have different degrees of controllability. The financial and non-financial measures have several advantages and disadvantages. The first advantage of non-financial measure is that it focuses on long-term organizational strategies.
Secondly, the non-financial measures take into account the intangible attributes of success that cannot be measured. Also, non-financial measures can be good indicators of future performance. For instance, investment in research and development on various attributes can improve future performance. One key disadvantage of non-financial measures is the cost and time used in the process exceed the benefit. Secondly, the use of some non-financial measures may conflict in the short term. Thirdly, non-financial measures do not have a common denominator. Thus, evaluating performance can be difficult. Finally, they lack statistical reliability.
Financial measures have a number of benefits. First, financial measures make it easy to evaluate various attributes of performance since the variables can be measured based on time or cost among others. Secondly, financial measures guarantee reliability and enable managers to predict future performance. Finally, the use of financial attributes reduces bureaucracies in performance management.
The first disadvantage of financial measures of performance is that they ignore attributes that cannot be quantified such as competitors and customer satisfaction among others. Secondly, the use of financial performance measures makes it difficult to implement some non-financial strategic plans. An entity should use both financial and non-financial performance measures. Therefore, when coming up with a performance management framework, attention should be focused on performance that an employee can control (Lau & Sholihin 2005).
References
Atrill, P & McLaney, E 2009, Management accounting for decision makers, Prentice Hall, Europe.
Drury, C 2012, Management and cost accounting, Cengage Learning, United States of America.
Lau, C & Sholihin, M 2005, “Financial and non-financial performance measures: how do they affect job satisfaction?” The British Accounting Review, vol.37, no.4, pp. 389-413.
Seal, W, Garrison, R & Noreen, R 2011, Management accounting, McGraw Hill, New York.
Weetman, P 2013, Management accounting: an introduction, Prentice Hall, Europe.