Variable Costing

Executive summaryThis report undertakes a review of marginal costing as used in the managerial accounting. It identifies various terminologies in the concept marginal costing. Logical definition of variable costs, fixed costs, CVP and breakeven analysis are key concepts covered by this report. it tries to prove the rational of marginal costing as used in short term decision making. As a costing technique it explicit and implicit various assumptions which includes, division of cost element into fixed costs and variable costs, variable costs are directly proportional to volume of production, fixed costs remains constant at all levels of production, fixed cost is shared according to production volume per unit, volume output is the only factor which influence cost and that selling price remain unchanged at all levels. This analysis gives logical evidence on the usage of this technique in three industries, manufacturing, hospitality and airline. It has been appraised and evaluated as the basis for product and service costing and identification of its strengths and weakness is critical. In this report, a comparison of marginal costing with alternative methods has thus led to its recommendation to be used in the three industries for short term. To cater for both long term and short term reconciliation of absorption and marginal costing has been recommended. In conclusion it is logical that every firm should use a costing method which is relevant to decision of the firm.

TABLE OF CONTENTS

TOC o “1-3” h z u Executive summary PAGEREF _Toc374733097 h 2Introduction PAGEREF _Toc374733098 h 3Assumptions of marginal costing PAGEREF _Toc374733099 h 3Uses of marginal costing in short term decision making PAGEREF _Toc374733100 h 4Types of costing methods PAGEREF _Toc374733101 h 4Marginal costing vs. absorption method PAGEREF _Toc374733102 h 5Advantages of marginal costing over absorption costing PAGEREF _Toc374733103 h 6Recommendation PAGEREF _Toc374733104 h 7Conclusion PAGEREF _Toc374733105 h 7References PAGEREF _Toc374733107 h 8

IntroductionVariable costing is a managerial accounting cost concept. According to Managerial accounting, by Ray. H. Garrison, Eric W. Noreen, Peter C. Brewer, variable costing is a method that has only variable cost in the unit product cost. Variable costs are costs that vary with an increase in production and decrease with a decrease in production. Therefore variable costs are directly proportional to volume of production. This technique is mainly not used for outside purpose but rather for short term decision making. Other methods do include wholly the manufacturing cost without differentiation as to whether fixed cost or variable cost. Manufacturing costs includes, direct materials, direct labor and variable manufacturing overhead. Under this managerial accounting concept there exist a logical relationship between the cost of goods (raw materials) and the manufacturing expenses which lead to the end product, result or deliverable to be placed in the market for sale. The inventory in this technique does not absorb all the firms cost fully. In this method cost of goods sold is made solely as a variable cost because it excludes fixed manufacturing overheads from cost of inventory. Fixed inventory is always expensed in the current period hence is treated as a (periodic cost) period cost while capitalizing cost as part of inventory cost is often referred to as a product cost.

Variable costing may also be called marginal costing which is the cost of goods which includes only variable costs in its unit product cost (inventory). According to the CIMA this is an accounting system where variable costs are charged to cost of units and fixed cost of the period are written off in full against the aggregate contribution. The difference between total sales and marginal cost is known as contribution. Contribution minus fixed cost you get profit. We can therefore say that contribution contributes to fixed costs. At some point the fixed cost is equal to contribution which is known as breakeven point.

Assumptions of marginal costing

It assumes that all elements of costs can be divided into fixed & variable costs, variable costs/ marginal costs are directly proportional to volume of production, Fixed cost remain constant at all levels of production. Fixed cost is shared according to production volume per unit output. To share fixed cost per unit output varies according to the volume of production, the selling price of every unit does not change at all levels of activities, the volume of output is the only factor which influence the cost

Uses of marginal costing in short term decision makingBreak even analysis is one of the short term analysis used to make decision. Break even analysis is used to determine when the firm is not making any profit or loss. This is needed in the short term rather than in long term. Break even analysis is contribution minus fixed costs which should be zero that is fixed cost is equals to contribution. Apart from break even analysis the firm can also use it in the following ways.

Pricing, to check the effect of reducing current price on profits,choose of Good Product Mix, calculation of Margin of Safety,it helps the managers introduce discounts without affecting the firm profits.

Marginal costing is used in a number of industries like, hospitality industry where prices are derived from the cost of sales mainly using the bottom up approach to pricing. It is also due to competition of the segment hence cost competitiveness has to be adopted for a firm to remain competitive in the market. The airline industry also uses the same principle as the hospitality sector hence these method can be used. It is also used in the manufacturing industry for inventory control and control of prices of every commodity and determines its selling price after calculating the breakeven point. There are various types of costing approaches used by various firms in the world.

Types of costing methodsUniform Costing. This is a type of costing which involve an agreement of two or many firms to use the same technique

Marginal Costing. This a type of costing approach where, variable cost and fixed costs are treated differently. Variable costs are included in the unit product cost whereas fixed costs are contributed for by the contribution.

Standard Costing and variance analysis. In this method is used in the manufacturing industry where there is standardization of good produced. The standard costs are estimated and then compared with the actual costs recorded thus important for cost ascertainment and cost control.

Historical Costing. This method is rarely used because it does not focus to future but costs are ascertained after they have been incurred.

Direct Costing. Direct costing method is a technique which charges all the direct costs in the product cost while the fixed costs (indirect costs) are written off from profits.

Absorption Costing. It is the practice of charging all costs, both variable and fixed to operations, processes or products. This differs from marginal costing where fixed costs are excluded.

The main methods of costing where one can have a distinct comparison of advantages and disadvantages are marginal costing and variable costing where the other typologies can fit.

Marginal costing vs. absorption methodMarginal costing always treats fixed costs in the current period which in real sense they are current periodic costs Whereas absorption costing may differ fixed overhead costs to the next period when inventories increase and

The ending inventory in the variable or marginal costing includes the variable costs while Absorption method include both the variable costs and fixed manufacturing overheads in the ending inventory

Marginal costing net operating income is not affected by increase in production volume While increase in production volume under absorption net operating income will increase with increase in output level thus increase inventories

They are used for short term decision making for price control and inventory control while Absorption method is used f0r the external purpose of the firm and mainly long term decision making

Advantages of marginal costing over absorption costingIt is easier to identify fixed costs. This method treats fixed ost in the current period which it really is unlike absorption which may carry forward fixed cost and include it in the next period. Income is not affected by changes in production volume. The volume of production affects the net operating income in absorption since fixed costs are distributed among the units of production.

Avoids misunderstandings concerning unit product costs. Under absorption method one can actually mistake product cost as Variable cost which would thus not be the case in marginal costing which include only variable cost in the unit cost.

Cost control is possible. This is because under this method one can fully ascertain costs and ensure control.

Its more easier to understand than other techniques. Managers should find it easier to understand variable costing reports because data are organized by behavior and because variable costing is much closer to cash flow.

Used in the CVP analysis. Variable costing statements is useful in the CVP analysis, it gives the relationship between the three elements which are important to every manager to make decision in the short run.

Limitation of Marginal Costing

1) it is difficult to distinctly separate variable cost and fixed cost as it is by this method. 2) The assumption of these costing techniques is often not very realistic. 3) Rather than contribution alone there are other factors that should be taken into account during pricing. For example, where fixed cost is very high, selling price should not be fixed on the basis of contribution alone without considering other key factors such as capital employed. 4) Due to its treatment separately or its direct deduction from sales, simple confusion of it as sales may lead to major problems. 5) The tax authority will not accept this method because the inventory valuation under this method will understate profits.RecommendationFrom the critical analysis of marginal costing and other alternative methods, there exists a rational for every firm in the mentioned industries (hospitality airline and manufacturing) to adopt marginal costing. This technique allows for easier cost volume analysis (CVP) which is used by managers for short term decision making on the appropriate adjustments to make to sales, production or even variable cost to achieve the desire profit. In marginal costing technique a firm is able to adjust the sales to the required level and reduce the marginal cost so as the contribution is able to meet the fixed costs and thus achieving the desired profit. For proper pricing per item variable costs or marginal costs have to be determined separately and included in the unit product cost and ending inventory. Generally it is important to use the two methods concurrently for both short term and long term decisions. Reconciliation should be made between the two methods so as counter the disadvantage of using one method which on the other hand is an advantage of the other

ConclusionCosting is one of the managerial accounting functions which needs a careful selection and evaluation of the effectiveness of every technique used by a firm. Despite the various methods of pricing a firm based on its industry should select the most effective method to the firm. Costing is the main function in every firm, the rational being every firm exists in its industry with the main aim as profit making. ReferencesCost and Management Accounting. Intermediate. ICA. p. 15. 

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