Assessment+1%2c+Costing+Systems+and+Techniques

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BREAK EVEN ANALYSIS

Breakeven analysis is a powerful management tool, and one that is critical in planning,decision-making, and expense control. Breakeven analysis can be invaluable in

determining whether to buy or lease, expand into a new area, build a new plant, and many

other such considerations. Breakeven analysis can also show the impact on your businessof changing your price structure. As the price goes down (and so your gross margin goes

down), breakeven shoots up - usually very rapidly. Breakeven analysis will not force a

decision, of course, but it will provide you with additional insights into the effects ofimportant business decisions on your bottom line.

Break-even analysis will provide a sales objective that can be expressed in either dollars

or units of production or sales, or whatever else is relevant. If the breakevenpoint is known, it can be a definite target to be reached and exceeded by carefully

reasoned steps.

Once you know the level of sales you have to reach before making a profit, you canevaluate the reasonableness of this target. What are the odds of reaching this breakeven

sales level? One way to test this is to convert the gross pound sales needed for breakeveninto some other unit which can then be compared against the capacity of the business or

the size of the market. If the breakeven occurs at or near the capacity of the business, or if

your analysis shows that you must capture all (or more than all) of the available target

market, the feasibility of your concept is suspect, and the odds of business success areloaded against you.

Another way to use breakeven analysis is to change the variables in the equation. If fixed

or variable expenses can be reduced, the breakeven point will go down. If prices can beincreased without hurting sales (and without increasing costs), the breakeven point will

go down. This is an excellent way to experiment with different alternatives. Clearly, thisis a subjective process - but then, so is the rest of business analysis. The purpose is tomake your business decision making as reasonable as possible.

Costing Systems and techniques for engineering companies

There are three major types of costing they include;

9. Absorption Costing

10.Marginal Costing

11.Activity based costing

Absorption Costing;

In product/service costing, an absorption costing system allocates or apportions a share ofall 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 ofthe 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


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production costs (of sales) measures the gross profit (manufacturing profit) earned. Gross

profit less costs 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. Thisis 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 betransferred to the following period

One method of determining the total cost of a given product or service is that of adding

the costs of overheads to the direct costs by a process of allocation, appointment andabsorption. Since overheads (or indirect costs) can be allocated as whole items to

production departments, it is possible to arrive at a normal amount that must be added to

the cost of each product in order to cover the production overheads.

Advantages

12.We cannot realistically produce unless fixed.

13.Costs are paid; therefore, they should be included in the production costs. Selling

can be set.

14.Prices are based on total costs and in times of uncertain demand, it is better to

consider final profit and not just contribution.

Disadvantages of Absorption Costing

The following are the criticisms against absorption costing:

15.You might have observed that in absorption costing, a portion of fixed cost is

carried over to the subsequent accounting period as part of closing stock. This isan unsound practice because costs pertaining to a period should not be allowed to

be vitiated by the inclusion of costs pertaining to the previous period and viceversa.

16.Absorption costing makes no distinction between fixed and variable costs thus isnot suited for (Cost-volume-profit) CVP analysis.

17.Further, absorption costing is dependent on the levels of output which may vary

from period to period, and consequently cost per unit changes due to the existenceof fixed overhead. Unless fixed overhead rate is based on normal capacity, such

changed costs are not helpful for the purposes of comparison and control.

Marginal Costing;In product/service costing, a marginal costing system emphasises the behavioural, rather

than the functional, characteristics of costs. The focus is on separating costs into variableelements (where the cost per unit remains the same with total cost varying in proportion

to activity) and fixed elements (where the total cost remains the same in each period

regardless of the level of activity). Whilst this is not easily achieved with accuracy, and isan oversimplification of reality, marginal costing information can be very useful for

short-term planning, control and decision-making, especially in a multi-product business.


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In a marginal costing system, sales less variable costs (regardless of function) measures

the contribution that individual products/services make towards the total fixed costs

incurred by the business. The fixed costs (regardless of function) are treated as periodcosts and, as such, are simply deducted from contribution in the period incurred to arrive

at net profit.

The principles of marginal costingThe principles of marginal costing are as follows.

For any given period of time, fixed costs will be the same, for any volume of sales and

production (provided that the level of activity is within the relevant range). Therefore,by selling an extra item of product or service the following will happen.

18.Revenue will increase by the sales value of the item sold.19.Costs will increase by the variable cost per unit.

20.Profit will increase by the amount of contribution earned from the extra item.21.Similarly, if the volume of sales falls by one item, the profit will fall by the

amount of contribution earned from the item.

Profit measurement should therefore be based on an analysis of total contribution. Sincefixed costs relate to a period of time, and do not change with increases or decreases in

sales volume, it is misleading to charge units of sale with a share of fixed costs. When a

unit of product is made, the extra costs incurred in its manufacture are the variableproduction costs. Fixed costs are unaffected, and no extra fixed costs are incurred when

output is increased.

Features of Marginal Costing

The main features of marginal costing are as follows:

Cost Classification

The marginal costing technique makes a sharp distinction between variable costs andfixed costs. It is the variable cost on the basis of which production and sales policies are

designed by a firm following the marginal costing technique.

Stock/Inventory Valuation

Under marginal costing, inventory/stock for profit measurement is valued at marginal

cost. It is in sharp contrast to the total unit cost under absorption costing method.

Marginal Contribution

Marginal costing technique makes use of marginal contribution for marking variousdecisions. Marginal contribution is the difference between sales and marginal cost. It

forms the basis for judging the profitability of different products or departments.

Advantages of Marginal Costing Technique

22.Marginal costing is simple to understand.23.By not charging fixed overhead to cost of production, the effect of varying

charges per unit is avoided.

24.It prevents the illogical carry forward in stock valuation of some proportion ofcurrent years fixed overhead.


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25.The effects of alternative sales or production policies can be more readily

available and assessed, and decisions taken would yield the maximum return tobusiness.

26.It eliminates large balances left in overhead control accounts which indicate the

difficulty of ascertaining an accurate overhead recovery rate.

27.Practical cost control is greatly facilitated. By avoiding arbitrary allocation offixed overhead, efforts can be concentrated on maintaining a uniform and

consistent marginal cost. It is useful to various levels of management.28.It helps in short-term profit planning by breakeven and profitability analysis, both

in terms of quantity and graphs. Comparative profitability and performance

between two or more products and divisions can easily be assessed and brought tothe notice of management for decision making.

Disadvantages

29.The separation of costs into fixed and variable is difficult and sometimes gives

misleading results.30.

Normal costing systems also apply overhead under normal operating volume andthis shows that no advantage is gained by marginal costing.

31.Under marginal costing, stocks and work in progress are understated. Theexclusion of fixed costs from inventories affect profit, and true and fair view of

financial affairs of an organization may not be clearly transparent.

32.Volume variance in standard costing also discloses the effect of fluctuating outputon fixed overhead. Marginal cost data becomes unrealistic in case of highly

fluctuating levels of production, e.g., in case of seasonal factories.

33.Application of fixed overhead depends on estimates and not on the actual figuresand as such there may be under or over absorption of the same.

34.Control affected by means of budgetary control is also accepted by many. In order

to know the net profit, we should not be satisfied with contribution and hence,fixed overhead is also a valuable item. A system which ignores fixed costs is less

effective since a major portion of fixed cost is not taken care of under marginal

costing.

35.In practice, sales price, fixed cost and variable cost per unit may vary. Thus, the

assumptions underlying the theory of marginal costing sometimes becomes

unrealistic. For long term profit planning, absorption costing is the only answer.36.Marginal costing is not a method of costing but a technique of presentation of

sales and cost data with a view to guide management in decision-making.

37.The traditional technique popularly known as total cost or absorption costing

technique does not make any difference between variable and fixed cost in the

calculation of profits. But marginal cost statement very clearly indicates this

difference in arriving at the net operational results of a firm.

Following presentation of two Performa shows the difference between the presentation of

information according to absorption and marginal costing techniques:

Marginal Costing versus Absorption Costing

After knowing the two techniques of marginal costing and absorption costing, we have


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seen that the net profits are not the same because of the following reasons:

Over and Under Absorbed Overheads

In absorption costing, fixed overheads can never be absorbed exactly because ofdifficulty in forecasting costs and volume of output. If these balances of under or over

absorbed/recovery are not written off to costing profit and loss account, the actual amount

incurred is not shown in it. In marginal costing, however, the actual fixed overheadincurred is wholly charged against contribution and hence, there will be some difference

in net profits.

CONCLUSION

Marginal cost is the cost management technique for the analysis of cost and revenue

information and for the guidance of management. The presentation of information

through marginal costing statement is easily understood by all managers, even those whodo not have preliminary knowledge and implications of the subjects of cost and

management accounting.

Activity Based Costing

Activity Based Costing is an accounting system that assigns costs to products based onthe resources they consume. The costs of all activities are traced to the product for which

they are performed. Overhead costs are also traced to a particular product rather than

spread arbitrarily across all product lines. The true cost of a product can be determined

with much more fidelity than was previously available with a traditional accountingsystem. An ABC system gives visibility to how effectively resources are being used and

how all activities contribute to the cost of a product.

38.More accurate costing of products/services

39.Better understanding overhead

40.Easier to understand for everyone

41.Utilizes unit cost rather than just total cost

42.Makes visible waste and non-value added

43.Supports performance management and scorecards

44.Enables costing of processes, supply chains, and value streams

45.Activity Based Costing mirrors way work is done

46.Facilitates benchmarking

Activity Based Costing Disadvantages

More time consuming to collect data

Cost of buying, implementing and maintaining activity based system


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Makes waste visible which some executives and managers don't want their boss to

see..

CONCLUSION

Absorption costing and marginal costing are two different techniques of cost accounting.

Absorption costing is widely used for cost control purpose whereas marginal costing isused for managerial decision-making and control. For this reason, absorption costing and

ABC are appropriate costing techniques for engineering companies.

However, ABC is the most appropriate as provides managers with useful information

they need regarding the contribution that each customer makes to overall profitability.

Also, ABC allows managers to see how to maximise performance and implement soundprofit-growth strategies. Also, ABC also makes it very clear that integrated costs

associated with the services that the customer demands play a crucial role in determining

each customer's contribution to net profit.

ABC is nevertheless a form of absorption costing and the point of absorption costing is

simply to make sure that all costs are covered. It is also a way of obtaining an accuratecomparison with outside alternative suppliers.

Assessment+1%2c+Costing+Systems+and+Techniques

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