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Absorption Costing

ABSORPTION COSTING   

Absorption costing , in actual practice, is charging of all the costs both fixed and variable to the production, processes and treats all costs as product costs. In real sense, in absorption costing, fixed overhead can never be absorbed exactly because of difficulty in determining costs and volume of output.

The Institute of Cost and Management Accountants (U.K) defines it as “the practice of charging all costs both variable and fixed to operations, processes or products”.

Absorption costing is otherwise called as total or full cost method. 

Practical Applications of Marginal Costing

Marginal costing technique may be applied with various aims and purposes. The important purposes are as follow.

Profit Planning

In order to determine the profit level of the firm in future period is absolutely important. Profit planning is therefore a part of operational planning. Marginal costing assists the management in the profit planning through computation of contribution ratio. In the real sense, profits are affected by various factors such as the marginal cost per unit, total fixed cost, selling price and volume of sales. Hence, the organization can achieve its profit by modifying one or more of the above variables.

Profit Volume Ratio

The ratio of contribution to sales is the p/v ratio or profit volume ratio. It may be expressed in percentage. It is one of the effective tools for studying the profitability of business. 

Break Even Point

BEP may be defined as that level or point of sales volume at which the total revenue is equal to total costs. Simply, it is a no-profit, no loss point. This is also a minimum point of production where total costs are recovered. If sales exceed the Break Even Point, organization earns a profit. If sales are below the Break Even Point, the organization incurs a loss. In other words, this is a point at which loss ceases and profit starts.

[ Talk about the BEP in single word; it is the point where income is exactly equal to expenditure.]

Break               Means Divide

Even                Means Equally

Point                Means Position or place [sale/produced units]

1.      Margin of safety. Margin of safety may be defined as the excess of actual sales or production at the selected activity over Break even sales or production. Simply, margin of sales is excess sales over the break even sales. It is abbreviated as M.O.S.

2.      Level of activity planning. Now a days, business concerns face the problems of finding the level of activity which is optimum for a business to adopt. In this respect, the management wants to take right decision from the different levels of production or selling activities available. The marginal costing technique helps the management to determine the optimum level of activity.

3.      Fixation of selling price. One of the important functions of the cost accountant is the ascertainment of cost for the purpose of fixation of selling price. At the time of price fixation, raw material cost, direct labor cost plus other overheads are also taken into account to find the total cost of the product. Apart from this, a certain percentage of profit is added to the total cost to arrive at the selling price. Marginal Costing of a product represents the minimum price for that product and any sales below marginal cost would entail a loss of cash.

4.      Decision to make or buy. Some time, a firm may buy certain products or parts or tools from outside, which may be made by the firm itself. The management must decide which one is most profitable to the firm. If the marginal cost of the product is lower than the price of buying from outside sources, it is better for the firm to manufacture the product by itself.

5.      Introduction of a new product. Existing firm may add additional products in its products line without any difficulty, with the help of its available production capacity. The new product is sold in the market at a reasonable price with large quantities. If it is a reputed company, the sales may increase. So, total cost would come down and automatically profit will be increased.

6.      Evaluation of performance. With the help of the marginal costing, the management can measure the operational efficiency of all the departments or sales division. Those departments or divisions which have a highest p/v ratio indicate the highest performance efficiency.

7.      Decision making In normal practice, price must not be less than total cost. So, marginal costing acts as a price fixer and contributes profit. But this principle cannot be successful at all times. If in any situation price is equal to marginal cost, there will be a loss. Sometimes, the firm has to face a loss when (i) competitors cannot be driven out (ii) there is cut-throat competition and so on. Marginal costing guides the management to take correct decisions whenever faced with this type of situations.

8.      Maintaining a desired level of profit. Sometimes, an industry has to reduce its price due to competition and government regulation. But the ultimate aim of the management is to maintain the same level of profit. For this purpose, marginal costing technique can assist the management to determine how many units have to be sold to maintain the same level of profit.

9.      Alternative methods of production. Management has to select a method of production among so many alternatives. Marginal cost gives the marginal contribution under each of the proposed methods which are worked out and the method which gives the maximum contribution is normally adopted. And also with the help of the marginal costing, the management should compare the alternative method of manufacture: either machine work or hand work and one machine or more machines.

10.  Decision to accept bulk order or foreign order. Sometimes, organization has to receive both bulk order and foreign order for supplying the goods. A decision has to be taken now whether to accept both orders or reject them. In this respect, marginal costing technique gives the correct direction to the management for accepting or rejecting the order.