Methods of Cost Accounting

Introduction 

A method of costing is simply defined as cost ascertainment. Different industries adopt diverse methods of costing, which depends on the production activities involved as well as the nature of the business ( Drury, 2013) . Methods of cost accounting can be grouped into four categories, namely absorption, variable, marginal, and activity-based costing. Each of the aforementioned method of cost accounting has both merits and demerits. Although the methods of accounting are different, it should be noted that the fundamental principle of cost accounting is the same. The purpose of this paper is to discuss the various methods of accounting along with their advantages and disadvantages. 

Absorption Costing 

Absorption costing refers to the managerial process of cost accounting which includes costs linked to the production of a specific item. The technique is a necessity for generally accepted accounting principles (GAAP) eternal reporting. Wages for employees producing a commodity, the raw materials used in production and all overhead costs including utility costs are some of the direct expenses included in the manufacturing process. Absorption costing incorporates all things straightforward in the production process. Also referred to as full costing, absorption costing combines fived overhead charges which are included as product costs ( Bhimani & Horngren, 2008).  Dissimilar to variable costing, absorption costing allots every expense to commodities produced whether they are sold or not. A producer might not merely consider the costs of labor and wool for the manufacturing of a jumper, but the cost of knitting machines, the plant in which the devices are fixed insurance, operating costs of tools and numerous other overhead expenses. 

Types of Absorption Costing systems 

The three distinct forms of absorption costing are evaluated below. 

Job Order Costing 

The cost calculation is allocated to the commodity in batches and lots. A batch is a non-recurring collection of some production units while a lot represents a manufacturing segment associated with the serial number of a specific item ( Drury, 2013). 

Process Costing 

Assigns cost calculation to products because they do not involve lots and batches. 

Activity Based Costing (ABC) 

In ABC, the calculation of cost is allocated from cost products to the completed product. Absorption costing is vital for small firms that at times lack financial resources. These are the corporations that cannot afford losses t dispose of commodities with no awareness of the accounting overhead. 

Benefits of Absorption Costing 

Absorption costing does not include all fixed expenses which depict some situations whereby all the stock is not sold. Since assets are involved in a firm's financial statements at the conclusion of a trading period, the method illustrates more fixed expenses that are linked to the products of ending stock. For some statements, absorption costing results in more precise accounting in regards to ending inventory. Further, additional costs are accounted for in non-sold items, therefore, reducing real expenses reported ( Gale & Stokoe, 2001). The outcome of this process is a higher net income computation as opposed to variable costing calculations. 

Disadvantages of Absorption Costing 

Absorption costing incorporates overhead costs and therefore not preferred when compared to variable costing in the process of making internal incremental decisions of pricing. The scenario is because variable costing includes additional costs of manufacturing the next progressive unit of the item. Additionally, using absorption costing develops a complicated situation where producing more pieces increases the total revenue. Because fixed expenses are disseminated across all units produced, the unit fixed cost decreases as extra are produced ( Hilton & Platt, 2013).  Consequently, an increase in production enhances net income because of fixed cost element of the cost of items sold diminishes. 

Variable Costing 

Variable costing refers to a model that allocates variable expenses to inventory. The approach stipulates that all overhead costs are charged to expenses when incurred, while variable overhead costs and direct materials are assigned to stock. Financial reporting does not require variable costs because the accounting systems such as IFRS and GAAP necessitate that overheads should also be consigned to inventory. Consequently, variable costing is just used for purposes of internal reporting. Nonetheless, it is also commonly applied in the role whereby costs are involved in ascertaining break even analysis ( Horngren, 2009).  This analysis is fundamental in determining the level of sales at which a company earns no revenue and therefore establishes the lowest probable cost at which the commodity can be sold, and formulate internal financial statements into a contribution margin format. 

The variable costs, in this case, must be aligned after issuing to other parties outside the corporation. Total expenses incurred by companies incorporate variable and fixed costs. Fixed costs are those expenses that will not change regardless of the output of production. Firms must pay their fixed costs whether or not they make sales because the costs are independent and not related to operations within the firm. Fixed costs include rent, insurance, employee salaries as well as office supplies ( Zimmerman & Yahya-Zadeh, 2011). Companies must pay their rent for the space occupied to conduct the routine business activities irrespective of the volume of items produced and sold. Despite the fact that fixed costs can change within a period, the alteration is not associated with the process of production ( Drury, 2013). 

Advantages 

Variable costing offers a clearer understanding of the influence of fixed expenses on the net revenue because the total fixed cost for the period is indicated on the income statement. 

Variable costing system is closely related to various models of regulating costs, and this includes flexible budgets and standard costing system. A clear understanding of the variable costing systems makes the application of those methods comfortable in the contemporary accounting world ( Gale & Stokoe, 2001). 

Corporations applying variable costing frameworks prepare statements of finances in contribution margin setup that offers vital information for cost volume profit (CVP) assessment. The data cannot be directly attained from a customary income statement prepared using absorption costing system ( Zimmerman & Yahya-Zadeh, 2011). 

The net operating revenue income figure produced by variable costing is fundamentally close to the cash flow. Variable costing is fundamental and widely used for businesses with cash flow problems. 

In regards to absorption costing system, revenue gained from distinct periods changes with the variation in the levels of inventory. Sometimes, sales and income move in the opposite direction. This is despite the fact that it does not take place under variable costing system ( Horngren, 2009).  

Disadvantages 

Financial statements that companies prepare under variable costing model are not confirmatory to the generally accepted accounting principles (GAAP). This may, therefore, ring numerous problems to companies because the figures may be denied by auditors ( Zimmerman & Yahya-Zadeh, 2011). 

Tax regulations of numerous nations across the globe prefer the use of absorption costing. 

Variable costing does not allocate fixed costs to units of commodities. The production costs cannot, therefore, be correctly matched with income and other revenues. 

Companies do not prefer variable costing because absorption costing is the fundamental base for assessing top executive’s effectiveness ( Drury, 2013). 

Marginal Costing 

Marginal costing, also referred to as incremental costing is a model of cost accounting as well as decision making applicable for internal reporting whereby only minimal expenses are charged to cost units while fixed costs are treated as a lump sum. Variable costs are those that vary with changes in output and are managed under this method as costs of the commodity. Under marginal costing, fixed costs are treated as expenses for the period. Marginal costing is used in decision making because the model permits the management’s attention to be emphasized on the variations resulting from the choice under consideration ( Horngren, 2009).  The reason for assessing the marginal cost of a product is to ascertain the point at which a company can attain economies of scale. 

Marginal costing stipulates that only variable expenses are used in the process of making decisions. Fixed costs are not involved since the model assumes that they are enjoined in time periods when realized. Examples include expenses incurred when manufacturing, the incremental increase in costs when production rises and expenses that disappear when shutting down a subsidiary. In marginal costing, cost data is given with variable costs while fixed expenses are illustrated distinctively for reasons of making decisions ( Zimmerman & Yahya-Zadeh, 2011). This is not a model of costing like job costing or process costing but a way to evaluate cost information to guide management more so for reasons of understanding the impact of profit changes because of the output volume. The direct costing approach is very vital for short-term choices but can lead to dangerous outcomes when applied to make decisions for a more extended period. This is because marginal costing does not involve all costs fundamental for the long run. Additionally, the model does not comply with external standards of reporting ( Horngren, 2009).  

Advantages 

The process is simple because it involves variable and cost concepts 

It is a vital short-term costing technique of survival often in a competitive world or recessions whereby orders are accepted provided they incorporate the marginal expenses of the business. The excess costs over the marginal cost contribute toward fixed expenses to ensure that losses are minimized ( Gale & Stokoe, 2001). 

It reveals the relationship between volume price and cost 

Over or under absorption are not evident in marginal costing 

Valuations of inventory are not distorted with contemporary year’s fixed expenses ( Horngren, 2009).  

Marginal costing offers better information making it a classic tool for making decisions. 

The procedure concentrates on the flexible elements of business by separating variable and fixed expenses. 

Marginal costing provides more specific impacts of production and the subsequent sales policies ( Drury, 2013). 

Disadvantages 

The use of historical data is a limitation because decisions by management is about the future 

The process assumes fixed costs as if they are not fundamental to production 

Stock valuation under this model is not accepted by the Inland Revenue because it assumes fixed costs 

The method does not recognize the future variability of fixed costs 

Marginal costing oversimplifies costs ( Horngren, 2009).  

It is not a proper costing technique in making future pricing decisions because it assumes fixed costs. The management must consider the total expenses and not the variable portion in future ( Drury, 2013). 

Marginal costing presents difficulties in classifying fixed and variable costs and therefore can be biased if fixed expenses are categorized as variable costs. 

Activity-Based Costing 

Activity-based costing (ABC) depicts an accounting framework that recognizes the operations a company undertakes and then allocates indirect costs to items. An ABC system identifies the association between activities, costa, and commodities and via this affiliation, allocates indirect expenses to products less arbitrarily compared to conventional approaches ( Gale & Stokoe, 2001). Some costs pose problems to assign using this cost accounting model. Indirect costs including office staff and management salaries sometimes present problems when being attached to specific products. This explains why the model is preferred in the manufacturing sector. ABC is often applied in the manufacturing industry because the process improves costa data reliability to produce almost-perfect costs ( Zimmerman & Yahya-Zadeh, 2011). The method accurately classifies that expenses a company incurs in the course of its production process. ABC is applied in target costing, product line analysis of profitability, commodity costing, service pricing and analysis of client profitability. It is famous because it assists organizations to develop a more comprehensive corporate focus as well as strategy if costs are better understood. 

Benefits 

ABC assists decrease costs by offering clear and meaningful information on the available opportunities 

ABC only operates with activities. Therefore, the management can make quality decisions by understanding the nature of all events ( Drury, 2013). 

The activities under this method can be categorized into two; value-adding events as well as non-value adding activities. ABC assists the management on the value adding activities and eradicates non-value adding activities ( Gale & Stokoe, 2001). 

Other costs are depicted as non-manufacturing expenses, for instance, advertisement. Despite the fact that advertisement is a non-manufacturing expense constituting a significant portion of the total cost of any item. The non-manufacturing costs can quickly be assigned because the association between costs and its causes can be correctly comprehended by utilizing ABC ( Gale & Stokoe, 2001). 

The precise cost allocation to various items results in proper pricing strategy. 

Disadvantages 

ABC is not sufficient for companies with minimal operations 

In case of smaller overheads, ABC is not applicable 

Some corporations are producing a single or few items. In such a case, the ABC is not relevant ( Gale & Stokoe, 2001). 

ABC model should not be applied to prepare monthly statements of financial income. 

Comparison of the Cost Accounting Methods 

In absorption costing framework, the cost of items incorporate all variable and fixed manufacturing expenses. This includes direct labor, direct materials as well as factory overhead. But when variable costing framework is applied, the fixed cost in the form of non-manufacturing and manufacturing is treated as a capacity or period cost and is, thus, not part of product cost. ABC involves all costs, involving fixed costs in ascertaining the production cost, while variable costing solely incorporates the variable expenses directly associated with the production process. Corporations that prefer variable costing method separately maintain overhead and fixed-cost operating expenses from the costs of production ( Gale & Stokoe, 2001). Fixed costs differentiating absorption and variable costing are the overhead expenses that remain constant with variations in levels of production. The non-hanging costs involve building rental and salaries among others. 

ABC and absorption costing are two standard models of cost accounting conducted in business and are pivotal in making decisions. The four models of cost accounting approach costing differently and serve different decision-making purposes. Company owners should understand the manner in which every costing approach operates to maximize the benefits and gains of each method. The two models of costing differ in both the applications of the cost data and its use ( Gale & Stokoe, 2001). Absorption costing emphasizes the requirements of financial statements outside the corporation, while ABC focusses on the needs of financial statements in the company setting. Absorption costing bases all costs on the produced commodity, while ABC considers the cost of processes of products. 

Conclusion 

The four methods of cost accounting are absorption, variable, marginal, and activity-based costing. The application of a specific method of cost accounting is dependent on the industry or business position as well as production activities involved. Each of the cost accounting method has both advantages and disadvantages. For instance, on one hand, absorption costing does not include all fixed expenses that depict some situations whereby all the stock is not sold while on the other hand, this method of cost accounting incorporates overhead costs and therefore not preferred when compared to variable costing in the process of making internal incremental decisions of pricing. 

References 

Bhimani, A., & Horngren, C. T. (2008).  Management and cost accounting  (Vol. 1). Pearson Education. 

Drury, Colin M.  Management and cost accounting . Springer, 2013. 

Gale, R. J., & Stokoe, P. K. (2001). Environmental cost accounting and business strategy. In  Handbook of environmentally conscious manufacturing  (pp. 119-136). Springer, Boston, MA. 

Hilton, R. W., & Platt, D. E. (2013).  Managerial accounting: creating value in a dynamic business environment . McGraw-Hill Education. 

Horngren, C. T. (2009).  Cost accounting: A managerial emphasis, 13/e . Pearson Education India. 

Zimmerman, J. L., & Yahya-Zadeh, M. (2011). Accounting for decision making and control.  Issues in Accounting Education ,  26 (1), 258-259.