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Costing Approaches Essay

4914 words - 20 pages


University of XXXXX

Faculty of Business and Law


Strategic management accounting


Word count: 3291/3000

Table of content

I. Introduction 4
II. Three systems to measure product costs 4
1. Variable costing: 4
2. Absorption costing: 5
3. Activity-based costing approach 7
III. Standard costing 9
1. Use of iterative operations for standard costing 9
2. Defining the standards 9
3. Purposes and advantages of standard costing and variance analysis 11 ...view middle of the document...

On an operating statement, variable costs are deducted to the sales revenues to get the total contribution, then production and non-manufacturing fixed costs are deducted to have the net profit. The stocks are valuated at their variable cost. It is simple to operate.

* Advantages and limits of variable costing:

This approach has the advantage to erase the effect of the fluctuations of stock level because it considers only the sales: the fixed costs are recorded for the period they are incurred whereas in a full costing approach, fixed costs are part of the product cost and are recovered only when the sale happens (the sale can happen in the next period). So it permits to assess managers monthly performances because they cannot manipulate the stock level to increase the amount of profit by deferring fixed overhead costs from one period to the next one.
It also avoids over-valuing the unsaleable stocks when the company has surplus production on several successive periods (Drury, 1998). Finally, it erases the problem of the arbitrarily allocation of fixed costs (e.g. director salary...) which happens in full costing system (Lucey, 1996).
However, this system makes it difficult to compare two periods: if the company sells products produced both during the previous period and in the actual period, the profit of this period will be greater than the previous one because only the fixed costs of the actual period will be recorded in the monthly profit statement. In consequence, the previous period will report “fictitious” losses when the actual one will report higher profits. (Drury, 1998)

* Variable costing for short term decision making

The main advantage of variable costing system is for short term decision making because it considers fixed costs as past costs that cannot be avoided: as such, they are irrelevant for decision making and only variable costs should be considered.
The most obvious example is accepting or not a onetime bid. If a company has a 10 000 surplus products at an actual price of 10£ per unit and that each unit costs 9£ using a full costing system (says 8.6£ with absorption costing and 9.1£ with ABC costing), the manager would refuse a bid from a foreign reseller willing to buy them at 7£ per unit because he calculates a loss of 16000£ or 21000£ (according to the method used). However, if the variable cost per unit is 6£, the manager can see a contribution of 10000£ towards fixed costs. If he hasn’t any other bid, he could accept it (after considering non quantitative information).

2. Absorption costing:

* The allocation process:

This system defines overheads as “those costs that create the environment in which production can take place, but which do not relate specifically to any particular job” (Atrill & McLaney, 2009, p98). Its principle is sharing them in a “fair” way using absorption rates. It is inappropriate to use a blanket rate because different jobs do not spend equal time in...

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