"Identify, discuss and critically evaluate the advantages and problems of using the following costing methods for internal reporting purposes":
absorption costing; marginal costing.
"Refer to the Sleepease case as and when necessary"
The absorption costing is the type of managerial costing where both the variable and fixed costs are charged to process or product. Thus, "absorption costing is a method for appraising or valuing a firm's total inventory by including all manufacturing costs as product costs, regardless of whether they are variable or fixed and therefore it is frequently referred as the full cost method." (Nawaz, 2013 p 50).
Accordingly, the company will be able to determine costs of a product after determining both the variable costs and fixed costs. Sleepease will derive several benefits from using the absorption costing for the production of their product.
First, the absorption costing will assist the company to take the account of all the production costs because the absorption costing will take into account all the fixed costs such as utility bills, facility rental and salaries. Moreover, the absorption costing will provide the accurate picture of the company profitability than the marginal costing. (Noreen, Brewer, Garrison, 2013). Additionally, the absorption costing is the best estimate the job costing for the Sleepease because the costing method considers all the element of the fixed overhead values of the inventory. (Lay, 2011).
Despite the benefits that Sleepease will derive from using the absorption costing, however, the absorption costing can cause organizational profits to appear better than the actual profit in the accounting period. Moreover, the absorption costing is not appropriate for the analysis volume and cost of production. Typically, management may face challenges in making decision about the operational efficiency since it may be difficult to determine the cost variation at different production levels.
B. Marginal Costing
Marginal costing is the cost production where a change in the total costs arises from making or producing additional item. (Murthy, Gurusamy, 2009). In other words, the marginal costing arises when an increase in the aggregate cost occurs because of an increase in the production of an extra unit of product. Thus, marginal cost is the cost incurred by producing an additional unit of an item. (Bhattacharyya, 2011). The major reason for analyzing the marginal costs is to identify the point a firm can achieve the economic of scale. Based the analysis of the marginal cost model, when there is a change in the number of items produced, there will be a change in the total costs of production. In most cases, the marginal costs deal with the change in the variable costs with there is a change in the total item produced.
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"Under the marginal costing, only those manufacturing costs that vary with output are treated as product costs. This would usually include direct material, direct labor, and the variable portion of manufacturing overhead. Variable costing is sometimes referred as direct costing or marginal costing. Fixed manufacturing overhead is treated as period cost just as selling and administrative expenses. Thus in inventory valuation or in the cost of goods sold fixed manufacturing overhead is not treated as product cost in marginal costing technique." (Nawaz, 2013 p 50).
The benefit of marginal costing is that it assists in understanding the impact of variable costing on a production of an item. Typically, the marginal costing assists a firm to control costs of production, and help in avoiding the unnecessary fixed overhead costs. By using the marginal cost model, management will be able to concentrate on producing the products that have the lowest variable cost.
Moreover, the marginal costing assists management to understand the impact of cost on profit fluctuation in the volume of sales. The marginal costing will also assist Sleepease to make the short-term profit planning which can be realized through the break-even profit charts and graph. The company can also make a comparative profit analysis of the different type of products produced, which will assist the management to make a decision regarding a particular product. Another benefit of marginal costing is that it is easy to implement because it focuses on the variable and fixed cost concepts. Moreover, the marginal costing delivers better information, which is useful for managerial decision. It also reveals information about the relationship between cost, volume and price. The marginal costing will also assist the company to control the cost of production by avoiding unnecessary allocation of the fixed overhead costs, the strategy will assist the management to concentrate on maintaining and achieving the consistent and uniform marginal costs. (Khan,., & Jain, 2003).
Despite the benefits that the Sleepease can derive from the application of marginal costing, the problem of using the marginal costing is that it will be difficult to separate the variable costs and fixed costs clearly, which may lead to a misleading result. Moreover, the marginal costing will not applicable for the Sleepease when the company decides to produce multiple products. (Horngren,. and Sorter, 1964):Moreover, the application of marginal costing is not suitable for all industry. For example, Sleepease may not be able to use the marginal costing to do the contract business. By eliminating the fixed overhead, the company may face challenges in determining the selling price. Moreover, the marginal costing can not provide the standard method for the budgetary control. The application of marginal costing may also lead to the undervaluation of….....