Derivation of a Cost, Essay Example

In costing production costs, different systems of costing can be used. The most popular systems are absorption costing and marginal costing. Absorption costing, also known as full costing method,  considers all production costs to be product costs, whether variable or not. This therefore means that the unit cost of a product under this method will be comprised of direct materials, direct labor, variable and fixed overheads. Each unit of product is allocated a portion of both fixed and variable manufacturing overhead costs. It is also called full costing method because it incorporates all costs of production as product costs. (Accounting for management 2009)

Marginal, direct or variable cost on the other hand, includes only the costs of production that vary with output. Examples of these costs are direct materials, direct labor and variable manufacturing overheads. Note that unlike in absorption costing where manufacturing fixed costs are treated as product costs, in variable costing they are treated as period costs. In each period, the full amount of fixed manufacturing cost is charged against contribution. Fixed costs are also eliminated in the cost of goods sold. According to Coulthurst (2000), marginal costing puts more emphasis on the behavioral characteristics of cost because it separates variable elements from the fixed elements. This method could best suit a business that deals in multi-products in decision making, planning on short-term basis and control.

Overproduction only seems as a good idea when a firm wants to look appealing to its stakeholders in terms of profitability. It gets to stabilize its products’ prizes. It is however a wrong move because overproducing results to a large portion of working capital being tied up in stock hence increasing the risk of obsolescence. (Accy403MSA, 2009). The profitability shown by a company that is overproducing does not reflect the true state of profitability since high risk is involved. The stakeholders would therefore not be amused if they discovered that the company is overproducing.

• The units of production produced were 21,000

1. The units of production shipped were 20,000
2. The units of production left in inventory were 21,000-20,000= 1,000

• The firm’s predetermined fixed overhead rate is Ksh 2,000,000

1. How much of the firm’s fixed costs stayed in inventory under:
2. a) Variable costing=0
3. b) Absorption costing.

• 2,000,000/1000=$ 2,000

1. Calculate unit cost
2. Using variable costing.

• 600,000/21,000=$ 28.57

1. Using absorption costing

• 600,000/20,000= $ 30

1. Based on this firm’s predetermined fixed overhead rate, how much of the firms fixed costs ended up on the year’s COGS and income statement
2. a) Under variable costing =No fixed cost ends up in the COGS. All fixed cost is charged to contribution/revenue hence reflected in the income statement.
3. b) Under absorption costing= All fixed costs are reflected in the COGS.
4. The method that reports higher profits is absorption costing because it carries forward closing stock of a certain period to the subsequent period. This reduces the amount of cost of goods sold chargeable to revenue hence higher profit. On the other hand, marginal costing charges all the fixed costs against contribution resulting to lower profits compared to profits in absorption costing.

References

Accounting for management (2009). Variable Costing Versus Absorption Costing. Retrieved on Oct 20, 2010 from http: http://www.accountingformanagement.com/variable_and_absorption_costing.htm

Accy403MSA (2009). Criticisms of absorption Costing. Retrieved on Oct 20, 2010 from http:// www.docstoc.com/docs/5689032/Criticisms-of-Absorption-Costing

Coulthurst N. (January 2000). ‘Process Costing’. Students’ Newsletter. Retrieved on Oct 20, 2010 from http:// http://accountantzed.tripod.com/technicalnotes/aprol2001abcosting.htm