Question No. 2 - MMPC 004 - Accounting for Managers - MBA and MBA (Banking & Finance)

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                            MBA and MBA (Banking & Finance)

MMPC 004 - Accounting for Managers

MMPC-004/TMA/JULY/2022

Question No. 2. Explain the following 
(a) Marginal Costing 
(b) Activity Based Costing

Solution: 

a)  Marginal Costing

Marginal costing in economics and managerial accounting refers to an increase or decrease in the total cost of production due to a change in the quantity of the desired output. It is variable, depending on the inclusion of resources required to produce or deliver additional unit(s) of a product or service.

Calculating marginal cost enables managers to make decisions on resource allocation, optimize the production and operation, control manufacturing costs, plan budget and profits, etc. It considers expenses incurred at each production stage, except for overhead pricing. The practice is common in manufacturing industries, allowing companies to achieve economies of scale.

Definition: Marginal Costing is a costing technique wherein the marginal cost, i.e. variable cost is charged to units of cost, while the fixed cost for the period is completely written off against the contribution. 

Marginal cost is the change in the total cost when the quantity produced is incremented by one. That is, it is the cost of producing one more unit of a good. 

For example, let us suppose: 

Variable cost per unit = Rs 25 

Fixed cost = Rs 1,00,000 

Cost of 10,000 units = 25 × 10,000 = Rs 2,50,000 

Total Cost of 10,000 units = Fixed Cost + Variable Cost = 1,00,000 + 2,50,000 = Rs 3,50,000 

Total cost of 10,001 units = 1,00,000 + 2,50,025 = Rs 3,50,025 

Marginal Cost = 3,50,025 – 3,50,000 = Rs 25 

The term marginal cost implies the additional cost involved in producing an extra unit of output, which can be reckoned by total variable cost assigned to one unit. It can be calculated as: 

Marginal Cost = Direct Material + Direct Labor + Direct Expenses + Variable Overheads

Characteristics of Marginal Costing 

•  Classification into Fixed and Variable Cost: Costs are bifurcated, on the basis of variability into fixed cost and variable costs. In the same way, semi variable cost is separated. 
• Valuation of Stock: While valuing the finished goods and work in progress, only variable cost are taken into account. However, the variable selling and distribution overheads are not included in the valuation of inventory.
• Determination of Price - the prices are determined on the basis of the marginal cost and marginal contribution.
• Profitability - the ascertainment of departmental and product's profitability is based on the contribution margin.

Features of Marginal Costing Features of marginal costing are as follows: 

 Marginal costing is used to know the impact of variable cost on the volume of production or output.  Break-even analysis is an integral and important part of marginal costing. 

 Contribution of each product or department is a foundation to know the profitability of the product or department. 

 Addition of variable cost and profit to contribution is equal to selling price. 

 Marginal costing is the base of valuation of stock of finished product and work in progress. 

 Fixed cost is recovered from contribution and variable cost is charged to production. 

 Costs are classified on the basis of fixed and variable costs only. Semi-fixed prices are also converted either as fixed cost or as variable cost.

Ascertainment of Profit under Marginal Cost 

‘Contribution’ is a fund that is equal to the selling price of a product less marginal cost. 

Contribution may be described as follows: 

Contribution = Selling Price – Marginal Cost 

Contribution = Fixed Expenses + Profit 

Contribution – Fixed Expenses = Profit

Marginal Costing Approach

The difference between product costs and period costs forms a basis for marginal costing technique, wherein only variable cost is considered as the product cost while the fixed cost is deemed as a period cost, which incurs during the period, irrespective of the level of activity. Facts Concerning Marginal Costing 

 Cost Ascertainment: The basis for ascertaining cost in marginal costing is the nature of cost, which gives an idea of the cost behavior, that has a great impact on the profitability of the firm. 

 Special technique: It is not a unique method of costing, like contract costing, process costing, batch costing. But, marginal costing is a different type of technique, used by the managers for the purpose of decision making. It provides a basis for understanding cost data so as to gauge the profitability of various products, processes and cost centers. 

 Decision Making: It has a great role to play, in the field of decision making, as the changes in the level of activity pose a serious problem to the management of the undertaking. 

Marginal Costing assists the managers in taking end number of business decisions, such as replacement of machines, discontinuing a product or service, etc. It also helps the management in ascertaining the appropriate level of activity, through break even analysis, that reflect the impact of increasing or decreasing production level, on the company’s overall profit.

Advantages of Marginal Costing 

The advantages of marginal costing are as follows: 

 Easy to operate and simple to understand. 

 Marginal costing is useful in profit planning; it is helpful to determine profitability at different level of production and sale. 

 It is useful in decision making about fixation of selling price, export decision and make or buy decision. 

 Break even analysis and P/V ratio are useful techniques of marginal costing. 

 Evaluation of different departments is possible through marginal costing. 

 By avoiding arbitrary allocation of fixed cost, it provides control over variable cost. 

 Fixed overhead recovery rate is easy. 

 Under marginal costing, valuation of inventory done at marginal cost. Therefore, it is not possible to carry forward illogical fixed overheads from one accounting period to the next period. 

 Since fixed cost is not controllable in short period, it helps to concentrate in control over variable cost.

b) Activity Based Costing

Activity-Based Costing (ABC) is a system of costing, where costs are first traced to activities and then to products. This costing system works with an assumption that activities are responsible for the costs that are incurred. As stated earlier, costs are charged to products based on the individual product's use for each activity. 

The Chartered Institute of Management Accountants, UK (CIMA) defines1 ABC as “an approach to the costing and monitoring of activities which involves tracing resource consumption and costing final outputs. Resources are assigned to activities, and activities to cost objects based on consumption estimates. The latter utilise cost drivers to attach activity costs to outputs”.

The important issues of the definition are as follows:

 

 ABC is a tactic to the costing and does monitoring of activities in a process. 

 It traces the consumption of resources and then the costing of resultant outputs. 

 In this, resources are assigned to activities and then activities to cost objects based on consumption estimates. 

 It utilises identified cost drivers to assign activity costs to depicted outputs. 

Another description of Activity-based costing is that it is a two-stage based costing method that allocates indirect costs and overheads to products and services. Some costs are tough to assign to a product or a service. It identifies the connection between overheads and manufactured products and gives indirect costs to the products. The method is less arbitrarily than the traditional costing system.

Features of Activity Based Costing (ABC) 

Features of Activity Based Costing are as follows: 

 ABC is a modern approach to the allocation of indirect costs. Costs allocated to each activity symbolise the resources consumed by the activity.
 As done in conventional costing, ABC is not restricted to the allocation of indirect costs to departments. It moves further to identify the individual activity for indirect cost allocation as the lowest unit. 

 Based on consumption, resources are allotted to each activity and then to cost objects. 

 ABC identifies the activities using the activity cost drivers and results in a more accurate cost calculation. 

 This approach facilitates easy identification of cost according to activities cost driver. 

 This costing method is suitable if there is more than one product in the manufacturing line and overheads have a high share in total cost. 

 This approach creates a straight cause and effect association with various resources. 

Development of Activity Based Costing 

Limits of the traditional costing system gave way for the development of ABC. The traditional arrangement segregates costs into fixed and variable. As the business grows, the costs become more complex, and then the traditional approach may not be appropriate for making complex decisions related to production and developing product strategies. The traditional methods facilitate financial reporting and primarily put prominence on calculating overhead rates for the valuation of stocks. It was seen that the traditional absorption costing approach could not go well with multi-product scenarios, so a change was in line. In fact, multiple-products scenario or product diversification requires accurate product cost ascertainment due to increasing market competition within the country and internationally. In the 1980s, ABC was first defined by Kaplan and Bruns2 . It was taken as the modern alternative to absorption costing, which could define product and profitability in a better way. It provides better information to make more effective decisions.

OBJECTIVES OF ACTIVITY BASED COSTING (ABC) 

Some objectives of ABC are listed as under: 

 To recognise several activities in the process of production, including the activities that add value. 

 To eliminate the non value-adding activities. 

 To put emphasis on the high-cost activities

 To incorporate activities based on distribution overheads. 

 To help in decision-making process in the identification of a suitable price of product and services. 

 To ensure accurate and precise cost determination of products and services. 

 To find options to improve the process and reduction of costs. 

MERITS AND DEMERITS OF ACTIVITY BASED COSTING (ABC) 

Merits 

 Removes Cross Subsidization Issues 

The traditional system gives rise to the issues of over and under-costing. Products may be subject to over-costing, which may result in under costing of other products. ABC may take care of this issue. ABC put the role of activities between costs and products and makes the relationship more explicit. 

 Deals with Complicated Processes 

There have been growth and development in all walks of life, including production of product and services. Due to this, complications in various processes have risen in the industries too. Now, there are cross-linkages in the production process and costing of products. The number of processes and activities involved in production has increased. ABC deals with these complications in costing that emerged due to processes. 

 Product Customisations 

Nowadays, production is being done with many variations, in terms of sizes, design etc. If the production takes place on one premise, the costing process will need refinement to price the products suitably. ABC helps here. 

 Identification of Cost Saving Chances 

In ABC, it is easier to identify cost saving opportunities. It considers costs to all areas, including various processes, products, managerial responsibility, customers, departments etc. It removes the issues related to the error of estimation.

In this system, costs are managed in the long run by controlling the activities that drive them. In other words, the aim is to manage the activities rather than costs. By managing the forces that cause the activities (cost drivers), costs will be managed long-term. Collecting and reporting on the significant activities a business engages in makes it possible to understand and manage costs more effectively.

Demerits 

 A Complex System 

ABC works with various cost pools and drivers. It is assumed to be more complex than the traditional system of product costing. This is one of the demerits. In fact, selection of drivers, common costs, driver rates etc., put forward a complex system. 

 Product and Process should be Fully Known 

One of the significant demerits is that the people who are employing ABC usually require significant experience in the products and processes of the industry. ABC is preferred if the firm uses cost-plus pricing, whereas marketbased prices may not favour it. 

 Rely on a sophisticated system 

ABC requires a minimum level of information technology in the organisation. Much data is needed and processed for implementing a particular decision. Small and new organisations may not take full advantage of ABC, due to poor information technology systems. 

 Consumes a lot of Time and efforts 

ABC is a time-consuming process. It comprises a number of steps and a lot of groundwork to start and complete the process. Organisations may put time and effort if they get utility out of the process. As mentioned earlier also, large manufacturing firms can utilise it better than small firms. 

 Increase in Indirect Costs 

Due to the high involvement of technology in ABC, indirect costs rise significantly.

PROCESS OF ACTIVITY BASED COSTING (ABC)

Stages in ABC 

Stages of ABC costing are mentioned as follows: 

• Identification of the organisational activities and manufacturing process For ABC, it is indispensable to study the organisational activities and manufacturing process to determine the number of stages involved. By this, all the activities involved in producing the product or service can be identified. ABC believes that activities cause cost.
• Classify the factors which determine the costs of an activity, known as cost drivers. According to CIMA, ‘cost driver is any factor which causes a change in the cost of an activity, e.g. the quality of parts received by an activity is a determining factor in the work required by that activity and therefore affects the resources required. An activity may have multiple cost drivers associated with it.’’4 As per this definition, in the traditional system of product costing, the number of cost drivers can be identified as direct labour hours, units produced, etc. In ABC, cost drivers are related more closely to the consumption of resources and activities. As mentioned earlier, ABC considers that activities bring about costs, so they are linked, and the identified cost drivers are the linkages amid them.
• Identify the costs of each activity, known as cost pools The cost pool concept is similar to the concept of the cost centre. CIMA defines cost pool as ‘the point of focus for the costs relating to a particular activity in an activity-based costing system. ‘It is the sum total of the cost elements allotted to an activity. The cost pool is taken as the point of focus to assign the total cost to an activity.
• Charge costs to the products It is known that ABC is the method of tracing and assigning costs:  from resources to activities and then  from activities to specific products