Absorption Costing And Margin Of Safety Accounting Essay

Category: Accounting

2 - Affects of Special Advertising Campaign

If the numbers of unit sold is that equal to the change in the break-even point, generally it would be same. However, with the special advertising in place, even though it will give the same profit this year, it might be worthwhile in the long term as it affects the following years.

Thinking of as a long term investment, with advertisement, the product and business becomes more exposed to the market and increases its brand reputation. This may result in a new influx of customers, which may aid in widening the existent customer base. Not only that, it might help retain current customers and remain its loyalty with the business. In return, this may increase sales for the following years because both the existing and new customers continue to buy from you, therefore help expand the business.

3 - New Scenario Outcome

New scenario modifier

Sales Fall by 15%: 2,000,000 x 85% = 1,700,000

10% Reduction in purchase: 1,340,000 x 85% x 90% = 1,025,100

Administration Expenses: 262,800 + 20,000 = 282,800

£

£

Sales

1,700,000

Variable Cost

- Cost of goods sold

1,025,100

- Other Operating Cost

300,000

1,325,100

Contribution

374,900

Fixed Cost

282,800

Net Profit

92,900

The new scenario will results in £4,300 less profit than the original plan.

4 - Alternative Supplier

Cost of alternative supplier with each product

Product 1

Product 2

Product 3

Sales

850,000

510,000

340,000

Variable Cost:

- Cost of goods sold

459,000

321,300

244,800

- Other Operating Cost

150,000

90,000

60,000

Total Variable Cost

609,000

417,300

304,800

New Contribution

241,000

98,700

35,200

Old Contribution

250,000

90,000

20,000

Difference

-9,000

+8,700

+15,200

On the table, not including the added fixed cost, when comparing in contribution; Product 2 and 3 appear to generate more contribution than the old supplier. However Product 1, unlike the other two, seems to be making less contribution compared to the old plan. This might suggest the it would be in the company's best interests to keep Product 1 with the usual suppler and shift the other two products to the new supplier.

It is also crucial to check if the additional administration expenses are still 20,000 or lower, as two products are used with the new supplier instead of all three.

5 - Qualitative issues

In qualitative issue, the new alternative supplier tends to have higher fixed cost with lower variable cost while the original supplier has a lower fixed cost with a higher variable cost.

If the business decides to increase the products brought from the supplier than before, it might consider switching all of the products to the new supplier. This is because with the fixed cost staying the same, even if it is more than the other supplier, the variable cost is lower than the other one. After break-even, the business will enjoy a considerable amount of profit more than the other one each time the product is brought more.

However if the business instead decides to decrease the number of item purchased and sold, switching back to the original supplier might give a better deal as it has a lower fixed cost. This means the revenue will breaks even faster and earns profit at a lower stage with a easier margin of profit, however increase profit will be gained slower than the other type as more products are sold.

6 - Process and Factors of Absorption Costing

Absorption is a method of costing which assigns all its costs (whether the cost is variable or fixed, direct or indirect), to charge into the cost units (product or service) which is produced or provided by the business. This form of costing can also be used to calculate profit and check stock valuation for business to use on their financial statement.

When calculating absorption, there are three main stages to follow. These are:

Allocation

Apportionment

Overhead Absorption

First, the business has to allocate its overheads. This is a process which charges both the direct and indirect overheads into a cost centre which is related to. (E.g. the cost of equipment or building that is devoted to the production of an exclusive product.) However, if the overhead cannot be allocated, it must be individually apportioned.

The second stage of the absorption costing is the apportionment. This is where the business has to allocate some of its department cost to other department. This means dividing up and giving a fair share of all the overhead cost from a service to the production cost centres.

For example, a like a store and maintenance cost, which does not earn money for its department (e.g. Maintenance, Store, Cleaning), will get moved to the other production centres.

When apportioning a department overhead, there are three methods in treating the allocation process. It could be ignored, eliminated or repeated distribution. Each one gives a varied result and works better depending on the scenario. (E.g. A that service department that works solely for a production department might find itself using the "Ignoring" technique better than a scenario where a department that works for another department as well as a production department while "elimination" method in this scenario would be better)

The last stage is the absorption itself. This is when all the overheads that was been allocated, and apportioned, will get absorb into production of the cost centre in each unit, while determining how much each cost unit can absorb by using cost absorption. The overheads will have to be broken down into pieces before being absorbed. This then is where the business finds out either the figure is over or under absorbed.

Overall, an example to summarise the whole of absorption costing; assume a business produces Herbert Kornfield T-shirts for sales. First, the business has to find out cost that is directly linked to the production of the goods, this means taking the machines (production departments) that is used to make and print the T-shirts into cost. Then the business needs to share out the service of the cost centres, like the maintenance and store cost, and spread it out over the production department on a reasonable base. Finally, these costs are absorbed into each individual T-shirts that is produced at the end to find out if the costs are recovered.

7 - Incorrect Decisions for Managers from Absorption Costing

While Absorption costing is useful in some cases, however it is sometimes not useful for managers and could instead be highly misleading which results in taking wrong decisions, planning and controlling choices.

The main reason of this is because absorption costing based on both types of cost and does not recognise the significance of fixed cost. In this type of costing, fixed costs get taken up in the cost unit; it is hard to tell the difference between the fix and variable cost.

Spreading the fixed costs over the numbers of units produced is part of the problem. As more products are produced, the cost per units falls. Also output may vary from periods so this is not helpful with controlling. Furthermore, this type of costing is only correct at the level of activity which was planned for. Any increase or decrease with the level throws off the balance with calculation and may mislead managers on profitability of the products sold.

Moreover, the other problem of the absorption costing is the overhead absorption. Calculating under or over absorption may not tell the real reason for inefficiencies. Using this type of costing can also disturb incentive decisions since the rate of overhead is based on units that are produced instead of units sold, this also makes harder for overheads to control.

In addition with this type of costing, some part of the fixed cost is moved over to the next accounting period as a part of the closing stock in inventory. This increases the inventory values and instead of retaining the cost, more overheads will have to be carried forward rather than being charged. Not only that, the capital tied to inventory from overproduction can cost a lot to upkeep. However, these costs will not be visible to managers when making decisions and it has a risk of over producing an item when it is unwanted

Overall, using profit per unit is not reliable as the overhead allocations are completely random. Also comparing between different products can be confusing because fixed costs are also randomly apportioned to it. Furthermore, decisions are less liable to choose from as the capacity levels are based on past information which could be easily questioned as it is less reliable.

What manager may needs is to make decision is the total cost, unlike absorption costing; the association with cost volume profit is ignored and possibly give managers a view on choices to make.