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Why absorption costing will produce higher profit than marginal costing?
In marginal costing, inventories are valued at variable production cost, whereas, in absorption costing, inventories are valued at their full production cost. So, if the opening and closing inventory levels differ, the profit reported under the two methods will also be different. If opening inventory values are less than closing inventory values, profit under absorption costing will be lower than that under marginal costing. If opening inventory values are higher than closing inventory values, profit under absorption costing will be greater than that under marginal costing.
Briefly outline the steps involved in allocating overheads using activity based costing.
Identify the organizations major activities. Collect the costs associated with each activity into cost pools. Identify the cost drivers i.e. those factors which give rise to the costs. Charge the costs to the products on the basis of the cost driver.
Why activity-based costing may be preferred to traditional absorption costing in the modern manufacturing environment.
Absorption costing uses volume as a basis for cost allocation. Therefore it tends to allocate too great a proportion of overheads to high volume products and too small to low volume products. ABC uses several bases or cost drivers to allocate overheads and as such will more closely link overhead allocations to the causes of overhead costs. Therefore ABC recognizes the complexity of manufacturing in its use of multiple cost drivers and so more detailed cost information is available. ABC also enables a good understanding of what drives overhead costs as it accumulates a good deal of data for analysis. Therefore ABC can be used as an information source for budget planning based on activity rather than incremental budgeting. ABC also establishes a long run product cost.
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Main steps involved in developing a target price and target cost for a product in a typical manufacturing company.
Step 1: Step 2: Step 3: Step 4: Step 5: Step 6: Step 7: Step 8: Determine a product specification of which an adequate sales volume is estimated. Set a selling price at which the organization will be able to achieve a desired market share. Estimate the required profit based on return on sales or return on investment. Calculate the target cost = target selling price target profit Compile an estimated cost for the product based on the design specification and current cost levels. Calculate target cost gap = estimated cost target cost. Make efforts to close the gap. Negotiate with the customer before deciding whether to go ahead with the project.
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Cost control Cost control is emphasized at the design stage so any engineering changes must happen before production starts. Faster time to market The early external focus enables the business to get the process right first time and avoids the need to go back and change aspects of the design and/or production process. This then reduces the time taken to get a product to the market.
Difference between traditional management accounting system and life cycle costing.
Traditional management accounting system do not accumulate costs over a products entire life and do not assess a products profitability over its entire life. Instead, they do it on a periodic basis and this makes the product seem less profitable than they really are. Life cycle costing tracks and accumulates actual costs and revenues attribute to each product over its entire life cycle. Hence, the total profitability of any given product can be determined.
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