Chapter 2- Traditional costing

Advantages of absorption costing

1.Ensures fixed production costs are included in product cost measurement.

2.Follows the matching (accrual) concept by carrying forward production costs in inventory.

3.Required for financial statements — includes fixed overhead in inventory valuation.

4.Helps identify under/over absorption, showing efficiency of resource use.

5.Supports the idea that all costs are variable in the long run — forms the basis for Activity-Based Costing (ABC).

Disadvantage’s of absorption costing

1. Overhead costs are spread across products or departments using estimates or assumptions that may not accurately reflect how those costs are actually incurred.- arbitrary and that’s why ABC is used.

2. Profits vary with changes in production volumes

Advantages of marginal costing

1.Simple to use — no need to apportion or absorb fixed overheads.

2. Shows how costs behave with changes in activity (variable vs fixed).

3.Provides more relevant information for short-term decision making.

4.Avoids the disadvantages of absorption costing (e.g., arbitrary overhead allocation).

Disadvantages of marginal costing

1.May give incomplete cost information when fixed costs are high.

2.Less suitable for long-term profitability analysis.

3.Treating direct labour as variable can be unrealistic when wages are fixed.

If inventory level increases

absorption costs give the higher profit 

if inventory level decreases

marginal costs gives the higher profit

Key Factors in Pricing Decisions

1. Costs – Price must cover production/service costs and include a profit margin. (→ Cost-plus pricing: add markup to cost to set price.)

2. Competitors – Prices are set considering competitor prices and the firm’s competitive strategy.

3. Customers – Price depends on customer value perception and willingness to pay.

4. Corporate Objectives – Pricing supports business goals (e.g., low prices to gain market share, high prices to show quality).

Full cost plus pricing equation

selling price = full cost per unit x (1+mark up percentage )

Advantages of full cost plus pricing

1. required profit will be made if budgeted profit is achieved 

2. Useful in contract-based industries (e.g. construction) where a few large contracts use most fixed costs and fixed costs are low compared to variable costs.

3. cheaper and quick

4. full cost plus pricing can be usually to justify it to customers 

Disadvantages of full cost plus pricing

1. Difficult to allocate fixed costs accurately, leading to over- or under-pricing.

2. If actual sales volume is lower than expected, overheads may not be recovered.

3. Mark-up may be arbitrary (personal choice) and ignore competition or customer demand.

Marginal cost plus pricing equation

selling price= marginal cost per unit x (1+ mark percentage)

Advantage of marginal cost plus pricing

• As accurate as total cost plus pricing, with uncertainty over fixed costs in both methods.

• Allows pricing below total cost in tough times to maintain capacity.

• Useful for one-off contracts as it includes only variable costs.

• Considers scarce resources to maximize profit from limiting factors.

disadvantages of marginal cost plus pricing

• Ignores factors like competition and customer demand.

• Mark-up is highly arbitrary since it must cover fixed costs.

• Best suited only for short-term or one-off decisions.

Target return on capital

the mark up is calculated as: profit mark up = targeted return on investment in the product/ budgeted level or production 

the targeted return on investment is calculated as: targeted return on investment in the product= total investment in the product x targeted rate of return 

Profit margin equation

selling price= total cost / (1-required margin)