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1. If the opening and closing inventory levels differ, the profit reported under the two methods will also be
different. In the long run, total profit under the two methods will be the same.
2. Marginal costing is more useful for decision-making purposes, but absorption costing is needed for financial
reporting purposes to comply with accounting standards.
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.
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F5 - Performance Management
Part A Specialist cost and management accounting techniques
Lack of understanding
ABC is a complex, time consuming technique which will not be sufficiently understood and accepted by
managers to enable them to provide meaningful product costs or extra information.
The costs of implementation ABC may exceed the benefits.
Main steps involved in developing a target price and target cost for a product in a
typical manufacturing company.
Step 1: Determine a product specification of which an adequate sales volume is estimated.
Step 2: Set a selling price at which the organization will be able to achieve a desired market share.
Step 3: Estimate the required profit based on return on sales or return on investment.
Step 4: Calculate the target cost = target selling price target profit
Step 5: Compile an estimated cost for the product based on the design specification and current cost levels.
Step 6: Calculate target cost gap = estimated cost target cost.
Step 7: Make efforts to close the gap.
Step 8: Negotiate with the customer before deciding whether to go ahead with the project.
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F5 - Performance Management
Part A Specialist cost and management accounting techniques
Customer focus
Customer requirements for quality, cost and time are incorporated into product and process decisions.
The value of product features to the customers must be greater than the cost of providing them and only
those features that are of value to customers are included.
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F5 - Performance Management
Part A Specialist cost and management accounting techniques
Cost control
Cost control is emphasized at the design stage so any engineering changes must happen before production
starts.
Life cycle costing shows all costs relating to product rather that relating to single period, thus providing more
accurate information for decision making.
The costs of researching, developing and designing products are also taken into account. This will allow more
accurate analysis when measuring the performance of new products.
The life cycle concept results in earlier actions to generate revenue or to lower costs than otherwise might be
considered.
Better decisions should follow from a more accurate and realistic assessment of revenues and costs, at least
within a particular life cycle stage.
Life cycle thinking can promote long-term rewarding in contrast to short-term profitability rewarding.
The life cycle concept helps managers to understand acquisition costs vs. operating and support costs.
It encourages businesses to find a correct balance between investment costs and operating expenses.
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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F5 - Performance Management
Part A Specialist cost and management accounting techniques
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