HISTORICAL COST CONVENTION, MARGINAL
AND ABSORPTION COSTING
Historical Cost Convention
Accounts are prepared under the historical cost convention. Historical cost accounts show the profits available to shareholders and are the most appropriate basis for presentation of the group’s balance sheet. Profit or loss determined under the historical cost convention includes stock holding gains or losses and, as a consequence, does not necessarily reflect underlying trading results. Also under the historical cost convention is the actual acquisition cost used for initial accounting recognition purposes. It assumes that assets are acquired in business transactions conducted at arm’s length. If an asset is acquired through some means other than cash, the cost of the asset is based on the value of the consideration given.
The development of accounting standards for financial instruments has essentially been shaped by the need to report the off-balance-sheet exposures that entities might have to derivative contracts, which under traditional reporting norms are not reported, as derivatives do not have an investment to begin with, and therefore, no cost to report. Because of failures in the finance world, accounting standard setters realized that the existing historical cost convention was wholly unfit for financial instruments where the historical cost may give no indication of the inherent risks.
Marginal Costing
Instead of the functional, characteristics of costs, the marginal costing system emphasizes the behavioral, rather than. The focus in this system is to separate costs into variable elements and fixed elements. Although this is not easily achieved because of the limitation in accuracy, and is an oversimplification of reality, marginal costing information can be very useful for short-term planning, control and decision-making. This is especially so in a multi-product business. In this system, sales less variable costs, regardless of function, measures the contribution that individual products/services make towards the total fixed costs incurred by the business. The fixed costs, regardless of function, are treated as period costs and, as such, are simply deducted from contribution in the period incurred to arrive at net profit.
Marginal costing is a simple, cheap and accurate method of comparing two items in order to make a choice between them. It is not a means of establishing the actual profitability of a product, customer, etc. This can be illustrated in the decision to choose the one that will produce the greater profit. For this purpose it is sufficient to compare the increase in profit resulting from each product. To do this, all aspects which are the same regardless of this decision can be ignored. This may include some items normally regarded as overhead costs, but will certainly not involve most of them. Similarly, direct costs which are the same for both can be ignored. Any incidental impact on other costs or sales of other products must be considered, however, if they differ as between the two which are the subject of the study. This is a very powerful but cheap and relatively simple technique which is much under-used.
Absorption Costing
Absorption costing is a traditional method where the cost of the product must show the full cost of getting the product out. More costs are capitalized (held out of current expenses) and put into inventory with the product rather than being expensed when they occurred. This means that these costs do not become expenses until the inventory is sold. In this way, matching is more closely approximated (Martin, 2004). These costs will not impact the P&L statement until the individual products are sold (Barnes, 1992). Thus, we see that this decision about the costing approach affects inventory costs and the timing of profit, which explains the strong external interest in a company’s approach.
Due to the absorption of fixed manufacturing overheads into the value of work-in-progress and finished goods stocks, the profit reported for a manufacturing business for a period is influenced by the level of production, and also by the level of sales (Coulthurst, 2000). If stocks remain at the end of an accounting period, it also follows that the fixed manufacturing overhead costs included within the stock valuation will be transferred to the following period. Technically, absorption costing is required for external reporting, although many companies apparently use something less than a pure full absorption costing system. Absorption costing method is most common for external reporting; however, it is also frequently used for internal reporting.
References
Coulthurst, N. (2003). Absorption and marginal costing systems. Accountant Zed. Available at [http://accountantzed.tripod.com/technicalnotes/aprol2001abcosting.htm]. Accessed [04/02/04].
Martin, J. R. (2004). Cost accounting systems and manufacturing statements. Management accounting concepts, techniques, and controversial issues. Available at [http://www.maaw.info/Chapter2.htm]. Accessed [04/02/04].
Barnes, F. C. (1992). Management’s Stake in Improved Decision Making with Activity-Based Costing. SAM Advanced Management Journal, 57(3), 20+ 1992
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