absorption versus marginal costing at Sleepease

Managerial accounting, there are different types of costing that can be used. Each method of costing has its advantages and disadvantages in different situations. It must be remembered, when determining what the best type of costing method is, that the objective of managerial accounting is to deliver useful information that can assist in managerial decision-making. Thus, managerial accounting matters to the extent that it can help to deliver on overall organizational objectives by providing strategic or tactical insights (Investopedia, 2016).

There are two major costing methods -- absorption costing and marginal costing. Absorption costing is a system of cost accounting that seeks to accumulate the different costs associated with the production process, and portion these out to different products. So the costs would be broken out into direct materials, direct labor, variable overhead and fixed overhead, rather than the convention categories in financial accounting. Using absorption costing has a few benefits.

First, it helps a company understand which products are genuinely profitable and which are not, because it accounts for the amount of time the company actually spends making the product. That gets factored into the way that the overheads are broken down among the different products. In particular, the treatment of overhead is different with absorption costing. Overhead is a challenge in managerial accounting because overhead is not directly attributable to the product.

Absorption costing wants overhead to be attributed to a product, so there has to be a cost basis. This is sometimes time spent on a given product, but sometimes it could be used on a per unit basis. That technique is less viable when the products are quite different from one another. A decision might have to be made with respect to set-up time as well, should that vary between products.

One of the issues that arises in the Sleepease case is that absorption costing allocates fixed costs based on the number of units produced, regardless of whether or not they sold (Accounting Tools, 2016). This hurts Spenser because there were 300 beds already in inventory at the beginning of 2015. The year ended with 100 beds in inventory, which means that even if the variable costs per bed do not change, the costs per bed will because the fixed costs will be spread out over fewer beds.

So that is one area where absorption costing can be challenging for a manager. But absorption costing has an advantage in that a manager can understand the changes in the cost of producing a good. The manager has an incentive as well to use the full capacity of a facility, and the manager is essentially charged for idle time or idle space. Further, changes in the variable costs can easily be identified, even they fall in a cost category that in financial accounting would be together, like fixed/variable labour.

SleepEase uses an absorption costing system at present. This makes a difference when determining profit. Sleepease could under some accounting systems claim a profit, having sold 1000 units in 2015 and only produced 800, but absorption costing accounts for this. Indeed, what happened was that the fixed overhead and the fixed selling and administrative expenses were allowed over the 800 beds produced, whereas the year before they would have been allowed over the 1200 beds produced. Because absorption costing looks at per unit figures, the profit would not have gone up by 10%.

Marginal costing is based on the idea that the cost of an item is its variable cost. It starts with the idea that the fixed cost is just that, fixed, regardless of managerial decisions. As such, the cost of producing a good is simply the marginal cost of producing it. Fixed costs are not taken into consideration. The advantage of this is that it is simpler to use, and in some respects more reliable, because it is easier to price out the variable costs.

There is no need to determine a system by which fixed costs are allocated to different products under a marginal costing system (Kaplan, 2016). The fixed costs are accounted for under marginal costing as something against which the contribution is counted. The revenues less the marginal costs are the contribution to fixed costs. One of the major conclusions with marginal costing is that the company has to earn enough on the goods it sells to cover the fixed costs.

If the contribution is lower than fixed costs, this is a problem to be addressed. What is also known is that under this scenario there is a profit per unit and only the units sold count, but that this is just the marginal profit, not the net profit. If Sleepease used this system, it would have recorded a profit of £83,000 in 2015, and a profit of £48,000 in 2014. This is an increase of 72.9%, mainly because the firm increased sales by 100 units without any increase in its fixed costs.

So there is a significant difference in the profit for the two different types, because of how many units are included in the cost figures. Overall, marginal cost has the benefit of being easier to use, and it accepts that the fixed costs are fixed. What absorption costing does for the manager is it views fixed costs as being an area of cost control.

Where in both systems, margins can be increased by lower the variable costs or increasing price, absorption costing forces the manager to pay more attention to fixed cost elements, and ensure that they are optimized. Production was not optimized in 2015, which is ultimately why Spenser did not get a bonus -- he increased sales but not enough.

In part, this was because he was handcuffed with a high inventory at the end of 2014 -- he could have produced more beds in 2015 because apparently reducing inventory levels was not one of the criteria against which he was going to be measured. Task 2. SleepEase SleepEase Absorption Costing 2014 2015 per unit per unit Revenue Revenue Variable Costs Variable Costs Fixed Costs Fixed Costs Profit Profit 16.25 153000 x 800 units 13000 SleepEase Marginal Costing 2014 2015 Revenue 900000 Revenue 1000000 Variable Costs 585000 Variable Costs 650000 Contribution 315000 Contribution 350000 Fixed Costs 267000 Fixed Costs 267000 Income 48000 Income 83000 Task 3.

What the above statements show is that the decision to not pay Spenser a bonus was rooted in the type of managerial accounting method used. The absorption method saw the profit decline substantially in the year, despite the increase in sales by 100 units. The marginal costing method showed a fairly strong increase in profit, one that would allow them to pay Spenser. So the decision is rooted in two things -- the underlying logic of the absorption system and the differences in the way that the units are treated.

The units are treated differently for costing purposes. The marginal costing method uses the number of units sold to calculate the costs, because it is only costing on the variable costs of the units sold during the year. The marginal costing method therefore saw an increase in the number of relevant units, from 900 to 1000, as that was the change in the units sold.

But by using this for the costing, the marginal costing system finds that the increase in sales by 100 units, combined with holding all of the fixed costs steady, increased profits significantly. By that logic, there should have been a bonus to Spenser. After all, Spenser was hired as the sales manager. His job is to sell more, and the company did that. Moreover, the selling and administration expense did not rise during 2015. That means that Spenser sold 100 additional units without incurring any additional costs associated with that activity.

That would seem to be cause for a raise, because Spenser did what was asked of him in terms of delivering more sales while containing costs. He was ultimately refused a bonus on the basis of an accounting methodology, related to production costs, which are outside of scope of the Sales Manager. The underlying logic of absorption costing here is that all of the costs are portioned out to the products that are produced. That means that if fewer products are made, this will be reflected in the financial results.

The fact that the production was reduced by 50% did not change the variables costs, but it did reflect in waste, and that shows up in absorption costing. The issue here is that this reflects on the bonus paid to Spenser. First, Spenser inherited an inventory of 300, and second, the production manager used that as a reason to cut back on production.

The fact that the factory was unused for long stretches is not reflective of the work that Spenser was doing, but a combination of poor decision-making on the part of the production manager and on the fact that excess goods were in inventory at the start of the year. Spenser lost his bonus through no fault of his own. Based on this analysis, Spenser should have been paid for his performance in 2015. He increased sales by 100 units, or 11.1%. By the marginal costing system, the company surpassed its profit goal, too.

Indeed, under financial accounting this was the case as well, because the company sold more than it made, which is a great way to make money. Only by absorption costing did the company not meet its financial objectives. Had that been within the scope of Spenser's decision-making, then it would make sense to deny him the bonus. But the Sales Manager is not responsible for production decisions, and the absorption costing issue was entirely related to the slide in production.

So the factor that rendered the year less profitable was entirely the fault of the production manager and the accounting method, neither of which are under Spenser's control. Spenser should only be evaluated on factors under his control. Again, it is worth reiterating that the selling expense also did not rise. If it had, that would override the prior argument, because the selling expense is something that the Sales Manager controls.

But if this particular cost did not increase, then that just means that the sales manager was efficient and was able to bring about an 11.1% increase in sales without even spending incremental money to do so -- by that score Spenser performed very well in 2015 and should definitely have been compensated for that performance. Task 4. The above demonstrates that performance management systems should focus on the factors that employees can control. This goes back to the basic use of managerial accounting.

Managerial accounting systems are used to help make effective managerial decisions. So managers have to understand the accounting method, and what the implications are of the choice of managerial accounting system. This case tells us two things. First, it tells us that the performance management system has to look at the factors that the sales manager can control when evaluating the performance of the sales manager. The bonus issue was the result of decisions made by other people.

The company could lose Spenser -- who performed well -- because of the unfairness in this system. A performance management system works when it incentivizes the activities that each role should be focusing on. That was not the case with the use of absorption costing to determine whether or not Spenser should be paid. Second, the production manager who let the production decline by one-third, because of overproduction in 2014, performed quite poorly. The company clearly was stuck paying the bills for all of those.