Working in the Margins: Everyone's Talking about Activity-Based Costing, but Are We Neglecting More Traditional Costing Methods? David Allen Reconsiders Marginal Costing and Brings an Old Established Technique into Contemporary Focus. (Management)
Allen, David, Financial Management (UK)
Activity-based costing has been one of the most strongly promoted techniques in accountancy in recent years. However, this form of absorption costing is usually so complex that it is possible only if users buy the latest version of some type of proprietary software.
Older members, in particular, will remember that absorption costing was always the preserve of financial accountants--there is only one past, so it is natural to seek the one "true" cost. Cost accountants (and, later, management accountants) on the other hand, have always been more interested in the future, where there is an infinite variety of possible opportunities.
To seek the one true future absorption cost is totally irrational, and is a waste of time for anyone wishing to help managers make a decision. Management accountants are far more interested in incremental revenues and outlays. For example, if a proposed marketing investment is expected to increase volume by 1,000 units, what extra costs are likely to be incurred? This is why they prefer what UK practitioners call a marginal costing approach.
The essence of the marginal approach is to focus on contribution per unit of limiting factor, for example, in a profit-seeking enterprise, incremental revenue minus incremental cost. Therefore, if total production is limited by machine hours, preference should be given to the products which show the highest contribution per machine hour, leading to the maximisation of contribution and profit.
Another trend has been to reduce the proportion of costs that are specific to products and vary with volume, where more and more costs are shared across products and are insensitive to volume changes. Interestingly, this has enhanced the attraction of the marginal approach, since it is the incremental contribution of an opportunity which is the crucial input to decision-making.
However, value-based management is nothing new. As with many techniques, the simple principles are well documented, but the practicalities are less well covered. This is perhaps because they are more specific to individual businesses, or more likely because practitioners are not motivated to share with the world what they regard as bringing them significant competitive advantage.
In this particular case, the original advocates of marginal costing--operating in conditions of relative stability, reflecting supply side restrictions such as rationing and licensing--focused sharply on the operational level of control, which is all about the here and now. At any point in time, there is normally only one limiting factor.
However, if we raise our sights to the tactical level the view changes. In the medium term, limiting factors can be perceived as waxing and waning, not least as a consequence of managerial action prompted by the focus inherent in the marginal approach. …