[ F5 ] The difference between absorption costing and marginal costing

The difference between absorption costing and marginal costing       

                                     ----Relevant to Paper F5

 

        Absorption costing is a method of product costing which aims to include in the total cost of a product (unit, job, and so on) an appropriate share of an organisation’s total overhead, which is generally taken to mean an amount which reflects the amount of time and effort that has gone into producing the product. In other words, absorption costing is a mean of incorporating a fair share of these costs into the cost of a unit of product or service provided.

 

        Product costs are built up using absorption costing by a process of allocation, apportionment and overhead absorption. The first stage of overhead apportionment involves sharing out (or apportioning) the overheads within general overhead cost centers between the other cost centers using a fair basis of apportionment (such as floor area occupied by each cost center for heating and lighting costs). The second stage of overhead apportionment is to apportion the costs of service cost centers (both directly allocated and apportioned costs) to production cost centers. The final stage in absorption costing is the absorption into product costs (using overhead absorption rates) of the overheads which have been allocated and apportioned to the production cost centers.

 

        Marginal costing is an alternative to absorption costing. Only variable costs (marginal costs) are charged as a cost of sales. Fixed costs are treated as period costs and are charged in full against the profit of the period in which they are incurred.

 

        When we calculate the profit using different method, the answers are not the same. An example can illustrate:

 

Example:

Selling price per unit                          $10

Variable costs per unit    

     Direct materials                             $2

     Direct labour                                  $3

     Production overhead                     $1

     Selling and distribution                  $1

Fixed costs:

Production: budgeted                         $8,000

          Actual                                        $8,500

Selling and distribution:

(budged and actual)                            $2,000

 

Activity levels:

                                              Year 1                 year2

                                               Units                  Units

Budgeted production             4,000                  4,000

Actual sales                           4,200                  4,000

Actual production                   4,400                  3,800

 

There is no opening inventory in year 1.

 

Required:

Prepare an income statement under absorption costing for years 1 & 2.

Prepare an income statement under marginal costing for year 1 & 2

 

Using absorption costing:

                                                  Year 1                Year 2

                                                     $                       $

Sales                                        42,000               40,000

 

Cost of sales:

     Opening inventory                                          1600

Production:

     Variable costs                      26,400               22,800

     Fixed costs                            8,800                 7,600

 

Closing inventory                       (1600)                   

(over)/under absorption              (300)                900

Gross profit                                  8,700              7,100

Variable selling & distribution     (4200)              (4,000)

Fixed selling & distribution         (2,000)              (2,000)

Net profit                                     2500                 1100

 

Workings :

1.  OAR= $8,000/4000=$2/unit

2.                                                 year1       year 2

Actual overhead                          8,500        8,500

Fixed overhead absorbed           8,800        7,600

(over)/under absorption              (300)         900

3.                                                year1         year2

Opening inventory                          -             200

Add: production                          4400          4000

Less:sales                                 (4200)       (3800)

Closing inventor                           200             -

Valued at full cost/unit$8           $1,600         $ 0

 

Using marginal costing:

                                                        Year 1             Year 2

                                                            $                    $

Sales                                               42,000            40,000

 

Variable production costs:

     Opening inventory                                             1,200

Production:                                     26,400            22,800

   

Closing inventory                           (1,200)                   

Variable selling & distribution         (4200)            (4,000)

Contribution                                  12,600             12,000

 

Fixed costs

   Production                                  (8,500)            (8,500)

   Selling & distribution                  (2,000)             (2,000)                    

Profit                                              2,100               1,500

 

Workings

1.                                                   year 1              year 2

Opening inventory                            -                     200

Add:production                              4,400               4,000

Less sales                                    (4,200)             (3,800)

Closing inventory                            200                       -

 

Valued at full cost/unit $6             $1,200                $0

 

AC profit                                                                         year 1                  year 2

Add: fixed overhead in opening inventory                      2,500                   1,100

Less: fixed overhead in closing inventory                           -                       400

MC profit                                                                        400                          -

200*$2                                                                          2,100                   1,500

 

        The difference in profits reported under the two costing systems is due to the different inventory valuation methods used. In the example, the difference $400 (2500-2100=400) is due to the difference in inventory.

        If inventory levels increase between the beginning and end of a period, absorption costing will report the higher profit bacause some of the fixed production overhead incurred during the period will be carried forward in closing inventory (which reduces cost of sales) to be set against sales revenue in the following period instead of being written off in full against profit in the period concerned.

        If inventory levels decrease, absorption costing will report the lower profit bacause as well as the fixed overhead incurred, fixed production overhead which had been carried forward in opening inventory is released and is also included in cost of sales.

        The difference between the figures will effectively be the OAR/unit * movement in inventory.

 

In all, we can conclude:

1.Production=sales  (so inventory is constant)

AC profit = MC profit

2.Production＜sales  (so inventory is constant)

AC profit＜ MC profit

3.Production＞sales  (so inventory is constant)