The full production cost per unit = £6 + £2 = £8 per unit
With production of 20,000 Splashes the fixed overhead will be over-absorbed.
£
Fixed production costs absorbed (20,000 units × £2) 40,000
Fixed production costs incurred 30,000
Over-absorbed fixed production cost 10,000
10,000 Splashes 15,000 Splashes 20,000 Splashes
£ £ £ £ £ £
Sales 100,000 150,000 200,000
Opening inventory 0 0 0
Full production costs 160,000 160,000 160,000
160,000 160,000 160,000
Less closing inventory
(at full production cost) 80,000 40,000 0
Full production of sales 80,000 120,000 160,000
Adjustment for over-
absorbed overhead 10,000 10,000 10,000
Full production costs 70,000 110,000 150,000
Gross profit 30,000 40,000 50,000
Administration, sales and
distribution costs 15,000 15,000 15,000
Net profit 15,000 25,000 35,000
Section summary
With absorption costing, fixed production costs are absorbed into product unit costs using a predetermined overhead absorption rate, based on the normal level of production for the period. Inventories are valued at their full production cost including absorbed fixed production costs.
3 The effect of marginal costing and absorption costing on
reported profit and inventory valuation
Introduction
Note that if there are changes in inventories during a period, marginal and absorption costing will report different profit figures.
The results of the last two examples can be compared as follows.
Sales volume (Splashes)
10,000 15,000 20,000
Marginal costing profit/(loss) £(5,000) £15,000 £35,000
Absorption costing profit £15,000 £25,000 £35,000
Increase in inventory units 10,000 5,000 0
In this example the inventory levels increased with the two lower sales volume figures and the reported profit figure was higher with absorption costing than with marginal costing.
This is because 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.
This is because as well as the fixed overhead incurred, fixed production overhead which had been brought forward in opening inventory is released and is included in cost of sales.
In our example the two reported profit figures were the same when sales volume was 20,000 Splashes, ie when production and sales volumes were equal and there was no change in inventory.
It is important to appreciate that the differences in reported profits occur only in the short run, ie in reporting the profit of individual accounting periods.
This is because in the long run, total costs will be the same by either method of accounting. Short term differences are the result of changes in the level of inventory.
3.1 Calculating the difference in reported profit
3/12
The difference in the profit reported by the two systems therefore results from the fixed production overhead that is carried forward in inventory in an absorption costing system.
In our example the profit figures can be reconciled as follows.
Sales volume (Splashes)
10,000 15,000
£ £
Marginal costing profit/(loss) (5,000) 15,000
Increase in inventory units @ £2 per unit (10,000 × £2) 20,000 (5,000 × £2) 10,000
Absorption costing profit 15,000 25,000
In both cases the absorption costing profit was higher because the inventory level increased and fixed production overhead was carried forward to next month in the absorption costing valuation.
Exam alert
The calculation of the difference between reported profits and inventory valuation in the two costing systems is a subject that lends itself well to objective testing questions or Section B questions. The March 2012 exam contained a Section B question asking for an explanation and calculation of the difference between absorption costing profit and marginal costing profit.
Learning outcome A1(a)
The overhead absorption rate for product X is £10 per machine hour. Each unit of product X requires five machine hours. Opening inventory of product X on 1 January 20X9 was 150 units and closing inventory on 31 December 20X9 it was 100 units. What is the difference in profit between results reported using absorption costing and results reported using marginal costing?
A The absorption costing profit would be £2,500 less B The absorption costing profit would be £2,500 greater C The absorption costing profit would be £5,000 less D The absorption costing profit would be £5,000 greater
Section summary
If there are changes in inventories during a period, marginal costing and absorption costing systems will report different profit figures.
If inventory levels increase, absorption costing will report a higher profit than marginal costing. If inventory levels decrease, absorption costing will report the lower profit.
If the opening and closing inventory volumes and values are the same, marginal costing and absorption costing will report the same profit figure.
In the long run, the total reported profit will be the same whether marginal or absorption costing is used. The difference in reported profit is equal to the change in inventory volume multiplied by the fixed production overhead rate per unit.
4 Marginal costing and absorption costing compared
5/13,11/11
Introduction
There are arguments in favour of each costing method.
4.1 Arguments in favour of absorption costing
(a) Fixed production costs are incurred in order to make output. It is therefore 'fair' to charge all output with a share of these costs.
(b) Closing inventory values, include a share of fixed production overhead, and therefore follow the requirements of the international accounting standard on inventory valuation (IAS 2).
(c) Absorption costing is consistent with the accruals concept as a proportion of the costs of production are carried forward to be matched against future sales.
(d) A problem with calculating the contribution of various products made by an enterprise is that it may not be clear whether the contribution earned by each product is enough to cover fixed costs, whereas by charging fixed overhead to a product it is possible to ascertain whether it is profitable or not. This is particularly important where fixed production overheads are a large proportion of total production costs. Not absorbing production would mean that a large portion of expenditure is not accounted for in unit costs.
4.2 Arguments in favour of marginal costing
(a) It is simple to operate.(b) There are no apportionments, which are frequently done on an arbitrary basis, of fixed costs. Many costs, such as the marketing director's salary, are indivisible by nature.
(c) Fixed costs will be the same regardless of the volume of output, because they are period costs. It makes sense, therefore, to charge them in full as a cost to the period.
(d) The cost to produce an extra unit is the variable production cost. It is realistic to value closing inventory items at this directly attributable cost.
(e) Under or over absorption of overheads is avoided.
(f) Marginal costing provides the best information for decision making.
(g) Fixed costs (such as depreciation, rent and salaries) relate to a period of time and should be charged against the revenues of the period in which they are incurred.
(h) Absorption costing may encourage over-production since reported profits can be increased by increasing inventory levels.
Exam alert
Make sure you are completely happy with the pros and cons and calculations for each method.
To demonstrate the last argument in favour of marginal costing, consider an organisation that produces a product that sells for £60 per unit.
Variable production costs are £35 per unit and the fixed production costs of £30,000 per period are absorbed on the basis of the normal capacity of 5,000 units per period.
Fixed administration, selling and distribution overheads are £19,000 per period. There was no opening inventory for the latest period.
Required
Calculate the profit reported for sales of 5,000 units last period for production volumes of 5,000 units, 6,000 units and 7,000 units, using:
(a) Absorption costing (b) Marginal costing
Absorption costing
Fixed production cost per unit = £30,000/5,000 = £6 per unit Full production cost per unit = £35 + £6 = £41 per unit
Production
5,000 units 6,000 units 7,000 units
£'000 £'000 £'000 £'000 £'000 £'000
Sales (5,000 units × £60) 300 300 300
Production cost @ £41 per unit 205 246 287
Less closing inventory – 41 82
205 205 205
Less over-absorbed fixed production cost – 6 12
Total production cost of sales 205 199 193
Gross profit 95 101 107
Administration costs 19 19 19
Net profit 76 82 88
Marginal costing
Production
5,000 units 6,000 units 7,000 units
£'000 £'000 £'000 £'000 £'000 £'000
Sales 300 300 300
Variable cost of production @ £35/unit 175 210 245
Less closing inventory – 35 70
Variable production cost of sales 175 175 175
Contribution 125 125 125
Fixed production costs 30 30 30
Administration costs 19 19 19
Net profit 76 76 76