CAT / FIA FMA Syllabus C. Cost Accounting Techniques - Reconcile the profits or losses - Notes ^{4 / 5}

Remember!

Profit ($) = Sales ($) - Cost Of Sales (COS) ($)

Sales ($) = Sales in units x Selling price  ($)

COS ($) = Sales in units x Inventory value  ($)

Sales in units = Opening inventory + Purchases (Production) - Closing Inventory

If production (units) is equal to sales (units)

• there will be no difference in profits

If inventory levels increase

between the beginning and end of a period, absorption costing will report the higher profit.

• This is because some of the fixed production OH will be carried forward in closing inventory (which reduces cost of sales and therefore reduces Expenses and therefore increases the Profit).

  LESS expenses you have .... MORE Profit you get

If inventory levels decrease

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

MORE expenses you have .... LESS Profit you get

Therefore:

1. If inventory levels increase, absorption costing gives the higher profit

2. If inventory levels decrease, marginal costing gives the higher profit

3. If inventory levels are constant, both methods give the same profit

Profits generated using absorption & marginal costing can also be reconciled as follows:

Difference in the profit = change in inventory in units x OAR per unit

Illustration 1 - If inventory levels increase

Production was 500 units and Sales 200 units.
No opening inventory.

OAR = $2 per unit

Calculate the difference in the Profit.

1. Step 1: Calculate Closing Inventory (CL)

   CL = Production - Sales =  500 - 200 = 300 units

2. Step 2: Change in Inventory

   OP = 0 units
   CL = 300 units

   Change in Inventory = Closing - Opening = 300 - 0 = 300 units (Increase)

   Increase in Inventory means AC > MC

3. Step 3: Difference in Profit

   = change in inventory in units x OAR per unit
   300 units x $2 per unit = $600

   AC Profit  > MC Profit by $600

Illustration 2 - If inventory levels decrease

Production was 500 units and Sales 800 units.
The opening inventory was 400 units.

OAR = $2 per unit

Calculate the difference in the Profit.

1. Step 1: Calculate Closing Inventory

   Sales = OP + Production - CL
   800 = 400 + 500 - CL
   CL = 900 - 800
   CL = 100 units

2. Step 2: Change in Inventory

   OP = 400 units
   CL = 100 units

   Change in Inventory = Closing - Opening = 100 - 400 = - 300 units decrease

   OP 400 > CL 100, therefore, there was a decrease in the inventory level

   Decrease in Inventory means MC > AC

3. Step 3: Difference in Profit

   = change in inventory in units x OAR per unit
   = 300 units x $2 per unit = $600

    MC Profit  > AC Profit by $600