CIMA BA2 Syllabus B. COSTING - AB v MC Profit - Notes ^{8 / 9}

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

Illustration - AB profit to MC profit

The absorption costing profit in a period is $36,000

Production units (budgeted and actual) are 14,000
Sales units 12,000

Budgeted fixed overhead $63,000

What is the marginal costing profit?

• Solution

  What is the change in inventory?

  Opening inventory 0 
  Production 14,000
  Sales (12,000)
  Closing inventory 2,000

  Therefore, we can see that the change in inventory is 2,000 (as opening inventory is 0 and closing inventory is 2,000)

  Inventory has increased from 0 to 2,000 - therefore absorption costing will have the higher profit

  What is the FOAR?

  Budgeted fixed overhead / Budgeted activity level = $63,000 / 14,000 = year $4.5 

  Difference in profit

  Change in inventory x FOAR = 2,000 x $4.5 = $9,000

  Absorption costing profit should be higher as inventory increased, therefore the marginal costing profit will be:

  AB profit - change in profit = $36,000 - $9,000 = $27,000

Illustration - Find the production units

Last month a manufacturing company's profit was $1,000 calculated using absorption costing. 

If marginal costing principles had been used, a loss of $3,000 would be occurred. 

The FOAR is $2/unit. 

Last month's sales were 5,000 units. 

What was last month's production units?

• Solution

  Difference in profit = change in inventory x FOAR

  Difference in profit is $4,000 ($1,000 - - $3,000)
  FOAR = $2/unit

  Therefore, the change in inventory is $4,000 / 2 = 2,000 units

  Absorption costing had the higher profit, therefore inventory must have increased over the period.

  Sales 5,000 + Inventory increase 2,000 = 7,000 production units last month

Which costing method is better for decision making?

In the short term, marginal costing is better for decision making as it only recognises - incremental and future costs, it does not take the fixed costs into account. 

However, one advantage of absorption costing is that it recognises that all production costs must be included before a profit and selling price are created, to ensure that all costs are absorbed.