Calculate Profits Under Absorption and Marginal Costing 7 / 9

Profit or loss

Profit or loss under absorption and marginal costing

  • In marginal costing, fixed production costs:

    - are not included in the COS
    - are treated as period costs (are written off as they are incurred)

  • In absorption costing, fixed production costs 

    - are absorbed into the cost of units
    - are included in the COS

  • In the long run, total profit for a company will be the same whether marginal costing or absorption costing is used.

Profit under Marginal costing

Marginal costing income statement$$
Salesx
LESS:Variable cost of sales:
Opening inventoryx
Production costsx
Variable Production Overhead costsx
x
LESS:Closing inventory(x)
(x)
x
LESS:Variable selling, dist, admin costs(x)
Contributionx
LESS:Fixed costs (actual incurred):
Productionx
Selling and distributionx
Administrationx
(x)
Net profitx

Note that inventories are valued at variable production costs only.

Illustration 1

A company produced 1,000 units of Product A.

The opening and closing inventory was 100 units and 500 units respectively.

The selling price and production costs for Product A were as follows:

Selling price   $30 per unit
Direct costs  $10 per unit
Variable production overhead costs$6 per unit
Total Fixed production overhead  costs 4,000

What is the Gross profit for Product A, using marginal costing?

Solution

  • Number of units sold = (OP + Produced - CL) =  (100 + 1,000 - 500) = 600 units
    Contribution per unit = 30 - 10 - 6 = $14 per unit
    Contribution =  600u x Contribution $14= $8,400
    Gross Profit = $8,400 - Fixed OH $4,000 = $4,400

Profit under Absorption costing

Absorption costing income statement$$
Salesx
LESSCost of sales
Opening inventoryx
Production costsx
Variable production overhead costsx
Fixed overhead absorbed (Budgeted fixed overhead/Budgeted activity level)x
x
LESSClosing inventory(x)
(x)
Fixed overhead (under)/over absorbedx/(x)
Gross profitx
LESSSelling, admin etc costs
(non production)(x)
Net profitx

Note that inventories are valued at full production cost

Illustration 2

A company produced 1,000 units of Product A.

The opening and closing inventory was 100 units and 500 units respectively.

There was no under or over absorption of fixed overheads.

The selling price and production costs for Product A were as follows:

$ per unit 
Selling price   30
Direct costs  10
Variable production overhead costs6
Fixed production overhead  costs (OAR) 4
Gross profit10

What is the Gross profit for Product A, using absorption costing?

  • Number of units sold = (OP + Produced - CL) =  (100 + 1,000 - 500) = 600 units
    Gross Profit =  600u x Gross profit $10 = $6,000

Illustration 3 - Calculate the value of closing inventory under marginal costing

During October, 4,000 units of Product X were produced but only 3,600 units were sold. 

At the beginning of October, there was no opening inventory. 

Using marginal costing, what was the value of the inventory of Product X at the end of October?

$
Direct materials1,000
Direct labour9,000
Variable production overhead2,000
Fixed production overhead4,000
Variable selling cost3,000
Fixed distribution cost1,000
Total cost incurred for product X20,000

Solution

Total variable production costs = 1,000 + 9,000 + 2,000 = 12,000
Total production = 4,000 units
Cost per unit = 12,000 / 4,000 = $3

Total sales = 3,600

Closing inventory = 4,000 - 3,600 = 400 units x $3 = $12,00

Note that variable non production costs and fixed costs are not used to value inventory under marginal costing

Marginal costingAbsorption costing
Closing inventories are valued at Marginal production costClosing inventories are valued at full Production cost
Fixed costs are period costsFixed costs are absorbed into unit costs
Cost of sales does not include a share Of fixed overheadsCost of sales does include a share of fixed overheads

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