Calculate the value of the closing inventory of product B using absorption costing

Chapter learning objectives

Upon completion of this chapter you will be able to:

• explain the importance of, and apply, the concept of contribution
• demonstrate and discuss the effect of absorption and marginal costing on inventory valuation and profit determination
• calculate profit or loss under absorption and marginal costing
• reconcile the profits or losses calculated under absorption and marginal costing
• describe the advantages and disadvantages of absorption and marginal costing

1 Marginal costing

The marginal cost of an item is its variable cost. The marginalproduction cost of an item is the sum of its direct materials cost,direct labour cost, direct expenses cost (if any) and variableproduction overhead cost. So as the volume of production and salesincreases total variable costs rise proportionately.

Fixed costs, in contrast are cost that remain unchanged in a time period, regardless of the volume of production and sale.

From this we can develop the following definition of marginal costing as used in management accounting:

Marginal costing is the accounting system in which variable costsare charged to cost units and fixed costs of the period are written offin full against the aggregate contribution.

Note that variable costs are those which change as output changes– these are treated under marginal costing as costs of the product.Fixed costs, in this system, are treated as costs of the period.

Marginal costing is also the principal costing technique used indecision making. The key reason for this is that the marginal costingapproach allows management's attention to be focussed on the changeswhich result from the decision under consideration.

The contribution concept

The contribution concept lies at the heart of marginal costing. Contribution can be calculated as follows.

Contribution = Sales price – Variable costs

The following information relates to a company that makes a singleproduct, a specialist lamp, which is used in the diamond-cuttingbusiness.

Fixed costs have been estimated to be $120,000 based on a production level of 1,200 lamps.

Let us look at the costs and revenues involved when different volumes of lamps are sold.

• We can see that the profit per lamp has increased from $100 when 1,200 lamps are sold to $120 when 1,500 lamps are sold.
• This is because all of the variable costs (direct materials, direct labour, direct expenses and variable overheads) have increased but the fixed costs have remained constant at $120,000.

Based on what we have seen above, the idea of profit is not aparticularly useful one as it depends on how many units are sold. Forthis reason, the contribution concept is frequently employed bymanagement accountants.

• Contribution gives an idea of how much 'money' there is available to 'contribute' towards paying for the overheads of the organisation.
• At varying levels of output and sales, contribution per unit is constant.
• At varying levels of output and sales, profit per unit varies.
• Total contribution = Contribution per unit x Sales volume.
• Profit = Total contribution – Fixed overheads.

Buhner Ltd makes only one product, the cost card of which is:

The selling price of one unit is $21.

Budgeted fixed overheads are based on budgeted production of 5,000units. Opening inventory was 1,000 units and closing inventory was 4,000units.

Sales during the period were 3,000 units and actual fixed production overheads incurred were $25,000.

(a) Calculate the total contribution earned during the period.

(b) Calculate the total profit or loss for the period.

2 Absorption costing

The principles of absorption costing have been discussed in the previous chapter – Accounting for overheads.

3 The effect of absorption and marginal costing on inventory valuation and profit determination

Absorption and marginal costing

Marginal costing values inventory at the total variable production cost of a unit of product.

Absorption costing values inventory at the full production cost of a unit of product.

• Inventory values will therefore be different at the beginning and end of a period under marginal and absorption costing.
• If inventory values are different, then this will have an effect on profits reported in the income statement in a period. Profits determined using marginal costing principles will therefore be different to those using absorption costing principles.

Absorption costing income statement

In order to be able to prepare income statements under absorptioncosting, you need to be able to complete the following proforma.

Absorption costing income statement

• Valuation of inventory – opening and closing inventory are valued at full production cost under absorption costing.
• Under/over-absorbed overhead – an adjustment for under or over absorption of overheads is necessary in absorption costing income statements.

Marginal costing income statement

In order to be able to prepare income statements under marginal costing, you need to be able to complete the following proforma.

Marginal costing income statement

• Valuation of inventory – opening and closing inventory are valued at marginal (variable) cost under marginal costing.
• The fixed costs actually incurred are deducted from contribution earned in order to determine the profit for the period.

A company commenced business on 1 March making one product only, the cost card of which is as follows:

The fixed production overhead figure has been calculated on thebasis of a budgeted normal output of 36,000 units per annum. The fixedproduction overhead incurred in March was $15,000 each month.

Selling, distribution and administration expenses are:

The selling price per unit is $35 and the number of units produced and sold were:

Prepare the absorption costing and marginal costing income statements for March.

Absorption costing income statement – March

Marginal costing income statement – March

Solution

Absorption costing income statement – March

Workings

(W1)

(W2)

Marginal costing income statement - March

Duo Ltd makes and sells two products, Alpha and Beta. The following information is available for period 3:

Fixed production overheads for the period were $105,000 and fixed administration overheads were $27,000.

Required:

(a) Prepare an income statement for period 3 based on marginal costing principles.

(b) Prepare an income statement for period 3 based on absorption costing principles.

Reconciling profits reported under the different methods

When inventory levels increase or decrease during a period then profits differ under absorption and marginal costing.

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

This is because fixed overheads held in closing inventory arecarried forward (thereby reducing cost of sales) to the next accountingperiod instead of being written off in the current accounting period (asa period cost, as in marginal costing).

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

This is because fixed overhead brought forward in openinginventory is released, thereby increasing cost of sales and reducingprofits.

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

A company commenced business on 1 March making one product only, the cost card of which is as follows.

• Marginal cost of production = $(5 + 8 + 2) = $15
• Full cost of production = $20 (as above)
• Difference in cost of production = $5 which is the fixed production overhead element of the full production cost.
• This means that each unit of opening and closing inventory will be valued at $5 more under absorption costing.

The number of units produced and sold was as follows.

Closing inventory at the end of March is the difference between thenumber of units produced and the number of units sold, i.e. 500 units(2,000 – 1,500).

• Loss for March under absorption costing = $375 (as calculated in Illustration 2).
• Loss for March under marginal costing = $2,875 (as calculated in Illustration 2).
• Difference in loss (profits) = $2,875 – $375 = $2,500.
• This difference can be analysed as being due to the fixed overhead held in inventory, i.e. 500 units of inventory 'holding' $5 fixed overhead per unit.
• 500 x $5 = $2,500 which is the difference between the profit in the profit statements under the different costing methods for March.

In an exam question you may be told the profit under eithermarginal or absorption costing and be asked to calculate the alternativeprofit for the information provided. 

There is a short cut to reconciling the profits:

(a) In a period where opening inventorywas 5,000 units and closing inventory was 3,000 units, a company had aprofit of $92,000 using absorption costing. If the fixed overheadabsorption rate was $9 per unit, calculate the profit using marginalcosting.

(b) When opening inventory was 8,500litres and closing inventory was 6,750 litres, a company had a profit of$62,100 using marginal costing. The fixed overhead absorption rate was$3 per litre. Calculate the profit using absorption costing.

4 The advantages and disadvantages of absorption and marginal costing

Advantages and disadvantages of absorption and marginal costing

• The main disadvantages of marginal costing are that closing inventory is not valued in accordance with SSAP 9 principles and that fixed production overheads are not 'shared' out between units of production, but written off in full instead.
• The main disadvantages of absorption costing are that it is more complex to operate than marginal costing and it does not provide any useful information for decision making (like marginal costing does).

5 Chapter summary

Test your understanding answers

(a) Total variable costs = $(3 + 6 + 2 + 5) = $16

Contribution per unit (selling price less total variable costs) = $21 – $16 = $5

Total contribution earned = 3,000 x $5 = $15,000

(b) Total profit/(loss) = Total contribution – Fixed production overheads incurred

= $(15,000 – 25,000)

= $(10,000)

(a)

Working

(a)

Since inventory levels have fallen in the period, marginalcosting shows the higher profit figure, therefore marginal costingprofit will be $18,000 higher than the absorption costing profit, i.e.$110,000.

(b)

Inventory levels have fallen in the period and therefore marginalcosting profits will be higher than absorption costing profits.Absorption costing profit is therefore $5,250 less than the marginalcosting profit.

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