Absorption Costing vs. Marginal Costing

Introduction

• Objective: Understand absorption and marginal costing differences.
• Purpose: Assign production costs to products.
• Key Difference: Treatment of fixed production costs.

Costing Methods Overview

• Absorption Costing
  • Full production costs (fixed & variable) allocated to products.
  • Inventory valued at full production cost (includes fixed).
  • Fixed costs absorbed into product cost.
• Marginal Costing
  • Only variable production costs allocated to products.
  • Inventory valued at variable production cost.
  • Fixed costs treated as period costs, written off in full.

Impact on Profit

• Different Inventory Levels:
  • If inventory levels differ, profits under each method differ.
  • Example: Different opening/closing inventory levels lead to profit differences.
  • Same Inventory Levels: Same production and sales volumes result in same profits.

Absorption Costing Format

• Steps:
  1. Begin with sales.
  2. Add opening inventory at full cost.
  3. Add full production cost (variable + fixed).
  4. Deduct closing inventory at full cost.
  5. Account for over/under absorbed overheads.
  6. Calculate total production cost of sales.
  7. Subtract from sales to get gross profit.
  8. Deduct non-manufacturing costs for net profit.
• Over/Under Absorbed Overheads:
  • Predetermined rates used.
  • Over-absorbed: Deduct difference.
  • Under-absorbed: Add difference.

Marginal Costing Format

• Steps:
  1. Begin with sales.
  2. Add opening inventory at variable cost.
  3. Add variable production cost.
  4. Deduct closing inventory at variable cost.
  5. Calculate contribution (sales - variable costs).
  6. Deduct fixed production costs.
  7. Deduct non-manufacturing costs for net profit.

Example Case: CM Limited

• Scenario:
  • Product sells for 60 per unit.
  • Variable costs: 35 per unit.
  • Fixed production costs: 30,000.
  • Fixed admin & overheads: 19,000 per period.
  • No opening inventory.
• Requirements: Calculate profit for sales of 5,000 units with production of 5,000, 6,000, and 7,000 units using both methods.

Absorption Costing Example

• Production vs. Sales:
  • 5,000 units produced and sold: Same inventory levels, no over/under absorption.
  • 6,000 units produced, 5,000 sold: 1,000 units in inventory, over absorption occurs.
  • 7,000 units produced, 5,000 sold: 2,000 units in inventory, more over absorption.
• Key Points:
  • Inventory changes affect gross profit due to fixed costs tied to inventory.
  • Potentially inflate profits by producing more.

Marginal Costing Example

• Key Differences:
  • Contribution stays the same across different production levels.
  • Fixed costs expensed as period costs, not tied to inventory.
  • Net profit remains constant regardless of production volume.

Arguments for Costing Methods

Absorption Costing

• Fair allocation of fixed costs to products.
• Aligns with international accounting standards.
• In line with accruals concept; costs match future sales.

Marginal Costing

• Simpler to operate.
• No arbitrary fixed cost apportionment.
• Fixed costs remain consistent.
• Better information for decision making.
• Avoids over/under absorption of overheads.

Conclusion

• Understanding differences is crucial for accurate costing analysis.
• Each method has its strengths and weaknesses.
• Choose based on the specific context and accounting requirements.

• Note: Practice examples and calculations to reinforce understanding.