welcome to contacts in this lesson are going to be looking at the absorption costing and Majan are costing we're going to be looking at that difference between the two and go through a fara example which will help you understand the two costing methods very well these are costing systems of assigning production costs to products so that is what absorption costing imagine are costing do they assign production costs to products and we'll see where they differ the key difference between the truth costing systems is how fixed production costs are treated if you can understand that aspect you'll be able to know which one is absorption costing in which n is made in are costing and you'll be able to calculate with whichever method you may be asked to do so the key difference here is on how fixed production costs are accounted for here are some of the other differences with absorption costing the full production costs are allocated to products and this includes absorbed fixed production overheads so these are allocated to product while with mention are costing only the variable production costs are allocated to products that is very key to understand these two costing systems the second thing is that inventory is valued at their production and their full production costs that's with absorption costing and by full production costs we mean both fixed and variable production costs so with the russian costing the inventory is valued at their full production costs with both fixed and variable and with magining inventory is value is valued at variable production costs and what happens to fixed fixed costs fixed production costs they are written off in full as period costs so there is another key thing with the two costing methods with absorption costing inventory will be valued at the full production cost while with imaginal costing they will only prevent it as variable production costs and what we do with the fixed costs that we expense them in food as period costs and we'll sleep there just now with the help of an example so if the opening and closing inventory levels differ if the opening and closing inventory levels are different that is where production volumes are different from sales volumes the profit reported for the accounting period under the two costing systems will therefore be different I hope that has made sense so you have opening balance and you have closing balance if the two will be different if for instance yet 50 for opening balance and for closing balance you have hundred that means they're both different if the two I defend that means that the profit reported and that the two costing systems will be different so if you are using absorption costing and then you use imagine are costing you'll see that the profit will be different and that is as a result of how they fixed production costs are treated and you understand right now so if you don't understand that statement you don't understand very well as we go through this example that you are about to go into now and in the last phone case if the opening and closing inventory levels are the same this is where the production volumes are the same as sales volume the profit reporter for the accounting period another two costing systems will therefore be the same and like Frank for example if the opening balance is zero and the closing balance is zero that means we have sold everything that we produced during that period that means the profit for the two costing systems will be the same so let's look at this example but before we do look at the format for absorption costing the form of absorbing absorption costing will begin with sales and then we are opening inventory at some cross remember this is absorption costing at full costs both variable and fixed production costs and then full production costs that we used to produce during this period and then we did that the closing inventory at full costs as well with that closing inventory at full costs and then what we have with absorption costing is over or under absorbed overhead what do this mean well with absorption costing what will be given is the fixed production cost for the period and we are also given the my capacity for the period in units so let me give you an example if we are given the fixed production cost for the period of fifty thousand gram and we are told that the normal production capacity in units is ten thousand units that will mean that the fixed production cost per unit will be fifty thousand Ren which is the sixth production cost for the period divided by the ten thousand which is the nomad capacity which will be given which will give us a rate of five rent for the fixed production cost per unit now if you take that amount sovereign and multiply it by the actual production in units so let's say you produce twelve thousand units for instance if you take the five run and multiply that side by the twelve thousand units we will get a fixed production cost of 60,000 rent and that would mean that we have over absorbed because it's over what we estimated or what we predetermined it to be so if we have over absorbed our overheads that will mean will deduct it it when we are calculating our net profit so if it's over absorption of overhead we deduct it that's why I put it in brackets here over but if you have amber absorbed so for that same example if you produced eight thousand units only will multiply eight thousand units times my friend per unit in terms of sixty production cost per unit and then we get four thousand drained and remember the fixed production cost is fifty thousand rain that means we def and absorbed the overhead so that means we left will have to add it here we'll add the and absorption of overhead here if that sounds a bit confusing you'll understand it much better when go through the example but here's something to remember if absorbed overheads at predetermined rate unless than actual overheads then we have under absorbed and we need to add the difference but if absorbed overhead at predetermined rate R greater than actual overheads then we have over absorbed and we need to deduct the difference so there is the key thing with overall and absorption of overheads which we do when we do using the absorption costing method so let's continue so after we've done that we'll put on this app or we'll add them pop and then we get the total production costs of sales total production cost of sales and who put that here and obviously it's in brackets and then we take the sales minus the total production cost of sales we get the gross profit here and then after the gross profit we have non manufacturing costs which we deduct and after non manufacturing cost we have our net profit and that is the ultimate goal this we're trying to get the net profit using the method that you asked to use now let's take a look at majinelgato it will be far and less difficult or challenging so here we go we have sales and we put the amount of sales there that we will have calculated we have opening inventory now this they keep difference remember the fixed production cost which is the key difference in the two methods with opening inventory we have at variable costs remember with absorption possibly costing it was at full cost including fixed production cost but with imaginal costing we have opening inventory only at variable cost and then we have variable production cost which will be what to produce during this period we add that and then we - or we deduct the closing inventory and variable cost and then what we have there is the variable production cost of sales so you can see this one is much simpler than the absorption costing but absorption costing is also easy and you look at that right now using the example so we take sales minus the variable production cost of sales and we get contribution because remember the key difference between the two again is that with absorption costing we have gross profit but imagine are costing we have what we call contribution and then after contribution now remember I say that the dimensional costing would if that the fully fixed production costs for the period so that is where we have the production here after contribution with the doctor feel fixed production costs put it in as women brackets as a negative and then goes that the non manufacturing costs which is in negative and then we get our net profit so we always arrive at our net profit regardless of which costing system we are using so let's go to the example which will make everything clear in this example we are told that a cm limited produces a product that sells for 6 P rent per unit we are also told that the variable production costs are 35 rent per unit and the fixed production costs of 30,000 grand absorbed on the basis of the normal capacity of 5000 units per period we're told that the fixed administration selling and distribution overheads 1919 thousand Rand per period there was no opening inventory for the latest period what are we required to do we're required to calculate the profit reported for sales of five thousand units last period for production volumes of five thousand units six thousand units and seven thousand units using both the absorption costing and imagine are costing so why are we required to do here here we are told that we sold 5,000 units but now we have to do three examples we sold 5,000 units when we only produce 5,000 units and another example we sold 5,000 units and we produce 6,000 units and another one we sold 5,000 units while we produced 7,000 units so for all these units that we produced we always sold 5,000 units so now let's look at this example using the absorption costing so I've drawn up the table over here now remember this is the same table as we had before the only thing I've done is that I've just done it in three different sets because where we produce 5,000 units here will produce 6,000 units and here we produce 7,000 units so now let's begin with our sales what our sales remember we're told that we sold 5,000 units in the period and how much is our selling price per unit is 60 rent per unit so take the 69 per unit times the 5,000 units and our sales figures are 300,000 and so we'll put that 300,000 room and up all of them cause remember and all the 3 examples to sort 5,000 units the only difference is how much you produce so let's move on to the next one remember we're told that we had no opening inventory during the latest period so for all the 3 production volumes we did not have in the inventory in stock but if we had opening inventory remember with absorption costing we used the full production cost that would be both variable and fixed production costs so you were to do that we have to figure out what the full production cost per unit is when first we are told that the variable production costs are there is 5 grand per unit and what is the fixed production cost per unit remember with a predetermined rate we take the fixed production costs for the period which is 30,000 REM and we divide that by the normal capacity or 5,000 units so we'll take 30,000 ran it divided by 5,000 units so that's what we will do over there and once you've done that we see that we have 6 grand per unit that is the fixed production cost per unit now let's carefully the food production cost per unit the full production cost per unit will be 35 REM which is the variable production costs class the six-run is the fixed production cost per unit and we get 41 rent per unit there is the food production cost per unit including both the variable and fixed production cost per unit so now that we have such one rent per unit that will be our cost of production so remember for opening inventory we put the - on the three because we have no opening inventory now let's focus on the production of 5,000 units what is the full production cost of producing 5,000 units when we take the 4 200 Newton just calculated the full production post multiplied by the 5,000 units which you produced during this current period and then we have two hundred and five thousand Rand and you put that under the full production cost and then we deduct any closing infantry well did we have any closing inventory well if you remember we produced 5,000 units and we sold 5000 units remember like I mentioned before and like we saw in the example all the three we only sold 5,000 units or worse or 5,000 units so whatever we produced in this example here in this first example is whatever we sold so we don't have any closing inventory so put a dash over there and then let's now look at the over or under absorption of overheads so we have moreover under absorption of overheads like I mentioned before if the opening inventory and the closing inventory are the same remember from my points at the beginning if they are the same then we have no overrun absorption of overheads or in other words if whatever produce is exactly what we sold like I say we've produced 5,000 units and we sold 5,000 units so there's no over under absorption of overheads the only time they would be of our and absorption of overheads is if the production volumes are different from the sales volumes but in the first example they are not different so that's why we put a dash of a day and then the method that you do obviously we'll add this together and the only figure we have days 205,000 rent so put that under total production cost of sales remember this is absorption costing and then once we've done that we take 30 thousand gram click sorry three hundred thousand rent of sales minus the total production cost of sales of two hundred and five thousand rain gives us a gross profit of 95,000 around and then what is the non manufacturing cost well let's go back to our example we are told here that the fifth administration selling and distribution overheads are 19 thousand rent for the period so that is what we'll put over the 19,000 rain and then we take the gross profit of 95,000 rent - the 19,000 ramp we get a net profit of 76,000 rent and there is how use absorption costing to calculate this first example now let's move on to the next one will produced 6000 units remember we sold 5,000 units in all the three so that's why the sales stays the same the 5,000 units which we sold multiplied by the 60 rent that we were given in the example and then we had no opening inventory and then now we ask ourself what is the full production cost now remember here we produce 6,000 units so what is the full production cost who produce 6,000 units and because this is the second one you're working on over here and we're using the four to one rent per unit so we take the four to one drain which is the full production cost per unit multiply the 6000 units which we produced so remember this is produced not sold this is the full production cost that we are talking about here we get a total of two hundred and forty six thousand rent so put that over there now let's go now to the closing inventory what is the closing inventory now remember we sold 5,000 units so if the sold 5,000 units and we produced 6,000 units we have a balance of 1,000 units so we're going to take the full production cost per unit of 100 per unit multiplied by the 1,000 units which are remaining in stock we have 41,000 rent so we put that under cost of a closing inventory so put it in negative because it's what's remaining now remember like I mentioned before which should make sense by now if the opening inventory figure is different from the closing inventory figure then we will have over under absorption of overhead oh if what we produced is different from what we've sold then we will have an absorption of overheads and here there is the case we have opening inventory of 0 and F closing inventory 41000 rent and we produce 6,000 units and we only sold 5,000 units so we have over 4 and absorption or the question is did we over absorbed or Dubnyk and that absorb well let's look at that first here we are told that the fixed production costs are absorbed on the basis of normal capacity of 5000 units per period but remember we produced 6000 units so what do we do the absorption the absorbance at predetermined rate which is very 30,000 REM which is the fixed production cost divided by the 5,000 units which is the normal capacity and we multiply that by 6,000 units which we produced during this period we get a total of 36,000 REM so we can see these fixed production costs here is more than the fixed production cost that we actually have on the period so the actual overheads were 30,000 ran that means with over absorbed so if we are absorbed we take the 36,000 gram which we which we estimated using the normal capacity - the 30,000 Rand which is the actual cover hands that we incurred during this period and we have absorption of 6000 REM and that is how you calculate the over or under absorption first you calculate the fixed production cost per unit using their predetermined rates which is using the normal capacity that you're given so you take 30000 ran which is the fixed production cost for the period divided by the normal capacity which is 5000 units and you get the fixed production cost per unit which is predetermined and you multiply this but what by what you produce during this period if the answer is not the actual fixed production cost then we have over absorption if the answer is less than the actual fixed production cost for the period then we have under absorbed so in this case we have over absorbed Constanza here is more 36,000 REM is more than the actual overheads of 30,000 rain so we have over absorbed so we need to deduct it so we have just detected here of absorption since we have absorbed by 6,000 we deducted it here and then what did you do we took all these and edit them up to two hundred and forty six thousand run which is the full production cost minus the closing inventory of 41,000 Rand - the absorption of overheads since its of absorption we did that and we have a total production cost of hundred and ninety nine thousand REM now what do we do take the sales three hundred thousand Rand - the hundred ninety nine thousand Rand which gives us a gross profit of hundred and one thousand ten now what you can see there there's a difference between the gross profit between the truth even though we sold the same amount of units and the reason for that is because some of the fixed production costs are lying in inventory are tied to the closing inventory so still some fixed production costs will be tied to the inventory in closing inventory because we divide the fixed production cost to each unit that we have and then what are the non manufacturing costs well it will be the same because in the example we told the non manufacturing costs were nineteen thousand just like in the first one and we have a net profit of 82,000 at random from here you can already tell that the net profit is different even though we only solve five thousand units in both examples the only difference between the two examples is that we produced more produced one thousand more which is six thousand here and you can see that the reason for that is because the fixed production costs are divided according to each unit and whatever is sold the fixed production cost will be incurred there but then whatever is not sold to the fixed production cost for those units will be lying in inventory so what you can see the absorption costing one of the weaknesses is that the more you produce the more net profit we'll have or the more you produce the more closing inventory will be and that means that more fixed production costs will be lying in inventory so now let's look at the production of 7,000 units since we've been going through this we'll just run through it quickly the sales are three hundred thousand ran we have no opening inventory and then where are the food production cost remember is 41 grand per unit the food production cost multiplied by the production of seven thousand units cause we produced seven thousand units we give two hundred and eighty seven thousand rent so put two hundred and 7,000 rayon as the full production cost and then we deduct the closing inventory remember we only sold 5,000 units but to produce 7,000 units that means our closing inventory is 2,000 units at food production cost so we take 41 rent per unit full production cost times the 2,000 units left in stock and we have 82,000 Ren so put that in brackets 8 to 2010 and then did you over absorb or degree and that absorb remember would do the same exercise absorption of overheads at predetermined rate we do the same thing for the thousand rand which is the fixed production cost for the period divided by the 5,000 units which is the normal capacity and multiplied by the units that we produce during this period we have 42,000 ran to be over and absorbed well I'm sure you can already tell by now the fixed production costs are only 30,000 rent and they absorb absorb over has a predetermined rate of 40 mm rent that means we offer absorption so we're going to take the 40 mm rent - 30,000 Ren who gives us an answer of 12,000 rain that means you have absorbed by 12,000 rain and with the of absorbed we deduct it so puts 12,000 rain in brackets over day and then we add the three we take two hundred eighty seven thousand rain - Katie 2010 - twelve thousand red which will give us total production cost of sales of 193,000 rain let me take the sales - they total production cost of sales gives us an answer of one hundred and seven thousand rent and again what you can see is that the gross profits keep changing then there never is the land manufacturing cost and marginal cost 19,000 which has not changed and then what is the net profit 107 thousand red - 19,000 rain gives us a net profit of 88 I was rent so if you are asked what is the weakness with the absorption costing the weakness may be that the production manager may decide to produce so much inventory which will inflate their profits and like I mentioned in the exam before it's because the fixed production costs will always be tied to inventory so if you have more inventory in stock or not closing inventory in stock that means we have some fixed production costs lying with those inventory and that means we are not deducting them during this period because they are lying in wind venturi and there will be in our balance sheet and that is why you able to inflate your profits by producing more I hope you have understood absorption costing by now now let's look at the imaginal costing we'll run through this example because now you know what you are calculating and what we produced during each period so this should be fairly simple what our sales remember the sales would be the same for the two examples because they're using the same example over here we sold 5,000 units and the selling price per unit is 16 and so 6-tier n times 5,000 units gives us a total of three hundred thousand friend so we sold for three hundred thousand rent for the three production units and we have no opening inventory like we saw it's the same example and what are they variable production cost well this should be simple remember it's variable production cost and not total production cost so the only dealing with variable production cost which is the divisor and over here which we are given so we take that to five friend multiplied by the five thousand units which we produced in our first example remember when dealing with this one for now five thousand units it gives us a variable production cost of one hundred and seventy-five thousand rent so we have hundred and seventy-five thousand right over there and did you have any closing inventory no for this first example we didn't because who produced five thousand units and we sold five thousand units so no closing inventory and here we have no overall and absorption of overheads that is why imaginal costing is much simpler to calculate so we have no we have no over or under absorption of overheads so and then we just add the three but we only have hundred and seventy-five thousand rain so put that under variable production cost of sales and if we take the sales minus variable production cost of sales it gives us a con bution uh 125,000 rain now remember this is contribution with Mazin are costing with absorption posting its gross profit and then what are the fixed production costs well we given the fixed production cost over here we're told that it's 30,000 rain for the period and remember with methanol costing we expands the full fixed production cost for the period it's not like the absorption costing way they are tied to each unit of inventory so we have fixed production cost of 30,000 rain and other non manufacturing costs for none for manufacturing costs and 19,000 grams so put that there let me take the contribution under than 25,000 rain - 30,000 rain - mending 19,000 rain gives us that a net profit of 76,000 so just then the 1 will be produced 5,000 units now let's forget that one will produce 6,000 units remember we still sold the same 5,000 units so that's why we still have the 300,000 rain should since the end times the 5,000 units which we sold and then we have no opening inventory now what is the variable production cost remember who produced 6,000 units so the variable production cost will be 35 rain remember Steff averin per unit a variable production cost so we take 35 M times 6,000 units which we produced gives us a total of two hundred and ten thousand and so that's what to put over there and what is our closing inventory remember who produce 6,000 units we sold 5,000 units so the remaining inventory in stock or the closing inventory is 1,000 units so we take 1,000 units times 35 grand per unit which is the variable production cost per unit and we get 35,000 grand so we did backed the closing inventory of 35,000 friend so we take the variable production cost of two hundred and ten thousand rain - the day 5,000 rain gives us a total of one hundred and seventy five thousand Rand so that's why we have hundred and seventy-five thousand rain of a day and then we think the sales minus the variable production cost of sales gives us a contribution of hundred and twenty-five thousand Trent and you can see the contribution stays the same with imagine our costing and what is the fixed production cost well the same as we as we saw before and then what is the non manufacturing cost well it's still the same as we saw before as well and what is the net profit the net profit is still 76,000 grand regardless of how many units we produce the regardless of how many units you produce the net profit will remain the same and that's because your expensing the full production cost and the closing inventory is only with the variable cost there is no fixed production cost tied to eat then let's do the last one we'll produce 7,000 units you have sales of 300,000 ran no opening inventory what is the variable production cost well it's 35 and per unit so it's 35 rent times the 7,000 units who produced this 245,000 rent and what is the closing inventory remember we sold 5,000 units but we produce 7,000 units or 7,000 minus 5,000 units we are left with 2,000 units in closing inventory so there are five grand times 2,000 units gives us a balance of gives us the amount of 70,000 rent which we put in brackets and a closing inventory and we take the two forty five thousand ran - the seventy thousand gives us a variable production cost of sales of a hundred and seventy-five thousand rain again we take the sales three hundred thousand rent - the variable production cost of sales and we get the growth contribution of 125,000 ran and the fixed production cost still the same non benefit sharing cost still the same and the net profit is hundred and twenty-five thousand rent - thirty thousand rain - 19 thousand rent gives us a net profit of seventy six thousand rent now let's quickly look at some arguments in favor of both absorption costing and machine are costing so let's first look at the absorption costing number one fixed production costs are incurred in order to make a finished product it is therefore fair to charge all finished products with a share of these costs so these arguments in favor of absorption costing and the second argument is that the closing inventory values include a share of fixed production costs and therefore follow the requirements of the internal accounting standards or ia s on inventory valuation the third argument is that the costing man model is in line with the accruals concept as part of production costs are carried forward to the meshed against future sales and the fourth argument is that a problem arising from calculating contribution which we do in magining or various products made is that it may not be clear whether the contribution and by each product is enough to cover the fixed costs whereas by charging a fixed production cost to a product as we do with absorption costing it is possible to ascertain whether it is profitable or not so these are some of the arguments that would be in favor of absorption costing now let's look at some arguments which would be in favor of methanol costing the first one is that it is simple to operate as we've seen in our example it's easier to calculate the net profit using imagine are costing than it is with absorption costing costing the second one is that there isn't there are no apportionment which are frequently done on an arbitrary basis of fixed costs the third one is fixed costs will be the same regardless of the volume of production because they are period costs and we saw though I example regardless of how much you produce fixed costs will be the same because they will be expensive as period costs and the fourth argument is that the cost to produce one more product is the variable production cost closing inventory can realistically be valued at this directly attributable cost which is the variable production cost the fifth argument is there are no instances of over or under absorption of overheads like we have the absorption costing the sixth argument is that the best information for decision making is provided by is profit is provided for by imaginal costing the best information for decision making is provided for by imaginal costing in the last argument that we have here is that fixed costs such as rent and depreciations and many other costs should be charged against the revenues of the period in which they are incurred I hope there has made sense and that you now understand the difference between absorption costing and Majan are costing and you know how to calculate that - if you have any questions or any queries leave them in the comment section below as I say we have gained value from this lesson please consider subscribing to our channel and liking this video till next time Cheers