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ABSORPTION COSTING AND MARGINAL COSTING Learning Objectives

By the end of this chapter you should be able to:
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Prepare profit statements using absorption costing method Explain and illustrate the concept of contribution

Discuss the usefulness of profit and contribution information respectively
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Prepare profit statements using the marginal costing method

Compare and contrast the use of marginal costing for period profit reporting and inventory valuation

Reconcile the profits reported by absorption and marginal costing

which is often the same as the budgeted capacity.  The operating (profit/income) statement does not distinguish between fixed and variable production costs. .  If the production level is not equal to the normal capacity there will be over or under absorbed fixed production overhead.  Absorption costing income statement: $ $ Revenue/ Sales X Production costs of sales Opening inventory (valued at full production costs) X Production (valued at full production costs) X Closing inventory (valued at full production costs) (X) (X) Gross profit X Adjustment: Over or (under) fixed production overhead X X Less: Non-production overhead X Variable selling overhead X Fixed selling overhead X Variable administration overhead X Fixed administration overhead X Variable distribution overhead X Fixed distribution overheads X (X) Net profit X Marginal Costing  Marginal costing is defined as “ the accounting system in which variable costs are charged to cost units and the fixed costs of the period are written off against the aggregated contribution.  Its special value is on decision-making.  Fixed production overheads are absorbed on the basis of normal capacity.ABSORPTION COSTING AND MARGINAL COSTING Absorption Costing  Absorption costing sometimes known as full or total costing. which include a share of fixed production overheads absorbed using any of the bases available. which is the basis of all financial statements for routine profit reporting.  All inventories are valued at full production cost. profit information does not lend itself to easy manipulation)  This costing method distinguishes fixed and variable costs as conventionally classified.  Contribution is a term given to the difference between sales value and marginal cost of sales.  Contribution information allows an easy calculation of profit if sales increase or decrease from a certain activity level by comparing total contribution with fixed overheads. (however. which would be avoided if that unit were not produced or provided.  Fixed production costs (both the fixed and variable costs) are absorbed into production and inventories valuation.  The marginal cost of a product or service is its variable costs.

The extra costs incurred in manufacture a unit of product is the variable production costs. Arguments for absorption costing Closing inventory valued in accordance with accounting principles (IAS 2)  It is fair to share fixed production costs between units of production as such costs are incurred in order to make output – less likely in setting selling prices which are below total costs. Period fixed costs are constant for any volume of sales and production provided that the level of activity is within the “ relevant range”.  It is easier to determine the profitability of several products by charging a share of fixed overheads to them rather than working out the total contribution from several products will cover fixed costs.The basic principles are: 1. 2. Marginal/ costing income statement: $ $ Revenue/Sales X Production costs of sales Opening inventory (valued at variable production costs) X Production (valued at variable production costs) X Closing inventory (valued at variable production costs) (X) (X) Gross margin X Less: Variable selling overhead X Contribution X Less: Fixed non-production overhead X Fixed selling overhead X Fixed administration overhead X Fixed distribution overheads X (x) Net profit X  Compare the profit calculation of absorption costing and marginal costing Absorption costing o A technique to assess profit in a period o Not necessary to distinguish variable costs from fixed costs o Inventories and production are valued at full production cost Marginal costing o A technique to assess profit in a period o Necessary to identify: variable costs. contribution and fixed costs o Inventories and production are valued at marginal (variable) production cost Inventory values are greater Inventory values are lower o Fixed production costs are absorbed o All fixed costs are treated as period into unit costs costs and write off against total contribution. (Fixed costs relate to a period of time and do not change with increases of decreases in sales volume) 3. Profit measurement should be based on an analysis of total contribution.  .

The profit differences are caused by the different valuations given to the closing inventories in each period. . absorption costing profit will be higher than marginal costing profit.   Arguments for marginal costing Simple to operate No apportionment of fixed costs.  Closing inventory realistically valued at variable production cost per unit. which avoid fixed costs being capitalized in unsaleable inventories. the two different costing methods produce profit differences only in the short run when inventories fluctuate. Reconciling the profit figures Reported profit figures using absorption costing and marginal costing will differ if there are any changes in the level of inventories in the period. If production is equal to sales or if opening and closing inventories are the same. If inventories remain constant then there will be no profit differences between the two methods. which had been carried forward in inventory with absorption costing is now being released to be charged against the sales for the period. it is generally accepted that marginal costing statements provide the best information for the purposes of management decision making. This is because some of the fixed production overhead is carried forward in inventory instead of being written off against sales for the period. With absorption costing. However. If inventory increases. If inventory reduces. However. Should absorption costing or marginal costing be used? There is no absolute correct answer as to when absorption costing or marginal costing is preferable.  Fixed costs are written off in the period they are incurred because do not relate to activity level. IAS 2 requires the use of absorption costing for external reporting purposes. In the long run. which are frequently on an arbitrary basis.  Contribution provides management with useful information about expected profits and short term decision making. there will be no difference in calculated profits using these costing methods. the total profit will be the same whichever method is used. Over or under absorption of overheads is avoided. an amount of fixed production overhead is carried forward in inventories to be charged against sales of later period. marginal costing profit will be higher than absorption costing profits. It is merely the timing of the sales that causes the profit differences from period to period. This is because all of the costs incurred will eventually be charged against sales. Supporters of absorption costing argue that fixed production overheads are a necessary cost of production and they should be included in the unit cost used for inventory valuation. This is because the fixed production overhead.

Supporters or marginal costing argue that management attention is concentrated on the more controllable measure of contribution. They say that the apportionment of fixed production overheads to individual units is carried out on a purely arbitrary basis. is of little use for decision making and can be misleading. .