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MARGINAL AND ABSORPTION COSTING (PART 2)
FOG Accountancy Tutorials
Overview
This video explains the practical application of marginal and absorption costing methods for profit estimation. It walks through a specific accounting problem, calculating profit using both methods and then reconciling the differences. The core distinction lies in how fixed production overheads are treated in inventory valuation, with absorption costing including them and marginal costing excluding them. The video emphasizes that this difference in inventory valuation directly impacts the reported profit.
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Chapters
- The video continues a lesson on marginal and absorption costing, focusing on a practical profit estimation problem.
- Key financial figures for Same Boy Complex Limited for the year ended December 31, 2017, are provided, including sales, direct materials, direct labor, factory overheads, selling costs, distribution costs, and administration costs.
- Crucial production and sales data are given: 2,000 units sold and 2,500 units manufactured, indicating a closing inventory.
- Additional information specifies that 40% of selling, distribution, and administrative costs are fixed, and one-third of factory overheads are variable.
Understanding the initial financial data and production figures is essential for applying costing methods and identifying the core problem of inventory valuation.
Sales: 16,000 GHS, Direct Materials: 4,000 GHS, Units Sold: 2,000, Units Manufactured: 2,500.
- Absorption costing includes all manufacturing costs (direct materials, direct labor, and all factory overheads, both fixed and variable) in the cost of production.
- The cost of production for 2,500 units is calculated as 10,000 GHS (4,000 + 3,000 + 3,000).
- Closing inventory (500 units) is valued based on the total cost of production: (500 units / 2,500 units) * 10,000 GHS = 2,000 GHS.
- Cost of sales is calculated as Cost of Production - Closing Inventory (10,000 - 2,000 = 8,000 GHS).
- Gross profit is Sales - Cost of Sales (16,000 - 8,000 = 8,000 GHS).
- Non-factory overheads (selling, distribution, administration) are deducted to arrive at the net profit of 4,000 GHS.
This method allocates fixed manufacturing overheads to products, which can lead to higher inventory valuations and potentially higher profits when inventory levels increase.
Closing inventory valued at 2,000 GHS by including a portion of the fixed factory overheads.
- Marginal costing only includes variable manufacturing costs (direct materials, direct labor, and variable factory overheads) in the cost of production.
- Only one-third of the factory overheads (1,000 GHS) is considered variable and included in the cost of production.
- The variable cost of production for 2,500 units is calculated as 8,000 GHS (4,000 + 3,000 + 1,000).
- Closing inventory (500 units) is valued based only on variable costs: (500 units / 2,500 units) * 8,000 GHS = 1,600 GHS.
- Variable selling, distribution, and administration costs (60% of the total) are added after calculating the contribution margin.
- Fixed costs (fixed factory overheads and fixed portions of selling, distribution, and administration costs) are deducted from the contribution margin to arrive at the net profit of 3,600 GHS.
This method treats fixed manufacturing overheads as period costs, expensing them in the period incurred, which can provide a clearer view of short-term profitability and decision-making.
Closing inventory valued at 1,600 GHS, excluding any fixed factory overheads.
- The difference in profit between the two methods (4,000 GHS under absorption costing vs. 3,600 GHS under marginal costing) arises solely from the treatment of fixed production overheads in inventory valuation.
- Absorption costing includes fixed overheads in inventory, increasing its value and thus increasing profit when inventory is held.
- Marginal costing excludes fixed overheads from inventory, treating them as a period expense, thus resulting in a lower inventory value and lower profit when inventory is held.
- The difference in profit (400 GHS) is equal to the fixed production overhead per unit multiplied by the number of units in closing inventory.
- A reconciliation statement can show that starting with the absorption costing profit and deducting the fixed overheads included in closing inventory leads to the marginal costing profit.
Understanding this difference is crucial for interpreting financial statements and making informed business decisions, as reported profits can vary significantly based on the costing method used.
The 400 GHS profit difference is explained by the fixed factory overheads (2,000 GHS total fixed overhead / 2,500 units produced * 500 units in closing inventory).
Key takeaways
- Absorption costing includes all manufacturing costs, fixed and variable, in product costs and inventory valuation.
- Marginal costing includes only variable manufacturing costs in product costs and inventory valuation.
- The difference in reported profit between the two methods is due to the treatment of fixed production overheads in the valuation of closing inventory.
- When inventory levels increase, absorption costing typically reports a higher profit than marginal costing.
- When inventory levels decrease, marginal costing typically reports a higher profit than absorption costing.
- Fixed costs are treated as period costs under marginal costing and expensed immediately.
- Reconciliation between the two methods involves adjusting for the fixed overheads included or excluded from inventory.
Key terms
Absorption CostingMarginal CostingCost of ProductionCost of SalesClosing InventoryFixed Production OverheadsVariable Production OverheadsContribution MarginReconciliation Statement
Test your understanding
- How does absorption costing differ from marginal costing in its treatment of fixed factory overheads?
- Why does the profit reported by absorption costing and marginal costing differ when there is a change in inventory levels?
- What is the formula for valuing closing inventory under absorption costing?
- What is the formula for valuing closing inventory under marginal costing?
- How can you reconcile the profit figures obtained from absorption and marginal costing?