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Marginal Costing Vs Absorption Costing

 Marginal Costing Vs. Absorption Costing

         The difference between marginal costing & absorption costing is as below:

  1. Under marginal costing: for product costing & inventory valuation, only variable cost is considered whereas, under absorption costing; for product costing & inventory valuation, both fixed cost & variable cost are considered.
  1. Under marginal costing, there is a different treatment of fixed overhead. Fixed cost is considered as period cost & by Profit/Volume ratio (P/V ratio), profitability of different products is judged. On the other hand, under absorption costing system, the fixed cost is charged to cost of production. A reasonable share of fixed cost is to be borne by each product & thereby subjective apportionment of fixed overheads influences the profitability of product.
  1. Under marginal costing, the presentation of data is so oriented that total contribution & contribution from each product gets highlighted. Under absorption costing, the presentation of cost data is on conventional pattern. After deducting fixed overhead, the net profit of each product is determined.
  1. Under marginal costing, the unit cost of production does not get affected by the difference in the magnitude of opening stock & closing stock. Whereas, under absorption costing, due to the impact of the related fixed overheads, the unit cost of production get affected by the difference in the magnitude of opening stock & closing stock.

Effects of opening & closing stock on profit:

         When income statements under absorption costing & marginal costing are compared, the under mentioned points should be considered:

  1. The results under both the methods will be same in situations where sales & production coincide i.e., there is neither opening stock nor closing stock.
  1. Profit under absorption costing will be more than the profit under marginal costing, when closing stock is more than the opening stock. The reason behind this is that, under absorption costing, a portion of fixed overhead, instead of being charged to the current period, is charged to the closing stock & carried over to the next period.
  1. Profit shown under absorption costing will be lower than the profit shown under marginal costing, when closing stock is less than the opening stock. The reason behind this is that, under absorption costing, to the current period, a portion of fixed cost related to previous year is charged.

Reconciliation of results of absorption costing & marginal costing:

         When comparison of the results of absorption costing & marginal costing is undertaken, the adjustments for under- absorbed & / or over absorbed overheads becomes necessary. Under absorption costing, on the basis of normal level of activity, the fixed overhead rate is predetermined. A situation of under-absorption &/or over-absorption arises when there is a difference between actual level of activity & normal level of activity.

(i) Under-absorbed fixed overhead = Excess of normal level of activity over actual level of activity * Fixed overhead rate per unit.

         If there is under-absorption, the profit under absorption costing, before comparison with profit as per marginal costing, should be reduced with under-absorbed fixed overheads. Alternatively, by adding the under-absorbed fixed overhead to the cost of production, the same objective can be achieved.

(ii) Over absorbed Fixed overhead = Excess of actual level of activity over normal level of activity * Fixed overhead rate per unit.

         If there is over absorption, then before the comparison of profit as per absorption costing with the profit as per marginal costing, with over-absorbed fixed overheads, the profit under absorption costing should be increased. Alternatively, by reducing the over-absorbed fixed overhead from the cost of production, the same objective can be achieved.

Problem 1: For a particular product, the following cost data is given:

                                                                                 Per unit ($)
Selling Price                                                                20
Variable cost                                                               12
Fixed cost                                                                     4
Normal production                                                      52000 units

         For the four consecutive periods, the following additional data are given:

                                    Period 1           Period 2           Period 3           Period 4           Total

                                    Units               Units               Units               Units               Units

Opening stock                -                       -                    12000              4000                  -
Production                  52000              60000              48000              60000              220000
Sales                           52000              48000              56000              64000              220000
Closing stock                -                     12000                 4000               -                       -

         Prepare a statement showing the profit for different periods under both marginal costing method & absorption costing method.

Solution:                     Under Marginal Costing

Particulars           Period 1($)     Period 2 ($)     Period 3($)      Period 4($)       Total ($)

Sales – (i)             1040000          960000            1120000             1280000       4400000    
Opening stock         -                      -                      144000                 48000            -
Production              624000        720000              576000               720000        2640000    
Total                       624000         720000              720000               768000        2640000
Less: Closing stock     -___         144000                48000                   -                     -____

Cost of goods

Sold (ii)                  624000         576000              672000               768000        2640000

Contribution

(i) –(ii)                   416000          384000              448000               512000        1760000

Less: Fixed Cost

52000 units @ 4   208000          208000               208000              208000          832000     
Profit                 208000         176000            240000            304000        928000     

                                    Under Absorption Costing

Particulars                  Period 1              Period 2          Period 3          Period 4     Total

                                           ($)                         ($)                    ($)                    ($)        ($)

Sales – (i)                    1040000          960000            1120000             1280000     4400000
Opening stock @
$ 16 per unit                     -                      -                     192000                64000
Cost of Production 
$ 16 per unit                  832000          960000             768000               960000    3520000
Total                              832000          960000              960000             1024000    3520000
Less: Closing stock
@ $ 16 per unit               -                    192000              64000                -                   -__
Cost of goods sold
(Actual)                       832000            768000            896000            1024000    3520000
Less: Over-absorbed           -                 32000                                       32000       64000    
Overheads                                             (Notes 1)                               (Notes 3)________
                                    832000            736000            896000              992000    3456000    
Add: Under-absorbed                                                   16000                                 16000
Overheads                                                                   (Notes 2)____________________
Cost of Sales after
adjusting under/over
absorbed overheads
-  (ii)                             832000           736000             912000             992000    3472000
Profit [(i) – (ii)       208000          224000           208000          288000    928000

         Notes: The following adjustments should be carried out for the purpose of comparison of results of absorption costing & marginal costing:

  1. The normal capacity is 52000 units. Actual production during the period is 60000 units. That means there is over-absorption of fixed overhead amounting $ 32000 [(60000 units – 52000 units) * $4].            
  1. Actual production is 4 8000 units which are less than normal production by 4000 units. That means there is under-absorption of fixed overhead amounting $ 16000 [(52000 units – 48000 units) * $4].
  1. Actual production is 60000 units which are more than normal production by 8000 units. That means there is over-absorption of fixed overhead amounting $ 32000 [(60000 units – 52000 units) * $4].

         There is difference of profits under both the methods. The reasons of such difference are:

  1. Period 1: During this period, since no opening or closing stock is there, there is no difference in profit figures under both the methods.

  2. Period 2: During this period, profit under Absorption costing is more than that of Marginal costing by $ 48000. This is due to the fact that fixed cost of 12000 units @ $ 4 is being carried forward for the next year.

  3. Period 3: During this period, profit under Absorption costing is less than that of Marginal costing by $ 32000. This is due to the fact that by 8000 units opening stock is more than that of closing stock. As a result, to the cost of production of current year, a portion of last year’s fixed overhead is being charged.

  4. Period 4: During this period, profit under Absorption costing is less than that of Marginal costing by $ 16000. This is due to the fact that to the cost of production of current years, the fixed overhead relating to opening stock is being charged.

Presentation of data:

         The difference of presenting the data under marginal costing & absorption costing is summarized in the under mentioned table:

Marginal Costing                                                      Absorption Costing

Sales                                                    XXX               Sales                                        XXX

Less: Variable Cost                                                     Less: Manufacturing cost of
            Manufacturing            XXX                                    goods sold (including
            Administration            XXX                                    fixed manufacturing
            Selling                         XXX     XXX                        overheads)                     XXX
Contribution                                       XXX                                                               XXX
Less: Fixed cost                                                          Less: Administration &
Manufacturing            XXX                                                Selling Expenses            XXX
            Administration            XXX                           Profit                                     XXX
            Selling                         XXX     XXX
Profit                                                XXX

         Note: Profits figure under the two methods will be different, if there are opening & closing inventories.

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