Difference Between Profit Calculations Under Marginal Costing and Absorption Costing

Article by Hajara Saleeth    8 Comments  

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Assume that by coincidence two firms have exactly the same costs and revanue, but that M ltd uses a marginal costing approach to valuation of stock-in-trade in its final accounts, whilst F Ltd has an absorption cost approach. Calculate the gross profit for each company for each of ther first three years of operating from the following:

1. All fixed factory overhead is $9000 per annum.
2. Direct labour costs over each of the three years- $3 per unit.
3. Direct material costs over each of the threee years- $5 per unit.
4. Variable overheads which vary in direct ratio to production were $2 per unit.
5. Sales are: Year 1- 900 units, Year 2- 1200 units, and Year 3- 1100 units Selling price remained constant at $29 per unit.
6. Production is at rate of: Year 1-1200 units, Year 2-1300 units and Year 3-1250 units.

As the first step the stock level has to be identified for each year. This stock levels remain unchanged irrelevant of the costing method used.

Profit calculation Under Marginal Costing

As the first step the marginal cost per unit has to be calculated to value the product.

Marginal cost per unit = Direct material cost per unit + Direct labour cost per unit + Other variable costs per unit

= $5 + $3 + $2

= $10

Profit Calculation Under Absorption Costing

As the first step of this calculation OAR should be calculated to allocate the production overhead to the product. OAR may differ from period to period and relevant OAR should be taken to value the product.

Overhead Absorption Rate = Budgeted overheads / Budgeted Activity Level (Labour hours or production Units)

Absorption cost of the goods for each year has to be calculated now:

Absorption cost per unit = Variable  production cost per unit + Overhead Absorption Rate (OAR) per Unit

Absorption cost per unit = (Direct material cost per unit + Direct labour cost per unit + Other variable costs per unit) + Overhead Absorption Rate (OAR) per Unit

Note: OAR may differ from period to period and relevant OAR should be taken to value the product.

*- The closing stock value of the previous year becomes the opening stock value of this year.