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Difference Between Profit Calculations Under Marginal Costing and Absorption Costing

Illustration

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.

Year 1 Year 2 Year 3
Opening Stock 300 400
(+) Production 1200 1300 1250
(-) Sales (900) (1200) (1100)
Closing Stock 300 400 550

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

Year 1       $ Year 2   $
Sales Revenue (Selling Price X No of units sold) 29X 900

=26100

29X1200

=34800

(-) Marginal Cost of goods sold
Opening stock (Opening stock in units X Marginal cost per unit) 10X300

=3000

(+) Production (Production level X Marginal cost per unit) 10X1200

=12000

10X1300

=13000

(-) Closing stock (Closing stock in units X Marginal cost per unit) (10X300

=3000)

(9000) (10X400

=4000)

(12000)
Contribution for the Period 17100 22800
(-) Fixed cost of the Period (9000) (9000)
Profit for the Period 8100 13800

Year 3  $
Sales Revenue (Selling Price X No of units sold) 29X1100

=31900

(-) Marginal Cost of goods sold
Opening stock (Opening stock in units X Marginal cost per unit) 10X400

=4000

(+) Production (Production level X Marginal cost per unit) 10X1250

=12500

(-) Closing stock (Closing stock in units X Marginal cost per unit) (10×550

=5500)

(11000)
Contribution for the Period 20900
(-) Fixed cost of the Period (9000)
Profit for the Period 11900

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)

Year 1 Year 2 Year 3
Production O/Hs $ 9000 $ 9000 $ 9000
Production Units 1200 1300 1250
OAR for the period $ 7.5 $ 6.9 $ 7.2

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.

Year 1 $ Year 2 $ Year 3 $
Direct  Material 5 5 5
Direct Labour 3 3 3
Other Variable O/Hs 2 2 2
OAR for the period 7.5 6.9 7.2
Absorption cost of the product 17.5 16.9 17.2
Year 1 $ Year 2 $
Sales Revenue (Selling Price X No of units sold) 29X 900

=26100

29X1200

=34800

(-) Absorption Cost of goods sold
Opening stock (Opening stock in units X Absorption cost per unit or the closing stock value of previous year) 300X17.5

=5250 *

(+) Production (Production level X Absorption cost per unit) 1200X17.5

=21000

1300X16.9

=21970

(-) Closing stock (Closing stock in units X Absorption cost per unit) (300X17.5

=5250)

(15750) (400X16.9

=6760)

(20460)
Gross Profit for the Period 10350 14340
Year  3 $
Sales Revenue (Selling Price X No of units sold) 29X1100

=31900

(-) Absorption Cost of goods sold
Opening stock (Opening stock in units X Absorption cost per unit or the closing stock value of previous year) 400X16.9

=6760 *

(+) Production (Production level X Absorption cost per unit) 1250X17.2

=21500

(-) Closing stock (Closing stock in units X Absorption cost per unit) (550X17.2

=9460)

(18800)
Gross Profit for the Period 13100

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

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10 thoughts on “Difference Between Profit Calculations Under Marginal Costing and Absorption Costing”

  1. Za says:

    Hey there,

    Good job , keep it up!! 🙂

    1. sasha says:

      thanx Za… I will be writing on investment appraisal with inflation on ma next article.. But I think I gave you the summary of that.. 😀

  2. hanxlk says:

    Nice article… All the best…

    1. sasha says:

      Thanx Haneez n Ashfaq…

  3. Ashfaq says:

    Great job keep up the good work

  4. Genial post and this post helped me alot in my college assignement. Gratefulness you seeking your information.

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  6. ACCA Study says:

    I like the explanation of the absorption costing principle – thanks

  7. chrisnecal says:

    I’ve a problem with calculation of marginal costing
    And absorbtion costing I need help

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