Income Determination under Marginal and Absorption Costing

The following points highlight the four cases of income determination under marginal costing and absorption costing. The cases are: 1. When there is Production but no Sales 2. When Production is Equal to Sales 3. When Production is more than Sales 4. When Production is Less than Sales.

Income Determination under Marginal Costing and Absorption Costing: Case # 1.

When there is Production but no Sales:

Under this case, the income under absorption costing may reflect profit though no sale has been made. This is due to the fact that fixed manufacturing overheads have been over absorbed above normal capacity production than its actual faked manufacturing overheads. But variable income statement will show loss as there are no sales.

Though no sales have been made but income statement will show gross profit equal to the amount of over absorption of fixed manufacturing overheads. Thus profit under absorption costing is influenced by various factors as quantity of production units, units sold, selling price, cost of production etc.

Illustration 1:

Following data relate to XYZ Company:

Normal capacity 40,000 units per month

Variable cost @ Rs.10 per unit

Actual production 44,000 units.

Sales− Nil

Fixed manufacturing overheads Rs.1,00,000 per month or Rs.2.50 per unit at normal capacity.

Other fixed expenses Rs.8,000.

You are required to prepare income statement under:

(a) Absorption costing and

(b) Marginal costing.

Income Statement (Absorption Costing)

Note: The above income statement will not show the profit if other fixed expenses are more than the gross profit.

Income Statement (Marginal Costing)

Income Determination under Marginal Costing and Absorption Costing: Case # 2.

When Production is Equal to Sales:

When production and sales are equal i.e., there is no opening or closing stock or when the inventory of finished goods does not fluctuate from period to period, net income will be the same under absorption costing and marginal costing techniques.

Illustration 2:

Following data relate to XYZ Company:

Output and sales 40,000 units. Sale price per unit Rs.15. Material and Labour cost per unit Rs. 8 Production overheads: Variable Rs.2 per unit Fixed Rs.50,000

Other fixed overheads Rs.1,00,000.

Prepare income statement under:

(a) Absorption costing and

(b) Marginal costing.

Income Statement (Absorption Costing)

Income Statement Marginal Costing)

Income Determination under Marginal Costing and Absorption Costing: Case # 3.

When Production is more than Sales:

When closing stock is more than the opening stock i.e., production exceeds sales, profit will be higher in absorption costing as compared to marginal costing. It will be clearer from the following illustration:

Illustration 3:

Following data relates to XYZ Ltd. which makes and sells toys.

Income Determination under Marginal Costing and Absorption Costing  with Illustration 3

You are required to present income statements using (a) absorption costing and (b) marginal costing. Account briefly for the difference in net profit between the two income statements.

Solution:

Income Statement (Absorption Costing)

Income Statement Marginal Costing)

The difference in profits Rs 50,000 (i.e., Rs 1, 80,000 – Rs 1, 30,000) is due to difference in valuation of closing stock. The value of closing stock in absorption costing is Rs 1, 80,000 whereas this value is Rs 1, 30,000 in marginal costing.

Income Determination under Marginal Costing and Absorption Costing: Case # 4.

When Production is Less than Sales:

When closing stock is less than the opening stock i.e., sales exceeds production (or production is less than sales), profit in marginal costing will be higher as compared to absorption costing. This will be more clear from the following illustration:

Illustration 4:

From the following data of X Ltd. prepare income statement under (a) absorption costing and (b) marginal costing. Explain briefly for the difference in profits between the two income statements.

Income Determination under Marginal Costing and Absorption Costing with Illustration 4

Solution:

Income Statement (Absorption Costing)

Income Statement (Marginal Costing)

The difference is profits Rs.5,420 (i e. Rs.4,64,700 – Rs.4,59,280) under absorption costing and marginal costing is due to element of fixed factory overheads included in the valuation of opening stock and closing stock as shown below :

Net profit ascertained under absorption costing will not be the same as under marginal costing because of:

a. Difference in Stock Valuation:

Stocks of work-in-progress and finished goods are valued at marginal cost (not including fixed costs) under marginal costing method whereas in absorption costing they are valued at cost of production which includes fixed costs. In other words, the valuation of stocks will be done at lower figure in marginal costing as compared to absorption costing therefore; profits under these two techniques of costing will differ.


b. Over- or Under-Absorption of Overheads:

In absorption costing method, there can never be hundred per cent absorption of fixed factory overheads because of the difficulty in forecasting costs and volume of output. There will be either over-absorption or under-absorption, whereas in marginal costing method, the actual amount of fixed factory overheads is wholly charged to Profit and Loss Account. Hence profits under the two techniques will differ.

Illustration 5:

Your company has a production capacity of 2, 00,000 units per year. Normal capacity utilisation is reckoned as 90%. Standard variable production costs are Rs 11 per unit. The fixed factory costs are Rs.3, 60,000 per year.

Variable selling costs are Rs.3 per unit and fixed selling costs are Rs.2, 70,000 per year. The unit selling price is Rs.20. In the year just ended on 30th June, 2010, the production was 1, 60,000 units and sales were 1, 50,000 units. The closing inventory on 30-6-2010 was 20,000 units. The actual variable production costs for the year were Rs.35,000 higher than the standard.

(i) Calculate the profit for the year

(a) By the absorption costing method, and

(b) By the marginal costing method.

(ii) Explain the difference in the profits.

Solution:

Profit Statement

Profit Statement

(ii) The difference in profits, Rs.20,000 (i.e., Rs.2,59,375 – Rs.2,39,375), as arrived at under absorption costing and marginal costing is due to the element of fixed factory cost included in the valuation of opening stock and closing stock as shown below :

Prepare statements showing the figure of profit by both the methods, i.e., marginal costing method and absorption costing method. Also explain the difference in profits.

Solution:

Statement of Profit (Absorption Costing Method)

(1) It should be noted that production in period I is more than normal production by 2,000 units and period II production is less than normal production by 1,000 units. Rate of fixed cost per unit has been determined with reference to normal production of 15,000 units. For this reason it is necessary to carry out adjustments for over-absorption/under-absorption of fixed costs.

Statement of Profit (Marginal Cost Method)

Illustration 6:

Sunita Enterprises released the figures given below from its records for Year 1 and Year 2:

Income Determination under Marginal Costing and Absorption Costing with Illustration 6

Income Statement (Absorption Costing)

Income Statement (Variable Costing)

Comments:

In Year 1, profit under Absorption Costing and Marginal (Variable Costing) are equal to nil because units produced are equal to units sold. In year 2, production is more than sales; profit under Absorption Costing is higher than Marginal (Variable) Costing. The profit is t 4, 80,000 which is just equal to the difference in the value of Closing Stock, i.e., Rs.24, 00,000 – Rs.19, 20,000 = Rs.4,80,000.

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