Under absorption costing, fixed costs are treated as product costs while marginal costing excludes fixed costs from product costs.

The example given here illustrates the method of income determination under absorption and marginal costing:

Example:

In the two income statements shown earlier, the net profits arrived at, under absorption costing and marginal costing are the same, this is so because there is no opening or closing stock of finished goods or work-in-process.

Valuation of stock in absorption costing is done at total cost (variable plus fixed cost) whereas in marginal costing, it is done at marginal cost i.e., variable cost only. Thus, the amount of profit and loss may be different under the two systems if there are opening or closing stocks.

This point of difference can be well understood with the help of following example:

Cost of production (5,000 units)

Variable cost (Rs. 4 per unit) = Rs. 20,000

Fixed cost (Re. 0.20 per unit) = Rs. 1,000

Sales (4,000 units @ Rs. 6 per unit) = 24,000

Closing stock 1000 units

Illustration 1:

A company produces only one product which had the following costs:

Variable manufacturing costs Rs. 4 per unit

Fixed manufacturing costs Rs. 1,00,000 per annum

The normal capacity is set at 1,00,000 units. There are no work-in-process inventories. Fixed overhead rate is Re. 1 per unit.

In 2010, the company produced 1,00,000 units and sold 90,000 units at a price of Rs. 8 per unit. In 2011, the company produced 1,10,000 units and sold 1,15,000 units at the same price.

You are required to prepare income statements for 2010 and 2011 based on absorption costing and variable costing.

Solution:

Illustration 2:

The following are the cost data relating to a factory for two years:

You are required to prepare a comparative profitability statement under absorption costing and marginal costing for the two years assuming that materials are issued on First-in-First-out (FIFO) basis.

Solution:

Work Notes:

Illustration 3:

ABC Motors assembles and sells motor vehicles.

It uses an actual costing system, in which unit costs are calculated on a monthly basis. Data relating to March and April, 2011 are:

The Selling Price per motor vehicle is Rs. 24,000.

Required:

(i) Present Income Statements for ABC Motors in March and April 2011 under:

(a) Variable costing and

(b) Absorption costing.

(ii) Explain the differences between:

(a) And

(b) For March and April.

Solution:

Working Notes:

The difference in net income under absorption costing and variable costing is as below:

March: Rs. 18,50,000 – 12,50,000 = Rs. 6,00,000

April: Rs. 26,70,000 — 31,20,000 = Rs. 4,50,000

The above shown differences in income are mainly due to the difference in the method of valuation of closing inventory. Under absorption costing, inventory is valued at total cost including fixed cost whereas under variable costing fixed cost is excluded from the same.