Absorption Vs Marginal and Reconciliation

ACCA F5 - Performance Management 

In this article we check the first condition discussed in earlier article "Marginal Costing"

Year	Relation between production and sales	Effect on inventory	Relation between variable and absorption income
1st	Production = 25,000 Sales = 20,000	increase by 5,000 units	Absorption > Variable (Total marginal)

Assumption:

Direct labour	5
Direct material	8
Variable production overhead	2
Fixed production overhead (budget output for per year is 360,000)	5
Standard production cost	20

Fixed production overhead incurred in given month is 160,000

Administration, sales and services expenses include:                                                     

Fixed     $100,000

Variable 20%

Selling price per unit = $40

Working in $1000 per unit

Absorption costing profit statement				Marginal costing profit statement
Sales  for 20,000 units		800		Sales 20,000 units		800
Less: Cost of sales - valued at full production cost Ø  Opening inventory - Ø  Variable cost of production (5+8+2) for 25,000 units 375 Ø  Fixed overhead absorbed 5*25,000 125 Ø  Less closing inventory 20*5,000 (100)		(400)		Less: Cost of sales - marginal production costs only Ø  Opening inventory - Ø  Variable cost of production (5+8+2) for 25,000 units 375 Ø  Less closing inventory 15*5000 (75)		(300)
		400				500
(under)/over -absorption = (absorbed-incurred)=125-160		(35)		Less other variable cost (20%*800)		(160)
Gross profit		365		Contribution		340
Less: non-production costs (20%*800,000)+100,000		260		Less fixed costs -actually incurred (160,000+100,000)		260
Profit/Loss		105		Profit/loss		80
Profit under absorption costing (105,000) > (80,000) Profit under marginal costing
Valuation of inventory - opening and closing inventory are value at full production cost. Closing inventory 100,000				Valuation of inventory - opening and closing inventory are value at marginal cost. Closing inventory 75,000
Under and over absorption adjustment is necessary.				No adjustment for overhead is needed and actually incurred fixed cost is used.
Closing inventory is valued 25,000 more in absorption costing than in marginal costing. This is because overhead is absorbed by all products equally under absorption costing while, under marginal costing total overhead for the period is recognised.
RECONCILATION: Difference in profit = 25,000  = Over-valuation of closing inventory in absorption costing