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How income statements are prepared using marginal and absorption costing

This paper aims at looking at how income statements are prepared using marginal and absorption costing. The absorption costing method charges all direct costs to the product costs as well as a share of indirect costs. The indirect costs are charged to products using a single overhead absorption rate which is calculated by dividing the total cost centre overhead to the total volume of budgeted production. (ACCA, 2006; Drury, 2006; Blocker et al., 2005). On the other hand under marginal costing, only variable costs are charged to cost units. Fixed costs are written off the profit and loss account as period costs. (Drury, 2006; Blocker et al., 2005). Sections a) and b) below show the marginal and absorption costing income statements respectively for H Ltd that manufactures and sells a single product during the years ending 2006 and 2007. It is assumed that the company uses the first-in-first-out (FIFO) method for valuing inventories. In addition it is assumed that the company employs a single overhead absorption rate each year based on budgeted units and actual units exactly equalled budgeted units for both years. Workings are shown the attached excel file.

Marginal Costing

H Ltd Income Statement (Marginal Costing)

2006

 

2007

£'000

£'000

Sales Revenue

3000

3600

Cost of Sales:

Opening Stock

0

400

Production cost (W1, W2)

700

500

Variable Marketing and Admin

1000

1200

Cost of Goods available for sale

1700

2100

Ending inventory (W3, W4)

200

100

1500

2000

Contribution Margin

1500

1600

Less Fixed costs

Marketing and Admin

400

400

Production overheads

700

700

1100

1100

Operating profit

400

500

Absorption costing.

H Ltd Income Statement (Absorption Costing)

2006

 

2007

£'000

£'000

Sales

3000

3600

Cost of Sales

Beginning Inventory

0

400

Production Cost (W5, W6)

1400

1200

Ending Inventory (W7, W8)

400

240

1000

1360

Gross Profit

2000

2240

Marketing and Admin Expenses

Fixed

400

400

Variable

1000

1200

1400

1600

Operating profit

600

 

640

Reconciliation of net income under absorption and Marginal Costing.

Reconciliation

 

2006

 

2007

£'000

£'000

Absorption operating profit

600

640

Less Fixed overhead cost in ending inventory (W9)

200

140

Marginal Costing net income

400

 

500

Under marginal costing inventory of finished goods as well as work in progress is valued at variable costs only. On the contrary, absorption costing values stocks of inventory of finished goods and work in progress at both variable costs and an absorbed amount for fixed production overheads. (ACCA, 2006; Lucy, 2002). In the case of H Ltd, under marginal costing, only variable costs are included in the ending inventory figure. This results in a profit figure of £400,000. On the other hand absorption costing includes additional £200,000 as fixed overhead in the ending inventory for 2006. As a result absorption operating profit is overstated by £200,000 in 2006. In like manner, the absorption profit under absorption costing is overstated by £140,000 due to an inclusion of £140,000 of fixed overhead cost in the ending inventory figure for 2007. To reconcile the profit under absorption costing and marginal costing, we may either subtract the fixed overhead included in ending inventory from the absorption cost operating profit to arrive at the marginal cost operating profit or add the fixed overhead costs in ending inventory to the marginal cost operating profit to arrive at the absorption cost operating profit.

Stock Build-ups

Stock build-ups may result from using absorption costing for performance measurement purposes because inventory is valued at both fixed and variable costs. Firstly, profit is overstated. In fact absorption costing enables income manipulation because when inventory increases fixed costs in the current year can be deferred to latter years and as such current net income is overstated which in effect results in financial statements that do not present fairly and as such affect users' decisions on the financial statements. Secondly, maintaining high levels of inventory may result in obsolescence and as such declines in future profitability resulting from the loss in value of the inventory. (Blocher et al., 2005; Storey, 2002).

Advantages of Absorption Costing and Marginal Costing

According to ACCA (2006) the following arguments have been advanced for using absorption costing:

  1. It is necessary to include fixed overhead in stock values for financial statements. This is because routine cost accounting using absorption costing produces stock values which include a share of fixed overhead. Based on this argument, financial statements prepared using absorption costing present a true and faithful representation of the actual results of operation of the company.
  2. For a small jobbing business, overhead allotment is the only practicable way of obtaining job costs for estimating and profit analysis.
  3. Analysis of under/over-absorbed overhead is useful to identify inefficient utilisation of production resources. 

ACCA (2006) also identifies a number of arguments in favour of marginal costing. Preparation of routine cost accounting statements using marginal costing is considered more informative to management for the following reasons:

  1. Contribution per unit represents a direct measure of how profit and volume relate. Profit per unit is a misleading figure.
  2. Build-up or run-down of stocks of finished goods will distort comparison of operating profit statements. In the case of closing inventory, the inventory is valued only at the variable cost per unit. This makes the profit under a situation where there is closing inventory to be the same as the case when there is no closing inventory thereby enabling the comparison of operating profit statements over time.
  3. Unlike under absorption costing, marginal costing avoids the arbitrary apportionment of fixed costs, which in turn result in misleading product cost comparisons.

Bibliography

  • ACCA (2006). Paper 2.4 Financial Management and Control: Study Text 2006/2007. www.kaplanfoulslynch.com
  • Blocher, E., Chen, K., Cokins, G., Lin, T. (2005). Cost Management A Strategic Emphasis. 3rd Edition McGraw Hill.
  • Drury, C. (2004). Management and Cost Accounting. 6th Edition. Thomson Learning, London.
  • Lucy, T (2002), Costing, 6th ed., Continuum.
  • Storey, P (2002), Introduction to Cost and Management Accounting, Palgrave Macmillan

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