Lecture_2_Marginal v Absorption costing profit statements.pptVIP

* The effects on total profit The total profit is the same for both methods The difference is one of timing of the profit, because the periods in which costs are charged against profits differ: in absorption costing not all fixed costs are written off as the period cost, but in marginal costing all fixed costs are written off as the period cost. * Explaining the profit difference There may be three cases with production and sales levels: (1) Production equals sales (2) Production exceeds sales (3) Sales exceed production * (1) Production equals sales When production equals sales stock levels do not change. In this case, both methods produce the same profit, because: Under marginal costing all fixed manufacturing costs will be written of as the period cost. Under absorption costing all fixed manufacturing costs will be written of as the cost of goods sold. * (2) Production exceeds sales When production exceeds sales, inventory levels increase. When inventory levels are rising, absorption costing shows a higher profit: in this case closing stock absorbs more overhead, which means that more overhead is carried forward as opening stock into the next period than when marginal costing is used. * (3) Sales exceed production When sales exceed production inventory levels decline. When inventory levels are falling, absorption costing shows a lower profit: in this case fixed costs incurred in earlier periods are brought forward as a part of opening stock and these costs to be written off during the current period * Weakness of absorption costing in decision making With an absorption costing system: profits can increase when sales volume declines, profits can decline when sales volume increases and costs remain unchanged. Thus, this method may lead to wrong decision making on appropriate production levels when sales volumes are volatile. * Advantages of marginal costing Shows consistent profit figures, despite changes in inventory levels In a period with increasing stocks