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I am looking at the below and i’m confused despite re-visiting my notes
MC profit
Less fixed overhead in opening inventory
Plus fixed overhead in closing inventory
AC profitMy question is why do we remove fixed overhead in opening inventory when calculating AC profit if opening inventory is calculated at variable costs?
Similarly i don’t fully understand why we are adding fixed overheads in opening inventory when we are calculating the MC profit.
I understand that AC profits are higher with and increase in inventory and that MC is lower, but i cannot connect the relation to the reconcilliation. Thank you for you’re assistance.
Hi Im not sure I fully understand how you see this.
The correct reconciliation is on page 5 of the CIMA P1 Open Tuition notes.
The reconciling factor depends on whether stock has increased or decreased in the period.
It its calculated by ‘change in inventory levels x Overhead Absorption rate’
It is added or deducted depending if stock increases or decreased in the period.
If stock levels increase, absorption costing gives the higher profit.
This is because fixed overheads held in closing inventory are carried forward so reducing cost of sales to the next accounting period instead of being written off in the current accounting period as with marginal costing.If stock levels decrease, marginal costing gives the higher profit.This is because fixed overhead brought forward in opening inventory is released, thereby increasing cost of sales and reducing profits.
If inventory levels are constant, both methods give the same profit.
This is also explained in our video series for chapter 1 of our Open Tuition CIMA P1 notes.
Hi, thanks for the reply. I understand all of the theory but i don’t understand the application of the below:
MC profit
Less fixed overhead in opening inventory
Plus fixed overhead in closing inventory
AC profitI have seen the above formula used when we have the the MC profit and the inventory levels at both MC and AC, where the question asks to calculate the AC profit….. What i don’t understand is:
1) Why do we remove fixed overhead in opening inventory when calculating AC profit if opening inventory is calculated at variable costs?
2) Why we are adding fixed overheads in opening inventory when we are calculating the MC profit
In some questions they don’t give the fix OAR rate so i would have to adopt the above method, it would be useful to understand it fully.
Thanks for you’re help and sorry if the answer is obvious.
Hi – can you post an example of a question where this happens and Ill use the numbers to explain. Please post the model answer also.
Many Thanks
Ok great! Please see below question,
A business reported a mc profit of 45,000 last period. It’s inventory values for the period were as follows:
Opening inventory: 16000
Closing inventory: 20,800If the business had used absorption costing, the inventory values would have been as follows
Opening inventory 28000
Closing inventory 36400What would the profit be using AC?
My QUERY:
MC profit
Less fixed overhead in opening inventory
Plus fixed overhead in closing inventory
AC profitI have seen the above formula used when we have the the MC profit and the inventory levels at both MC and AC, where the question asks to calculate the AC profit….. What i don’t understand is:
1) Why do we remove fixed overhead in opening inventory when calculating AC profit if opening inventory is calculated at variable costs?
2) Why we are adding fixed overheads in opening inventory when we are calculating the MC profit
In some questions they don’t give the fix OAR rate so i would have to adopt the above method, it would be useful to understand it fully.
Thanks for you’re help and sorry if the answer is obvious.
Hi,
The difference in opening stock is $12000 ( 28000 – 16000) and the difference in closing stock is $15600 (36400 – 20800 ) so the actual movement in the period is $3600.
We know that when stock increases absorption costing is more (SIAM) so we add this difference to marginal costing profit to find absorption costing profit ( 45,000 + 3600 = $48600)1) I think you’ve misunderstood the concepts/ calculations because we definitely dont deduct overhead from marginal costing profits to find AC profits.
2) Nor do we add fixed overheads to MC profit.The calculation you usually need is to find the difference in reported profits which is the number of units x OAR . The direction of the adjustment to profits being determined whether its an increase or decrease in stock levels in that period.
When this information is not available – such as the question you posted in the example – then you need to find another method of finding the movement in inventory in the period – which is shown by my workings.
Hope that explains,
Kind Regards
Cath
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