The nature and purpose of profit statements

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The nature and purpose of, profit statements and their preparation in absorption and marginal costing formats.

Some definitions:

Marginal cost (MC): the additional cost caused when one more unit is made. Marginal cost will be the sum of all variable costs per unit.

Total absorption cost (TAC): the total cost of manufacturing a unit. This is the sum of the marginal cost and a fair share of the fixed production costs.

Fixed overhead absorption rate: budgeted fixed production costs divided by budgeted output in units.

Profit per unit: selling price per unit less total absorption cost per unit ie less marginal costs and all fixed production costs.

Contribution per unit: selling price per unit less marginal cost per unit

Here is a cost card showing selling price and costs per unit:

Note: total absorption cost per unit = $65 ($40 marginal cost + $25 fixed cost per unit)

Let us say that in a month, 1000 units were made and 900 of those were sold. This means that there must be 100 items left in inventory. The profit can be calculated in two ways.

Marginal cost (MC) approach

Note:

1. Under marginal costing closing inventory is valued at its marginal cost

2. All fixed costs are deducted as a lump sum, sometimes referred to as a period cost.

Total absorption cost (TAC) approach

Note: 

1. Under TAC closing inventory is valued at its total absorption cost

2. Fixed costs are accounted for in the total absorption cost of sales.

Commentary on the two methods of calculating profits

You will see that the two profits are different, with TAC profits of $31,500 and MC profits of 29,000, i.e. TAC profits are $1,500 greater.

This difference can be reconciled to the difference in closing inventory valuation. In TAC, the closing inventory of $6,500 contains some fixed costs ($6,500 = 100 x ($40 + $25)). These will be accounted for in the next period when those items are sold. In the MC approach all fixed costs are deducted in the period.

Both methods are correct. It’s simply if inventories are valued differently then profits will be different.

Commentary on the two methods of calculating the cost of production

Marginal cost: each unit causes $40 additional costs and when sold will generate $100 additional revenue. The contribution of $40 means that each unit makes the company $40 richer. It would even be worthwhile making for $40 MC and selling as low as $41 as that would generate a small contribution. Marginal cost is therefore good for decision making.

However, because MC does not take into account all production costs, it can be argued that the cost of production and the value of inventory is understated.

Total absorption cost: each unit costs $65 to produce, but each unit does not cause an extra $65 as fixed costs are fixed. Despite a TAC of $65 is would still be worth selling units at $50, so TAC can be bad for decision making.

However, all production costs are taken into account and arguable TAC is better for stock valuation.

Either methods can be used in internal cost accounting, but for external reporting in the financial statements TAC has to be used for stock valuation.

Calculating the cost of a product or service

This part of the syllabus has been substantially covered. All that remains is to introduce a couple of pieces of terminology.

Prime cost  = direct material + direct labour + direct expenses

Factory cost = prime cost + production overheads

Total cost = factory cost + non-production overheads