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When opening inventory was 8,500 litres and closing inventory was 6,750 litres, a firm had a
profit of $62,100 using marginal costing
Assuming that the fixed overhead absorption rate was $3 per litre, what would be the
profit using absorption costing?
FYI, i have read and watched all your notes and lectures.
The solution given is :
As inventory decreases over the period, the cost of sales will be higher with absorption
costing, since they will include fixed overhead in the opening inventory now sold. The extra
cost of sales (and thus reduction in profit) = (8,500 – 6,750) × $3 = $5,250.
This means that since profit will be lower with absorption costing by $5,250, the absorption
costing profit will be $(62,100 – 5,250) = $56,850.
is the answer correct?
If correct, what i do not understand is:
i) “As inventory decreases over the period,”, what is the inventory decreasing?
ii) as i know, absorption costing includes the fixed production overhead in closing inventory valuation, therefore the closing valuation will be higher than marginal costing, thus absorption costing profit will be higher than the marginal costing. but why the solution tells the absorption costing profit is lower than the marginal costing?
You write that you have watched my free lectures, but I do explain in the lectures that the only difference ever between the marginal and absorption profits is the change in inventory multiplied by the fixed overheads per unit.
Here, the inventory is decreasing (falling) by 8,500 – 6,750 = 1,750 units. The standard fixed overhead is $3 per unit. Therefore the marginal profit is higher than the absorption profit by 1,750 x $3 = $5,250.
Look again at examples 2 and 3 of Chapter 10 of our free notes and my lecture working through (and explaining) these examples.