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Hi.
I have noticed something when preparing the p&l statement under absorption costing fir which i need some assistance.
After calculating the gross profit, we are supposed to calculate the under/over absorbed. However the way it is done is that the OAR is multiplied by the amount produced; not the amount actually sold. Why is that ?. The p&l only would show the amount sold accrued to the amount it took to produced the sold items. Shouldn’t the overheads absorbed be the OAR x the amount sold.
The overheads absorbed will be the actual production x the overhead absorption rate.
The actual sales are likely to be either higher or lower that the actual production, but the difference is accounting for by the change in the level of inventory (and the valuation of inventory includes fixed overheads at the OAR).
It is difficult to explain in more detail in words. If you watch the free lectures on both marginal and absorption costing (and the reconciliation between them) then it should make sense.
Hi John. I did view your lecture, which subsequently brought me to this question:
Maybe if I clarify my question, it would make more sense:The reason why the closing inventory is being stripped off from the COS is because you are accruing the amount sold vs the amount it took to produce the sold items, isnt it?
However, the amount that is being added/subtracted as under/over absorbed (in Absorbtion costing statement) will be the same regardless of the amount sold. ie: given a number of combinations where 1000 units are produced and the amount sold ranges from 0-1000 units the amount taken as under/over absorbed will always remain the same, because it just depends on actual amount produced and actual o/h incurred. However, the amount that has been produced is clearly out of the picture in the p&l after the closing stock has been stripped off
Isn’t it more reasonable to base the amount absorbed based on the amount sold rather than the amount produced
@alighere said:
Hi.I have noticed something when preparing the p&l statement under absorption costing fir which i need some assistance.
After calculating the gross profit, we are supposed to calculate the under/over absorbed. However the way it is done is that the OAR is multiplied by the amount produced; not the amount actually sold. Why is that ?. The p&l only would show the amount sold accrued to the amount it took to produced the sold items. Shouldn’t the overheads absorbed be the OAR x the amount sold.
Alighere:
No. I perfectly understood your question, but I repeat – the amount absorbed is always based on the actual production.
Maybe this will convince you:
Suppose the budget overheads were $200,000 and the budget production was 10,000. So the OAR is $20 per unit. Suppose materials and labour are $30 per unit. So the total standard cost is $50. The selling price is $80.
Suppose there is no opening inventory. The actual production 25,000 units. The actual sales are 20,000, and therefore the closing inventory is 5,000.
The revenue is 20,000 x 80 = 1,600,000.
The variable cost of production is 25,000 x $30 = 750,000
The fixed overheads (by definition) should stay at 200.000
Therefore the cost of production should be 950,000.
The closing inventory is valued at 5,000 x $50 = 250,000
Therefore the cost of sales should be 950,000 – 250,000 = 700,000
Therefore the profit should be 1,600,000 – 700,000 = 900,000However, using absorption costing we say the profit per unit should be 80 – 50 = $30 per unit. Therefore a total profit of 20,000 x 30 = 600,000
Why is this wrong? It is because in arriving at 600,000 we have effectively charged/absorbed overheads of 25,000 units produced at $20 per unit = 500,000.
But the fixed overheads should really stay at 300,000.
So we have over-charged/over-absorbed fixed overheads by 500,000 – 200,000 = 300,000.
So we adjust the absorption profit of 600,000 by the over absorption of 300,000 to arrive at the correct profit of 900,000.chanee23:
I don’t understand why you simply copy a question that I have already replied to!!
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