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l don’t understand the reasoning in this statement kindly explain it to me, if inventory levels increase between the beginning and end of a period absorption costing will report the higher profit because some of the fixed production overhead incurred during the period will be carried forward in the closing inventory to be set against sales revenue in the following period,instead of being written off in full against profit in the period concerned.Thanks
Absorption costing includes fixed production overheads in the cost per unit, and therefore includes it in the inventory valuation, whereas marginal costing does not – marginal costing charges the whole of the fixed overheads in the year in which they are incurred.
Since absorption costing does include fixed overheads in the inventory valuation, all that is actually charged in the current year are the overheads on those items that are actually sold. If inventory is increasing then it means they are selling less than they are producing, and so the fixed overheads charged in the current year will be less than the total fixed overheads incurred (the extra is carried forward in inventory and becomes part of the cost of sales in the following year).
Having said all that, this is of little relevance for Paper F5 (now called Paper PM), because it is examined at Paper F2. I assume that you read this in a Study Text – they put it there because in theory most topics from F2 can be examined in F5, but in practice comparing absorption and marginal costing is not examined in F5.
If you watch my free lectures for F5 (PM) then they cover everything needed to be able to pass the exam well (and revise the relevant F2 topics).
Should you really want to spend time on absorption and marginal costing, then watch my free Paper F2 lectures on this area – it is impossible for me to type out the whole lectures here 🙂
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