With the assumption of you having the basic knowledge on Product Costing Techniqes - Marginal, Absorption & ABC costing approaches, we will proceed forward.
Few Key Points to Highlight in Product Costing
A product is costed based on production related expenses - Direct Costs & Indirect Production Overheads.
All these expenses are either variable or fixed or semi-variable expenses.
- All Direct Costs (Material & Labour) are variable expenses.
- Production OHs can be in both forms (variable or fixed or both).In Marginal Costing a product is costed based on Production Variable Costs whereas in Absorption Costing the Production Fixed Overheads will also be absorbed to the product cost.
If you manufacture a unit of any product, you will have to incur an amount equivalent to production variable cost (Direct & indirect) but in general you do not have to incur any additional fixed cost as fixed expenses do not vary with the volume of output but a periodic cost.
Okay!! Breath well.... We are now going to learn the impact on P&L Statement..............
To generalize things, let's take a scenario where a product is costed based on absorption costing technique - where both variable and fixed production costs are captured under product cost.
The real deal comes when you try to prepare the Profit & Loss Statement. Until that point you can chill as you always do.
Remember - Overhead is absorbed to product cost at a pre-determinded OAR, as you are not aware of the actual overhead cost until end of the period. Hence, there can be a difference between Absorbed OH and Actual OH.
This means that the product cost calculated at the begining of the period may not be 100% accurate.
If,
Actual OH > Absorbed OH - Under Absorbed (you have absorbed less)
Actual OH < Absorbed OH - Over Absorbed (you have absorbed more)Under/Over Absorption = Actual OH - Absorbed OH
Whereas,
Absorbed OH = OAR * Actual Activity LevelThis will lead to a requirement for an adjustment in the Profit and Loss Statement in order to reflect the accurate overhead incurred (Refer Absorption Profit Format).
Profit & Loss Statement Structure
If you have absorbed less (under absorbed), a lesser amount of cost will be reflected in P&L. Hence, you have to separately deduct the under absorbed amount to arrive at Gross Profit and vice versa.Movement from Absorption Profit to Marginal Profit
If you closely observe the above two structures you will realize that all expenses recorded are more or less similar but only difference is in production fixed overhead.
In Marginal profit card production fixed overhead has been captured in full whereas in Absorption profit card the production fixed overhead is captured under product cost and;
some fixed cost part has been brought foward from last year (through opening inventory)
some fixed cost part has been carried forward to next year (through closing inventory).
Taking the variable cost component to another period along with the product is acceptable but how on earth can we move fixed cost component to different periods along with the movement of inventory? Logic behind this argument is very simple to understand. Fixed cost is incurred as a bulk for the considered period and it has nothing to do with the production. So if fixed cost is independent, how can you play with it? But let's argue on this factor in a different episode...........
How do you Calculate the Cost of Sales?????
WOW!!!!!
Above Cost of Sales calculation is an extraction from the Absorption Profit Card. If closely studied,
A portion of fixed cost has been added to the period from opening inventory.
A portion of current year's fixed cost has been carried forward (deducted) to the next year through closing inventory.
In simple language the fixed cost came from opening stock has been realized as a cost in current period which should not happen and a fixed cost portion from closing stock which has to be captured under current period has been taken to next year.
If you are moving from Absorption profit to Marginal profit, the adjustment should be as stated below.
The fixed cost portion from Opening Stock should be taken out from current year's cost, and
The fixed cost potion from Closing Stock should be taken in as a cost of current year.
The difference in profits have actually caused by the change in inventory level. If you still want to go a step deeper, it is from the fixed cost portion of change in inventory level.
Hence, the reconciliation of profits is not rocket science.
Let's summarize three special scenarios.
If inventory levels increase, absorption costing gives the higher profit.
If inventory levels decrease, marginal costing gives the higher profit.
If inventory levels are constant, both methods give the same profit.
Hope you understood how product costing has an impact on Profit & Loss Statement preparation. Let's stop it from there for this session.
Too much of anything is not good ahhh!!!
Purindu B Jayatilake
MSc Eng (Reading), MBA, BSc (Hons) Eng, ACMA (UK), CGMA
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