The income statement prepared with absorption costing and marginal costing will give different results under the following conditions:
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- Varying levels of production: When there are variations in the level of production, absorption costing and marginal costing methods will result in different net profits. This is because absorption costing allocates fixed manufacturing overheads to products produced, while marginal costing treats fixed overheads as period costs.
- Inventory levels: If there are changes in the levels of inventory from one period to another, absorption costing and marginal costing methods will produce different results. Under absorption costing, the value of closing inventory includes a portion of fixed manufacturing overheads, while marginal costing values closing inventory at variable production costs only.
- Selling and production capacity: If a company is operating below its production or selling capacity, marginal costing will result in higher profits as fixed manufacturing overheads are treated as period costs. However, absorption costing will allocate fixed overheads to the products produced, resulting in a lower net profit.
- Fixed overheads: If a company incurs significant fixed manufacturing overheads, absorption costing and marginal costing methods will produce different results. Under absorption costing, these fixed overheads are allocated to products, while marginal costing treats them as period costs.
In summary, the difference in net profit between absorption costing and marginal costing arises due to the treatment of fixed manufacturing overheads. Absorption costing includes these costs in the cost of goods sold, while marginal costing treats them as period costs.