Absorption vs marginal costing - Advantages and disadvantage...

Learning Outcomes

After working through this article, you will be able to distinguish between absorption and marginal costing, explain how each method values inventory and calculates profit, and articulate the principal advantages and disadvantages of both approaches. You will also recognise when each costing method is suitable, how their use can affect reported profits, and address common exam pitfalls.

ACCA Management Accounting (MA) Syllabus

For ACCA Management Accounting (MA), you are required to understand the distinction between absorption and marginal costing techniques in decision-making and profit reporting. In particular, revision should focus on:

• The definition and calculation of absorption and marginal costing
• The treatment of fixed production overheads in both methods
• The impact of each method on profit calculation when inventory levels change
• Inventory valuation principles under absorption and marginal costing
• Advantages and disadvantages of each approach
• Suitability of methods for different scenarios

Test Your Knowledge

Attempt these questions before reading this article. If you find some difficult or cannot remember the answers, remember to look more closely at that area during your revision.

1. Which costing method includes fixed production overheads in inventory valuations?
   1. Absorption costing
   2. Marginal costing
   3. Both
   4. Neither
2. If closing inventory increases in a period, which method will usually report a higher profit?
   1. Marginal costing
   2. Absorption costing
   3. Both show the same profit

3. List two principal advantages of marginal costing.

4. In which method is fixed production overhead treated as a period cost rather than part of inventory?

Introduction

Absorption costing and marginal costing are two core methods for determining product costs and measuring profit in management accounting. Each approach treats fixed production overhead differently, which leads to differences in reported profits, especially when inventory levels change.

A clear understanding of both methods is required for interpreting profit statements, valuing inventories in line with accounting standards, and using results for planning, control, and decision-making. Additionally, choosing the appropriate costing technique is essential, as each has distinct strengths and limitations.

Key Term: Absorption costing
A costing method that allocates all direct costs and allocates both variable and fixed production overheads to the cost of products. Fixed production overheads are included in inventory valuations and cost of sales.

Key Term: Marginal costing
A costing method that assigns only variable production costs (direct and variable production overhead) to products. Fixed production overheads are treated entirely as period costs and written off in full against profit for the period.

Absorption vs Marginal Costing: Overview

Absorption costing and marginal costing are alternative approaches to determining product cost and measuring profit for management and financial reporting.

Key Difference: Treatment of Fixed Production Overheads

• Absorption costing: Allocates a share of fixed production overhead to each unit produced and includes it in inventory valuations.
• Marginal costing: Treats all fixed production overheads as period costs, charged in full against profits of the period incurred.

Inventory Valuation

• Absorption costing: Inventory is valued at total production cost (direct materials, direct labour, variable and fixed production overhead).
• Marginal costing: Inventory is valued only at variable production cost (excludes fixed production overhead).

Profit Calculation

• When inventory levels increase, absorption costing profits are usually higher, as some fixed production overhead is carried forward in closing inventory. If inventory falls, marginal costing typically shows higher profit, as more fixed costs have been charged against revenue.

Worked Example 1.1

A company produces a single product. In a period, it incurs:

• Variable production cost per unit: $8
• Fixed production overhead per unit (based on budgeted output): $2
• Production: 1,000 units
• Sales: 900 units

Question: Calculate the profit for the period using (a) absorption costing and (b) marginal costing. Ignore all non-production costs and selling price for simplicity.

Answer:

• Under absorption costing, each unit is valued at $10 ($8 + $2).
  • Cost of goods sold = 900 x $10 = $9,000
  • Closing inventory = 100 x $10 = $1,000
  • All fixed production overheads (1,000 x $2 = $2,000) are included in product cost.
• Under marginal costing, each unit is valued at $8.
  • Cost of goods sold = 900 x $8 = $7,200
  • Closing inventory = 100 x $8 = $800
  • Fixed production overheads of $2,000 are expensed in full in the period. The reported profit will be higher under absorption costing by the fixed overheads carried in closing inventory ($200).

Comparing Absorption and Marginal Costing

Tabular Summary

Advantages of Absorption Costing

• Complies with accounting standards for inventory valuation (IAS 2)
• Matches all production costs with revenue, smoothing profit over periods
• Simple for use in profit reporting for external statements
• Useful where inventory levels are stable
• Ensures all costs are recouped in product pricing

Disadvantages of Absorption Costing

• Reported profit may fluctuate with changes in inventory, not just activity
• Can obscure the actual impact of changes in sales/production levels
• Not suitable for short-term decision-making (e.g., accept/reject special orders)
• Overheads absorbed may not reflect actual usage if budgeted overheads/production differ from actuals

Exam Warning

In exam scenarios, remember: If inventory increases, absorption costing reports higher profit than marginal costing; if it decreases, marginal costing reports higher profit.

Advantages of Marginal Costing

• Simple treatment of fixed production overhead—written off in full, so profit reflects current period
• Useful for short-term decision-making, as it shows contribution per unit
• Eliminates effects of inventory changes from profit calculation—profit follows sales volume
• Avoids the need to determine overhead absorption rates

Disadvantages of Marginal Costing

• Not permitted for external financial reporting (does not comply with IAS 2)
• Ignores long-term need to recover fixed costs through pricing
• Can understate inventory value on the statement of financial position
• May be less appropriate where fixed costs are significant in total and need to be apportioned for pricing or reporting

Revision Tip

Use marginal costing for internal analysis and decision-making. Use absorption costing for financial statements and inventory valuation.

Reconciliation of Profits and Inventory Changes

The difference in profit between absorption and marginal costing is:

(Change in inventory units) x (fixed production overhead rate per unit)
If closing inventory is greater than opening, absorption costing profit is higher.

Worked Example 1.2

A business produces 4,000 units in a period, sells 3,500, and the fixed production overhead absorption rate is $4 per unit. There is no opening inventory.

Question: By how much will absorption costing profit exceed marginal costing profit?

Answer:
(Closing inventory of 500 units x $4) = $2,000. Absorption costing profit will be $2,000 higher.

When to Use Each Method

• Absorption costing is required for published financial statements and for valuing inventory in accordance with international standards.
• Marginal costing is recommended for internal decision-making, break-even analysis, and assessing the impact of changes in production and sales volume.

Key Term: Contribution
The difference between sales revenue and variable costs. It represents the amount available to cover fixed costs and generate profit.

Suitability and Limitations

• Absorption costing confers a full-costing view, suitable for reporting to stakeholders.
• Marginal costing isolates variable costs, supporting decision-making but unsuitable for statutory accounts.

Worked Example 1.3

A product sells for $15, with a variable cost of $9 per unit and total fixed production overheads of $12,000 per period. Calculate the contribution per unit and explain its relevance to marginal costing.

Answer:
Contribution per unit = $15 - $9 = $6. Contribution shows how much each sale contributes to covering fixed costs and then profit, a key focus of marginal costing.

Summary

Absorption costing includes all production costs in product valuation and is required for external reporting. Marginal costing includes only variable costs in product valuation and treats fixed production overhead as a period expense. Marginal costing gives more consistent profits when inventory levels change, and is useful for internal management decisions, while absorption costing should be used for financial statements. Each method has unique strengths and weaknesses. Understanding both is essential for ACCA exam success.

Key Point Checklist

This article has covered the following key knowledge points:

• The difference between absorption and marginal costing methods
• How each method treats fixed production overhead
• The effect of each method on profit and inventory valuation
• When profit differs under each method
• Main advantages and disadvantages of both approaches
• When to use each costing method in practice

Key Terms and Concepts

• Absorption costing
• Marginal costing
• Contribution