Absorption vs marginal costing - Contribution format vs abso...

Learning Outcomes

On completion of this article, you will be able to distinguish between absorption and marginal costing methods, explain the construction and interpretation of contribution format and absorption profit statements, identify how each method treats fixed costs and inventory, calculate profits under both approaches, and reconcile profit differences due to inventory movements.

ACCA Management Accounting (MA) Syllabus

For ACCA Management Accounting (MA), you are required to understand both absorption and marginal costing principles, and how they impact costing, reporting, and profit analysis. This article focuses on:

• The calculation and meaning of contribution in marginal costing
• The treatment of fixed and variable costs under absorption and marginal costing
• Preparation and interpretation of profit statements in both contribution and absorption formats
• Effects of inventory changes on reported profits under both methods
• Reconciliation of profit figures between absorption and marginal costing
• Advantages and disadvantages of absorption and marginal costing

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. Under which costing method are fixed production overheads treated as period costs and not included in inventory valuation?
2. True or false? If closing inventory is higher than opening inventory, absorption costing profit will generally be higher than marginal costing profit.
3. Which statement best describes "contribution" in marginal costing?
   a) Sales minus all costs
   b) Sales minus fixed costs
   c) Sales minus variable costs
   d) Variable costs minus sales
4. Briefly explain why profits differ under absorption and marginal costing when inventory levels change.

Introduction

Absorption and marginal costing are two ways to calculate product costs for profit determination and inventory valuation. These approaches differ mainly in how fixed production overheads are treated—either included in unit costs (absorption costing) or expensed in the period (marginal costing). This article explains the principles of both methods, shows how to prepare the corresponding profit statements, and highlights how inventory changes affect reported profits and decision-making.

Key Term: absorption costing
A costing method that allocates both variable and fixed production overheads to each unit produced, including them in inventory valuation and the cost of sales.

Key Term: marginal costing
A costing method that includes only variable production costs in unit cost, treating fixed production overheads as a period expense charged in full to the statement of profit or loss.

Key Term: contribution
The difference between sales revenue and all variable costs, representing the amount available to cover fixed costs and profit.

Comparing Absorption and Marginal Costing

Classification of Costs

Absorption costing includes direct materials, direct labour, variable production overheads, and a share of fixed production overheads in the product cost. Marginal costing, however, counts only variable costs (direct materials, direct labour, variable production overheads) as product costs; fixed overheads are written off in the period as an expense.

Profit Statement Formats

Contribution Format (Marginal Costing)

The contribution format highlights contribution as a subtotal, separating variable and fixed costs:

Absorption (Full Costing) Profit Statement

The absorption format focuses on gross profit after cost of sales:

Worked Example 1.1

A company produces a single product. The following data relate to January:

• Units produced: 2,000
• Units sold: 1,500
• Selling price per unit: $40
• Direct materials per unit: $10
• Direct labour per unit: $6
• Variable production overhead per unit: $4
• Fixed production overheads: $8,000 per month

Required: Prepare both the marginal costing (contribution format) and absorption costing profit statements for January. Assume no opening inventory. Fixed overheads are absorbed at $4/unit.

Answer:
Step 1 – Unit costs:

• Marginal cost per unit: $10 + $6 + $4 = $20
• Absorption cost per unit: $20 (as above) + $4 fixed overhead = $24 Step 2 – Inventory:
• Units produced but not sold: 2,000 – 1,500 = 500 closing inventory Step 3 – Profit statements:

Marginal Costing:

Absorption Costing:

Profit difference: Absorption profit $24,000 – Marginal profit $22,000 = $2,000

Reason: $4 (fixed O/H rate) × 500 units (increase in inventory) = $2,000 in fixed costs carried in closing inventory under absorption costing, reducing expense in the period.

Inventory Movement and Profit Reconciliation

When inventory increases, absorption costing profit is higher. When inventory falls, marginal costing profit is higher. The difference is explained by the amount of fixed production overhead absorbed into closing inventory.

Reconciliation formula:

Profit difference = Change in inventory (units) × Fixed overhead absorption rate per unit
(Add if inventory increases, subtract if decreases)

Worked Example 1.2

A business had opening inventory of 1,000 units and closing inventory of 600 units. The fixed production overhead absorption rate is $5 per unit. If the profit reported under absorption costing is $45,000, what is the profit under marginal costing?

Answer:
Inventory change: 600 – 1,000 = –400 units (decrease)
Adjustment: –400 × $5 = –$2,000 (subtract from absorption profit)
Marginal costing profit = $45,000 – $2,000 = $43,000

Advantages and Disadvantages

Marginal Costing

Advantages:

• Simpler; no overhead absorption or need to calculate under/over-absorbed overheads
• Fixed costs clearly separated; useful for decision-making
• Contribution per unit is constant, aiding short-term analyses

Disadvantages:

• Inventory values not compliant with accounting standards (IAS 2 requires production overheads be included)
• May understate profit when inventory increases

Absorption Costing

Advantages:

• Aligns with IAS 2 inventory valuation requirements
• Recognises that all production costs are incurred to manufacture units

Disadvantages:

• More complex; requires overhead absorption calculations and adjustments
• Can distort profit measurement when inventory levels change

Exam Warning

Under accounting standards, only absorption costing is acceptable for external financial statements. Marginal costing is mainly used for internal decision-making and reporting.

Revision Tip

When reconciling profit differences, always check inventory movement and use the fixed overhead rate per unit for your calculation.

Summary

Absorption costing assigns both variable and fixed production costs to units and inventory, spreading fixed costs across all units produced. Marginal costing charges only variable costs to units; fixed costs are expensed in the period, unaffected by output. Contribution format profit statements highlight the portion of sales covering fixed costs and profit. Profit differences between methods arise whenever inventory levels change, as absorption costing defers some fixed costs in closing inventory. Both methods are essential—absorption for statutory reporting, marginal for planning and decision support.

Key Point Checklist

This article has covered the following key knowledge points:

• Differences in cost treatment between absorption and marginal costing
• Calculation and meaning of contribution
• Preparation and interpretation of contribution and absorption format profit statements
• Impact of inventory changes on reported profit under each method
• Reconciliation of profit figures between the methods
• Strengths and weaknesses of absorption and marginal costing

Key Terms and Concepts

• absorption costing
• marginal costing
• contribution