Absorption vs marginal costing - Profit reconciliation betwe...

Learning Outcomes

After reading this article, you will be able to distinguish between absorption and marginal costing methods, explain how each values inventory and calculates profit, and perform reconciliations between the two approaches. You will be able to prepare profit statements under both methods, interpret the effect of inventory changes on reported profit, and explain the practical and exam implications of these differences.

ACCA Management Accounting (MA) Syllabus

For ACCA Management Accounting (MA), you are required to understand the impact of absorption and marginal costing on profit calculation and inventory valuation, as well as the process for reconciling profits between the methods. Focus your revision on:

• Comparing absorption and marginal costing, including their treatment of fixed production overheads
• Applying each method to prepare profit statements
• Explaining and calculating the effect on inventory values and profits
• Reconciling profits calculated under both methods
• Discussing advantages and disadvantages of each approach
• Identifying key terms associated with costing methods

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 absorption costing, which costs are included in the inventory valuation?
   1. Only variable production costs
   2. Only fixed production costs
   3. All production costs (fixed and variable)
   4. All costs, including non-production
2. If opening inventory is 2,000 units and closing inventory is 4,000 units, and the fixed production overhead absorption rate is $8 per unit, by how much will profit under absorption costing exceed profit under marginal costing?
   1. $0
   2. $8,000
   3. $16,000
   4. $32,000

3. True or false? Marginal costing attributes all fixed production overheads as period costs.

4. Briefly explain why profits differ between absorption and marginal costing when inventory levels change.

Introduction

Absorption and marginal costing are two alternative methods for assigning costs to inventory and determining profit in manufacturing and service companies. The key difference lies in how fixed production overheads are treated in the accounts, which in turn affects both the valuation of inventory and the calculation of profit. Understanding this difference, and the practical implications for financial reporting and decision making, is essential for ACCA exam success.

Key Term: Absorption costing
A method that allocates all production costs (both variable and fixed) to units produced, so that inventory includes a share of fixed overheads.

Key Term: Marginal costing
A costing method that includes only variable production costs in the unit cost; fixed production overheads are treated as a cost of the period, not allocated to inventory.

The Treatment of Fixed Production Overheads

The fundamental distinction between absorption and marginal costing is the way fixed production overheads are dealt with:

• In absorption costing, each unit of output is charged with both variable and fixed production overheads. This means inventory on the statement of financial position reflects a portion of fixed overheads.
• With marginal costing, only variable production costs are included in the cost per unit. Fixed overheads are expensed in full against the profit of the period in which they arise.

Key Term: Inventory valuation
The practice of measuring unsold inventory at a specific cost, determined according to a chosen costing method.

Why does this matter?

When production exceeds sales, some fixed overheads are held in closing inventory under absorption costing, effectively deferring their recognition as an expense. In contrast, marginal costing always recognizes the entire fixed overhead cost as an expense of the period, regardless of changes in inventory levels.

Profit Statements Under Each Method

It is essential to understand the layout and implications of profit statements under both methods.

Marginal costing profit statement

• Sales
• Less variable cost of goods sold (including variable costs of opening inventory, plus variable production costs, minus variable cost of closing inventory)
• Less variable non-production costs (e.g., variable selling expenses)
• Contribution
• Less total fixed costs (all period fixed costs)
• Profit

Absorption costing profit statement

• Sales
• Less total cost of goods sold (including both variable and fixed costs in opening inventory, plus total production costs, minus total cost of closing inventory)
• Gross profit
• Less non-production overheads (e.g., administration, selling)
• Profit

In practice, variable non-production costs and fixed non-production costs are charged after gross profit, as period expenses.

The Impact of Inventory Changes on Profit

When production and sales volumes are equal, both methods produce the same operating profit because all costs incurred are matched with units sold. However, if inventory levels increase or decrease during the period, profits will diverge.

• If inventory increases (closing inventory > opening inventory): Absorption costing profit is higher than marginal costing profit. Fixed overheads are included in inventory and not fully expensed.
• If inventory decreases (closing inventory < opening inventory): Marginal costing profit is higher. Fixed overheads from previous periods are released from inventory and expensed.

This difference arises because absorption costing carries a portion of fixed overhead forward in unsold stock, whereas marginal costing writes off all fixed overhead immediately.

Worked Example 1.1

A company produces 10,000 units, sells 9,000 units, and incurs $45,000 of variable production costs ($4.50 per unit) and $30,000 of fixed production overhead. The fixed absorption rate is $3 per unit. There are no opening inventories.

Required: Calculate profit under both absorption and marginal costing.

Answer:
Under marginal costing:
Sales (9,000 × selling price)
Minus variable production cost of 9,000 units sold = 9,000 × $4.50 = $40,500
Contribution = Sales – variable costs
Less all $30,000 fixed production overhead
Under absorption costing:
Production cost per unit = $4.50 + $3.00 = $7.50
Total production cost (10,000 × $7.50) = $75,000
Closing inventory = 1,000 units × $7.50 = $7,500
Cost of goods sold = $75,000 – $7,500 = $67,500
Fixed overhead included in closing inventory = 1,000 × $3.00 = $3,000
Only $27,000 ($30,000 – $3,000) of fixed overhead is expensed this period.
Therefore, absorption costing profit is $3,000 higher, due to the fixed overhead deferred in inventory.

Reconciling Profit Between Methods

To reconcile profits calculated under both methods, use the following formula:

If closing inventory exceeds opening inventory, the absorption costing profit is higher by this amount. If inventory falls, marginal costing profit is higher.

Worked Example 1.2

Opening inventory: 2,500 units.
Closing inventory: 1,000 units.
Fixed overhead absorption rate: $6 per unit.
Absorption costing profit: $80,000.

Required: Calculate the marginal costing profit.

Answer:
Profit difference = (1,000 – 2,500) × $6 = (–1,500) × $6 = –$9,000
Marginal costing profit = $80,000 – $9,000 = $71,000

Exam Warning

Beware: In exam questions, you may be told the profit figure under one method and have to reconcile to the other. Always consider inventory changes and multiply the change in units by the fixed overhead rate.

Advantages and Disadvantages

Absorption costing

• Complies with external reporting standards (IAS 2 – Inventory)
• Includes all production costs in inventory value
• May give misleading profit if production is not aligned with demand

Marginal costing

• Useful for decision making—shows contribution from sales
• Profits are not distorted by inventory level changes
• Not permitted for published accounts under international standards

Key Point Checklist

This article has covered the following key knowledge points:

• Distinguish between treatment of fixed overheads in absorption and marginal costing
• Prepare profit statements under each method
• Calculate and interpret the effect of inventory changes on profit
• Reconcile profits between absorption and marginal methods
• Explain the reasons for profit differences linked to inventory levels
• Identify the application and limitations of each approach

Key Terms and Concepts

• Absorption costing
• Marginal costing
• Inventory valuation