Absorption and marginal costing
Absorption and marginal costing are two ways of answering one question: should fixed production overheads be included in the cost of inventory? The answer changes the reported profit whenever inventory levels change, and that is exactly what the exam tests. Expect to calculate a profit under one method, find the difference between the two, reconcile them, or pick the correct statement about which profit is higher and why. One rule, learned properly, answers almost all of them.
The two methods
Absorption costing charges each unit with its full production cost: direct materials, direct labour, variable production overheads and a share of fixed production overheads, absorbed at a predetermined rate. Inventory is valued at full production cost, so part of the period's fixed production overhead is carried forward in closing inventory.
Marginal costing charges each unit with its variable (marginal) costs only. Fixed production overheads are treated as a period cost: the whole amount is charged against profit in the period it is incurred, and inventory is valued at variable production cost.
Under both methods, non-production costs (administration, selling and distribution) are period costs and never go into inventory.
| Absorption costing | Marginal costing | |
|---|---|---|
| Fixed production overhead | Absorbed into units; part carried forward in inventory | Charged in full in the period |
| Inventory valued at | Full production cost | Variable production cost |
| Under- or over-absorption | Arises, and adjusts profit | Does not arise |
| Key subtotal | Gross profit | Contribution |
Contribution
Contribution = sales revenue − all variable costs (production and non-production). Contribution per unit = selling price − variable cost per unit. It is the amount each unit sells for over its variable cost, available first to "contribute" towards fixed costs and then to profit. Because fixed costs do not change with output in the short term, each extra unit sold adds its contribution to profit. This makes marginal costing especially useful for short-term decisions.
The profit statements
| Absorption costing | Marginal costing |
|---|---|
| Sales | Sales |
| Less cost of sales at full production cost (opening inventory + production − closing inventory) | Less variable cost of sales at variable production cost (opening inventory + production − closing inventory) |
| Adjust for under-absorbed (add) or over-absorbed (deduct) fixed production overhead | Less variable selling and distribution costs |
| = Gross profit | = Contribution |
| Less all non-production costs, fixed and variable | Less all fixed costs: production and non-production |
| = Profit | = Profit |
Why the profits differ
The only difference between the two profits is the fixed production overhead held in inventory.
- If inventory rises (production > sales), absorption costing carries some of this period's fixed overhead forward into next period, so absorption profit is higher.
- If inventory falls (sales > production), absorption costing releases fixed overhead from the opening inventory into this period, so marginal profit is higher.
- If inventory does not change, the two profits are the same.
The difference = change in inventory (units) × fixed production overhead absorption rate per unit.
Advantages and disadvantages
| Absorption costing | Marginal costing | |
|---|---|---|
| For | Required for external financial statements by IAS 2 Inventories; recognises that fixed overheads are needed to produce; avoids fluctuating profits when sales are seasonal but production is steady | Profit follows sales, not production; contribution helps short-term decisions; no arbitrary apportionment of fixed overheads; no under- or over-absorption |
| Against | Profit can be raised simply by producing for inventory; under- and over-absorption complicate results; apportionment is subjective | Not acceptable for external inventory valuation; can encourage prices that ignore fixed costs |
Worked example
Gombe Kettles Co makes one product. Data per unit: selling price $50; variable production cost $20; variable selling cost $2 per unit sold. Fixed production overhead is budgeted at $120,000 a period, on budgeted production of 12,000 units, so the absorption rate is $10 a unit and full production cost is $30 a unit. Fixed selling and administration costs are $40,000 a period. Actual fixed costs equal budget.
| Units | Period 1 | Period 2 |
|---|---|---|
| Opening inventory | 0 | 2,000 |
| Production | 12,000 | 11,000 |
| Sales | 10,000 | 12,500 |
| Closing inventory | 2,000 | 500 |
Absorption costing
| $ | Period 1 | Period 2 |
|---|---|---|
| Sales (at $50) | 500,000 | 625,000 |
| Opening inventory (at $30) | 0 | 60,000 |
| Production (at $30) | 360,000 | 330,000 |
| Closing inventory (at $30) | (60,000) | (15,000) |
| Less cost of sales before adjustment | 300,000 | 375,000 |
| Less under-absorbed fixed overhead | 0 | 10,000 |
| Gross profit | 200,000 | 240,000 |
| Variable selling costs (at $2) | (20,000) | (25,000) |
| Fixed selling and administration | (40,000) | (40,000) |
| Profit | 140,000 | 175,000 |
In Period 2 only 11,000 units were made, so 11,000 × $10 = $110,000 was absorbed against actual fixed overhead of $120,000: $10,000 under-absorbed, added to cost of sales. In Period 1, 12,000 × $10 = $120,000 was absorbed exactly.
Marginal costing
| $ | Period 1 | Period 2 |
|---|---|---|
| Sales (at $50) | 500,000 | 625,000 |
| Opening inventory (at $20) | 0 | 40,000 |
| Production (at $20) | 240,000 | 220,000 |
| Closing inventory (at $20) | (40,000) | (10,000) |
| Less variable cost of sales | 200,000 | 250,000 |
| Less variable selling costs (at $2) | 20,000 | 25,000 |
| Contribution | 280,000 | 350,000 |
| Fixed production overhead | (120,000) | (120,000) |
| Fixed selling and administration | (40,000) | (40,000) |
| Profit | 120,000 | 190,000 |
Reconciliation
| $ | Period 1 | Period 2 |
|---|---|---|
| Marginal costing profit | 120,000 | 190,000 |
| Add fixed overhead in closing inventory (2,000 × $10; 500 × $10) | 20,000 | 5,000 |
| Less fixed overhead in opening inventory (0; 2,000 × $10) | 0 | (20,000) |
| Absorption costing profit | 140,000 | 175,000 |
In Period 1 inventory rose by 2,000 units, so absorption profit is $20,000 higher. In Period 2 inventory fell by 1,500 units, so marginal profit is 1,500 × $10 = $15,000 higher. Over the two periods together, absorption profit is $5,000 higher, exactly the fixed overhead in the 500 units still in inventory.
Common mistakes
- Valuing marginal costing inventory at full cost, or absorption costing inventory at variable cost.
- Including variable selling costs in inventory. Only production costs go into inventory.
- Using the change in inventory value instead of the change in units × the fixed overhead rate per unit.
- Getting the direction wrong: inventory up means absorption profit is higher; inventory down means marginal profit is higher.
- Forgetting the under- or over-absorption adjustment in the absorption statement.
Exam technique
For a reconciliation question you rarely need either full statement. Find the change in inventory in units, multiply by the fixed production overhead per unit, and decide the direction from whether inventory rose or fell. Write that one line first. Build full statements only when the question asks for a profit figure and gives no other route.
Study with AI
I am studying ACCA Management Accounting (MA), absorption and marginal costing. Give
me a single-product example over two periods with changing inventory. Ask me to
calculate profit under each method and reconcile them, then check my answer with
full workings. Then give me three short questions on which profit is higher and why.AI assistants sometimes include selling costs in inventory or reverse the direction of the difference: check every working against these notes.
Lecturer's note: Think of fixed production overhead as a parcel. Under marginal costing the parcel is opened and charged in full the moment it arrives. Under absorption costing a little of it is wrapped inside every unit made, and it is only charged when the unit is sold. So if you build up inventory, some parcels are still sitting on the shelf, uncharged, and absorption profit is higher. Sell off inventory and the old parcels come off the shelf into this period's cost.
Key points
- Absorption costing includes fixed production overhead in unit cost and inventory; marginal costing treats it as a period cost.
- Contribution = sales − all variable costs; it is the key subtotal in marginal costing.
- Profit difference = change in inventory units × fixed production overhead per unit.
- Inventory rising: absorption profit higher; falling: marginal profit higher; unchanged: equal.
- IAS 2 requires absorption costing for financial statements; marginal costing is more useful for short-term decisions.
Quick check
- Opening inventory is 400 units and closing inventory 900 units. The fixed production overhead absorption rate is $15 a unit. Absorption costing profit is $60,000. What is the marginal costing profit?
- A product sells for $40. Variable production cost is $18 a unit and variable selling cost $4 a unit. Fixed costs are $30,000. What is the contribution per unit?
- Which method must be used to value inventory in published financial statements, and why?
Answers
- Inventory rose by 500 units, so absorption profit is higher by 500 × $15 = $7,500. Marginal profit = $60,000 − $7,500 = $52,500.
- $40 − $18 − $4 = $18. Fixed costs do not affect contribution per unit.
- Absorption costing: IAS 2 Inventories requires inventory cost to include a share of fixed production overheads, based on normal capacity.