Marginal vs Absorption                           

Reporting profit with absorption costing 

Absorption costing is the ‘traditional’ way of measuring profit in a manufacturing company.  Inventory is valued at the full cost of production, which consists of direct materials and direct labor cost plus absorbed production overheads (fixed and variable production overheads). 

Fixed production overhead may be under- or over-absorbed because the absorption rate is a predetermined rate and calculated at specified level of activity. .  

Over and under absorption is the difference between absorbed and actual overheads. If absorbed are greater than actual overheads, it is over absorption and vice versa. 

Format of marginal costing statement of profit is given below. 



Sales                                                                 X 

Opening inventory at full product cost of last period                         X  

Add: production cost:  

Direct materials cost (A)                                                 X  

Direct labour cost (B)                                                  X  

Variable production overheads (C)                                         X  

Fixed production overheads absorbed (D)  

Less closing inventory (A+B+C+D)/units produced x closing inventory units (X)  

   

Add: Under absorbed or Less: Over absorbed fixed production overheads X (X) (X) 

Gross profit  

Less: Non-production overheads:  

       Selling & distribution costs                                          X  

       Administration costs                                         (X) 


Net profit                                                          X 



MARGINAL COSTING AND ABSORPTION COSTING COMPARED 

 The difference in profit between marginal costing and absorption costing 

The profit for an accounting period calculated with marginal costing is different from the profit calculated with absorption costing if inventory level change over period. If opening and closing inventory level is same, then profit of marginal and absorption is equal. 

The difference in profit is entirely due to the differences in inventory valuation as fixed overheads are treated as period cost in marginal costing and as product cost in absorption costing. 

The main difference between absorption costing and marginal costing is that in absorption costing, inventory cost includes a share of fixed production overhead costs.  

• The opening inventory contains fixed production overhead that was incurred last period. Opening inventory is written off against profit in the current period. Therefore, part of the previous period’s costs is written off in the current period income statement provided that the opening inventory is sold during the current year. 

• The closing inventory contains fixed production overhead that was incurred in this period. Therefore, this amount is not written off in the current period income statement but carried forward to be written off in the next period income statement. 

The implication of this is as follows (assume costs per unit remain constant): 

• When there is no change in the opening or closing inventory, exactly the same profit will be reported using marginal costing and absorption costing.  

• If inventory increases in the period (closing inventory is greater than opening inventory), the fixed production overhead brought forward from last period will be less than share of production overhead carried forward to next period, thus the absorption costing profit would be higher than marginal costing profit. 

• Similarly, if inventory decreases in the period (closing inventory is less than opening inventory), marginal costing profit would be higher than absorption costing. 

The difference in the two profit figures is calculated by preparing reconciliation statement and format of this statement is given below. 

Reconciliation statement Rs. 

Profit under absorption costing X 

Add: Difference in opening inventory (Units in opening inventory x FOAR/unit) X 

Less: Difference in Closing inventory (Units in closing inventory x FOAR/unit) (X) 

Profit under marginal costing X 


comparing marginal and absorption costing profit 

To calculate the difference between the reported profit using marginal costing and the reported profit using absorption costing, you might need to make the following simple calculations. 

• the increase or decrease in inventory during the period, in units. 

• the fixed production overhead cost per unit. 

• Multiplication of increase or decrease in inventory and fixed production overhead rate is equal to difference in both profits 

The important points to remember are:  

• If there has been an increase in inventory, the absorption costing profit is higher. If there has been a reduction in inventory, the absorption costing profit is lower. 

• Ignore fixed selling overhead or fixed administration overhead. These are written off in full as a period cost in both absorption costing and marginal costing, and only fixed production overheads are included in inventory values.