Absorption and Marginal Costing
Absorption and marginal costing tests whether you can value inventory under both methods and reconcile the profit difference. The exam expects correct treatment of fixed production overhead and a clear explanation of why profit changes with inventory.
Core rules
- Absorption costing includes fixed production overhead in product cost via a predetermined rate: budgeted overhead / budgeted activity at normal capacity. Over- or under-absorption = absorbed overhead - actual overhead.
- Marginal costing treats fixed production overhead as a period cost; inventory carries only variable production cost.
- Contribution = sales - variable costs. Profit = contribution - fixed costs.
- When inventory changes, absorption profit - marginal profit = change in inventory units × fixed overhead absorption rate. Opening inventory reduces the difference; closing inventory increases it.
Worked example
Budgeted fixed production overhead is ₦120,000 and normal activity is 12,000 units, so the absorption rate is ₦10 per unit. Production is 10,000 units and sales are 9,000 units; opening inventory is zero, so closing inventory is 1,000 units. Under absorption costing, ₦10,000 of fixed overhead is carried in inventory; under marginal costing it is expensed. Absorption profit is therefore ₦10,000 higher than marginal profit, assuming no other differences. If production were 8,000 and sales 9,000, inventory would fall by 1,000 and absorption profit would be ₦10,000 lower.
Traps
Using actual activity to set the absorption rate; forgetting over- or under-absorption; adding fixed selling costs to product cost; reversing the profit reconciliation; assuming marginal profit is always higher.