MI · Certificate Level

Absorption and Marginal Costing

Detailed coverage of the full absorption costing method (calculating overhead absorption rates, preparing absorption costing profit statements, dealing with over- and under-absorption) and the marginal costing method (contribution analysis, marginal costing profit statements). Comprehensive profit reconciliation between the two methods and the reasons for the difference. Advantages and disadvantages of each approach. Impact on inventory valuation and reported profit. Comparison with IAS 2 requirements.

35 min read

Learning Objectives

•Prepare a profit statement using full absorption costing
•Calculate overhead absorption rates and account for over- and under-absorption
•Prepare a profit statement using marginal costing
•Reconcile the profit difference between absorption and marginal costing
•Explain how changes in inventory levels cause the profit difference between the two methods
•Evaluate the advantages and disadvantages of absorption and marginal costing
•Explain the impact of each method on inventory valuation
•Describe the requirements of IAS 2 regarding inventory valuation and how they relate to absorption costing

Absorption Costing — Detailed Method

Absorption costing (also called full costing) includes all production costs in the cost of a unit of output: direct materials, direct labour, variable production overheads, AND a share of fixed production overheads. Every unit produced "absorbs" a proportion of the fixed overheads incurred in the period.

Steps to calculate the absorption cost per unit:

Identify direct costs per unit: Direct materials + Direct labour = Prime cost
Calculate the overhead absorption rate (OAR):
OAR = Budgeted fixed production overheads ÷ Budgeted activity level
The activity base is typically: machine hours (for machine-intensive production), direct labour hours (for labour-intensive production), or units of production (if all units are identical).
Calculate the full production cost per unit:
= Direct materials + Direct labour + Variable production OH + (OAR × hours per unit or per unit rate)

Absorption costing profit statement format:

	£
Revenue	X
Less: Cost of sales
Opening inventory (at full production cost)	X
+ Production costs (at full production cost)	X
− Closing inventory (at full production cost)	(X)
= Cost of sales (standard)	(X)
± Over/under-absorption adjustment	X/(X)
= Adjusted cost of sales	(X)
Gross profit	X
Less: Non-production overheads (selling, admin)	(X)
Net profit	X

Over- and Under-Absorption

Because the OAR is based on budgeted overheads and budgeted activity, the amount of fixed overhead absorbed into production will differ from the actual fixed overhead incurred whenever actual activity or actual spending differs from budget.

Overhead absorbed = Actual production × OAR per unit

Overhead incurred = Actual fixed production overhead

Over-absorption: If overhead absorbed > overhead incurred → too much has been charged to production → the excess is credited back to the profit statement (increases profit). Occurs when actual production exceeds budget or actual overhead spending is less than budget.

Under-absorption: If overhead absorbed < overhead incurred → too little has been charged → the shortfall is debited to the profit statement (reduces profit). Occurs when actual production falls below budget or actual overhead spending exceeds budget.

Journal entries:

Over-absorption: Dr Fixed OH control, Cr Profit or loss (the credit increases profit)
Under-absorption: Dr Profit or loss, Cr Fixed OH control (the debit reduces profit)

Marginal Costing — Detailed Method

Marginal costing (also called variable costing or direct costing) includes only variable production costs in the cost of a unit of output: direct materials, direct labour, and variable production overheads. Fixed production overheads are treated as period costs — charged in full to the profit statement in the period incurred, regardless of production or sales volume.

Marginal cost per unit:

= Direct materials + Direct labour + Variable production overhead

No fixed production overhead is included in the unit cost.

Key concept — Contribution:

Total contribution = Revenue − Total variable costs

Contribution per unit = Selling price per unit − Variable cost per unit

Variable costs include ALL variable costs: variable production costs AND variable selling/distribution costs (e.g., sales commission, variable delivery costs).

Marginal costing profit statement format:

	£
Revenue	X
Less: Variable cost of sales
Opening inventory (at variable production cost)	X
+ Variable production costs	X
− Closing inventory (at variable production cost)	(X)
= Variable cost of sales	(X)
Less: Variable selling costs	(X)
Contribution	X
Less: Fixed production overheads (total for period)	(X)
Less: Fixed selling and admin overheads	(X)
Net profit	X

Notice the key structural difference: In marginal costing, fixed production overheads appear below the contribution line as a lump sum deducted from contribution. In absorption costing, they are included within cost of sales (absorbed into the cost of each unit). There is no over/under-absorption in marginal costing because fixed overheads are simply expensed in full.

Profit Reconciliation — Why the Difference Arises

Absorption and marginal costing produce different profits whenever the level of production differs from the level of sales (i.e., inventory levels change). The difference arises because the two methods treat fixed production overheads differently in the inventory valuation.

The mechanism:

Under absorption costing, each unit of closing inventory carries a share of fixed production overhead. When inventory increases (production > sales), some fixed overhead is "deferred" in inventory — not charged to the profit statement this period.
Under marginal costing, ALL fixed production overheads are charged to the period — none is deferred in inventory.
Therefore, when inventory increases: absorption costing defers fixed overhead → absorption profit is higher.
When inventory decreases (sales > production): absorption costing releases fixed overhead from opening inventory → more cost in the period → absorption profit is lower.

Reconciliation formula:

Absorption profit − Marginal profit = Change in inventory (units) × Fixed OAR per unit

Where change in inventory = closing inventory − opening inventory (in units).

If inventory increases (positive change): Absorption profit > Marginal profit by (increase in units × OAR)
If inventory decreases (negative change): Absorption profit < Marginal profit by (decrease in units × OAR)
If inventory is unchanged: Profits are the same

Alternative reconciliation approach:

	£
Marginal costing profit	X
Add: Fixed OH in closing inventory (closing units × OAR)	X
Less: Fixed OH in opening inventory (opening units × OAR)	(X)
= Absorption costing profit	X

Advantages and Disadvantages

Absorption costing:

Advantages	Disadvantages
Required by IAS 2 for external financial reporting — inventory must include a share of fixed production overheads based on normal capacity	Fixed overheads are "unitised" and treated as if they are variable — which they are not. This can mislead decision-making.
Shows the full cost of production, which is useful for pricing decisions (cost-plus pricing)	Profit is affected by production levels, not just sales. A manager can increase reported profit by overproducing (building inventory to absorb more fixed overhead), even if the extra units are not needed.
Follows the matching concept — costs are matched to the revenue they help generate (via inventory)	Over/under-absorption adjustments add complexity
Provides a consistent inventory valuation across periods	Different absorption bases (labour hours, machine hours, units) can give different unit costs and different profits

Marginal costing:

Advantages	Disadvantages
Profit is driven by sales volume, not production — cannot manipulate profit by overproduction. More intuitive for managers.	Not compliant with IAS 2 for external reporting — inventory values exclude fixed overheads and are understated.
Contribution is a key output — directly useful for decision-making (breakeven analysis, CVP, special orders, make/buy, limiting factors)	Does not show the full production cost — may lead to underpricing if prices are set without considering fixed overhead recovery.
Simpler — no need to calculate OARs, no over/under-absorption adjustments	Fixed costs are treated as period costs, but some fixed costs may be directly related to specific products or segments — marginal costing ignores this.
Highlights the variable cost behaviour, which is essential for short-term decision-making	In the long run, all costs must be covered (including fixed) — marginal costing may understate the total resources consumed.

IAS 2 requirement: For external financial reporting, IAS 2 requires inventories to be valued at the lower of cost and net realisable value. "Cost" includes all costs of purchase, costs of conversion, and other costs incurred in bringing the inventories to their present location and condition. Costs of conversion include a systematic allocation of fixed and variable production overheads based on normal capacity. This means absorption costing is required for published financial statements. Marginal costing is used internally for management decision-making.

Examiner Focus

Absorption vs marginal costing profit reconciliation is one of the most frequently tested quantitative questions across all MI and management accounting exams. You MUST be able to: prepare profit statements under both methods, calculate the difference, and reconcile using the formula: difference = change in inventory units × fixed OAR per unit.

Common Pitfall

The most common error is calculating the closing inventory value incorrectly. Under absorption costing, inventory is valued at the FULL production cost (including fixed OH). Under marginal costing, inventory is valued at the VARIABLE production cost only (excluding fixed OH). Getting this wrong will cascade through the entire profit statement.

Study Tip

A quick sense-check: if inventory INCREASES, absorption profit should be HIGHER (because some fixed OH is deferred in inventory). If inventory DECREASES, absorption profit should be LOWER. If you get the opposite, you have made an error somewhere.

Watch Out

Variable SELLING costs (e.g., sales commission at £1 per unit) are based on units SOLD, not units produced. This applies under BOTH methods. They are not included in the inventory valuation under either method — they are a selling cost, not a production cost.

Examiner Focus

Know why IAS 2 requires absorption costing: inventory must include a share of fixed production overheads based on normal capacity. This is for EXTERNAL reporting. Marginal costing is used INTERNALLY for decision-making. Be prepared to explain the advantages of each — examiners often ask for a recommendation of which to use in a specific scenario.

Common Pitfall

When production = sales (no inventory change), profits are the SAME under both methods. When total production = total sales over multiple periods (opening inventory = closing inventory), total profits over those periods are the same — the timing of profit recognition differs, but the total is identical.

Key Definitions

Absorption costing (full costing)

A costing method that includes ALL production costs (direct materials, direct labour, variable and fixed production overheads) in the unit cost of a product. Fixed overheads are absorbed using a predetermined OAR. Required by IAS 2.

Marginal costing (variable costing)

A costing method that includes only VARIABLE production costs in the unit cost. Fixed production overheads are treated as period costs and expensed in full in the period incurred.

Prime cost

Direct materials + Direct labour. The directly traceable production costs before any overhead is added.

Overhead absorption rate (OAR)

The rate used to charge fixed production overheads to units of production. OAR = Budgeted fixed production OH ÷ Budgeted activity (units, labour hours, or machine hours).

Over-absorption

Overhead absorbed into production exceeds actual overhead incurred. Occurs when actual production > budget or actual spending < budget. The excess is credited to profit (increases profit).

Under-absorption

Overhead absorbed is less than actual overhead incurred. Occurs when actual production < budget or actual spending > budget. The shortfall is debited to profit (reduces profit).

Contribution

Revenue minus ALL variable costs (production and non-production). The amount available to cover fixed costs and generate profit. A key concept in marginal costing and decision-making.

Period cost

A cost charged to the profit statement in the period it is incurred, rather than being included in the inventory valuation. Under marginal costing, fixed production overheads are period costs.

Product cost

A cost included in the valuation of inventory. Under absorption costing, both variable and fixed production costs are product costs. Under marginal costing, only variable production costs are product costs.

Normal capacity (IAS 2)

The production expected to be achieved on average over a number of periods under normal circumstances, taking into account planned maintenance. Used as the basis for fixed overhead absorption under IAS 2.

Key Formulas

Worked Examples

Practice Questions

Question 1 of 8

Under marginal costing, fixed production overheads are treated as:

Question 2 of 8

If production exceeds sales (inventory increases), compared to marginal costing, absorption costing will report:

Question 3 of 8

Budgeted fixed production overheads are £200,000 and budgeted production is 50,000 units. Actual production is 48,000 units and actual fixed overheads are £200,000. The over/(under)-absorption is:

Question 4 of 8

A company produced 5,000 units and sold 4,500 units. The fixed OAR is £8 per unit. The difference between absorption and marginal profit is:

Question 5 of 8

IAS 2 requires inventory to be valued using:

Question 6 of 8

Over-absorption of fixed overheads occurs when:

Question 7 of 8

The key advantage of marginal costing for management decision-making is that it:

Question 8 of 8

Over three complete periods, a company starts and finishes with zero inventory. Total profit under absorption costing compared to marginal costing will be:

Source and Version

Syllabus: ICAEW ACA Certificate Level 2026 · Reviewed: 2026-05-04

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