Section 5 of 8
| Absorption costing | Marginal costing | |
|---|---|---|
| Fixed production overheads | Included in unit cost; deferred in closing inventory | Period cost — written off in full in the period incurred |
| Inventory valuation | Full production cost (variable + fixed) | Variable production cost only |
| Income statement | Gross profit after over/under-absorption adjustment | Contribution format (revenue − variable costs = contribution; then deduct fixed costs) |
Profits differ only when inventory levels change between the start and end of the period.
| Inventory change | Absorption profit vs marginal profit |
|---|---|
| Closing inventory > opening inventory (inventory increases) | Absorption profit higher |
| Closing inventory < opening inventory (inventory decreases) | Absorption profit lower |
| Closing inventory = opening inventory (no change) | Profits are equal |
The difference always equals:
$$\text{Difference} = \text{Change in inventory (units)} \times \text{Fixed overhead per unit (OAR)}$$
Production 5 000 units, Sales 4 200 units, Selling price £18, Variable cost £7, Fixed overheads £20 000 OAR = £20 000 ÷ 5 000 = £4 per unit; Closing inventory = 800 units
ABSORPTION MARGINAL
Revenue 4 200 × £18 £75 600 Revenue 4 200 × £18 £75 600
CoS 4 200 × £11 £46 200 Variable CoS 4 200 × £7 £29 400
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Gross profit £29 400 Contribution £46 200
Less fixed OH £20 000
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Profit £26 200
Difference = £29 400 − £26 200 = £3 200 = 800 units × £4 per unit ✓ (Fixed overhead is deferred in 800 units of closing inventory under absorption costing)
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