ASCM-L12 — Marginal Costing vs Absorption Costing
Understanding the differences between marginal costing and absorption costing and their impact on inventory valuation and profit measurement.
Learning Objectives
By the end of this lesson students should be able to:
• distinguish marginal and absorption costing
• prepare costing statements using both methods
• explain differences in profit
• understand inventory valuation differences
• evaluate advantages and limitations of each method
• answer examination-style questions
CONCEPT OVERVIEW
Marginal Costing
Under marginal costing:
✓ Only variable production costs are included in product cost
✓ Fixed production overheads are treated as period costs
✓ Contribution is calculated
Why is Contribution Important?
Under absorption costing:
✓ All production costs are included in product cost
✓ Fixed production overheads are absorbed into units
✓ Gross profit is calculated
KEY DIFFERENCES
| Feature | Marginal Costing | Absorption Costing |
|---|---|---|
| Product Cost | Variable costs only | All production costs |
| Fixed Overheads | Period cost | Product cost |
| Inventory Valuation | Variable cost only | Includes fixed overhead |
| Profit Statement | Contribution approach | Gross profit approach |
| Decision Making | Very useful | Less useful |
| External Reporting | Not normally used | Widely used |
PROFIT STATEMENTS
Marginal Costing Statement
Sales Revenue
Less Variable Costs
=
Contribution
Less Fixed Costs
=
Profit
Absorption Costing Statement
Sales Revenue
Less Cost of Sales
=
Gross Profit
Less Non-Production Costs
=
Profit
INVENTORY VALUATION
Marginal Costing
Inventory includes:
✓ Direct Materials
✓ Direct Labour
✓ Variable Production Overheads
Fixed production overheads excluded.
Absorption Costing
Inventory includes:
✓ Direct Materials
✓ Direct Labour
✓ Variable Production Overheads
✓ Fixed Production Overheads
WHY PROFITS DIFFER
When Production Exceeds Sales
Closing Inventory Increases
↓
Some Fixed Overheads carried forward in inventory
↓
Absorption Costing Profit
>
Marginal Costing Profit
When Sales Exceed Production
Opening Inventory Released
↓
Fixed Overheads charged to current period
↓
Marginal Costing Profit
>
Absorption Costing Profit
WORKED EXAMPLES
Example 1 — Inventory Valuation
Variable Cost Per Unit:
£8
Fixed Overhead Per Unit:
£2
Marginal Cost Inventory:
£8
Absorption Cost Inventory:
£10
Example 2 — Closing Inventory
Closing Inventory:
1,000 units
Fixed Overhead Per Unit:
£2
Fixed Overhead Deferred:
1,000 × £2
=
£2,000
xample 3 — Profit Comparison
Difference:
£2,000
Caused by fixed overhead included in inventory.
RECONCILIATION OF PROFITS
Product Comparison Example
| Product | Contribution per Unit |
|---|---|
| A | £8 |
| B | £12 |
| C | £5 |
Based on contribution alone:
1. Product B
2. Product A
3. Product C
Product B contributes the most towards fixed costs and profit.
Formula & example
Difference in Profit
=
Change in Inventory Units
×
Fixed Overhead Rate Per Unit
Example
Increase in Inventory:
500 units
Fixed Overhead:
£4 per unit
Difference:
500 × £4
=
£2,000ADVANTAGES & LIMITATIONS
Marginal costing
Marginal Costing
Advantages
✓ Simpler
✓ Useful for decision-making
✓ Highlights contribution
✓ Supports planningLimitations
✓ Excludes fixed production overheads
✓ Not suitable for external inventory valuation
Absorption Costing
Absorption Costing
Advantages
✓ Includes all production costs
✓ Suitable for inventory valuation
✓ Widely acceptedLimitations
✓ Profit may be affected by inventory levels
✓ Less useful for managerial decisionsStructured Practice
Level 1 — Concept Check
Define:
a) Marginal Costing
b) Absorption Costing
Level 2 — Application
Explain why profits may differ under marginal and absorption costing.
Level 3 – Examination Style Question
Closing Inventory increased by 800 units.
Fixed Production Overhead Rate:
£5 per unit
Calculate the difference between absorption costing profit and marginal costing profit.
(3 marks)
📌 Additional structured questions are available in the 🎯 Question Papers + YouTube Explanation section.
∗ Additional structured questions are available in the Question Papers and YouTube Explanation section. Students should practise regularly and review video explanations for procedural clarity.
Enrolled students may submit questions from recognised textbooks, past examination papers or other genuine academic material for expert clarification through the Student Doubt Support facility.
ACADEMIC SUPPORT NOTE
📌 This is one of the most important AS Cost & Management Accounting examination topics.
Students should master:
✓ Costing Method Comparisons
✓ Inventory Valuation
✓ Profit Reconciliation
✓ Fixed Overhead Treatment
✓ Examination Interpretation Questions
🎥 Full worked solutions are available in the YouTube Learning Library.
📩 Students may submit costing comparison doubts through the Student Doubt Support facility.
Proficiency Check
Learn → Practise → Apply → Evaluate
1. Can you distinguish marginal and absorption costing?
2. Can you explain inventory valuation differences?
3. Can you explain profit differences?
4. Can you reconcile profits?
5. Can you evaluate advantages and limitations?
6. Can you answer comparison questions confidently?
If unsure, revisit:
• Costing Method Differences
• Inventory Valuation
• Profit Reconciliation
• Worked Examples
Detailed Activity Solutions
Solution to Level 3 question
Difference in Profit
=
800 × £5
=
£4,000
Absorption costing profit exceeds marginal costing profit by £4,000 because fixed production overheads are included in closing inventory.
HOW THIS TOPIC APPEARS IN THE EXAMINATION
Common examination tasks include:
✓ Costing Method Comparisons
✓ Inventory Valuation
✓ Profit Reconciliation
✓ Fixed Overhead Treatment
✓ Advantages & Limitations
✓ Evaluation Questions
Self-Assessment Checklist
□ I understand marginal costing
□ I understand absorption costing
□ I can explain inventory valuation differences
□ I can explain profit differences
□ I can reconcile profits
□ I can answer examination questions confidently
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