Marginal vs absorption costing, worked through a coffee roastery
The two methods differ in one thing only: how they treat fixed production overhead. That single difference is why they report different profits in the same month. Here it is worked through Alma Roasters, with a reconciliation you can follow line by line.
Marginal and absorption costing differ in exactly one thing: whether fixed production overhead is treated as part of the cost of a product or as a cost of the period. Marginal costing leaves it out of the product cost and charges the whole lot against the month. Absorption costing builds a share of it into every unit. Everything else the two methods do is identical, and once you see that one difference clearly, the profit figures they produce stop being confusing.
The difference only bites when inventory changes, so the cleanest way to see it is a month where a business makes more than it sells. Mateo Reyes at Alma Roasters had exactly that month.
Alma Roasters: the month's figures
In one month, Mateo roasted 2,000 bags of coffee and sold 1,600 of them, leaving 400 bags in the storeroom as closing inventory. Here is the cost information:
| Item | Amount |
|---|---|
| Selling price | £9.00 per bag |
| Direct materials (green beans) | £2.40 per bag |
| Direct labour | £1.20 per bag |
| Variable production overhead | £0.90 per bag |
| Fixed production overhead | £3,000 for the month |
| Bags produced / sold | 2,000 made, 1,600 sold |
The variable production cost of one bag is £2.40 + £1.20 + £0.90 = £4.50. Hold on to that number, because it is the only product cost marginal costing recognises.
Marginal costing: fixed overhead is a period cost
Under marginal costing, a bag of coffee costs £4.50 to make, full stop. The £3,000 of fixed overhead is not part of any bag; it is charged in full against the month, whether Mateo sold 1,600 bags or none. The layout works down from sales to contribution, then takes out the fixed cost in one lump:
| Marginal costing | |
|---|---|
| Sales (1,600 × £9.00) | £14,400 |
| Less variable cost of sales (1,600 × £4.50) | (£7,200) |
| Contribution | £7,200 |
| Less fixed production overhead | (£3,000) |
| Profit | £4,200 |
Notice the closing inventory of 400 bags is valued at £4.50 each under this method. It carries no fixed overhead at all.
Absorption costing: fixed overhead is built into the unit
Absorption costing shares the fixed production overhead across the units made, using an overhead absorption rate (OAR). Mateo produced 2,000 bags and his fixed overhead was £3,000, so the rate is £3,000 ÷ 2,000 = £1.50 per bag. Every bag now carries £4.50 of variable cost plus £1.50 of fixed overhead, a full production cost of £6.00.
| Absorption costing | |
|---|---|
| Sales (1,600 × £9.00) | £14,400 |
| Less cost of sales (1,600 × £6.00) | (£9,600) |
| Profit | £4,800 |
Why the profits differ, and the reconciliation
The two methods disagree by £600, and that number is not a mystery once you know where to look. Inventory rose by 400 bags this month. Under absorption costing, each of those unsold bags carries £1.50 of fixed overhead, so 400 × £1.50 = £600 of fixed overhead has been parked in the closing inventory on the balance sheet instead of being charged as an expense. Marginal costing charged all £3,000 against the month; absorption costing only charged £2,400 of it and carried the other £600 forward. Less expense means more profit, so absorption profit is exactly £600 higher.
That gives you the rule that saves time in the exam:
Profit difference = change in inventory (units) × fixed overhead per unit = 400 × £1.50 = £600.
The direction follows common sense. When inventory rises, absorption shows the higher profit, because it is holding back some fixed cost in stock. When inventory falls, the reverse happens: absorption releases fixed overhead out of opening inventory and reports the lower profit. When production equals sales and inventory does not change, both methods report the same profit.
Which one should Mateo use?
For his own decisions, marginal costing tells the cleaner story: contribution per bag shows what each sale actually adds once the variable cost is covered, which is what he needs for pricing and for deciding whether to take on a wholesale order. But for his year-end financial statements he must use absorption costing, because the accounting standard on inventory (IAS 2) requires fixed production overhead to be included in the cost of stock. So Mateo, like most businesses, ends up needing both: absorption for the published accounts, marginal for the decisions. Knowing why they differ, rather than just how, is what MA is really testing.
Frequently asked questions
What is the only real difference between marginal and absorption costing?
How they treat fixed production overhead. Marginal costing treats it as a period cost and charges it all against the month. Absorption costing treats it as a product cost and includes a share of it in every unit through an overhead absorption rate. Everything else the two methods do is the same.
Why do the two methods give different profits?
Because they value inventory differently. Absorption costing carries fixed overhead inside unsold stock, so when inventory changes, some fixed cost is held back or released. The profit difference always equals the change in inventory units multiplied by the fixed overhead per unit.
When do marginal and absorption costing give the same profit?
When there is no change in inventory, which happens when production equals sales in the period. With nothing added to or taken from stock, there is no fixed overhead to defer, so both methods report an identical profit.
Which method is allowed in financial statements?
Absorption costing. The inventory standard, IAS 2, requires fixed production overhead to be included in the cost of inventory, so published accounts use absorption. Marginal costing is used internally for decision making, where contribution is the more useful figure.