Reconciling Profits and Comparing Marginal and Absorption Costing

When two methods give two profits from the same business, someone will ask why. The answer is short and exact: the whole difference lies in the fixed production overhead that sits inside stock. Once you can see where that overhead is, you can calculate the gap in a few seconds. You can also work backwards from one profit to the other without redoing the whole statement.

This topic gives the reconciliation rule and the logic behind it, shows how to reconcile in three common exam formats (using units, using stock values, and using a full two-month case), and sets out the advantages and disadvantages of absorption and marginal costing so that you can argue either side. It builds on the previous topic, where both statements were prepared.

Why the two profits differ

The profit under each method differs only because of how stock is valued. Absorption costing puts a share of fixed production overhead into the cost of each unit. So:

• Opening stock contains fixed overhead that was incurred last period. When that stock is sold, the overhead is written off in this period’s cost of sales.
• Closing stock contains fixed overhead incurred this period. It is not written off this period but carried forward to the next.

Under marginal costing, no fixed overhead is put into stock, so all of this period’s fixed production overhead is charged this period. None from the previous period is released. Assuming the cost per unit is the same in each period, the effects are:

The formula

Two things to work out: the change in stock in units (opening stock + production − sales = closing stock) and the fixed production overhead per unit.

The earlier example explained

In the Zaria Tools example, month 1 had production of 3,200 and sales of 2,800, so stock rose by 400 units. The fixed overhead per unit was ₦80. Difference = 400 × ₦80 = ₦32,000, and absorption profit (₦191,000) is higher than marginal profit (₦159,000) by exactly that. In month 2, stock fell by 400 units (from 400 to nil), so absorption profit (₦163,000) is lower than marginal profit (₦195,000) by 400 × ₦80 = ₦32,000. Over both months, stock starts and ends at nil, so the total profit is equal (₦354,000).

A reconciliation statement

Rather than recalculating, write: marginal costing profit + fixed overhead in closing stock − fixed overhead in opening stock = absorption costing profit.

Three exam formats

Format 1: given stock in units

A firm makes 12,000 units and sells 10,500. Fixed production overhead is ₦72,000 and fixed selling overhead ₦20,000. Absorption costing profit is ₦64,000. What would marginal costing profit be?

1. Stock increased by 12,000 − 10,500 = 1,500 units.
2. Fixed overhead per unit.
   ₦72,000 ÷ 12,000 = ₦6.
3. Difference = 1,500 × ₦6 = ₦9,000.
   Absorption profit is the higher.
4. Marginal profit.
   ₦64,000 − ₦9,000 = ₦55,000.
   (The ₦20,000 of fixed selling overhead is irrelevant: it is charged in full under both methods.)

Format 2: stock decrease in units

Opening stock was 2,000 units. 8,000 units were produced and 9,500 sold. Fixed production overhead was ₦64,000. Absorption profit was ₦80,000.

1. Closing stock.
   2,000 + 8,000 − 9,500 = 500 units.
   Stock decreased by 1,500 units.
2. Fixed overhead per unit.
   ₦64,000 ÷ 8,000 = ₦8.
3. Difference = 1,500 × ₦8 = ₦12,000.
   Absorption profit is the lower.
4. Marginal profit.
   ₦80,000 + ₦12,000 = ₦92,000.

Format 3: given stock values

Sometimes stock values are given under both methods, not units.

Increase in stock. A company uses marginal costing. Opening stock was ₦10,000 and closing stock ₦18,000. Profit was ₦120,000. Under absorption costing, opening stock would have been ₦16,000 and closing stock ₦30,000.

• Increase in stock under marginal costing.
  ₦18,000 − ₦10,000 = ₦8,000.
• Increase under absorption.
  ₦30,000 − ₦16,000 = ₦14,000.
• Difference = ₦14,000 − ₦8,000 = ₦6,000, so absorption profit is higher: ₦120,000 + ₦6,000 = ₦126,000.

Decrease in stock. A company uses absorption costing. Opening stock was ₦60,000 and closing stock ₦42,000. Profit was ₦150,000. Under marginal costing, opening stock would have been ₦36,000 and closing stock ₦28,000.

• Decrease under absorption.
  ₦60,000 − ₦42,000 = ₦18,000.
• Decrease under marginal.
  ₦36,000 − ₦28,000 = ₦8,000.
• Difference = ₦18,000 − ₦8,000 = ₦10,000, so marginal profit is higher: ₦150,000 + ₦10,000 = ₦160,000.

The logic is that the method with the larger change in stock value has the larger effect on profit. A bigger increase raises profit more; a bigger decrease reduces it more.

Absorption costing and marginal costing compared

The ideas in more depth

Profit manipulation under absorption costing

Because absorption profit rises when stock rises, a manager can increase reported profit by producing more than is sold, even if no extra sales are made. The extra fixed overhead is parked in stock. Marginal costing removes this temptation because profit depends only on sales and costs, not on how much is produced.

This is one reason managers in a bonus scheme linked to profit should be watched when stock builds up.

Which method for which purpose

When the cost per unit changes between periods

The formula in units assumes the fixed overhead per unit is constant. If it changes (for example, because production volume changes the rate), work with stock values instead, as in format 3: take the fixed overhead in closing stock minus the fixed overhead in opening stock.

Why total profit is equal over a long time

All production costs are eventually charged when the goods are sold. If, over several periods, stock starts and ends at the same level, total profit is the same under both methods. Absorption costing simply shifts the timing of when part of the fixed production overhead is recognised.

When the absorption rate is based on actual production

The rule “change in stock × fixed overhead per unit” uses the rate at which fixed overhead is put into stock. If the firm uses a predetermined rate based on normal activity, as in the Zaria example (₦80), the difference is 400 × ₦80 = ₦32,000, and any over- or under-absorbed overhead is adjusted separately in the statement.

If instead the rate is calculated from actual overhead and actual production, there is no under- or over-absorption, and the rate is ₦240,000 ÷ 3,200 = ₦75 in month 1. The difference becomes 400 × ₦75 = ₦30,000. In an exam, use the rate that the question gives you for valuing stock under absorption costing.

The fixed overhead account view

Another way to see the difference is to follow the fixed production overhead through the books. Under marginal costing, the whole month’s fixed production overhead (₦240,000) goes straight to the income statement. Under absorption costing, the overhead account is credited with the amount absorbed (3,200 × ₦80 = ₦256,000). That amount is split between cost of sales (2,800 units × ₦80 = ₦224,000) and closing stock (400 × ₦80 = ₦32,000).

The income statement bears ₦224,000 of absorbed overhead, and the balance on the overhead account, a credit of ₦16,000 from over-absorption, is added to profit. The net charge for fixed production overhead is therefore ₦224,000 − ₦16,000 = ₦208,000, against ₦240,000 under marginal costing. The difference is ₦32,000, which is the amount sitting in closing stock.

A case where the cost per unit changes

When the fixed overhead per unit differs between periods, work with stock values. A company’s opening stock was 1,000 units and closing stock 1,500 units. Under absorption costing, the fixed overhead per unit was ₦40 last period and is ₦50 this period. Fixed overhead in opening stock = 1,000 × ₦40 = ₦40,000. In closing stock = 1,500 × ₦50 = ₦75,000. Absorption profit exceeds marginal profit by ₦75,000 − ₦40,000 = ₦35,000. If the units formula had been used with the current rate, 500 × ₦50 = ₦25,000, which would be wrong. The values method is the safer approach whenever rates differ.

Worked example: full reconciliation

1. Marginal costing, January.
   Contribution = 2,600 × (₦160 − ₦70) = 2,600 × ₦90 = ₦234,000.
   Fixed costs = ₦180,000 + ₦40,000 = ₦220,000.
   Profit = ₦14,000.
2. Marginal costing, February.
   Contribution = 3,100 × ₦90 = ₦279,000.
   Profit = ₦279,000 − ₦220,000 = ₦59,000.
3. Absorption costing, January.
   Full cost per unit = ₦70 + ₦60 = ₦130.
   Production cost = 3,000 × ₦130 = ₦390,000.
   Closing stock = 400 units × ₦130 = ₦52,000.
   Cost of sales = ₦338,000.
   Sales = 2,600 × ₦160 = ₦416,000.
   Gross profit = ₦78,000.
   Absorbed overhead = ₦180,000 = actual, so no adjustment.
   Less fixed selling ₦40,000.
   Profit = ₦38,000.
4. Absorption costing, February.
   Opening stock ₦52,000 + production 2,800 × ₦130 = ₦364,000 = ₦416,000.
   Closing stock = 400 + 2,800 − 3,100 = 100 units × ₦130 = ₦13,000.
   Cost of sales = ₦403,000.
   Sales = 3,100 × ₦160 = ₦496,000.
   Gross profit = ₦93,000.
   Under-absorbed overhead = ₦180,000 − (2,800 × ₦60 = ₦168,000) = ₦12,000, deducted: ₦81,000.
   Less fixed selling ₦40,000.
   Profit = ₦41,000.
5. Reconcile.
   January: stock +400 units × ₦60 = +₦24,000.
   ₦14,000 + ₦24,000 = ₦38,000. ✓
   February: stock fell from 400 to 100, −300 units × ₦60 = −₦18,000.
   ₦59,000 − ₦18,000 = ₦41,000. ✓

Three months: the difference builds and reverses

Using Sokoto Foods again (fixed overhead ₦60 a unit), extend the example to a third month in which production is 3,200 units and sales 3,000. The table follows the stock units and the fixed overhead in stock.

The running total of the monthly differences (24,000 − 18,000 + 12,000 = ₦18,000) equals the fixed overhead in closing stock at the end of month 3 (300 × ₦60). That is a useful check: cumulative difference = fixed overhead now held in stock. Over a long run, the two methods report the same total profit; they differ only by the fixed overhead sitting in stock at the end.

How a manager could inflate absorption profit

In month 3, with contribution of ₦90 a unit and fixed costs of ₦220,000, marginal profit = 3,000 × ₦90 − ₦220,000 = ₦50,000, and absorption profit is ₦50,000 + ₦12,000 = ₦62,000. Suppose management decided to produce 3,700 units instead of 3,200, without selling any more. Closing stock would rise by 500 units, so absorption profit would rise by 500 × ₦60 = ₦30,000, to ₦92,000. Marginal profit would stay at ₦50,000. No customer has bought anything extra, but reported profit has risen by 60%, simply because more fixed overhead has been put into stock.

If a manager’s bonus is tied to absorption profit, there is an incentive to overproduce, tying up cash in stock and risking obsolescence. This is one reason why boards ask for stock levels as well as profit, and why marginal profit is a safer guide to underlying performance.

Production above or below normal capacity

The absorption rate (₦60) was based on normal production of 3,000 units. In month 3, production was 3,200, so ₦192,000 of overhead was absorbed (3,200 × ₦60) against an actual ₦180,000, an over-absorption of ₦12,000 that is added to profit in the absorption statement. In month 2, production of 2,800 absorbed ₦168,000, an under-absorption of ₦12,000 that is deducted. These adjustments are part of the absorption profit. The stock-based difference (change in stock × ₦60) still explains the gap with marginal profit.

Two more exam-style reconciliations

Case 1: stock rises, absorption profit known. Absorption costing profit is ₦340,000. Opening stock was 500 units and closing stock 1,100 units. Fixed production overhead per unit is ₦25. Stock rose by 600 units, so the absorption profit is higher by 600 × ₦25 = ₦15,000. Marginal profit = ₦340,000 − ₦15,000 = ₦325,000.

Case 2: stock falls, marginal profit known. Marginal costing profit is ₦210,000. Opening stock was 900 units and closing stock 300 units. Fixed production overhead per unit is ₦40. Stock fell by 600 units, so the absorption profit is lower by 600 × ₦40 = ₦24,000. Absorption profit = ₦210,000 − ₦24,000 = ₦186,000.

In both cases, the direction follows the rule: stock up means absorption profit is higher; stock down means it is lower. Check the direction before the arithmetic.

What the reconciliation tells management

• A large gap between the two profits signals a large change in stock. Management should ask whether the stock build-up is deliberate, planned for seasonal demand, or the result of falling sales.
• If absorption profit is rising while sales are flat, check whether production is being increased only to absorb overhead.
• If absorption profit is below marginal profit, stock is being reduced, and the business is recognising overhead from earlier months.
• The marginal figure is a better guide to the effect of sales volume on profit; the absorption figure follows the financial reporting rules.

Common mistakes in the exam

• Getting the direction wrong. Remember: stock up, absorption profit up.
• Including fixed selling or administration costs in the difference.
• Using the wrong fixed overhead per unit, such as one based on sales instead of production or normal activity.
• Using units sold instead of the change in stock.
• Applying the unit formula when the fixed overhead per unit changed between periods, instead of using stock values.
• Adding the difference to the wrong profit. Check which method the given profit refers to.
• Listing advantages of one method only, when both are asked for.

Quick revision

• Profit difference = change in stock (units) × fixed production overhead per unit.
• Stock up: absorption profit higher. Stock down: absorption profit lower. No change: equal.
• Reconciliation: marginal profit + fixed overhead in closing stock − fixed overhead in opening stock = absorption profit.
• Ignore fixed selling and administration costs.
• Absorption: complies with financial reporting, can help control overheads, but less use for decisions. Marginal: simple and useful for decisions, but stock not valued for reporting.

Practice questions

These are original questions written in the style of the Institute of Chartered Accountants of Nigeria (ICAN) exam. Try each one before you open the answer.

Section A style: multiple choice

Section B style: written questions

A further written question

Model answers

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