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Absorption Costing
Absorption costing is a system of costing which measures cost of a product or a service as its direct costs and variable production overheads plus a share of fixed production overhead costs.
Reporting profit with absorption costing
Sales
Opening Inventory – at full cost of production
Direct Material
Direct Labour
Production Overheads (fixed and variable)
Less: Closing Inventory
Full Production cost of sales/ full cost
(Under)/over absorption
Overhead absorbed
Overhead incurred
over absorbed
Non-Production Overheads
Administration, Selling and Distribution cost
Profit
Advantages of Absorption costing
• Inventory values include an element of fixed production overheads.
• Calculating under/over absorption of overheads may be useful in controlling fixed overhead expenditure.
Disadvantages of Absorption costing
• More complex costing system than marginal costing.
• It does not provide information that is useful for decision making
Comparison between Absorption costing and Marginal costing
• The profit calculated with marginal costing is different from the profit calculated with absorption costing.
• The difference in profit is due to entirely to the differences in the inventory valuation; as in absorption costing inventory cost includes a share of fixed production overheads i,e opening inventory contains fixed production overheads incurred in last period which is written off in the current period and closing inventory contains fixed production overheads that was incurred in this period but carried forward to be written off in the next period.
• When there is no change in the opening and closing inventory, exactly same profit will be reported using marginal costing and absorption costing.
 When there’s an Increase in inventory (i.e. closing inventory is greater than opening):
 It reduces cost of sales and increases profit.
 The absorption profit will be higher.
 When there’s a Decrease in inventory (i,e closing inventory is greater than opening):
 It reduces cost of sales and increases profit.
 The absorption profit will be higher.
Profit Reconciliation: Between Absorption and Marginal costing
To calculate the difference between reported profits using marginal costing and the reported profit using absorption costing follow simple calculations:
Step I
• Calculate increase/decrease in inventory during the period in units: (opening inventory absorption & marginal minus closing inventory absorption marginal).
Step II
• Calculate fixed production overhead cost per unit.
Step III
• The difference in profit is the increase or decrease in inventory quantity multiplied by the fixed production cost per unit.

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