Reconciliation of Profit Under Marginal and Absorption Costing

What is the Reconciliation of Profit Under Marginal and Absorption Costing?

We have often heard about the reconciliation of profit under marginal and absorption costing. It means making adjustments in the calculation of profits obtained from one costing method to arrive at the same profit under another costing method.

Why the Need for Reconciliation Arises?

Marginal and Absorption Costing methods are very different from each other. Both of these are costing methods used to arrive at the cost of goods sold and also value inventory. The principle difference is in valuing the inventory. Companies mainly use absorption costing for financial and tax reporting. Often, companies follow marginal costing for internal management’s decision-making purposes. Thus, there arises a need to reconcile profit under marginal and absorption costing.

Inventory Valuation under Marginal Costing

Marginal costing considers only variable manufacturing costs like raw material costs and variable labor costs.

Inventory Valuation under Absorption Costing

Absorption costing considers both fixed and variable manufacturing costs in valuing inventory. It includes all costs of manufacturing the product, whether variable or fixed. Costs like direct material, direct labor (fixed or variable), factory overheads, etc.

Consequence: Difference in Profits

A different approach by these methods leads to a difference in inventory value. This inventory value carries the same difference in the ‘cost of goods sold’. Thus, the two methods give different profits.

How to Reconcile the Profits?

Before learning to make the reconciliation statement, let’s first see how this difference is created.

Understand the Difference in Profits with an Example

Let’s consider an example to understand the reconciliation of profit under marginal and absorption costing.

Company X makes and sells chairs. It provides the following costing and selling data for a month:

  • Company X sells 2,400 units a month at $18;
  • Production: 4,000 units.
  • Variable Costs:
    • Variable production cost per unit is $7.20;
    • Variable non-production cost per unit 10% of sales revenue;
  • Fixed Costs:
    • Fixed production costs (per month) $11,800;
    • Fixed non-production costs (per month) $7,200;

Following is the profit statement of company X using Absorption costing:

ParticularsQtyRateValue
Variable Manufacturing Cost4,000.00 7.20 28,800.00
Fixed Manufacturing Cost4,000.002.9511,800.00
Cost of Goods Produced4,000.0010.15 40,600.00
Op. Inventory–  –    –  
Cl. Inventory1,600.0010.1516,240.00
Cost of Goods Available for Sale2,400.0024,360.00
Variable Non-Manufacturing Cost2,400.001.80  4,320.00
Fixed Non-Manufacturing Cost2,400.003.00 7,200.00
Fixed Manufacturing Cost– – 
Cost of Goods Sold2,400.0014.95 35,880.00
Sales2,400.0018.00 43,200.00
Profit2,400.003.057,320.00

Following is the profit statement using Marginal costing:

ParticularsQtyRateValue
Variable Manufacturing Cost4,000.007.2028,800.00
Fixed Manufacturing Cost–  –  –  
Cost of Goods Produced4,000.007.2028,800.00
Op. Inventory     –  –  –  
Cl. Inventory1,600.00 7.2011,520.00
Cost of Goods Available for Sale2,400.00 17,280.00
Variable Non-Manufacturing Cost2,400.001.80  4,320.00
Fixed Non-Manufacturing Cost2,400.003.007,200.00
Fixed Manufacturing Cost2,400.004.9211,800.00
Cost of Goods Sold2,400.0016.9240,600.00
Sales2,400.0018.0043,200.00
Profit2,400.001.08  2,600.00

We can also see the comparative statements in the following pic. The differences column presents the differences between the two methods.

Prepare Reconciliation Statement

Reconciliation can be done in two ways,

Begin from Profits of Absorption Costing

We will take profit from the absorption costing method and reduce the overvaluation of inventory to arrive at the profit as per marginal costing.

ReconciliationValue
Profit as per Absorption Costing7,320.00
Reduce:
Overvaluation of Inventory (1600* 2.95)
(10.15 – 7.2 = 2.95)
4,720.00
Profit as per Marginal Costing2,600.00

Begin from Profits of Marginal Costing

We will follow the exact reverse process in this case.

ReconciliationValue
Profit as per Marginal Costing2,600.00
Add:
Undervaluation of Inventory (1600* 2.95)
(10.15 – 7.2 = 2.95)
4,720.00
Profit as per Absorption Costing7,320.00

Conclusion

You will notice that the absorption costing method will always value inventory higher than the marginal costing method. The simple reason is that marginal costing does not take manufacturing fixed costs into consideration.



Sanjay Borad

Sanjay Bulaki Borad

MBA-Finance, CMA, CS, Insolvency Professional, B'Com

Sanjay Borad, Founder of eFinanceManagement, is a Management Consultant with 7 years of MNC experience and 11 years in Consultancy. He caters to clients with turnovers from 200 Million to 12,000 Million, including listed entities, and has vast industry experience in over 20 sectors. Additionally, he serves as a visiting faculty for Finance and Costing in MBA Colleges and CA, CMA Coaching Classes.

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