1. Introduction and Objectives
How an organization accounts for fixed manufacturing overhead directly impacts inventory valuation and reported net income. This lesson contrasts Marginal Costing (Variable Costing) and Absorption Costing (Full Costing), mapping the structural divergence required under global financial and management accounting standards. [
 
2. Structural Inventory Treatment
  • Absorption Costing (Full Costing): Treats fixed manufacturing overhead (FMOH) as a product cost. Under US GAAP and IFRS, FMOH must be capitalized into inventory assets (WIP and Finished Goods) and only hit the income statement when the product is sold.
  • Marginal Costing (Variable Costing): Treats FMOH strictly as a period cost. FMOH is expensed in full directly on the income statement in the period it occurs and is never capitalized into inventory assets. Only variable manufacturing costs are tied to the product.

3. Operating Profit Divergence Framework
Because absorption costing buries fixed costs inside unsold inventory, profit fluctuations can occur simply by altering production volumes, even if sales remain completely flat.
  • When Production > Sales: Absorption Profit > Marginal Profit (Fixed overhead is deferred in inventory assets).
  • When Sales > Production: Marginal Profit > Absorption Profit (Fixed overhead is released from inventory assets).
  • When Production = Sales: Absorption Profit = Marginal Profit.

4. Mathematical Reconciliation Formula
Absorption Operating Profit − Marginal Operating Profit = (Change in Inventory Units) × Fixed Overhead Rate per Unit
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