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The difference in profits reported under the two costing systems is due to the different inventory valuation methods used.
(a) If inventory levels rise between the beginning and end of a period, absorption costing will report the greater profit because some of the fixed manufacturing overhead incurred during the period will be carried forward in closing inventory (which reduces cost of sales) to be set against sales revenue in the subsequent period instead of being written off in full against profit in the period concerned.
(b) If inventory levels drop, absorption costing will report the lesser profit because as well as the fixed overhead incurred, fixed manufacturing overhead which had been carried forward in beginning inventory is released and is also included in cost of sales.
(a) If inventory levels rise between the beginning and end of a period, absorption costing will report the greater profit because some of the fixed manufacturing overhead incurred during the period will be carried forward in closing inventory (which reduces cost of sales) to be set against sales revenue in the subsequent period instead of being written off in full against profit in the period concerned.
(b) If inventory levels drop, absorption costing will report the lesser profit because as well as the fixed overhead incurred, fixed manufacturing overhead which had been carried forward in beginning inventory is released and is also included in cost of sales.
