VertiFarm Inc. operates an indoor vertical farm. In its first month of operations, it produced 10,000 units of lettuce and sold 8,000 units. The fixed production overheads were $20,000.

If VertiFarm uses absorption costing instead of marginal costing, how will its reported profit differ?

Answer options:

Absorption costing profit will be $4,000 lower.

Absorption costing profit will be $4,000 higher.

Absorption costing profit will be $20,000 higher.

There will be no difference in profit.

How to approach this question

Calculate the Fixed Overhead Absorption Rate (OAR). Multiply the OAR by the change in inventory (Production - Sales). If production > sales, absorption profit is higher.

Full Answer

B.Absorption costing profit will be $4,000 higher.✓ Correct

Fixed Overhead Absorption Rate (OAR) = $20,000 / 10,000 units = $2 per unit. Change in inventory = Production (10,000) - Sales (8,000) = 2,000 units increase. Difference in profit = 2,000 units × $2 = $4,000. Because inventory increased, absorption costing defers some fixed costs into the balance sheet, resulting in a higher profit than marginal costing.

Common mistakes

Getting the direction wrong (thinking absorption profit is lower when inventory increases).

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