Absorption Costing vs Marginal Costing: Key Differences Explained
Absorption costing includes all production costs in product cost; marginal costing includes only variable costs. This guide explains the difference, how each works, and which is used for what purpose.
What Is Absorption Costing?
Absorption costing (also called full costing) includes all manufacturing costs in the cost of a product — both variable costs (direct materials, direct labour, variable overhead) and a share of fixed production overhead. Fixed overhead is absorbed into unit cost using an overhead absorption rate (OAR), typically based on budgeted hours.
What Is Marginal Costing?
Marginal costing (also called variable costing or direct costing) only includes variable production costs in the cost of a product. Fixed production overhead is treated as a period cost and charged to the income statement in full in the period it is incurred, regardless of production levels. The marginal cost of a unit = Direct materials + Direct labour + Variable overhead only.
Impact on Profit Reporting
The key difference between the two methods appears when inventory levels change between periods. Under absorption costing, some fixed overhead is carried in closing inventory — reducing the fixed cost charged to profit in that period. Under marginal costing, all fixed overhead is charged immediately. If inventory increases: absorption costing reports higher profit than marginal costing. If inventory decreases: absorption costing reports lower profit. If inventory is unchanged: both methods report the same profit.
Reconciling the Two Profit Figures
Profit difference = Change in inventory units x Fixed overhead per unit (under absorption). If closing inventory is 500 units higher than opening, and fixed overhead per unit is 8, absorption profit exceeds marginal profit by 4,000.
Which Method Is Used When?
IFRS and UK GAAP require absorption costing for external financial reporting — inventory on the balance sheet must include a share of production overhead. Marginal costing is used for internal management accounting because it makes the contribution from each product clear and avoids fixed cost distortions in short-term decision-making. Both are examined in ACCA PM and CIMA P1.
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