The difference between marginal costing and absorption costing

Marginal costing applies only those costs to inventory that were incurred when each individual unit was produced, while absorption costing applies all production costs to all units produced. This results in the following differences between the two methods:

  • Cost application. Only the variable cost is applied to inventory under marginal costing, while fixed overhead costs are also applied under absorption costing.
  • Profitability. The profitability of each individual sale will appear to be higher under marginal costing, while profitability will appear to be lower under absorption costing.
  • Measurement. The measurement of profits under marginal costing uses the contribution margin (which excludes applied overhead), while the gross margin (which includes applied overhead) is used under absorption costing.

Overhead costs are charged to expense in the period under marginal costing, whereas they are applied to products under the absorption costing method (which may defer expense recognition to a later period).

An additional difference is that absorption costing is required by the applicable accounting frameworks for financial reporting purposes, so that factory overhead will be included in the inventory asset. Marginal costing is not allowed for financial reporting purposes, so its use is restricted to internal management reports.