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Marginal and absorption costing: concepts and inventory valuation

Edexcel IAL Accounting · WAC12 Corporate and Management Accounting

Marginal costing charges only variable costs to products; absorption costing also spreads fixed production overheads over the units made. The choice changes the value of inventory and therefore reported profit.

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The two concepts

Marginal costing: product cost = variable production costs only (direct materials, direct labour, variable overheads). All fixed costs are period costs, charged in full against the period in which they arise. Profit is found through contribution.
Absorption (full) costing: product cost = variable production costs plus a share of fixed production overheads, absorbed with an overhead absorption rate (budgeted fixed production overhead / budgeted or normal output). Non-production fixed costs (administration, selling) are still period costs.

Inventory valuation

Closing inventory is valued at product cost.

Example: 10,000 units made, 8,000 sold; variable cost £12 per unit; fixed production overhead £60,000 (OAR £6.00 per unit).

Marginal: 2,000 x £12 = £24,000
Absorption: 2,000 x £18.00 = £36,000

Under absorption costing, £12,000 of this year's fixed overhead is carried forward in inventory to next year. IAS 2 requires absorption costing (production overheads included) for published financial statements.

Advantages and disadvantages

	Marginal costing	Absorption costing
For	Simple; no arbitrary apportionment of fixed costs; profit moves with sales, not production; ideal for short-term decisions (contribution)	Required by IAS 2 for external reporting; recognises that fixed costs are needed to make products; better for long-term pricing (prices must cover all costs); avoids showing a loss when building inventory for seasonal sales
Against	Not acceptable for published accounts; may lead to prices that do not cover fixed costs in the long run	Profit can be raised by overproducing; apportionment and OAR based on estimates; can mislead short-term decisions

Worked example

Opening inventory is nil. 6,000 units are made and 5,200 sold. Variable production cost £9 per unit; fixed production overheads £36,000 based on normal output of 6,000. Value closing inventory under each method.

Closing inventory = 6,000 - 5,200 = 800 units
Marginal: 800 x 9 = £7,200
OAR = 36,000 / 6,000 = £6; absorption: 800 x (9 + 6) = £12,000

Answer: Marginal £7,200; absorption £12,000

Key idea: Marginal costing: products carry variable costs only and all fixed costs are period costs. Absorption costing: products also carry fixed production overhead (via an OAR), so closing inventory is valued higher.

Check yourself

Budgeted fixed production overheads are £84,000 and normal output is 12,000 units. Calculate the fixed overhead absorption rate per unit.
Show answer
£7.00. 84,000 / 12,000 = £7 per unit.
Closing inventory is 1,500 units. Direct materials £8, direct labour £6 and variable overhead £2 per unit. Value the inventory using marginal costing.
Show answer
£24000. 1,500 x 16 = £24,000.
Using the same inventory (1,500 units, variable cost £16) with fixed production overhead absorbed at £5 per unit, value it using absorption costing.
Show answer
£31500. 1,500 x 21 = £31,500.
Closing inventory rises by 900 units during the year. The fixed production overhead absorption rate is £4.50 per unit. By how much will absorption costing profit exceed marginal costing profit?
Show answer
£4050. 900 x 4.50 = £4,050.
Under marginal costing, how are fixed production overheads treated?
- Included in the value of closing inventory
- Ignored completely
- Added to share capital
- As period costs, charged in full against the period's profit
Show answer
As period costs, charged in full against the period's profit. Only variable costs go into product cost.
Which method must be used to value inventory in published financial statements?
- Marginal costing
- Absorption costing (IAS 2)
- Either, at the directors' choice
- Selling price
Show answer
Absorption costing (IAS 2). IAS 2 requires production overheads to be included in inventory cost.
Which is an advantage of marginal costing?
- It is required for published accounts
- It always gives a higher profit
- It spreads fixed costs over units
- Profit is not affected by changes in inventory levels
Show answer
Profit is not affected by changes in inventory levels. Fixed costs are charged in the period, so profit follows sales.

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Last updated 8 November 2026. Spotted a mistake? Tell us.