Marginal costing and absorption costing are two different approaches to the allocation of costs in managerial accounting. While both methods are used to determine the cost of products or services, they differ in how they treat fixed manufacturing overhead costs.

Here’s a comparison of marginal costing and absorption costing:

1. Treatment of Fixed Manufacturing Overhead:

   • Marginal Costing: In marginal costing, fixed manufacturing overhead costs are considered period costs and are not allocated to individual products or services. These costs are treated as separate expenses and are deducted from total revenue to calculate the contribution margin (sales revenue minus variable costs). As a result, only variable production costs (direct materials, direct labor, and variable overhead) are included in the product’s cost.

   • Absorption Costing: Absorption costing, also known as full costing, assigns both variable and fixed manufacturing overhead costs to individual products or services. Fixed overhead costs are absorbed or allocated to products based on a predetermined rate or allocation base, such as direct labor hours or machine hours. This method aims to reflect the total cost of production, including both variable and fixed costs, in the cost of each unit.

2. Inventory Valuation:

   • Marginal Costing: Under marginal costing, inventory valuation includes only the variable production costs (direct materials, direct labor, and variable overhead) directly attributable to the production of goods or services. Fixed manufacturing overhead costs are not included in the valuation of inventory.

   • Absorption Costing: Absorption costing includes both variable and fixed manufacturing overhead costs in the inventory valuation. Fixed overhead costs are spread across the units produced and are considered part of the cost of each unit. As a result, inventory valuation under absorption costing is generally higher compared to marginal costing, especially if production exceeds sales.

3. Profit Determination:

   • Marginal Costing: Marginal costing helps in determining the contribution margin per unit and the overall contribution margin ratio. Contribution margin is the difference between sales revenue and variable costs, and it represents the amount available to cover fixed costs and generate a profit. By deducting fixed costs from the contribution margin, the net profit can be calculated.

   • Absorption Costing: Absorption costing determines the gross profit by deducting both variable and fixed manufacturing costs from sales revenue. This method includes fixed overhead costs in the cost of each unit, resulting in a higher cost per unit compared to marginal costing. Consequently, the gross profit calculated under absorption costing may differ from the net profit calculated under marginal costing.

Both marginal costing and absorption costing have their advantages and uses. Marginal costing provides valuable insights into the contribution margin and helps in short-term decision-making, such as pricing and product mix choices. Absorption costing, on the other hand, is required for external financial reporting purposes and provides a comprehensive view of the total cost of production. The choice between the two methods depends on the specific needs of the business and the context in which the cost information is being used.