Advantages and Disadvantages of Marginal Costing

Everything you need to know about the advantages and disadvantages of marginal costing.

Marginal costing is the ascertainment of marginal costs and of the effect of changes in volume or type of output by differentiating between fixed costs and variable costs.

Marginal costing is not a method of costing such as job costing, process costing and operating costing, etc., but it is a special technique concerned with the effect of fixed overhead on the profitability of a business.

It brings out the relationship between the cost, volume of output and profit. Other terms in use are Direct costing which is used in U.S.A., contributory costing, variable cost and comparative costing.

Marginal cost is defined as the amount at any given volume of output by which aggregate costs are changed, if the volume of output is increased or decreased by one unit.

It is the sum total of prime cost plus variable overheads plus variable portion of semi-variable overheads. Marginal cost is also termed variable cost, direct cost, activity cost, volume cost or out-of-pocket cost.

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Learn about the Advantages and Disadvantages of Marginal Costing

Advantages and Disadvantages of Marginal Costing

Advantages:

1. Constant in nature – Variable costs fluctuates from time to time, but in the long run, marginal costs are stable. Marginal costs remain the same, irrespective of the volume of production.

2. Effective cost control – It divides cost into fixed and variable. Fixed cost is excluded from product. As such, management can control marginal cost effectively.

3. Treatment of overheads simplified – It reduces the degree of over or under-recovery of overheads due to the separation of fixed overheads from production cost.

4. Uniform and realistic valuation – As the fixed overhead costs are excluded from product cost, the valuation of work-in-progress and finished goods become more realistic.

5. Helpful to management – It enables the management to start a new line of produc­tion which is advantageous. It is helpful in determining which is profitable whether to buy or manufacture a product. The management can take decision regarding pricing and tendering.

6. Helps in production planning – It shows the amount of profit at every level of output with the help of cost volume profit relationship. Here the break-even chart is made use of.

7. Better results – When used with standard costing, it gives better results.

8. Fixation of selling price – The differentiation between fixed costs and variable costs is very helpful in determining the selling price of the products or services. Sometimes, different prices are charged for the same article in different markets to meet varying degrees of competition.

9. Helpful in budgetary control – The classification of expenses is very helpful in budgeting and flexible budget for various levels of activities.

10. Preparing tenders – Many business enterprises have to compete in the market in quoting the lowest price. Total variable cost, when separately calculated, becomes the ‘floor price’. Any price above this floor price may be quoted to increase the total contribution.

11. “Make or Buy” decision – Sometimes a decision has to be made whether to man­ufacture a component or a product or to buy it ready-made from the market. The decision to purchase it would be taken if the price paid recovers some of the fixed expenses.

12. Better presentation – The statements and graphs prepared under marginal costing are better understood by management executives. The break-even analysis presents the behaviour of cost, sales, contribution etc. in terms of charts and graphs. And, thus the results can easily be grasped.

Disadvantages

1. Difficulty to analyse overhead – Separation of costs into fixed and variable is a difficult problem. In marginal costing, semi-variable or semi-fixed costs are not considered.

2. Time element ignored – Fixed costs and variable costs are different in the short run; but in the long run, all costs are variable. In the long run all costs change at varying levels of operation. When new plants and equipment are introduced, fixed costs and variable costs will vary.

3. Unrealistic assumption – Assumption of sale price will remain the same at different levels of operation. In real life, they may change and give unrealistic results.

4. Difficulty in the fixation of price – Under marginal costing, selling price is fixed on the basis of contribution. In case of cost plus contract, it is very difficult to fix price.

5. Complete information not given – It does not explain the reason for increase in production or sales.

6. Significance lost – In capital-intensive industries, fixed costs occupy major portions in the total cost. But marginal costs cover only variable costs. As such, it loses its significance in capital industries.

7. Problem of variable overheads – Marginal costing overcomes the problem of over and under-absorption of fixed overheads. Yet there is the problem in the case of variable overheads.

8. Sales-oriented – Successful business has to go in a balanced way in respect of selling production functions. But marginal costing is criticised on account of its attaching over- importance to selling function. Thus it is said to be sales-oriented. Production function is given less importance.

9. Unreliable stock valuation – Under marginal costing stock of work-in-progress and finished stock is valued at variable cost only. No portion of fixed cost is added to the value of stocks. Profit determined, under this method, is depressed.

10. Claim for loss of stock – Insurance claim for loss or damage of stock on the basis of such a valuation will be unfavourable to business.

11. Automation – Now-a-days increasing automation is leading to increase in fixed costs. If such increasing fixed costs are ignored, the costing system cannot be effective and depend­able.

Marginal costing, if applied alone, will not be much use, unless it is combined with other techniques like standard costing and budgetary control.

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Advantages and Disadvantages of Marginal Costing: 8 Points

Advantages of Marginal Costing:

The advantages to be gained from a system of marginal costing may be summarised as follows:

1. Valuable Aid to Management – The most useful contribution of marginal costing is the assistance it renders to the management in vital decision-making. In marginal costing system, the cost data required for decision-making and profit planning is readily available from accounting records. A few of the managerial problems that are simplified by the use of marginal costing are – make or buy decisions, pricing of products, selection of a suitable sales mix, choosing from among alternative methods of production, etc.

2. Facilitates cost control – By separating the fixed and variable costs, marginal costing provides an excellent means of controlling costs.

3. Avoids arbitrary apportionment of overheads – Marginal costing avoids the complexities of allocation and apportionment of fixed overheads which is really arbitrary.

4. No under/over absorption – In marginal costing there is no complication of under-absorption and over-absorption of overheads.

5. Basis for pricing – Marginal costing furnishes a better and more logical basis for fixation of selling prices and tendering for contract particularly when business is dull.

6. Relative Profitability – In case a number of products are being manufactured, marginal costing facilitates the study of relative profitability of different products. It will show where the sales effort should be concentrated so that overall profits position may be improved.

7. Realistic valuation of stock – In marginal costing stocks of finished goods and work-in-progress are valued at their variable cost only. This prevents the carry forward in stock valuation of a proportion of current year’s fixed overheads.

8. Valuable adjunct to other techniques – Marginal costing is a valuable adjunct to budgeting and standard costing techniques.

Disadvantages of Marginal Costing:

Marginal costing suffers from the following limitations:

1. Difficulty in Analysis – It may be very difficult in practice to segregate all costs into fixed and variable. Moreover, certain expenses are purely caused by managerial decisions and cannot be strictly classified as fixed or variable, e.g., amenities to staff, bonus to workers, etc.

2. Difficulty in Application – The technique of marginal costing is difficult to apply in industries like shipbuilding, contracts, etc., where the value of work- in-progress is large in proportion to turnover. Thus, if fixed overheads are not included in the closing value of work-in-progress, losses on contracts may result every year, while on completion of contract there may be large profits.

3. Improper Basis for Pricing – In marginal costing prices are based on contribution which does not cover fixed costs. This may prove dangerous in the long run.

4. Ignores Time Factor – In marginal costing time factor is ignored. For instance, the marginal cost of two jobs may be identical, but if one job takes twice as long to complete as the ether, the true cost of job taking longer time is higher than that of the other. This is not disclosed by marginal costing.

5. Less Effective Cost Control – Marginal costing ignores the fact that fixed costs are also controllable. By placing fixed overheads in a separate category, the importance of their controllability is reduced. Moreover, marginal costing is not as effective as standard costing and budgetary control in controlling costs.

6. Limited Scope – With the increased use of automatic machinery the proportion of fixed costs (maintenance, depreciation etc.,) increases. As marginal costing ignores fixed costs, this system becomes less effective in capital intensive industries.

7. Unrealistic Statements – The exclusion of fixed overhead from stock valuation affects the Profit and Loss Account and also produces an unrealistic Balance Sheet.

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Advantages and Disadvantages of Marginal Costing: 10 Points

Advantages:

The following are the advantages of marginal costing:

(a) Simplicity – The technique of marginal costing is simple to understand and easy to operate. This is because of the exclusion of fixed costs and the associated arbitrary allocation of overheads.

(b) Avoids fixed overhead being capitalized – This technique avoids carry forward of a portion of fixed cost to a subsequent period as a part of inventory to be capitalised.

(c) No distortion in profit – Since period costs are not charged to output, the profit and loss statement is not distorted by changes in inventory levels. Cost comparison becomes meaningful.

(d) Highlights contribution – Excess of sales revenue over variable cost of sales is the contribution generated for meeting fixed costs. Besides being a measure of performance, contribution is a more reliable measure of decision-making, both tactical and strategic.

(e) No over- or under-absorption of overheads – Since fixed costs are charged to profit in full in the year in which they are incurred, marginal costing does not give rise to the problem of over- or under-absorption.

(f) Decision-making – Marginal costing helps management with adequate information appropriate enough in taking vital business decisions such as make or buy, discontinuance of a particular product, or a particular line of activity, pricing during depression, export pricing, suitable product mix, replacement of machines, sub-contracting, etc.

(g) Profit planning – Marginal costing facilitates profit planning by means of break-even analysis, showing the effect of increase or decrease in production on the profitability of the concern. The technique is also of immense use in making cost-volume-profit analysis.

(h) Control over expenditure – The essence of marginal costing is the segregation of expenses as fixed and variable. Such segregation assists management in exercising control over expenditure. It is, in other words, an instrument of cost control. Management is enabled to compare the actual variable expenses with the budgeted variable expenses and take corrective action through analysis of variances.

(i) Responsibility accounting – Since under marginal costing fixed expenses are treated as period costs, there is no arbitrary allocation of such expenses to the various departments. As such, responsibility accounting becomes more effective when it is based on marginal costing.

(j) Budgetary planning – Besides highlighting contribution not merely of every product but in total also, marginal costing also shows contribution per unit of a key factor. This information is immensely useful in budgeting and production planning.

Disadvantages:

In spite of the above advantages of marginal costing, the technique suffers from the following limitations:

(i) Difficulty of Segregation:

Since marginal costing is the ascertainment of marginal cost and the effect on profit of changes in the volume or type of output by differentiating between fixed costs and variable cost, it is absolutely necessary to segregate the expenses into fixed and variable items.

However, it is not that easy to segregate the expenses. Most of the expenses are neither totally variable nor wholly fixed. As such, the expenses are to be separated with reasonable accuracy. Otherwise, the technique ceases to be accurate.

(ii) Exclusion of Fixed Costs:

Although fixed costs are independent of production because of the fact that they accrue on time basis, there is no justification for excluding them from the purview of product costing since they also contribute to production. In modern times when production is highly mechanised, fixed costs are incurred in larger proportion than the variable costs in many industries. In large contracts in particular, fixed costs cannot be excluded while valuing work-in- progress in order to show the correct position of the contract.

(iii) Stock Valuation:

Apart from work-in-progress in the case of large contracts, even stocks of manufacturing concerns cannot be shown in the balance sheet by excluding fixed costs. If they are excluded, stocks of work-in-progress and of finished goods would be under-valued and to that extent, the balance sheet fails to reflect a true and fair view of the affairs of the business.

(iv) Cost-plus Contracts:

In the case of cost-plus contracts, the contractor would like to recover from the contract the full cost of the contract plus profit. As such, it is necessary to take the fixed cost also into consideration while arriving at the cost of the contract.

(v) Ignores Time Value:

Cost comparison based on variable costing becomes unreal in the case of two different jobs having the same variable cost, but take different time to complete owing to usage of different fixed facilities. The cost of a job which takes longer time to complete and uses a costlier machine would naturally be higher. But this fact is totally ignored by marginal costing.

(vi) Shortsighted Approach:

The distinction between variable cost and fixed cost holds good only in the short run. In the long run, however, the distinction ceases and the concern should be able to cover the full cost, and also make profit.

(vii) No One Cost has Priority:

The technique of marginal costing over­ emphasises the influence of variable cost on product cost. It gives the impression that from out of the sale price of a product, variable cost is recovered first, fixed cost is recovered later and then profit is realised. This is not the correct impression. In point of fact, the sale price of a product contains a portion of variable cost, fixed cost and also profit. None of the costs has any priority over the other.

(viii) Not Useful for Price Fixation:

The marginal costing approach to product costing may result in fixation of selling price which may not cover the full amount of cost. In times of depression, however, price may be fixed even lower than the variable cost. But, under normal circumstances, the price fixed should cover not merely the variable cost but a portion of fixed cost also besides the profit margin.

(ix) Variable Cost per Unit Need not be the Same:

This technique assumes that variable cost per unit is the same for any level of production. This may be true for a particular range of output. In case there is a major change in the level of activity, variable cost per unit need not remain the same owing to increased price of materials, increased cost of transport, shortage of skilled labour, high discounts on bulk purchases, etc.

(x) Technique is Unacceptable:

This technique is not recognised by the income tax authorities for valuation of stock. It is also not suitable for preparing financial statements as it is not an accepted accounting procedure for external reporting. It is suitable only for internal reporting as an aid to decision-making.

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Advantages and Disadvantages of Marginal Costing: 8 Points

Advantages:

Marginal costing system has the following advantages:

(1) Marginal costing system is very useful for internal purposes – decision making, planning and control.

(2) Calculation of cost of sales, under marginal costing system, is very simple to understand.

(3) Marginal costing system is very simple to operate as it does not require complex apportionments of overheads.

(4) Marginal costing system avoids the problem of selecting a suitable basis for overhead recovery rate.

(5) The departmental performance can be evaluated more scientifically by using marginal costing system. Fixed costs are kept outside the evaluation process as the department has no role to play for the incurrence of common fixed costs.

(6) It eliminates the problem of over / under absorption of overheads.

(7) The effects of change in selling prices, variable costs can be more readily available and quick decisions can be taken in time.

(8) It avoids the illogical carry forward of current year’s fixed cost to next period in the form of stock.

Disadvantages:

Marginal costing system, however, has the following limitations:

(1) Marginal costing system is not very useful in situations where a very small proportion of total cost is variable cost. For example, in telecommunication business, majority portion of the total cost is depre­ciation and insurance of network, rates and taxes, etc., which are fixed in nature; marginal costing system may not be very useful here.

(2) In many organisations, the splitting of semi-variable costs into fixed element and variable element may not be possible accurately. In this case, marginal costing system may give misleading results.

(3) Valuation of finished stock, WIP on the basis of marginal cost is not acceptable for external reporting. For example, a listed company cannot value its stock at marginal cost as it is not acceptable as per AS-2 “Inventories”.

(4) In highly seasonal businesses, for example, winter garment manufacturing stock is build up during the ‘off-season’, in order to cope with the peak seasonal demand. In this situation, profit under marginal costing system may fluctuate widely if there is change in stock level and sales.

(5) In long-run, revenue must cover all cost, whether direct or indirect, fixed or variable. Marginal costing may run the risk of understating unit costs by excluding fixed cost. Pricing based on this unit costs may not be sufficient for the survival of the enterprise.

(6) Cost of all the factors of production are changing continuously. In such a situation, any decision based on marginal costing system (where it is assumed that there is no change in material price, labour cost or selling prices) may not be useful at all.

(7) Valuation of stock, WIP at marginal cost may not show the true profit of the organization. It also violates the Generally Accepted Accounting Principles and distorts true and fair view of the financial statements.

(8) Income tax authority does not accept the valuation of stock at marginal cost.

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Advantages and Disadvantages of Marginal Costing – Explained

Advantages # Marginal Costing:

With the help of marginal costing technique, managerial decisions can be taken regarding several matters which are discussed as under:

1. How Much to Produce:

The level of output which is most profitable for a running concern can be determined. Therefore, the production capacity can be utilised to the maximum possible extent.

Ascertainment of the most profitable relationship between costs, price and volume of business shall also assist management in fixing best selling prices. Thus, maximisation of profit can be achieved and profit planning becomes easier on the basis of applying marginal costing technique.

2. What to Produce:

The manufacture of which product should be undertaken can be decided upon after comparing the profitability results of different products. Certain products or activities may turn to be unprofitable with the passage of time. Selection of orders and products depends on their profitability and sales effort can be properly directed.

When existing capacity is to be utilised for producing different products in varying quantities, marginal costing is a good guide for deciding the optimum combination of products to match the available capacity and resources. Thus, for the choice of alternative products and introduction of new products, marginal costing technique is helpful to a great extent.

3. Whether to Produce:

The decision whether a particular product should be manufactured in the factory or bought from outside source can be taken by comparing the price at which it can be had from outside and the marginal cost of producing that article in the factory.

4. How to Produce:

(a) Method of manufacture – When a particular product can be manufactured by two or more methods, the ascertainment of marginal cost of manufacturing the product under each method shall be helpful in deciding as to which method should be adopted for its manufacture.

(b) Hand or machine labour – The problem of employing machine or to produce entirely by hand labour can be solved with the help of marginal costing technique.

5. When to Produce:

In periods of trade recession, whether the production in the plant is to be suspended temporarily or permanently closed down, can be decided upon after carefully examining the marginal cost structure.

6. At what Cost to Produce:

(a) Efficiency and economy of plants – The marginal cost indicates the efficiency and economy of different plants over different ranges of products, volume and output.

(b) No profit no loss points – With the help of technique of break-even charts involved under marginal costing system, the point of no-profit-no-loss can be revealed and information can be presented to management so as to facilitate comparisons.

(c) Lease or ownership of plant – A plant or an asset may be taken on lease or may be owned. The costs of lease and ownership are studied and the better alternative is adopted after judging and assessing the minimum sacrifice and maximum differential gain through the technique of marginal costing.

(d) Cost control – For purposes of control also, financial results presented through marginal costing technique are useful. Cost control can be effected through comparing fixed and variable elements of costs with budgeted costs.

(e) Inventory valuation – Inventory valuation becomes more realistic when it is based on marginal cost.

7. Profit Maximisation:

The technique of marginal costing can be applied to maximise the profits of a company in the following ways:

(i) Profit Planning:

It is the planning of future operations to attain maximum profit. Profit-volume ratio is an important indicator of the relative profitability of the different sectors of the business whenever there is any change in the sale price, variable costs or product mix. Under the technique of marginal costing, contribution in terms of key factor is also calculated so as to know the comparative profitability under different alternatives. Cost-volume-profit analysis serves as a fore warner of future danger signals and it focuses on the scope of earning profits. Thus, achievement of maximum profit can be planned through the use of marginal costing technique.

(ii) Performance Evaluation:

The performance of different departments, units, segments or lines of a business can be evaluated with the help of marginal costing technique. The evaluation assists in taking proper and timely action to reduce losses and thus maximise profits.

(iii) Optimisation of Product Mix:

Whenever the firm is a multi-product firm, the most ticklish problem is to decide the optimum output for each type of product so as to maximise profits. The optimum product mix can well be decided upon with the help of marginal-costing technique. The profitability of all the products can’t be the same and the degree of profitability of each variety of product is measured through the use of marginal costing. The contribution analysis is very significant in this respect.

(iv) Evaluation of Alternate Investment Plans:

There is always a problem before the management to pick up that alternative which is the best in regard to investing money. The investment should be made in such activities which yield highest marginal contribution. Alternate use of production facilities or methods of manufacture etc., may be possible. The marginal costing techniques come to the rescue of management in arriving at a correct decision in this respect.

To illustrate, suppose, for an existing business, per unit total cost of a product is Rs. 10 after allocating fixed overheads to it. The per unit marginal cost works out to Rs. 8 i.e., without allocation of fixed overheads. A bulk special order to supply the product at Rs. 9 is received. Per unit total cost is now calculated at Rs. 9.50 after allocating fixed overheads to the entire production.

On the basis of absorption costing, the offer can’t be accepted, since it will result in a loss. However, on the basis of marginal costing, the offer must be accepted, since the fixed overheads have already been absorbed by the existing production, no additional fixed overheads arc going to be incurred and the marginal cost of Rs. 8 leaves a profit margin of Re. 1 per unit still. This decision will certainly maximise the total profit.

8. Cost Control:

Under marginal costing, total costs are divided into fixed and variable elements according to the nature of the behaviour of costs. The management comes to know about the exact trend of cost behaviour in respect of each and every item. If some are semi-variable in nature, an attempt is made to segregate the fixed and variable elements present therein. The segregation is very crucial for determination of marginal costs.

This exercise, in itself, opens the eyes of management in respect of the need for controlling costs. It provides him with an insight into the exact nature of every single item of cost. The management is also enlightened about its ability to control certain costs. Controllable costs can be given prime attention by the management.

The management can resort to horizontal and vertical comparison of such costs, in particular, for effecting cost control. Principle of exception may also be applied. Standard and budgeted marginal costs can be pre-determined and these can serve as a suitable yardstick of cost control. It is, therefore, said that “standard marginal costing system in conjunction with budgetary control can serve as the best means of cost control.”

Limitations # Marginal Costing:

1. Classification into fixed and variable elements—a difficult task – It is a tough job to analyse costs under fixed and variable elements, since the nature of costs is not certain in some cases. Certain costs may be partly fixed and partly variable and the division of such costs into fixed and variable parts separately is based on assumptions and not facts.

Certain overheads have no relation to volume of output or even with the time; thus, they cannot be categorised either as fixed or variable. Management’s decisions regarding bonus to workers, facilities to administrative staff, etc., are taken without any consideration of time or production volume.

2. Faulty decisions – If the fixed overheads arc not taken into consideration, the management’s decision regarding price-fixing manufacturing the product, etc., may prove to be faulty and deceptive. Marginal cost of different products may be the same, still the manufacture of a particular product may not be profitable on account of heavy fixed costs.

3. Difficult application – The application of marginal costing technique is difficult in most of the concerns. It cannot be easily applied in job costing.

4. Under or over-recovery of overheads – Variable overheads arc estimated and therefore its absorption not being based on actuals, may result in under or over-recovery of overheads.

5. Better technique available – The systems of budgetary control and standard costing serve the purpose better than marginal costing system. Through variance analysis, the impact on profitability due to changes in volume and efficiency can be studied and hence this technique is not required.

6. Unrealistic under fluctuating production – When production fluctuates highly, marginal cost data become unrealistic. This happens particularly in case of seasonal factories.

7. Incorrect valuation of stock – It is not appropriate to exclude fixed costs of production from the value of stocks. It gives a distorted picture of profit. Since the fixed costs have also been incurred, the product costs should bear them.

Thus, wrong decisions may be taken on the basis of marginal costing, particularly in times of early recession when marginal costing projects the bleak picture in a magnified way. The situation may lead to further recession and may create a scare.

In the long run, the system may not be suitable and full costs might have to be taken care of. Full picture is revealed only when total cost and net profit are calculated. Under marginal costing elements full information like extensive use of equipment, expansion of resources, return on capital employed etc. is not provided.

On account of these severe limitations, one should be very cautious in the application of marginal costing technique to specific situations. If marginal costs are not presented properly and the interpretation is not correctly made with regard to all the variable factors in a particular situation, marginal costing may lead to a wrong path. Wrong decisions may be taken under such circumstances.

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Advantages and Disadvantages of Marginal Costing: 9 Quick Points

Advantages of Marginal Costing:

The main advantages of marginal costing are as under:

1. Income statement

2. Ascertainment of real profit

3. Profit planning

4. Cost control

5. Managerial thinking

6. Less complicated technique

7. Basis of managerial reporting

8. Total of profitability

9. Area of price policy.

1. Income statement – Management can understand the income statement easily by allocating the variable cost and fixed cost.

2. Ascertainment of real profit – Under this technique real profit can be ascertainment easily. Profit is directly related to sales.

3. Profit planning – This technique helps in profit planning in short term cases. Variable and fixed costs are segregated out of the total cost.

4. Cost control – This technique is a part of cost control and cost reduction. It facilitates the preparation of flexible budget.

5. Managerial thinking – This technique confirm to the managerial thinking and philosophy. The information is very much useful for management.

6. Less complicated technique – This technique is less complicated and free from any confusion. Fixed overheads are not included in the cost of production.

7. Basis of managerial reporting – It serves as a good basis for managerial reporting. The information is provided regarding sales. Fixed cost are also effective in treating the profits.

8. Tool of profitability – This technique serves as a tool of profitability appraisals.

9. Area of Price Policy – The most use of this technique is in the area of price policy and its determination. Correct and sound decisions are taken on the basis of information revealed by this technique.

Disadvantages of Marginal Costing:

The main disadvantages of marginal costing are as under:

1. No importance to time factor

2. Fails in long term

3. More emphasis on selling function

4. Undervaluation of stock

5. Not suitable for external reporting.

1. No importance to time factor – This technique does not give dues importance to time factor.

2. Fails in long term – For long term price policy, this technique fails in providing solution.

3. More emphasis on selling function – This technique provides much emphasis on selling function and it ignores production function.

4. Undervaluation of stock – Valuation of stock under marginal cost may amount to under valuation, which may create working capital problem.

5. Not suitable for external reporting –This technique is not suitable at all for external reporting, etc.

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