Advantages and Disadvantages of Marginal Costing
Introduction: What is Marginal Costing?
Marginal costing is a method of cost accounting and decision-making used for internal reporting in which only marginal costs are charged to cost units and fixed costs are treated as a lump sum. It is also known as direct, variable, and contribution costing.
In marginal costing, only variable costs are used to make decisions. It does not consider fixed costs, which are assumed to be associated with the time periods in which they were incurred.
Marginal costs include:
- The costs actually incurred when you manufacture a product
- The incremental increase in costs when you ramp up production
- The costs that disappear when you shut down a production line
- The costs that disappear when you shut down an entire subsidiary
In this technique, cost data is presented with variable costs and fixed costs shown separately for the purpose of managerial decision-making.
Marginal costing is not a method of costing like process costing or job costing. Rather, it is simply a way to analyze cost data for the guidance of management, usually for the purpose of understanding the effect of profit changes due to the volume of output.
The direct costing concept is extremely useful for short-term decisions, but can lead to harmful results if used for long-term decision-making, since it does not include all costs that may apply to a longer-term decision. Furthermore, marginal costing does not comply with external reporting standards.
Video: Variable (Marginal) vs. Absorption Costing Part One
Video: Variable (Marginal) Costing vs. Absorption Costing Part Two
Common Use Cases for Marginal Costing
Marginal costing can be a useful tool for evaluating some types of decisions. Here are some of the most common scenarios where marginal costing can provide the most benefit:
Automation investments: Marginal costing is useful to determine how much a firm stands to gain or lose by automating some function. The key costs to take into consideration are the incremental labor cost of any employees who will be terminated versus the new costs incurred from equipment purchase and subsequent maintenance.
Cost reporting: Marginal costing is very useful for controlling variable costs, because you can create a variance analysis report that compares the actual variable cost to what the variable cost per unit should have been.
Customer profitability: Marginal costing can help determine which customers are worth keeping and which are worth eliminating.
Internal inventory reporting: Since a firm must include indirect costs in its inventory in external reports, and these can take a long time to complete, marginal costing is useful for internal inventory reporting.
Profit-volume relationship: Marginal costing is useful for plotting changes in profit levels as sales volumes change. It is relatively simple to create a marginal costing table that points out the volume levels at which additional marginal costs will be incurred, so that management can estimate the amount of profit at different levels of corporate activity.
Outsourcing: Marginal costing is useful for deciding whether to manufacture an item in-house or maintain a capability in-house, or whether to outsource it.
Advantages and Benefits of Marginal Costing
Cost control: Marginal costing makes it easier to determine and control costs of production. By avoiding the arbitrary allocation of fixed overhead costs, management can concentrate on achieving and maintaining a uniform and consistent marginal cost.
Simplicity: Marginal costing is simple to understand and operate and it can be combined with other forms of costing (e.g. budgetary costing and standard costing) without much difficulty.
Elimination of cost variance per unit: Since fixed overheads are not charged to the cost of production in marginal costing, units have a standard cost.
Short-term profit planning: Marginal costing can help in short-term profit planning and is easily demonstrated with break-even charts and profit graphs. Comparative profitability can be easily assessed and brought to the notice of the management for decision-making.
Accurate overhead recovery rate: This method of costing eliminates large balances left in overhead control accounts, which makes it easier to ascertain an accurate overhead recovery rate.
Maximum return to the business: With marginal costing, the effects of alternative sales or production policies are more readily appreciated and assessed, ensuring that the decisions taken will yield the maximum return to the business.
Disadvantages and Limitations of Marginal Costing
Disadvantages and Limitations of Marginal Costing
Classifying costs: It is very difficult to separate all costs into fixed and variable costs clearly, since all costs are variable in the long run. Hence such classification sometimes may give misleading results. Furthermore, in a firm with many different kinds of products, marginal costing can prove less useful.
Accurately representing profits: Since the closing stock consists only of variable costs and ignores fixed costs (which could be considerable), this gives a distorted picture of profits to shareholders.
Semi-variable costs: Semi-variable costs are either excluded or incorrectly analyzed, leading to distortions.
Recovery of overheads: With marginal costing, there is often the problem of under or over-recovery of overheads, since variable costs are apportioned on an estimated basis and not on actual value.
External reporting: Marginal costing cannot be used in external reports, which must have a complete view of all indirect and overhead costs.
Increasing costs: Since it is based on historical data, marginal costing can give an inaccurate picture in the presence of increasing costs or increasing production.
Conclusion: Marginal Costing Can Be Helpful for Short-Term Decision Making
Marginal costing is a useful analysis tool which usually helps management make decisions and understand the answer to specific questions about revenue.
That said, it is not a costing methodology for creating financial statements. In fact, accounting standards explicitly exclude marginal costing from financial statement reporting. Therefore, it does not fill the role of a standard costing, job costing, or process costing system, all of which contribute actual changes in the accounting records.
Still, it can be used to discover relevant information from a variety of sources and aggregate it to help management with a number of tactical decisions. It is most useful in the short term, and least useful in the long term, especially where a firm needs to generate sufficient profit to pay for a large amount of overhead.
Furthermore, direct costing can also cause problems in situations where incremental costs may change significantly, or where indirect costs have a bearing on the decision.