Understanding the advantages and disadvantages of marginal costing is very important to the management of every organization especially when it comes to short-term decision making. So, this article gives the definition, example, advantages, and disadvantages of marginal costing.
Advantages and Disadvantages of Marginal Costing
What is Marginal Costing?
Marginal costing which is also known as variable or direct costing is a costing technique in which only variable costs are charged to the cost unit and fixed overheads are treated as periods. Therefore, they are written off against the contribution of the period in which they are incurred. Under this costing, costs are classified into fixed and variable costs. It is very useful for management decisions making.
Marginal Costing Example
Let’s use the scenario below as an example of variable costing.
ACD and Co provide the standard cost card of producing a unit of its product as follow:
|Variable manufacturing overheads||5|
|Fixed manufacturing overheads||10|
The budgeted production capacity of the company is 20,000 units. The variable administrative cost is $1 of the unit sold, and variable selling and distribution overheads are $1.5 for each sales unit. The fixed administrative overhead is $60,000. Selling and distribution overhead is $40,000 respectively. The actual production and sales for the year ended 2020 are 19,000 units and 15,000 units respectively. The selling price is $50 while the income tax rate is 30%.
Using variable costing approach, the income statement of ACD and Co will be prepared as thus:
Advantages of marginal costing technique
It is simple to understand
It is very simple and easy to understand because it doesn’t involve the arbitrary apportionment of fixed overheads. Also, it can be easily combined with other costing techniques like standard costing, budgeting, and others.
It avoids over or under absorption
Under direct costing, fixed costs are treated as period costs. Therefore, they are not included in the determination of product costs. So, marginal costing avoids the problem of under or over-absorption of fixed production overheads.
It is suitable for cost control
Marginal costing is a suitable tool for controlling costs. This is because fixed overheads are not included in the cost of production. It gives managers control over the costs of their departments.
It is suitable for decision making
The variable costing method is a suitable method for making management decisions such as optimal product mix decisions, make or buy decisions, adding a segment or deleting a segment, acceptance or rejection of special orders, and others. It is suitable for decision-making because only variable costs are considered in the determination of the product costs. Fixed costs are excluded from the cost of production.
Effective for measuring profitability
This costing technique is very effective in measuring the profitability of a product. This is because only variable costs are considered in the inventory valuation. With marginal costing, managers can’t use inventory to inflate the profit for the year.
Effective performance comparison
Marginal costing is an effective method for comparing the performance of various products or departments. This is because only costs directly attributable to the products or department are considered in the performance evaluation. It clearly shows the relationship between cost, volume, and profit. Therefore, marginal costing is very useful for cost volume profit analysis (break-even analysis).
Disadvantages of Marginal Costing Technique
The limitations of marginal costing include the following:
It is not acceptable for inventory valuation
Inventories are undervalued using marginal costing because the value of inventories doesn’t include fixed costs. However, using marginal costing to value inventory is not acceptable by the GAAP and IFRS.
Difficulty in separating costs
The use of variable costing requires the separation of costs into fixed and variable costs which is technically difficult. Therefore, the classification may lead to misleading results.
The use of marginal costing may lead to underpricing of products since fixed costs are not included in determining the cost of production. Valuing the product at any price lower than the total costs of production may lead to underpricing.
It is not suitable for jobs comparison
The exclusion of fixed costs from the total costs makes the comparison of jobs to be difficult.
It is not acceptable for external reporting
The use of variable costing for the preparation and presentation of external reports is not acceptable by the Generally accepted accounting principle (GAAP), by international financial reporting standards (IFRS), and others.
The relationship between variable costs and output may not linear
It assumes that fixed costs are constant and variable costs are varying with the level of activity. However, variable costs may not vary with the level of activity and fixed costs may not remain unchanged in reality.
Direct costing is very important to management decision-making. It helps make short-term decisions but is less useful for long-term decisions. Despite the advantages of marginal costing, it remains only useful for internal management decisions due to its limitations. It is acceptable for presenting financial statements for external use. CONTACT US for any management-related assignment or task.
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Afeez is one of the founding partners of Marasas Consulting limited. He consults for both individuals and entities in the area of accounting, management, audit, tax, and investment. He has a wide range of experience both online and offline which allows him to provide relevant and timely professional advice and assistance to business owners with their accounting, tax, management, audit, and investment plans.
Afeez is a member of the Institute of Chartered Accountants of Nigeria (ICAN) and a member of the Nigerian Institute of Management (Chartered). He is a certified Google analyst and strategist. He earned his Bachelor degree in Management and Accounting from Obafemi Awolowo University, Ile-Ife, Nigeria, and earned an ordinary national diploma in Accountancy from The Polytechnic of Ibadan, Oyo State, Nigeria. He earned certification in “Excel Crash Course” and “Reading of Financial Statement” from Corporate Finance Institute, Canada.
Afeez is dedicated to helping clients achieve business success by helping them to establish solid and sound accounting, tax, and financial processes.