Meaning, Features, Objectives, Scope, Advantages, and Disadvantages of Marginal Costing
Meaning of Marginal Costing
The term ‘marginal cost’, derived from the word ‘margin’, is a well-known concept of economic theory. The accountant’s concept of marginal cost differs from the economist’s concept of marginal cost. From the economist’s point of view, the cost incurred in producing an additional unit of product is termed marginal cost From the accountant’s point of view, marginal cost applies to the total cost obtained by adding prime cost and variable cost. In other words, all costs than fixed costs are the marginal cost.
Marginal costing is not a distinct method of costing like job costing, process costing, operating costing, etc., but a special technique used for managerial decision-making. Marginal costing is used to provide a basis for the interpretation of cost data to measure the profitability of different products, and cost centre in the course of decision making Marginal costing is a technique that also divides costs into two categories, but of somewhat different natures. Marginal costing distinguishes between fixed and variable costs as conventionally classified. The marginal cost of a product is its variable cost.
The Institute of Cost and Management Accountants, London, has defined Marginal Costing as “The ascertainment of variable costs and of the effect on profit of changes in volume or type of output by differentiating between fixed costs and variable costs”.
Marginal Costing is also known as “Variable Costing’. 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. In practice, this is measured by the total variable attributable to one unit.
Features of Marginal Costing
The features of marginal costing are as follows:
1) It is a technique of analysis and presentation of costs that helps management in taking many managerial decisions and is not an independent system of costing such as process costing or job costing.
2) All elements of cost-production, administration and selling and distribution are classified into variable fixed and variable. and fixed components. Even semi-variable costs are analyzed.
3) The variable costs (marginal costs) are regarded as the costs of the products.
4) Profitability of departments and products is determined by their Contribution margin.
5) Closing stock is valued at variable cost.
Objectives of Marginal Costing
The following are the objectives of marginal costing:
1) Aggregate fixed cost remains constant at all levels of output and sales. As a result, the total cost does not change in proportion to the change in output.
2) Inclusion of fixed costs as product cost leads to variations in cost per unit based on different levels of activities during different periods.
3) Once facilities have been installed and fixed costs have been committed, these are incurred irrespective of capacity utilization.
4) Fixed costs are identifiable with a particular accounting period. Therefore it is improper to carry forward fixed costs to a subsequent year as part of inventory valuation.
5) Since fixed costs are not influenced by the level of output and sales, these are irrelevant for most decisions at the operations stage. Fixation of the minimum price, dumping, acceptance or rejection of an order, the decision to produce or shut down, decisions regarding product mix, etc., are all guided by variable cost and differential cost, not by fixed cost. Hence, there is a need for marginal costing
Scope of Marginal Costing
The marginal costing, as explained so far, has many scopes which are as follows:
1) Helps in the Prediction of Profit: This relationship enables management to predict profit over a wide range of volume. This knowledge is very useful in preparing a flexible budget.
2) Helps in Determining Prices: In a lean business season, the company has to determine the price of the products very carefully. It becomes necessary sometimes to bring down the price to boost the sale of a product. For all decisions like this, management must determine, by cost-volume-profit analysis, what impact this price reduction is going to have on a profit position of a company.
3) Helps in Decision-making: Analysis of the cost-volume-profit relationship helps in decision making. There are situations when management has to decide whether it should add to its capacity or not. With the knowledge of cost-volume-profit analysis, a manager can easily take decisions showing in its report how utilization of available capacity will lead to an increase in profit.
4) Helps in Profit Planning: Cost-volume-profit analysis helps in profit planning. Under profit planning, the company first declares the profit that it wants to make during the ensuing year. Thereafter, the sales level necessary to yield that profit is attempted. Cost-volume-profit analysis helps in profit planning in the following ways:
i) It helps in estimating income at a particular sales level.
ii) It helps to determine the change in profit due to changes in sales volume.
ii) It helps to execute the idea of profit planning. In other words, we arrive at the sales level to be attempted for the desired profit by the knowledge of the relationship existing between cost, volume and profit.
Advantages of Marginal Costing
The advantages of marginal costing are as follows:
1) Simple to Operate and Easy to Understand: The technique of variable costing is very simple to operate and easy to understand. Since fixed costs are kept outside the unit cost; the cost statements prepared based on variable costs are much less complicated.
2) Removes Complexities of Under-Absorption of Overheads: It does away with the need for allocation. apportionment and absorption of fixed overheads and hence removes the complexities of under-absorption of overheads.
3) Helps Management in Production Planning: Variable cost remains the same per unit of output irrespective of the level of activity. It is constant and helps the management in the production planning
4) Aid to Management: It is a valuable aid to management for decision making and fixation of selling prices selection of a profitable product/sales mix, making or buy decision, the problem of key or limiting factor determination of the optimum level of activity, close or shut down decisions, evaluation of performance and capital investment decisions, etc.
5) Helps in Cost Control: Since fixed costs are not controllable and it is only variable or marginal cost that is controllable, variable costing, by dividing costs into controllable and non-controllable, help in cost control.
6) Profit Planning: It helps the management in profit planning by making a study of the relationship between cost, volume and profits. Further, break-even charts and profit graphs make the whole problem easily understandable even to a layman.
Disadvantages of Marginal Costing
The disadvantages of marginal costing are as follows:
1) Segregation into Fixed and Variable – A Difficult Task: It is difficult to classify all the costs into fixed and variable with accuracy since some costs have no relation to the volume of output or even with the time. For example, management’s decision regarding bonuses to workers may not be directly related to time or output.
2) Apportionment of Fixed Costs: In the case of multiple products, separate break-even points are to be calculated. This poses a problem of apportionment of fixed costs to each product.
3) Based upon several Assumptions: The technique of variable costing is based upon several assumptions that may not hold goods under all circumstances.
4) Problems regarding Under or Over-Absorption: Although the technique of variable costing overcomes the problem of under or over-absorption of fixed overheads, problems still exist regarding the under or over-absorption of variable overheads.
5) Unable to Fix Selling Prices: Fixation of selling prices, in the long run, cannot be done without considering fixed costs. Thus, pricing decisions cannot be based on marginal cost alone.
6) Useful Only in Sports Profit Planning and Decision Making: Variable costing is especially useful in short-profit planning and decision making. For decisions of far-reaching importance, one is interested in special-purpose costs rather than the variability of costs.
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