Limitations of Marginal Costing Features, Scope, Advantages, Disadvantages

Limitations of Marginal Costing

Marginal costing is a useful tool for decision making, but it has certain limits, therefore businesses need to be well aware of the limitations of marginal costing. By understanding the limitations of marginal costing and adopting a more suitable approach to cost analysis, they can improve their decision making processes and overall performance.

Limitations of Marginal Costing are as follows:

Common Misunderstanding in Expense Categories
Marginal costing sometimes overlooks the factor of time
Not for Every Industry
Limited Output
Fixed Costs Can Be Managed
Challenges in differentiating fixed and variable components
Dependence on key factors
Scope for Low Profitability
Faulty valuation
Unpredictable Nature of Cost
Marginal costing ignores the time factor and investment
Understating of W-I-P

1. Common Misunderstanding in Expense Categories

People often think expenses can be easily sorted as either fixed or variable. However, this simple idea doesn’t consider expenses like employee bonuses, which depend on management decisions and don’t relate to how much is produced or the time taken.

2. Marginal costing sometimes overlooks the factor of time

There are cases where two outputs have the same marginal cost, even if one takes twice as much time to make. However, in reality, tasks that take more time usually end up costing more.

3. Not for Every Industry

Marginal costing doesn’t work well in some industries, like shipbuilding and contracts.

4. Limited Output

There are certain limitations of marginal costing one of which is limited output. Once a certain amount is produced, fixed expenses might unexpectedly increase, so it’s not always reliable beyond a certain level of production.

5. Fixed Costs Can Be Managed

Marginal costing overlooks the idea that fixed costs can be controlled. Using budgetary control techniques can help effectively manage the amount of fixed overheads.

6. Marginal costing ignores the time factor and investment

The marginal cost of two jobs may be the same but the time taken for their completion and the expenses associated with the machines used can vary. The true cost of a job which takes longer time and uses a expensive machine would be higher. Marginal costing does not reveal this fact.

7. Understanding of Work-in-Progress (WIP)

In the context of marginal costing, it is important to note that under certain circumstances, stocks and WIP can be inaccurately undervalued.

8. Challenges in differentiating fixed and variable components

It is difficult to classify the expenses into fixed and variable categories. Most of the expenses are neither entirely variable nor completely fixed. For example, various amenities provided to workers may have no relation either to the volume of production or time factor.

9. Dependence on key factors

The contribution of a product itself is not a guide for optimum profitability unless it is linked with the key factor.

10. Faulty valuation

Overheads of a fixed nature cannot altogether be excluded particularly in large contracts, while valuing the work-in-progress. To accurately reflect the correct position, fixed overheads have to be included in the work-in-progress.

11. Scope for Low Profitability

Sales staff may mistakenly confuse marginal cost with total cost and sell products at a price; which will result in loss or low profits. Hence, it is imperative to inform the sales staff to exercise caution when providing information regarding marginal costs.

12. Unpredictable nature of Cost

Some of the assumptions regarding the behaviour of different costs may not hold in a realistic situation. For example, the assumption that fixed costs will remain static throughout is not correct. Fixed costs may change from one period to another. For example, salary bills may go up because of annual increments or due to changes in pay rates etc. The variable costs do not remain constant for each unit of output. Price changes in wage rates, raw materials, and other factors may occur after reaching a certain level of output due to material shortages, a shortage of skilled labour, bulk purchase concessions, etc.

Marginal Costing Meaning

Marginal costing is a distinct method of costing like job costing, process costing, operating costing, etc., but a special technique used for managerial decision making. It is used to provide a basis for the interpretation of cost data to measure the profitability of different products, and cost centres 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 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 other than fixed costs are the marginal 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 making 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 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) The 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) The inclusion of fixed costs as product costs 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 the 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 make 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 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, helps 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

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 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.