Marginal Costing in Cost Accounting: Definition, Salient Features, Advantages and Limitations

In this article we will discuss about:- 1. Introduction to Marginal Costing 2. Definition of Marginal Costing 3. Salient Features 4. Advantages 5. Limitations.

Definition or Introduction to Marginal Costing:

Marginal costing is a technique of costing fully oriented towards managerial decision making and control. Marginal costing is not a method of cost ascertainment like job or process or operating costing. Marginal costing, being a technique, can be used in conjunction with any method of cost ascertainment. It can also be used in combination with other techniques such as budgeting and standard costing.

Marginal costing is helpful in determining the profitability of products, departments, processes and cost centres. While analysing the profitability, marginal costing interprets the cost on the basis of nature of cost.

The emphasis is on behaviour of the costs and their impact on profitability.

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Definition of Marginal Costing:

Marginal costing is defined by I.C.M.A. as the ascertainment of marginal costs and of the effect on profit of changes in volume or type of output by differentiating between fixed costs and variable costs.

In the words of J. Batty, marginal costing is “a technique of cost accounting which pays special attention to the behaviour of costs with changes in the volume of output.”

From the above definitions, it is understood that marginal costing involves the following:

(1) Ascertainment of marginal cost.

(2) Deriving of cost-volume-profit relationship by differentiating between fixed costs and variable costs.

Salient Features of Marginal Costing:

(1) Marginal costing is a technique of control or decision making.

(2) Under marginal costing the total cost is classified as fixed and variable costs.

(3) Fixed costs are ascertained separately and excluded from cost of products. The fixed costs are charged to costing profit and loss account. The need for apportionment and absorption of overheads does not arise at all.

(4) The stocks of work-in-progress and finished goods stocks are valued at variable cost. Fixed costs will not be included in valuation of the stocks.

(5) Contribution is ascertained by reducing the marginal cost or variable cost from the selling price.

(6) The profitability of products, departments or processes is determined on the basis of contribution.

(7) Profit is ascertained by reducing the fixed cost from the contribution of all the products or departments or processes or divisions, etc.

(8) The profitability of various levels of activity is ascertained by calculating cost-volume-profit relationship.

Advantages of Marginal Costing:

Marginal costing is an important technique of managerial decision making. It is a tool for cost control and profit planning.

Under mentioned are the advantages of marginal costing technique:

(1) Simplicity:

The statement prepared under marginal costing can be easily followed as it breaks up the cost as variable and fixed.

(2) Stock Valuation:

Stock valuation can be easily done and understood as it includes only the variable cost.

(3) Meaningful Reporting:

Marginal costing serves as a good basis for reporting to management. The profits are analysed from the point of view of sales rather than production.

(4) Effect of Fixed Costs:

The fixed costs are treated as period costs and are charged to P & L A/c directly. Thus they have practically no effect on decision making.

(5) Profit Planning:

The cost-volume-profit relationship is perfectly analysed to reveal efficiency of products, processes and departments. ‘Break-even point’ and ‘Margin of Safety’ are the two important concepts helpful in profit planning. Most advantageous volume and cost to maximise profits within the existing limitations can be planned.

(6) Cost Control and Cost Reduction:

Marginal costing technique is helpful in preparation of flexible budgets as the costs are split into fixed and variable portions. The emphasis is laid on variable cost for control. The fixed costs are also controlled by ascertaining them separately for computing profit and for control. The constant focus on cost and volume, and their effect on profit pave way for cost reduction.

(7) Pricing Policy:

Marginal costing is immensely helpful in determination of selling prices under different situations like recession, depression, introduction of new product, etc. Correct pricing policy can be developed under the marginal costing technique with the help of the cost information, revealed therein.

(8) Helpful to Management:

Marginal costing is helpful to management in exercising decisions regarding make or buy, exporting, key factor and numerous other aspects of business operations.

Limitations of Marginal Costing:

1. Classification of Cost:

Break up of cost into variable and fixed portions is a difficult problem. More over clear cut division of semi variable or semi fixed cost is complicated and cannot be accurate.

2. Not Suitable for External Reporting:

Since fixed cost is not included in total cost, full cost is not available to outsiders to judge the efficiency.

3. Lack of Long-Term Perspective:

Marginal costing is more suitable for decision making in the short-term. It assumes that costs are classified into fixed and variable. In the long-term all the costs are variable. Therefore it ignores time element and is not suitable for long-term decisions.

4. Under Valuation of Stock:

Under marginal costing only variable costs are considered and the output as well as stocks are undervalued and profit is distorted. When there is loss of stock the insurance cover will not meet the total cost.

5. Automation:

In these days of automation and technical advancement, huge investments are made in heavy machinery which results in heavy amount of fixed costs. Ignoring fixed costs, in this context, for decision making is not rational.

6. Production Aspect is Ignored:

Marginal costing lays too much emphasis on selling function and as such production function has been considered to be less significant. But from the business point of view both the functions are equally important.

7. Not Applicable in All Types of Business:

In contract type of business and job order business, full cost of the job or the contract is to be charged. Therefore it is difficult to apply marginal costing in these types of business.

8. Misleading Picture:

Each product is shown at variable cost alone, thus giving a misleading picture about its cost.

9. Less Scope for Long-Term Policy Decisions:

Since cost, volume and profit are inter-linked in price determination, which can be changed constantly, development of long-term price policy is not possible.