Advantages, Limitations and Applications of Marginal Costing
(i) The technique is simple to understand and easy to operate because it avoids the complexities of apportionment of fixed costs which, is really, arbitrary.
(ii) It also avoids the carry forward of a portion of the current period’s fixed overhead to the subsequent period. As such cost and profit are not vitiated. Cost comparisons become more meaningful.
(iii) The technique provides useful data for managerial decision-making.
(iv) There is no problem of over or under-absorption of overheads.
(v) The impact of profit on sales fluctuations are clearly shown under marginal costing.
(vi) The technique can be used along with other techniques such as budgetary control and standard costing.
(vii) It establishes a clear relationship between cost, sales and volume of output and breakeven analysis.
(viii) It shows the relative contributions to profit which are made by each of a number of products, and shows where the sales effort should be concentrated.
(ix) Stock of finished goods and work-in-progress are valued at marginal cost, which is uniform.
(i) Segregation of costs into fixed and variable elements involves considerable technical difficulty.
(ii) The linear relationship between output and variable costs may not be true at different levels of activity. In reality, neither the fixed costs remain constant nor do the variable costs vary in proportion to the level of activity.
(iii) The value of stock cannot be accepted by taxation authorities since it deflates profit.
(iv) This technique cannot be applied in the case of contract costing where the value of work-in-progress will always be high.
(v) This technique also cannot be used in the case of cost plus contracts unless fixed costs and profits are considered.
(vi) Pricing decisions cannot be based on contribution alone.
(vii) The elimination of fixed costs renders cost comparison of jobs difficult.
(viii) The distinction between fixed and variable costs holds good only in the short run. In the long run, however, all costs are variable.
(ix) With the increased use of automatic machinery, the proportion of fixed costs increases. A system which ignores fixed costs is, therefore, less effective.
(x) The technique need not be considered to be unique from the point of cost control.
The following are the 4 applications of marginal costing:
- Cost control: in marginal costing there is fixed cost as well as variable cost . fixed cost is controlled by top management and variable cost is controlled by lower management. Sometimes there are the cases when profit decreases even when sale increases in such situations marginal cost helps the concern in finding out the reasons.
- Evaluation of performance: it helps in evaluating the performance of each sector of concern.
- Profit planning: profit increased and decreased due to change in selling price, variable cost etc. marginal cost helps in profit planning.
- Decision making: marginal cost helps in short-term decision-making. Like:
a) Fixing the selling price: Selling price must be equal to the marginal cost. If selling price is more than the marginal cost then there will be loss.
b) Key factor: A factor which puts limit on the production and profit of the business is called key or limiting factor. A company is not able to sell all its production. Sometimes a company can sell all its produces and sometimes not. So choice has to be made regarding whose production has to be increased or who’s decreased.
c) Make or buy decision: It is better for the company to use its idle capacity and produce component parts in the factory itself rather than buying them from the market. If its cost is less than it is better to make it in the factory.
d) Selection of good product mix: This happens in the case when company is producing number of products in that case it is better to select a good product mix which gives more of profit.
e) Effect of change in sale price: Management must be aware of the effect of change in price and make necessary changes from time to time.
f) Closing down activities: Sometimes it becomes necessary for the management to close or suspend some activities of a particular product.
g) Alternative method of production: Marginal costing is helpful in knowing which alternative method of production is to be selected.
h) At the end while selecting alternative course of action management must maintain desired level of profit.