Marginal Costing: Meaning, Characteristics and Assumptions

After reading this article you will learn about Marginal Costing:- 1. Meaning of Marginal Costing 2. Basic Characteristics of Marginal Costing 3. Assumptions 4. Advantages 5. Limitations.

Concept:

  1. Meaning of Marginal Costing
  2. Basic Characteristics of Marginal Costing
  3. Assumptions of Marginal Costing
  4. Advantages of Marginal Costing
  5. Limitations of Marginal Costing



1. Meaning of Marginal Costing:

The Institute of Cost and Management Accountants, London, has defined Marginal Costing 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 this technique of costing only variable costs are charged to operations, processes or products, leaving all indirect costs to be written off against profits in the period in which they arise.

Thus, in this context, marginal costing is not a system of costing such as process costing, job costing, operating costing, etc. but a technique which is concerned with the changes in costs and profits resulting from changes in the volume of output. Marginal costing is also known as ‘variable costing’.



2. Basic Characteristics of Marginal Costing
:

The technique of marginal costing is based on the distinction between product costs and period costs. Only the variable costs are regarded as the costs of the products while the fixed costs are treated as period costs which will be incurred during the period regardless of the volume of output.

The main characteristics of marginal costing are as follows:

a. It is a technique of analysis and presentation of costs which help management in taking many managerial decisions and is not an independent system of costing such as process costing or job costing.

b. All elements of cost—production, administration and selling and distribution are classified into variable and fixed components. Even semi-variable costs are analysed into fixed and variable.

c. The variable costs (marginal costs) are regarded as the costs of the products.

d. Fixed costs are treated as period costs and are charged to profit and loss account for the period for which they are incurred.

e. The stocks of finished goods and work-in-process are valued at marginal costs only.

f. Prices are determined on the basis of marginal cost by adding ‘contribution’ which is the excess of sales or selling price over marginal cost of sales.



3. Assumptions of Marginal Costing
:

The technique of marginal costing is based upon the following assumptions:

a. All elements of cost—production, administration and selling and distribution—can be segregated into fixed and variable components.

b. Variable cost remains constant per unit of output irrespective of the level of output and thus fluctuates directly in proportion to changes in the volume of output.

c. The selling price per unit remains unchanged or constant at all levels of activity.

d. Fixed costs remain unchanged or constant for the entire volume of production.

e. The volume of production or output is the only factor which influences the costs.



4. Advantages of Marginal Costing:

The following are the important advantages of marginal costing:

a. The technique of marginal costing is very simple to operate and easy to understand. Since, fixed costs are kept outside the unit cost; the cost statements prepared on the basis of marginal cost are much less complicated.

b. It does away with the need for allocation, apportionment and absorption of fixed overheads and hence removes the complexities of under-absorption of overheads.

c. Marginal cost remains the same per unit of output irrespective of the level of activity. It is constant in nature and helps the management in production planning.

Advantages of Marginal Costing

d. It prevents the carry forward of current year’s fixed overheads through valuation of closing stocks. Since fixed costs are not considered in valuation of closing stocks, there is no possibility of factitious profits by over-valuing stocks.

e. It facilitates the calculation of various important factors, viz., break-even point, expectations of profits at different levels of production, sales necessary to earn a predetermined target of profit, effect on profit due to changes of raw materials prices, increased wages, change in sales mixture, etc.

f. It is a valuable aid to management for decision-marking and fixation of selling prices, selection of a profitable product/sales mix, make or buy decision, 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.

g. It facilitates the study of relative profitability of different product lines, departments, production facilities, sales divisions, etc.

h. It is complimentary to standard costing and budgetary control and can be used along with them to yield better results.

i. Since fixed costs are not controllable and it is only variable or marginal cost that is controllable, marginal costing, by dividing costs into controllable and non-controllable, help in cost control.

j. It helps the management in profit planning by making a study of relationship between cost, volume and profits. Further, break-even charts and profit graphs make the whole problem easily understandable even to a layman.

k. It is very useful in management reporting, marginal costing facilitates ‘management by exception’ by focussing attention of the management towards more important areas than to waste time on problems which do not require urgent attention of the higher managements.



5. Limitations of Marginal Costing
:

In spite of so many advantages, the technique of marginal costing suffers from the following limitations:

a. The technique of marginal costing is based upon a number of assumptions which may not hold good under all circumstances.

b. All costs are not divisible into fixed and variable. There are certain costs which are semi-variable in nature; it is very difficult and arbitrary to classify these costs into fixed and variable elements.

c. Variable costs do not always remain constant and do not always vary in direct proportion to volume of output because of the laws of diminishing and increasing returns.

d. Selling prices do not remain constant forever and for all levels of output due to competition, discounts for bulk orders, changes in the general price level, etc.

e. Fixed costs do not remain constant after a certain level of activity. Further, marginal costing ignores the fact that fixed costs are also controllable.

f. The exclusion of fixed costs from the stocks of finished goods and work-in-progress is illogical since fixed costs are also incurred on the manufacture of products. Stocks valued on marginal costing are undervalued and the profit and loss account cannot reveal true profits. Similarly, as the stock is undervalued, the balance sheet does not give a true picture.

g. Although the technique of marginal costing overcomes the problem of under or over-absorption of fixed overheads, the problem still exists in regard to under or over-absorption of variable overheads.

h. Marginal costing completely ignores the ‘time factor’. Thus, if two jobs give equal contribution but one takes longer time to complete, the one which takes longer time should be regarded as costlier than the other. But this fact is ignored altogether under marginal costing.

i. The technique of marginal costing cannot be applied in contract or ship-building industry because in such cases, normally the value of work-in-progress is very high and the exclusion of fixed overheads may result into losses every year and huge profit in the year of completion of the job.

j. Cost control can be better be achieved with the help of other techniques, viz., standard costing and budgetary control than by marginal costing technique.

k. 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.

l. In the present days of automation, the proportion of fixed costs in relation to variable costs is very high and hence managerial decisions based upon only the marginal cost ignoring equally important element of fixed cost may not be correct.

Although, the technique of marginal costing suffers from the above mentioned limitations, it is a very useful tool in the hands of the management and is extensively used for cost control, decision-making and profit planning.


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