Margianl Costing is a technique of decision making, which
involves:
(a) Ascertainment of total costs
(b) Classification of costs into
(1) Fixed and
(2) Variable
(c) Use of such information for analysis and decision making.
Thus, Marginal costing is defined as the ascertainment of marginal
cost 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
mainly concerned with providing information to management to assist in decision
making and to exercise control. Marginal costing is also known as ‘variable
costing’ or ‘out of pocket costing’
Advantages of Marginal Costing:
Marginal costing technique is frequently used for short-term decision-making.
It helps management in the following areas —
a)
Cost control: -
Marginal costing divides total cost into fixed and variable cost. Fixed Cost
can be controlled by the Top management to a limited extent and Variable costs
can be controlled by the lower level of management. Marginal costing by
concentrating all efforts on the variable costs can control total cost.
b)
Profit Planning: - It helps in short-term profit planning by making a study of
relationship between cost, volume and Profits, both in terms of quantity and
graphs. An analysis of contribution made by each product provides a basis for
profit-planning in an organisation with wide range of products.
c)
Fixation of selling price: - Generally prices are determined by demand and supply of products
and services. But under special market conditions marginal costing is helpful
in deciding the prices at which management should sell. When marginal cost is
applied to fixation of selling price, it should be remembered that the price
cannot be less than marginal cost. But under the following situation , a
company shall sell its products below the marginal cost:
(i) To
maintain production and to keep employees occupied during a trade depression.
(ii) To
prevent loss of future orders.
(iii) To
dispose of perishable goods.
(iv) To
eliminate competition of weaker rivals.
(v) To
introduce a new product.
(vi) To help
in selling a co-joined product which is making substantial profit?
(vii) To
explore foreign market
d)
Make or Buy: - Components and spare parts may be made in the factory instead of
buying from the market. In such cases, the marginal cost of manufacturing the
components or spare parts should be compared with market price while taking
decision “to make or buy”. If marginal cost is lower than the market price, it
is more profitable to make than purchasing from market.
e)
Evaluation of Performance: - The different products and divisions have different profit
earning potentialities. The Performance of each product and division can be
brought out by means of Marginal cost analysis, and improvement can be made
where necessary.
f)
Limiting Factor: - when a limiting factor restricts the output, a contribution
analysis based on the limiting factor can help maximising profit. For example,
if machine availability is the limiting factor, then machine hour utilisation
by each product shall be ascertained and contribution shall be expressed as so
many rupees per machine hour utilized. Then, emphasis is given on the product
which gives highest contribution.
g)
Helpful in taking Key Managerial
Decisions:- In addition to above, the following are the
important areas where managerial problems are simplified by the use of marginal
costing :
a)
Selection of Suitable Product mix.
b)
Analysis of Effect of change in Price.
c)
Maintaining a desired level of profit.
d)
Alternative methods of production.
e)
Diversification of products.
f)
Alternative course of action etc.
a) Misleading Results: It
is very difficult to segregate all costs into fixed and variable costs very
clearly, since all costs are variable in the long run. Hence such segregation
sometimes may give misleading results.
b) Distorted Picture of Profits: The closing stock consists
of variable cost only and ignores fixed costs. This gives Distorted Picture of
Profits.
c) Avoids Semi-Variable Costs: Semi-Variable costs are not
considered in the analysis.
d) Problem of Recovery of Overheads: There is problem of under or
over-recovery of overheads, since variable costs are apportioned on estimated
basis and not on the actuals.
e) Ignorance of Time Factor: Since
the time factor is completely ignored; comparison of performance between two
periods on the basis of contribution alone will give the misleading results.
f) Under
marginal costing, stocks and work in progress are understated. The exclusion of
fixed costs from Stock Valuation affects profit, and true and fair view of
financial affairs of an organization.
g) Marginal cost data
becomes unrealistic in case of highly fluctuating levels of production, e.g.,
in case of seasonal factories.
h) It
can correctly assess the profitability on a short-term basis only, but for long
term it is not effective.
i)
It does not provide any effective yardstick for evaluation of
performance.
j)
Contribution of marginal costing is not a foolproof indicator of
profitability.
k) Marginal
cost, if confused with total cost while fixing selling price may lead to a
disaster.