Advantages And Disadvantages Of Marginal Costing

Advantages And Disadvantages Of Marginal Costing

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. Additional or specific fixed cost may be a relevant cost. Following are the advantages of Marginal Costing:

• Variable cost remains constant per unit of output and fixed costs remain constant in total during short period. Thus control over costs becomes more effective and easier.  Standards can be set for variable costs, while Budgets can be established for fixed cost in order to exercise full control over the total activities.
• Marginal costing brings out contribution or profit margin per unit of output, and clearly brings out the effect of change in activity. It facilitates making policy decisions in a number of management problems, such as determining profitability of products, introducing a new product, discontinuing a product, fixing selling price, deciding whether to make or buy, utilising spare capacity, profit-planning, etc.
• The distinction between product cost and period cost helps easy understanding of marginal cost statements.
• Closing inventory of work-in-progress and finished goods are valued at marginal or variable cost only. This method leads to greater accuracy in arriving at profit as it eliminates any carry over of fixed costs of the previous period through inventory valuation.
• As a corollary to above, since fixed costs do not enter into product-cost, it eliminates the process of allocating, apportioning and absorbing overheads, and adjusting underand over-absorbed overheads. Therefore, the method is simpler to operate.

Disadvantages or Limitations of Marginal costing are as follows:

• The technique is based on the segregation of costs into fixed and variable ones, while many expenses are neither totally fixed nor totally variable at various levels of activity.Thus, classifying all expenses into two categories of either fixed or variable is a difficult task.
• The assumptions regarding behaviour of costs, such as, fixed cost remains static, are often not realistic.
• Contribution is not the only index to take decisions. For example, where fixed cost is very high, selling price should not be fixed on the basis of contribution alone without considering other key factors such as capital employed.
• Marginal cost, if confused with total cost while fixing selling price may lead to a disaster.
• Inventory valuation at marginal cost will understate profits and may not be acceptable by tax-authorities. Any claim based on cost will be very low, as it will not have a share of fixed cost.

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