Features of Marginal Costing
In marginal costing, the relationship between costs, production volume, and profit is studied. To understand how changes in production levels impact costs and profitability, it separates total costs into fixed and variable components. As a result of changes in activity levels, this method is particularly useful for making short-term decisions and understanding cost behavior.
Basic Concepts of Marginal Costing
The basic concepts of marginal costing are as follows:
a. Variable Costs:
A variable cost is one that varies directly with production and sales levels. For example, raw materials, direct labor, and variable manufacturing overhead are examples of variable costs.
b. Fixed Costs:
The fixed costs, on the other hand, remain constant regardless of improvements in production levels. Examples of fixed costs are rent, salaries of permanent staff, and depreciation.
c. Contribution Margin:
Marginal costing uses the concept of contribution margin as a key concept. The contribution margin is the difference between sales revenue and variable costs, so it indicates what will be available to cover fixed costs and make a profit. Deducting variable costs from the unit’s selling price gives you the contribution margin per unit. An assessment of the profitability of different products or product lines can be done by calculating the contribution margin ratio.
d. Treatment of Fixed Costs:
In marginal costing, fixed costs are not attributed to individual units of production but rather are treated as period costs. In fact, fixed costs are taken into account when calculating the total contribution for the period, since they remain unchanged regardless of production volume changes. Therefore, short-term decisions are not affected by fixed costs.
e. Variable Costing for Inventory Evaluation:
In marginal costing, only production costs are considered when valuing inventory. In contrast, in absorption costing, in which both fixed and variable production costs are included in the cost of goods sold, fixed production costs are not assigned to inventory but are treated as period costs.
Advantages of Marginal Costing
The advantages of marginal costing are as follows:
a. Decision Making:
Marginal costing is particularly useful for decision making purposes. It helps determine the optimal production level, pricing decisions, and product mix decisions. Managers are able to quickly and effectively assess the financial impact of various decisions by considering variable costs and contribution margins.
b. Breakeven Analysis:
Breakeven analysis is one of the most important tools in marginal costing. It determines the level of sales at which total revenue equals total costs, resulting in no profit or loss for the company. Management can use the breakeven point to determine the sales level needed to cover all costs and determine how much to target for pricing and sales.
c. Cost-Volume-Profit (CVP) Analysis:
Marginal costing is crucial for CVP analysis, which examines how changes in costs, volumes, and sales prices affect profit levels. In this way, sales revenue, variable costs, fixed costs, and profit or loss can be understood. In order to determine how various pricing and cost-control strategies affect profitability, CVP analysis is particularly useful.
d. Short-term Decision Making:
Marginal costing is particularly useful when making short-term decisions, including special order decisions, make-or-buy decisions, and determining how changes in volume will impact the company. Management can quickly determine the financial implications of these decisions based on variable costs and contribution margins.
e. Simple Costing Method:
Marginal costing is simpler and more straightforward than absorption costing, another method of financial reporting. A unit of production is allocated all manufacturing costs (both fixed and variable) as product costs under absorption costing. When determining inventory value and cost of goods sold, marginal costing only takes into consideration variable costs.
Limitations of Marginal Costing
The limitations of marginal costing are as follows:
a. Not Suitable for External Reporting:
A marginal costing method is not suitable for external financial reporting purposes, even though it is helpful for internal decision-making. According to Generally Accepted Accounting Principles (GAAP), firms must prepare financial statements using absorption costing, which includes both fixed and variable costs. Under the matching principle, costs and revenues in the same accounting period are matched in absorption costing.
b. Treatment of Fixed Costs:
There is some criticism that treating fixed costs as period costs in marginal costing may not accurately reflect the true costs of production. Rent and depreciation, which are essential for the existence of a business, should be taken into account in the calculation of product costs.
c. Assumptions of Cost Behavior:
Marginal costing assumes that cost behavior is linear and that variable costs remain constant per unit throughout a given activity cycle. Variable costs may not always behave linearly, and economies of scale can affect the variable cost per unit.
d. Incomplete Cost Picture:
Marginal costing excludes fixed costs from the product costs, thus providing an incomplete picture of the total production costs. The lack of adequate consideration of fixed costs can lead to suboptimal pricing and production decisions.
e. Suitable for Short-Term Decisions:
Marginal costing is suitable for short-term decisions. Long-term strategic and planning decisions may benefit from absorption costing or activity-based costing.
Application of Marginal Costing
An application of marginal costing are as follows:
a. Pricing Decision:
Marginal costs provide managers with the data they need to determine the right price for a product by considering variable costs along with the contribution margin. By understanding the contribution margin per unit, managers can set prices that ensure profit margins.
b. Product Mix Decision:
A cost analysis can help determine a profitable product mix by comparing the contribution margins of various products. It assists in identifying products with high margins and those that need to be cost-reduced.
c. Making the Make-or-Buy Decision:
Marginal costing helps organizations determine whether it’s more cost-effective to produce or buy parts. Managers can make well-informed decisions based on the comparison between variable costs incurred during production and external purchase costs.
d. Sales Volume Planning:
The breakeven analysis can help managers determine where the level of sales needs to be to cover all costs and achieve the desired profit level. Marginal costing can be used to set sales targets and to create sales volume plans.
e. Special Order Decision:
If there are special orders at reduced prices, marginal costing provides a valuable tool for assessing whether a given order will be profitable. This is done by considering incremental revenue and variable costs associated with the special order.
In addition to understanding the relationship between costs, production volumes, and profits, marginal costing is an important cost accounting technique. As a key metric for decision-making, it segregates costs into fixed and variable components. It is especially useful for short-term decision-making, breakeven analysis, and determining the impact of changes in sales volume and costs on profitability.
For long-term planning and strategic decisions, however, it may not provide a complete cost picture and is not suitable for external financial reporting. Even though marginal costing has its limitations, it remains an indispensable tool in managerial accounting, assisting managers in making informed decisions and optimizing resource utilization in the organization’s interest.
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I am Bijisha, an enthusiast with a profound eagerness for learning. I hold a Bachelor’s degree in Business Administration(BBA) from Apex College. I am constantly driven by a relentless curiosity and a genuine desire to expand my knowledge horizons.
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