MARGINAL COSTING-3

Advantages of Marginal Costing

Marginal costing is an important technique of managerial decision making. It is a tool for
Cost control and profit planning. The advantages of Marginal costing technique are:
1.Simplicity: the statement under marginal costing can be easily followed as it breaks up the cost as variable and fixed.
2.Stock valuation: stock valuation can be easily done and understood as it includes only variable cost.
3.Meaningful reporting: marginal costing serves as a good basis for reporting to management. The profits can be analysed from the point of view of sales rather than production.
4.Effect of fixed costs: the fixed costs are treated as period costs and are charged to P&L A/c directly. Thus they have practically no effect on decision making.
5.Profit planning: the cost-volume relationship is perfectly analysed to reveal the efficiency of products, processes and departments. ‘Break even point’ and ‘margin of safety’ are the two important concepts helpful in profit planning. Most advantageous volume and cost to maximize profits within the existing limitations can be planned.
6.Cost control and cost reduction: Marginal costing technique is helpful in preparing flexible budgets as the costs are split into fixed costs and variable portions. The emphasis is laid on variable cost for control. The fixed costs are also controlled by ascertaining them separately for computing profit and for control. The constant focus on cost and volume, and their effect on profit pave way for cost reduction.
7.Pricing policy: Marginal costing is immensely helpful in determination of selling prices under different situations like recession, depression, introduction of new product, etc., correct pricing policy can be developed under the marginal costing technique with the help of the cost information revealed therein.
8.Helpful to management: Marginal costing is helpful to management in exercising decisions regarding make or buy, exporting, key factor and numerous other aspects of business operations.

Limitations of Marginal Costing

1.Classification of Cost: Break up of cost into variable and fixed portions is a difficult problem. Moreover clear cut division of semi variable or semi fixed cost is complicated and cannot be accurate.
2.Not suitable for external reporting: Since fixed cost is not included in total cost, full cost is not available to outsiders to judge the efficiency.
3.Lack of Long-term Perspective: Marginal Costing is more suitable for decision making in the short-term. It assumes that costs are classified into fixed and variable. In the long term all the costs are variable. Therefore it ignores time element and is not suitable for long- term decisions.
4.Under Valuation of Stock: Under marginal costing, only variable costs are considered and the outputs as well as stocks are undervalued and profit is distorted. When there is loss of stock the insurance cover will not meet the total cost.
5.Automation: In these days of automation and technical advancement, huge investments are made in heavy machinery which result in heavy amount of fixed costs. Ignoring fixed costs, in this context for decision making is not rational.
6.Production aspect is ignored: Marginal costing lays too much emphasis on selling function and as such, production function has been considered to be less significant. But from the business point of view, both the functions are equally important.
7.Not applicable in all types of business: In contract type of business and job order business, full cost of the job or the contract is to be charged. Therefore, it is difficult to apply marginal costing in these types of business.
8.Misleading picture: Each product is shown at variable cost alone, thus giving a misleading picture about its cost.
9.Less scope for long-term policy decisions: Since cost, volume and profit are inter linked in price determination, which can be changed constantly, development of long-term price policy is not applicable.

Applications of Marginal Costing in Business

1. Key factor or limiting factor:
Any factor concerned with production or sales which imposes ‘limits’ on the production or sales can be called ‘limiting factor’ or key factor. It can be limited sales, limited production, limited raw materials in use or limited finance.

2. Make or buy decision:
Many durable products are assembled by using a large number of parts or components. Some of them may be made by the firm which is assembling the product. It may buy some products from outside. When an assembling firm receives an offer from outside for a component it is already making, the ‘make or buy decision’ must be taken. Marginal Costing helps in taking the make or buy decision.

3. Fixation of selling price:
Marginal costing technique is widely used in the area of determining selling price. Prices will have to be fixed in different situations, under specific constraints, etc. Total cost must be recovered and profit also to be made by fixing appropriate selling price.

4. Export decision:
When idle capacity still exists, exporting is usually the most profitable strategy. So companies which have already recovered their fixed costs from local sales can export just above their variable cost and still make good profits. This is generally termed as dumping.

5. Sales mix or product decision:
When a firm sells two or more products, the ratio of different products in the total sales is called sales mix or product mix. The firm should always design a product mix which maximizes the profit.

6. Product elimination decision:
When two or more products are sold by a firm as a sales mix, situations may arise where it may be felt that a particular product has to be eliminated. Elimination may be with or without replacement

7. Plant merger decision:
Two or more plants may be operating under the same management producing similar products. It may also be possible for one firm to acquire another competing firm. Marginal costing helps in making such decisions.

8. Plant purchase decision:
Purchasing plant is a long-term capital expenditure decision involving investment and the required return on investment. Here, effective contribution from the plant and the contribution as a percentage on investment are the deciding factors.

9. Further processing decision:
Two or more products may be produced in a joint process. The decision to further process or not depends on the overall contribution received. If further processing can result in additional contribution from the product, it is desirable.

10. Shut down decision:
When a firm is running at loss, the management will have to decide upon its shut down. It may be complete shut down or partial or temporary shut down.

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