Uses and Limitations of Marginal Costing
Managerial Uses of Marginal Costing:
(a) Cost Ascertainment:
Marginal costing is a strategy that makes it easier to record and report expenses. The division of expenses into fixed and variable components simplifies cost determination. The key issue in this respect is simply separating the semi-variable cost into fixed and variable components. However, this may be solved by using any of the ways available.
(b) Cost Control: Management can better understand marginal cost statements compared to absorption costing. The division of expenses into fixed and variable allows management to exert control over production costs, hence influencing efficiency.
In reality, whereas variable costs are under control at the lower levels of management, fixed costs may be managed at the highest level. Management may use this approach to investigate the behavior of costs under various production and sales situations, allowing them to exercise better cost control.
(c) Decision-Making: Each day, modern management encounters several decision-making challenges. Profitability is the primary factor for determining the optimal course of action. Marginal costs via ‘contribution’ helps management solve challenges.
Marginal costing may help address decision-making difficulties such as profit planning, product pricing, purchasing choices, and product mix.
Limits of Marginal Costing:
(a) It is difficult to separate fixed and variable expenses. In reality, it is difficult to establish a clear border between fixed and variable expenses. The difference between them is only valid in the short term. In the long term, nevertheless, all costs are changeable.
(b) Marginal costs prioritizes sales above production. However, the true efficiency of a firm can only be determined by taking into account both the selling and producing activities.
(b) Eliminating fixed expenses from inventory assessment is irrational, since these costs are also incurred during manufacturing. Furthermore, it leads to an underestimation of stock value, which is neither cost nor market price.
(d) Pricing decisions cannot be solely based on contribution. When production and sales are expanded, either via substantial use of existing technology or by replacing human work with machines, the contribution may become unrealistic. Another potential is that too many sales will be impacted at marginal cost, depriving the company of necessary earnings.
(e) Over or under-absorption of fixed overheads may be mitigated, but variable overheads continue to provide challenges.
(f) The approach is restricted for sectors that need carrying big stockpiles as work-in-progress, such as contracting enterprises.