Marginal costing is a technique of assigning the cost to the product in which only the variable costs are considered in calculating the cost of the product, while fixed costs are charged against the revenue of the period.
The revenue arising from the excess of sales over variable costs is technically known as Contribution under Marginal Costing
The following are the importance or usefulness of marginal costing
Helps in determining the volume of production
Marginal Costing helps in determining the level of output that is most profitable for a running concern.
The production capacity, therefore, can be utilised to the maximum possible extent.
It helps in determining the most profitable relationship between cost, price and volume in the business which helps the management in fixing the best selling price for its products.
Thus, maximization of profit can be achieved.
Helps in selecting production lines
The technique of Marginal Costing helps in determining the most profitable production line by comparing the profitability of different products.
Certain products or activities may turn out to be unprofitable with the passage of time.
Production of such products can be discontinued while production of those products which are more profitable can be taken up. It can help in the introduction of new products and work as a good guide for deciding the optimum mix of products keeping in mind the available capacity and resources.
Helps in deciding whether to produce or procure
The decision whether a particular product should be manufactured in the factory or procured from an outside source can be taken by comparing the price at which it can be had from outside.
In case the procurement price is lower than the marginal cost of production, it will be advisable to procure the product from outside rather than manufacture it in the factory.
Helps in deciding method of manufacturing
In case a product can be manufactured by two or more methods, ascertaining the marginal cost of manufacturing the product by each method will be helpful in deciding as to which method should be adopted.
Helps in deciding whether to shut down or continue
Marginal Costing, particularly in periods of trade depression, helps in deciding whether the production in the plant should be suspended temporarily. or continued in spite of low demand for the firm’s products.
Differences between variable or marginal costing and absorption costing:
There is only one difference in the treatment of cost between variable costing
and absorption costing that affects the profit. Variable costing treats fixed
manufacturing overheads as a period cost and absorption costing treats fixed
manufacturing overheads as a product cost.
Product cost is a cost that is traceable to a product. A product cost can either be an expense or an asset. A product cost will be an expense if the specific product to which it relates is sold and an asset if the specific product to which it
relates is not sold and forms part of the inventory.
A period cost is a cost that is not included in the inventory valuation and as a
result always treated as an expense in the period in which it occurs.
The difference between the two systems will therefore always be in the portion
of fixed cost capitalised in opening and closing inventory under the absorption
what should method should a company use, marginal costing or absorption costing
The majority of companies use absorption costing for both external and internal reporting purposes, as this is consistent with the international accounting requirement, IAS 2.
This states that product cost should be derived including all costs of production (including an allocation for fixed manufacturing overheads). Therefore, the
absorption costing method needs to be continued for external reporting purposes.
However, for internal reporting purposes, variable costing should be considered, as it has the following benefits:
It provides more useful information for decision-making.
The separation of fixed and variable costs helps to provide relevant information for decision-making. Fixed costs remain the same irrespective of the level of volume.
Consequently when volume is changing or fluctuating, the impact of managerial decisions on profit can be more correctly observed.
Fixed costs relate to the capacity of the firm to produce for a period of time, rather than the production of specific products. Consequently, the fixed costs should be charged to the income statement as a period cost.
Where inventory levels fluctuate significantly, profits can be distorted when calculated on an absorption costing basis as the inventory changes will have a significant impact on the amount of fixed manufacturing overheads charged to a
Variable costing results in a lower inventory cost value and therefore is less likely to be written down to net realisable value.
If surplus inventory cannot be disposed of, the profit calculation for the current period may be overstated by a higher margin under-absorption costing if the inventory is subsequently written off or sold at substantial mark-downs.
Absorption costing is a function of sales and production.
Consequently, it is possible for managers to manipulate profits favourably in the short term by boosting production, thereby leading to increased closing inventory