Advantages and Disadvantages of Marginal Costing

Advantages

1. The marginal cost remains constant per unit of output whereas the fixed cost remains constant in total. Since marginal cost per unit is constant from period to period within a short span of time, firm decisions on pricing policy can be taken. If fixed cost is included, the unit cost will change from day to day depending upon the volume of output. This will make decision-making task difficult.
2. Overheads are recovered in marginal costing on the basis of pre-determined rates. If fixed overheads are included on the basis of pre-determined rates, there will be under-recovery of overheads if production is less or if overheads are more. There will be over-recovery of overheads if production is more than the budget or actual expenses are less than the estimate. This creates the problem of treatment of such under or over-recovery. Marginal costing avoids such under or over-recovery of overheads.
3. Advocates of marginal costing argue that under the marginal costing technique, the stock of finished goods and work in progress are carried on marginal cost basis and the fixed expenses are written off to profit and loss account as period costs. This shows the true profit of the period.
4. Marginal costing helps in carrying out break-even analysis, which shows the effect of increasing or decreasing production activity on the profitability of the company.
5. Segregation of expenses as fixed and variable helps the management to exercise control over expenditure. The management can compare the actual variable expenses with the budgeted variable expenses and take corrective action through analysis of variances.
6. Marginal costing helps the management in taking a number of business decisions like make or buy, discontinuance of a particular product, replacement of machines, etc.

Disadvantages

1. It is difficult to classify costs exactly into fixed and variable. Most of the expenses are neither totally variable nor wholly fixed.
2. Contribution itself is not a guide unless it is linked with the key factor.
3. Sales staff may mistake marginal cost for total cost and sell at a price, which will result in loss or low profits. Hence, sales staff should be cautioned while giving marginal cost.
4. Overheads of fixed nature cannot altogether be excluded particularly in large contracts while valuing the work-in-progress. In order to show the correct position fixed over heads should be included in work-in-progress.
5. Some of the assumptions regarding the behaviour of various costs etc., are not necessarily true in a realistic situation. For example, the assumption that fixed cost will remain static throughout is not correct.

Q. What are the advantages and limitations of Marginal Costing?