Marginal costing

Marginal costing recognises that, in practice

whilst variable costs always vary directly with levels of production, some indirect costs may also change.

The marginal cost is

the extra cost of an extra unit.

Decision making situations:

Make or Buy
Acceptance of additional work
Price setting
Closing of a potentially loss-making production line or department
Optimum use of Scarce Resources

Make or buy decisions

Considering whether to buy or produce a product

Special order decisions

Deciding whether to accept a one-off order at below the normal selling price

Price Setting

Setting a selling price for a job/product/service

Closing of a potentially loss-making line or production department

Where it appears that a particular product/branch/service is making a loss

Optimum use of Scarce Resources

Calculating the most profitable production pattern when inputs are in short supply

Advantages of marginal costing

The simpler of the two methods of costing
Misleading overhead allocation is avoided
Incorrect decisions based on 'profit' rather than 'contribution' are avoided
The most profitable production patterns can be calculated

Uses of marginal costing

Useful for decision making
Able to calculate selling price (but mark-up has to be larger)

Limitations of marginal costing

The classification between direct and indirect overhead is not always easy to make

At low output levels, the firm may set the selling price too low to 'cover' the indirect and fixed overheads of the firm

IAS 2 prohibits the use of marginal costs for inventory valuation in the published accounts of limited companies

Firms that have high indirect costs relative to direct costs will find that price setting cannot be based solely on marginal costing techniques

Not allocating indirect overheads to cost centres means that some costs are not the responsibility of one area - which may encourage inefficiency in controlling the costs

It does not ensure full cost recovery as overheads are not considered when calculating the marginal cost

Mark-up percentage for the selling price will be higher than ABC or absorption costing which may be less accurate

Indirect and direct costs are both divided into either fixed or variable costs. Fixed costs are not allocated to cost centres and cost units, but are regarded as time-based and are linked to accounting periods rather than units of output