There are various advantages of marginal costing, however, it’s necessary to understand what marginal cost is. Marginal costing is a method for presenting sales and cost data to managers in order to assist them in making short-term decisions such as sales mix selection, make or purchase, special order acceptance, and so on. Managers utilize it for cost control, budgeting, and profit forecasting as well.
Marginal costs are centered on variable or direct production expenses – such as labor, materials, and equipment – rather than fixed costs that the company would incur whether it boosts production or not. Administrative overhead and marketing efforts are examples of fixed expenditures that are the same regardless of the number of units produced.
They include the costs that actually occur in manufacturing a good, the additional cost increase in ramping up production, the cost of shutting down a production line, and the cost of shutting up a whole subsidiary.
Marginal costs are not a costing method such as process costs or task costs. Rather, it is just a means of analyzing management cost data, usually to comprehend the influence of the variations in profit owing to the amount of output.
The notion of direct costing is tremendously effective for short-term decisions but can, if utilized for long-term decision making, lead to damage because it does not cover all expenses that could be incurred in making a long-term decision. Moreover, external reporting criteria do not meet minimal costs. Discussed below are some advantages of marginal cost.
Advantages of Marginal Costing
Control of cost:
One of the main advantages of marginal costing is control of costs and cost management is also the key issue. The raising of the selling price to improve the profit margin may be problematic in the modern competitive environment as it might lead to market share loss. The other technique of increasing profit is by reducing costs and controlling costs.
Cost controls are designed to prevent an increase in costs above the current level.
Marginal costing helps to separate costs from variable to fixed in this task. The fixed costs remain unchanged regardless of the level of output, however, the variable costs vary according to the volume of production. At medium or low management, certain aspects of fixed costs are not controllable
In such circumstances, the variable costs for cost control purposes should be more focused. Since costs are separated from fixed costs and variable costs in marginal prices, variable costs can concentrate instead of fixed costs, hence preventing superfluous efforts to control fixed costs.
Decision making
Decision-making is an important advantage attached to marginal cost. In any organization, managerial decision-making is extremely important. A decision based on the appropriate information should be made. Details on the cost behavior are provided in the form of fixed and variable costs using the marginal costing technique. Different alternatives are used to estimate cost behaviors through cost separation between fixed and variable.
This makes decision-making easy, making it an important advantage of marginal cost. Some of the decisions must be decided based on the comparative study of costs, while the resulting revenue is the decisive factor in some decisions. Marginal costing aids in the generation of both kinds of information, allowing for logical decisions based on facts rather than intuition.
Make or buy decisions are one of the key domains of decision-making.
One of the reasons for the decision is that every businessman has to choose whether to manufacture or purchase the component in the factory. In these circumstances, the marginal cost shall be compared with the purchase price. The only relevant component to examine here is marginal costs.
If the marginal cost of producing a component is less than the cost of purchasing it, the additional component is created rather than purchased from the market. Likewise, if the purchase price is less than the marginal cost, it is better to buy it on the market. The component should be obtained from the market if the market price is less than the production cost.
A decision must be made as to whether a component should be bought on the open market or manufactured in the factory. The component should be created if the additional expenses are less than the purchase price, and vice versa.
Another key domains decision in case of key factor or limiting factor. If it were up to him, every entrepreneur would want to make and sell an endless number of the product (s). In practice, however, this is not the case. There is usually something that limits a company’s activity level.
The main factor, limiting factor, controlling factor, or principal factor is an example of such a factor. In most circumstances, sales are the most important aspect in determining the volume of output to be generated.
However, there may be instances where demand for the product is high but other resources, such as labor, machine capacity, material, financing, and so on, are scarce. In such cases, any element that limits a firm’s volume of activity is referred to as the key factor, because it governs the decision of how much to create.
When sales are the most important factor, the product’s profitability is calculated using the P/V ratio. When any other factor is the key factor, the product with the largest contribution per unit of the key factor is the most lucrative. The following formula can be used to determine the profitability of any significant element other than sales.
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Key Factor Analysis
After taking the restrictions of the various resources into account, the management must design a plan. These restrictions are also known by the theme ‘Budgets and Budgetary Control’ as limiting considerations or major budget factors. The main considerations can include raw material availability, the availability of skilled workers, the availability of machinery, and the product demand in the market.
An advantage of Marginal cost is that it assists the management to pick the optimum production plan by making the most useful use of scarce resources and optimizing profit. For example, in cases where the main determinant is raw materials and their availability is limited to a given quantity, the corporation produces three items, A, B, and C. In such instances, a strategy for marginal costs helps to make a declaration showing the amount of the contribution per kilogram.
The product that contributes the most to the raw material per kilogram has the priority and is produced to the greatest degree possible. In the order of priority, the other products are next picked up. In the given situation, the resulting product combination generates the most profit.
Short-term profit planning
The field of profit planning is another key advantage of marginal costs. Profit planning, also referred to as the budget or operating plan, can be described as preparing future activities in order to achieve a predetermined profit objective. The low-costing technique contributes to producing the facts necessary to plan and take decisions for profit.
For instance, calculating profits if the product mix changes, having an impact on profit if the selling prices change, changing profits if a product ceases to be sold or if new products are introduced, and deciding to change the sales mix is one of the areas in which the necessary data are generated by marginal costs for the decrease in the amount required.
The segmentation of costs into fixed and variable so makes profit planning particularly useful.
Marginal costs can be of use in shorter-term profit planning and can readily be shown via diagrams and profit tables. Comparative profitability may simply be evaluated and advised for decision-making by the management.
Fixation of the selling price
Another advantage of marginal cost is the fixation of the selling price. In determining the market price for goods, the distinction between fixed costs and variable costs is highly helpful. Sometimes, for the same item in different marketplaces, different prices are charged in order to meet varying levels of competition.
The marginal cost of a product is the minimum price, with cash losses resulting from any sales below the marginal cost. The cost of the goods should be established at a level which not only covers marginal costs but also contributes reasonably to the common fund to meet fixed overheads. It would be easy to determine such a price for a product if its marginal cost and overall profitability of the concern are recognized.
Price Change:
It is contended that price in short term should cover total cost and profit. But in a competitive market, price is determined by the market forces. In this connection, marginal costing is helpful in price determination in the short run.
Price in long run should be as much as to cover the total cost and normal profit. But in the competitive world, the minimum price has to be determined. If any item of cost seems to be irrelevant, it should be ignored and should not be taken into account in determining the price. Under certain special circumstances, the price may be fixed as below cost. But this price should cover all variable costs and some part of fixed cost.
In fixing the price, marginal cost, fixed cost, and price are more important points. Price changes may hike in price or reduction in price. In both cases, the quantity sold will be affected and it may affect the profit position. Management may be forced to make a decision, that how much quantity to be produced and sold if the price is reduced by a certain amount. Similarly, it is to be decided that what production technique should be applied to reduce the burden of fixed costs
Ultimate return to the business:
With marginal costing, the impacts of different sales or production policies may be more easily comprehended and examined, guaranteeing that the decisions made will provide the best possible return on investment.
Preparing tenders:
Many businesses must compete in the marketplace by offering the lowest pricing. When total variable costs are assessed separately, the ‘floor price’ is determined. Any price that is higher than this floor price might be mentioned to enhance the overall contribution.
Pricing policy:
Marginal costing is extremely useful in determining selling prices in a variety of conditions, including recessions, depressions, the launch of new products, and so on. With the use of the cost information given in the marginal costs technique, correct pricing may be produced.
Market expansion and sales promotion scheme
Taking on additional areas or expanding its marketing organization might help enhance sales volume. It will necessitate additional funds. Marginal costing will aid in the provision of enough and relevant facts for making this decision.
The management must assess the profitability of different sale plans, which may include trade discounts, free presents, additional commission, and price reductions, among other things. In all of these scenarios, marginal costing will aid in profit estimation via contribution analysis. If the goal is to increase the overall contribution, the profit will be the maximum.
Simplicity
In addition, an added advantage of marginal cost is that it is simple to operate. Because it avoids the complexity of apportioning fixed costs, which is truly random, the technique is straightforward to understand and run. The statement proposed by marginal costing is simple to understand since it divides the cost into two categories: variable and fixed.
Production Planning:
uses the cost volume profit connection to illustrate the amount of profit at each level of output. The break-even chart is used in this case.