It helps them in maximizing output or better capacity utilization. Fixed cost relating to closing stock is carried forward to the next year. A system which ignores fixed costs is less effective since a major portion of fixed cost is not taken care of under marginal costing. Criticism against Marginal Costing 6. Marginal cost pricing is suitable for pricing over the life-cycle of a product. Marginal cost refers to the movement in the total cost, due to the production of an additional unit of output.
In Ma rginal Costing, fixed production overheads are not shared out among units of production. Disadvantages of Marginal Costing The disadvantages, demerits or limitations of marginal costing are briefly explained below. Email me your assignments and I will send you back the solutions. There are two alternative approaches for the valuation of inventory; they are Marginal Costing and Absorption Costing. Variances in the opening and closing stock affects the cost per unit.
Our tutors are highly qualified and hold advanced degrees. The purpose of absorption costing is to provide a fair and an accurate picture of the profits. You do not show the expense until you actually sell the items in inventory. Absorption costing method avoids separation of costs into fixed and variable elements, which is not easily and accurately achieved. From this approach, it is not possible to identify an amount of net profit per product, but it is possible to identify the amount of contribution per product towards fixed overheads and profits. However, the assumption has to be made that the sales mix remains constant.
Cost Recognition The variable cost is considered as product cost while fixed cost is considered as period costs. Because you assign a per-unit amount for fixed expenses, each product in inventory has a value that includes part of the fixed overhead. Some fixed costs are liable to change from one period to another. The fixed costs are constant only for short period. Fixed overheads are usually applied based on a predetermined overhead absorption rate. From the above example, one can immediately see the revenue that needs to be generated to reach a particular operating income level, given alternative levels of fixed costs and variable costs per unit.
Disadvantages of Variable Costing Variable costing shows full payment for fixed-overhead expenses for the accounting period. Both fixed and variable cost is considered as product cost. It highlights the significance of fixed costs on profits. Marginal costing shows more clearly the impact on profit of fluctuations in the volume of sales. This fundamental marginal cost equation plays a vital role in profit projection and has a wider application in managerial decision-making problems.
Inevitable changes make it difficult to fully predict a company's future costs. With a major change in activity there may be considerable change in the rates and prices of men, material due to shortage of material, shortage of skilled labour, concessions of bulk purchase, increased transportation costs, changes in productivity of men and materials etc. The concept marginal costing is based on the behaviour of costs with volume of output. It is computed in situations where the has been reached: the fixed costs have already been absorbed by the already produced items and only the direct variable costs have to be accounted for. It can be combined with standard costing and budgetary control and thereby makes the control mechanism more effective.
Identification of variable costs and contribution enables management to use cost information more easily for decision making. Moreover, it is also very difficult to per-determine the degree of variability of semi-variable costs. If so, a company can earn some incremental profits from these customers. The downside, however, is that it may offer less insight to those charged with making strategic decisions regarding production practices and costs. This can improve your profits for the period. In this case, it may be necessary to draw up a breakeven chart for each product or a group of products. These costs could be direct costs or indirect costs variable and fixed overheads.
Marginal costing is not allowed for financial reporting purposes, so its use is restricted to internal management reports. Profitability is the main criterion for selecting the best course of action. There is no meaning in the exclusion of fixed costs from the valuation of finished goods since the fixed costs are incurred for the purpose of manufacture of products. Disadvantages of Absorption Costing Absorption costing can artificially inflate your profit figures in any given accounting period. This is possible only when lowest possible price is charged.