Marginal costing

Advantages and Limitations of Marginal Costing

Advantages:

• Simpler than absorption costing — no overhead apportionment required
• Avoids misleading overhead allocation that can distort decision making
• Prevents wrong decisions based on absorbed "profit" rather than contribution
• Identifies the most profitable production pattern when resources are scarce
• Easily understood — the cost per unit and contribution are clearly visible

Limitations:

• Classification between direct and indirect costs is not always straightforward
• At low output, selling price may be set too low to cover fixed overheads
• IAS 2 prohibits use of marginal costs for inventory valuation in published accounts
• Not suitable where high indirect costs dominate — price setting becomes unreliable
• Fixed costs not allocated to departments → reduced accountability and potential inefficiency
• Does not ensure full cost recovery — overheads excluded from marginal cost calculation
• Mark-up must be higher than under absorption or ABC costing to achieve the same selling price