Do you feel that marginal costing is more relevant for taking short term decisions?

Marginal costing is a method of cost accounting and decision-making used for internal reporting in which
only marginal costs are charged to cost units and fixed costs are treated as a lump sum. It is also known as
contribution costing.

In marginal costing, only variable costs are used to make decisions. It does not consider fixed costs, which
are assumed to be associated with the time periods in which they were incurred.

Marginal costs include:

The costs actually incurred when you manufacture a product

The incremental increase in costs when you ramp up production
The costs that disappear when you shut down a production line
The costs that disappear when you shut down an entire subsidiary
In this technique, cost data is presented with variable costs and fixed costs shown separately for the
purpose of managerial decision-making.

Marginal costing is not a method of costing like process costing or job costing. Rather, it is simply a way
to analyse cost data for the guidance of management, usually for the purpose of understanding the effect of
profit changes due to the volume of output.
The direct costing concept is extremely useful for short-term decisions, but can lead to harmful results if
used for long-term decision-making, since it does not include all costs that may apply to a longer-term
decision. Furthermore, marginal costing does not comply with external reporting standards.

Advantages and Benefits of Marginal Costing

Cost control: Marginal costing makes it easier to determine and control costs of production. By avoiding
the arbitrary allocation of fixed overhead costs, management can concentrate on achieving and maintaining
a uniform and consistent marginal cost.

Simplicity: Marginal costing is simple to understand and operate and it can be combined with other forms
of costing (e.g. budgetary costing and standard costing) without much difficulty.
Elimination of cost variance per unit: Since fixed overheads are not charged to the cost of production in
marginal costing, units have a standard cost.

Short-term profit planning: Marginal costing can help in short-term profit planning and is easily
demonstrated with break-even charts and profit graphs. Comparative profitability can be easily assessed
and brought to the notice of the management for decision-making.
Accurate overhead recovery rate: This method of costing eliminates large balances left in overhead control
accounts, which makes it easier to ascertain an accurate overhead recovery rate.

Maximum return to the business: With marginal costing, the effects of alternative sales or production
policies are more readily appreciated and assessed, ensuring that the decisions taken will yield the
maximum return to the business.

Disadvantages and Limitations of Marginal Costing

Classifying costs: It is very difficult to separate all costs into fixed and variable costs clearly, since all costs
are variable in the long run. Hence such classification sometimes may give misleading results.
Furthermore, in a firm with many different kinds of products, marginal costing can prove less useful.
Accurately representing profits: Since the closing stock consists only of variable costs and ignores fixed
costs (which could be considerable), this gives a distorted picture of profits to shareholders.
Semi-variable costs: Semi-variable costs are either excluded or incorrectly analysed, leading to distortions.
Recovery of overheads: With marginal costing, there is often the problem of under or over-recovery of
overheads, since variable costs are apportioned on an estimated basis and not on actual value.
External reporting: Marginal costing cannot be used in external reports, which must have a complete view
of all indirect and overhead costs.
Increasing costs: Since it is based on historical data, marginal costing can give an inaccurate picture in the
presence of increasing costs or increasing production.

Conclusion: Marginal Costing Can Be Helpful for Short-Term Decision Making

Marginal costing is a useful analysis tool which usually helps management make decisions and understand
the answer to specific questions about revenue.
That said, it is not a costing methodology for creating financial statements. In fact, accounting standards
explicitly exclude marginal costing from financial statement reporting. Therefore, it does not fill the role of
a standard costing, job costing, or process costing system, all of which contribute actual changes in the
accounting records.

Still, it can be used to discover relevant information from a variety of sources and aggregate it to help
management with a number of tactical decisions. It is most useful in the short term, and least useful in the
long term, especially where a firm needs to generate sufficient profit to pay for a large amount of
overhead.
In short-run profit planning & decision-making, marginal costing is especially useful. But for far-reaching
importance, rather than on variability on costs, one will be interested in special purpose cost. The use of
recovering fixed cost through product pricing is disregarded by marginal costing technique, which is not
good for long term continuity of business. In the long run, assets have to be recovered.

Variability of costs establishment is not an easy task. In real life situations, fixed costs are rarely
completely fixed & variable costs are rarely completely variable.

Furthermore, direct costing can also cause problems in situations where incremental costs may change
significantly, or where indirect costs have a bearing on the decision.