Uses & Limitations of Marginal Costing (Cambridge International AS Accounting)

Spec point — the uses and limitations of marginal costing

Uses & limitations of marginal costing

What are the uses of marginal costing?

• The contribution can be assessed to see whether it is positive or not to assist:

  • Make or buy decisions
  • Whether to accept **special one-off orders **
  • Whether to** close** a department or not

• Products can be ranked in order of contribution per limiting factor for:

  • Strategising production plan when there is a limiting factor

• It can be used to analyse if existing customer sales cover fixed costs to assess whether:

  • Penetration pricing* can be implemented when entering a new market

    • to see if it is financially viable for selling price to be set very low so it only covers variable costs

• It can be used to analyse how target profits can be met

  • The contribution minus the fixed costs gives the profits

What are the limitations of marginal costing?

• Inaccuracy in grouping fixed costs and variable costs can lead to incorrect analysis

• Fixed costs are excluded from product cost

• Not useful for long-term decision-making as this requires full cost information

• Cannot be used for inventory valuation because closing inventory is only valued at variable cost only

  • This is not acceptable under financial accounting standards

• Some assumptions are unrealistic, for example:

  • Selling price per unit is constant
  • Fixed costs remain unchanged
  • Variable cost per unit remains constant

What are non-financial factors?

• Non-financial factors are qualitative aspects of a business that cannot be measured directly in monetary terms but affect business performance

What is the significance of non-financial factors?

• Product quality

  • Decisions based purely on contribution may reduce product quality to cut variable costs
  • Poor quality can damage brand image and future sales

• Customer satisfaction

  • Decisions such as discontinuing a product due to unprofitability may be financially better for the business but could lead to loss of loyal customers

• Employee morale

  • Decisions such as wage cuts may improve contribution but lower morale and motivation of workers, leading to decline in efficiency

• Marginal costing only focuses on short-term profitability

  • Management must consider long-term factors such as growth, market leadership and sustainability