Marginal Costing Advantages And Disadvantages

9.2. Marginal costing

Marginal costing (sometimes also called direct or variable costing) is costing technique, under which only variable (i.e. marginal) production costs are charged to the product costs. It is not accepted under IFRS or US GAAP, but it is important for decision-making as it highlights only the changes of costs that result from certain decision.

Costs of the product/service under marginal costing method include ONLY variable production costs.

Fixed costs are not allocated to the product and are booked directly to income statement as expenses.

If the marginal costs are below the selling price, then the product is considered to be profitable and it is worth a production.

9.2.1. Scheme of profit and loss under marginal costing

Disadvantages of marginal costing compared to absorption costing

• Not acceptable under IFRS/IAS or US GAAP

• Absorption costing (or ABC) can also help to understand costs in greater detail as marginal costing technique does not analyze fixed costs at all

• In practice, it may be difficult to distinguish between variable and fixed costs or the result of doing so may be misleading

• Is less appropriate for longer-term planning as fixed costs per unit may vary over the longer time

9.3. Activity based costing (ABC)

Activity based costing (ABC) is costing technique, under which all costs are allocated to company activities according to what are the drivers of the activities. Costs are then allocated to products based on product´s consumption of these activities. ABC was developed to overcome the disadvantages of absorption costing, is very appropriate for pricing and product prioritization considerations. But unless this method is adjusted, it is not acceptable under IFRS and US GAAP (mainly because it allocates also selling and administrative overheads). Costs of the product/service under absorption costing method include direct costs and allocated share of overheads (production and usually also non-production as

• Technique is strongly recommended for entities with great diversity of products and with high overheads, where it wouldn´t be fair to allocate costs only based on only one activity.

9.3.3. Disadvantages of using Activity based costing (ABC)

• Some costs may not have any cost driver or can have more than one cost driver (e.g. CFO salary, statutory audit fees).

• Time-consuming, difficult and costly implementation; thus often carried out only by large companies.

• Sometimes difficult to explain to management due to its complexity.

• It does not comply with US GAAP or IFRS (mainly because it allocates also selling and administrative overheads), so entities using ABC need to maintain two accounting systems, which may differ.

9.3.4. When Activity based costing (ABC) is less useful

ABC is less useful (or maybe does not make sense), if the entity:

• produces a single product

• does not have many different activities driving the costs

• cannot influence selling price of its products (e.g. regulated industries), because the entity cannot decide to increase the price if the product is found unprofitable

• makes its products based on specific customer