Marginal costing is a type of costing method under which only variable costs are included to the value of the product (or job, contract, batch, process, etc.).
Therefore, fixed costs are not allocated to the product and are expensed.
It is also known as variable costing method.
This costing method is not acceptable for inventory valuation either under IAS 2 or US GAAP but it is important for decision-making as it highlights only the changes of costs that result from certain decision.
By deducting variable costs from the revenues is obtained CONTRIBUTION.
Advantages of marginal costing compared to absorption costing
- Much simpler method, easier to understand and easily demonstrated by break-even graphs
- Provides meaningful information for decision making as it:
- is consistent with the concept of contribution (contribution per unit remains unchanged if production volumes change)
- provides less opportunities to manipulate profit by changes in inventory levels
- does not result into unabsorbed overheads
Marginal costing method is useful for
- decisions, where you need to choose one of more possible production alternatives
- short-term decisions, because the entity needs to cover its fixed costs in the long-term
Disadvantages of marginal costing compared to absorption costing
- Not acceptable for inventory valuation under IFRS or US GAAP
- Absorption costing (or ABC) can also help to understand costs in greater detail as marginal costing method 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 may vary with production volume over the longer time
More about comparison of throughput costing, variable costing, absorption costing and Activity Based Costing (ABC) methods here.