Marginal Costing (or Direct Costing)
When reviewing different costing systems, marginal (or direct) costing shouldn't be ruled out. When output is at any given level, it is normally possible to increase the level of output without increasing all costs proportionally, because a certain proportion of the costs will remain fixed at the same level even if the output increases. Therefore, only the variable costs will increase with an increased level of output, and it is only this increase in variable costs that needs to be taken into account by management, when taking decisions as to how to increase the level of output. The increase in these variable costs per unit of output is referred to as the marginal cost, and is an important item of information for management in calculating what effect an increase in the level of output of goods or services will have on the level of profit. Costing that is based on variable costs per unit, without taking fixed costs into account at that stage, is known as marginal costing.
Direct costing therefore requires the division of costs into fixed and variable costs. The dividing line between the two is not always clear cut, because costs that are fixed at certain levels of output will become variable if a larger increase in output is planned. For example, the rent of the factory may be relatively fixed if there is no provision for its increase in the foreseeable future. However, to obtain certain higher levels of output the management would need to consider renting further factory premises, and at that level the additional costs of renting the new factory would need to be taken into account in management decision making. Such costs might be referred to as “stepped" costs because they increase in steps when certain levels of output are reached.
The sales revenue per unit less the variable costs per unit gives the amount of contribution, this being the marginal profit available out of which fixed costs can be paid, thereby arriving at the amount of profit after payment of all costs. If the amount of contribution is equal to the fixed costs, the enterprise is breaking even.
Marginal costing is a tool for management decision-making, as it shows the effect on contribution and therefore on profit of increasing sales by one further unit. Decisions on expanding or discontinuing product lines may be taken by analyzing the contribution to profit of each product or service and deciding which product lines should be expanded and which should be discontinued.
The main disadvantage of marginal costing is that the distinction between fixed and variable overheads are not as clear-cut in reality as they are in theory. The price, fixed cost and variable cost can all vary frequently within an accounting period, and stepped costs are very common in reality, becoming relevant at various levels of output. It is therefore difficult to be certain of the marginal cost or the contribution made by an additional unit of output at a particular moment in time.