Marginal or direct costing is the accounting system in which variable costs are charged to cost units and fixed costs of the period are written off in full against the aggregate contribution.
Arguments for (benefits) the use of marginal or direct costing include the following:
- For non-profit planning purposes, management requires cost volume and profit relationship data, which are more readily available from direct cost statements than from absorption costing.
- Since fixed factory overhead is absorbed as a period of cost, increasing or reducing production and differences in the number of units produced versus the number sold do not affect the per-unit production cost.
- Direct costing reports are more easily understood by management because the statements follow management’s decision-making process more closely than do absorption costing statements.
- Reporting the total fixed cost for the period in the income statement directs management’s attention to the relationship of this cost to profits.
- The elimination of allocated joint fixed cost permits a more objective appraisal of income contributions according to products, sales areas, kinds of customers, etc. Cost volume relationships are highlighted.
- The similarity of the underlying concepts of direct costing, flexible budgets, break-even analysis, and standard costs facilitate the adoption and use of these methods for reporting cost control and financial planning.
- Direct costing provides a means of costing inventory that is similar to management’s concept of inventory cost as the current out-of-pocket expenditures necessary to produce or replace the inventory.
- The computation of product costs is simpler and more reliable under direct costing because the basis of allocating the fixed cost, which involves estimates and personal judgment, is eliminated.
- A “true and proper” profit results from direct costing because only variable costs should be identified with production. Fixed costs occur with the passage of time.