Marginal Costing in Decision Making – Applications and Concepts

Marginal Costing in Decision Making is a managerial accounting technique used to analyze how changes in cost and volume affect a company’s profit. It focuses on the relationship between sales, variable costs, and contribution marginto assist management in short-term business decisions. Under marginal costing, only variable costs—those that change with production levels—are considered in calculating the cost of a product, while fixed costs are treated as period costs and written off in full. This approach helps managers determine the most profitable product mix, set optimal selling prices, evaluate the impact of special orders, and decide whether to make or buy a component. Marginal costing is especially useful for break-even analysis, profit planning, and cost-volume-profit (CVP) analysis, as it provides a clear view of how each unit sold contributes to overall profit after covering variable expenses. By focusing on contribution rather than total cost, marginal costing enables faster, more informed, and data-driven decision-making in dynamic business environments.

Table of Contents

1. Pricing Decision
2. Make or Buy Decisions
3. Accept an Order or Reject
4. Key Factor/Limiting Factor
5. Replacement Decision
6. Alternative Choices
7. Expansion of Business
8. Shutdown Point
9. Capacity Decisions
10. Alternative Methods of Production
11. Decision to Drop a Product Line
12. Decision Regarding Equipment Replacement
13. Product Diversification
14. Sell or Further Process Decision
15. Evaluation of Capital Expenditure Proposals
16. Optimal Level of Activity
17. Decision Regarding Temporary Shut Downs
18. Decision Regarding Additional Shifts
19. Product Mix Decision

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1. Pricing Decision

The price is determined by the market forces, viz. demand, Supply, etc. At the same time, our experience states that these two market forces are influenced even by the price. Further it is well known that the majority of the companies aim at earning reasonable to maximum rate of profit. If at all a company wants to earn profit, its price should be higher than its costs. This implies that the companies should base their prices on costs.

Types of Pricing Decisions:

1. Pricing additional or special sales
2. Pricing under normal and favourable conditions
3. Pricing under abnormal conditions

2. Make or Buy Decisions

This kind of decision typically arises when the product being manufactured has a component part that can either be made within the factory or brought from an outside supplier.

The decision about whether to produce parts and components in-house, or to sub-contract work to external supplies, is referred to as the ‘make-or-buy decision’. Making products in-house is often cheaper than buying them, because an external supplier will charge a price which must cover his fixed costs and give him a profit, but the direct comparison of in-house costs with supplies prices is only one factor in the make-or-buy equation.

3. Accept an Order or Reject

When a business is operating at something lower than its normal value, such a special order can prove attractive depending on the effect of incremental revenues and costs on overall profits of the business.

4. Key Factor/Limiting Factor

The limiting factor decision therefore involves the determination of the contribution earned per unit of limiting factor by each different product.

A key factor is defined as the factor in the activities of an undertaking which, at a particular point of time or over a period, will limit the volume of output.

Profitability = Contribution ÷ Key Factor

Thus, Contribution per unit of key factor may be ascertained & maximised according to priority (ranking).

5. Replacement Decision

One of the more important decisions involving alternative choices is whether or not to buy new capital equipment. Replacement of equipment is a capital investment or long-term decision but one aspect of asset replacement decisions that we will consider at this stage is how to deal with the book value (i.e. the written down value) of old equipment.

This is a problem that has been known to cause difficulty, but the correct approach is to apply relevant cost principles (i.e. past or sunk costs are irrelevant for decision-making).

6. Alternative Choices

A major part of decision making involves the analysis of a defined set of alternatives against selection criteria. Sometimes the management has to select a course of action from amongst various alternative courses. Each course of action has its own merits and limitations. The course of action to be selected should ensure maximum profit to the business concern. The appraisal of the various courses of action available is possible through the analysis of contribution. The course of action ensuring highest contribution is generally adopted by the management.

7. Expansion of Business

While considering a new plant design or the redesign or expansion of an existing system, a high-level decision regarding the production capacity is called for. One of the most vital decisions which have to be made regarding production capacity is whether the company should build so much capacity to satisfy all demands during peak periods or whether it should maintain a smaller capacity and hope that failure to render service during requirements will not have unbearable consequences. Generally, companies providing utilities have a policy of building capacity to cope with peak demands (during hot summer days), but the investment made for peak demands is tremendous.

8. Shutdown Point

Shutdown point occurs exactly when the marginal profit of the business reaches a negative scale.

Very often it becomes necessary for a firm to temporarily close down the factory due to trade recession with a view to reopening it in the future. In such cases, the decision should be based on the marginal cost analysis. If the products are making a contribution towards fixed expenses or in other words if selling price is above the marginal cost, it is preferable to continue because the losses are minimised. Shut down costs are those costs which have to be incurred under all situations in the case of stopping manufacture of a product or closing down a department or division. Shut down costs are always fixed costs.

9. Capacity Decisions

While considering a new plant design or the redesign or expansion of an existing system, a high level decision regarding the production capacity is called for. In order to determine future capacity of the plant adequate consideration should be given to certain factor such as sales forecasts of physical volume, policy decisions on what will be purchased instead of made, engineering estimates of machine productivity and production plans on how equipment will be used. Upon this must be super imposed central management policies regarding desired capacity including policies regarding provisions for peak versus normal requirements, backward taper of capacity provision for growth and balance of facilities.

Main reasons for the determination of capacity are as follows:

1. Selecting a base activity for overhead rate determination or overhead distribution.
2. It is required in connection with Schedule VI of the Companies Act for indicating the licensed and installed capacity and also the actual production.
3. It is necessary for the Cost Auditor to give his comments on capacity utilisation.
4. It helps to compare the actual capacity utilisation with the budgeted capacity utilisation and to analyse the deviations for taking corrective action.
5. Capacity utilisation is an important factor in price fixation.
6. It enables the company to analyse the under or over absorption of overheads for proper treatment.
7. Capacity determination helps in preparation of flexible budgeting and achieving overall control over the operation of business.

10. Alternative Methods of Production

Labour force is necessary for the purpose of converting the raw materials into finished goods. The companies use both the manual labour force and the mechanical labour force for this purpose. Both are, to some extent, good substitutes. That means, manual labour force may be replaced, to some extent, by the mechanical labour force and vice versa.

That means, some works can be carried out either by the manual labour force or by the mechanical labour force. Further a work may be carried out with the help of one machine or the other. In this type of situation, the question arises as to which is the most economical method of production? In order to answer this question and to select the most economical method of production, the costs which differ between the alternatives are to be considered as relevant costs. The alternative which involves the minimum cost is to be selected as the most economical alternative.

Alternatively, the amount of contribution from each alternative is to be considered and the alternative which ensures higher amount of contribution is to be preferred.

11. Decision to Drop a Product Line

Since the objective of any business organisation is to maximise its profits, the firm can consider the economies of dropping the unprofitable products, and adding a more remunerative product(s). In such cases, the firm may have two alternatives as under:

1. To drop the unprofitable product and to leave the capacity unutilized.
2. To drop the unprofitable product and to utilize the capacity for the manufacture of a more remunerative product.

12. Decision Regarding Equipment Replacement

One of the more important decisions involving alternative choices is whether or not to buy new capital equipment. Generally, the economic advantage offered by such an investment is the realisation of operating cost savings which are translated into increased net profits. Therefore, some means of applying relevant cost to the measurement of such increased profit and, in turn, to the incremental capital investment is necessary.

13. Product Diversification

Companies are diversifying their lines of product either for the purpose of survival in the market or for the purpose of accomplishing higher results or for both. Further, limited product life, availability of idle capacity, possibility of utilizing the wastes, by-products, to produce a new product, etc. encourage or forces the companies to introduce a new product either in addition to the existing products or in place of an existing product. It is therefore necessary to find out whether it is economical and profitable to introduce a new product or not. In order to answer this question, it is necessary to estimate the costs that would associate, with the new product and the anticipated revenue from the same.

14. Sell or Further Process Decision

Often management has to decide whether to sell joint products at the split off point or to sell them after further processing. If further processing adds to the profit of the firm, the decision will be in favour of further processing. Incremental revenue (that is, the difference between sale value after further processing and sale value at the split off point) is compared with differential cost (that is, the additional cost of further processing) to determine whether further processing will result in additional profit. The allocation of joint cost in no way influences the decision because the total income effect does not get changed by the method of allocation of joint cost. Allocation of joint cost is useful for inventory valuation only and not for decision making

15. Evaluation of Capital Expenditure Proposals

The concept of relevant cost and revenue is very much considered while making an evaluation of capital expenditure proposal. By relevant cost we mean the amount of capital outlay, which is necessary for funding the initial investment at the beginning of the year at time t₀, the amount of working capital needed to finance the day-to-day operation of the manufacturing organisation, the amount that will be generated from the sale of old equipment is also considered.

16. Optimal Level of Activity

It is very well-known that every business organisation usually wishes to earn maximum possible amount of profit. A number of avenues are available to the companies to achieve this objective. Setting the plant at the optimum level is one of the important avenues. This deals with the economies of large-scale
production and sales, and also the resultant effect on the selling price, because, whenever there is an increase in the volume of output, some economies accrue in the production costs.

17. Decision Regarding Temporary Shut Downs

It is found in practice that a business continues its operations even when the demand for its products is low and it is operated far below its normal capacity. Such a situation is forced on the business because it is expensive in many cases to shut down the business for a short time only.

In case operations are continued, instead of being temporarily closed down, the revenues from the sales of its products may not be adequate to cover fixed costs. There are some fixed costs, which can be substantially reduced due to temporary closing down of operations, while others have the tendency to remain constant.

The decision would depend upon a comparison of direct economic consequence of shutting down business operations and continuing them at below normal capacity.

The following non-cost factors are also to be considered for these types of decisions:

1. Loss of market share to competition (Effect on Goodwill).
2. Strain in labour-management relations.
3. Availability of skilled labour on re-opening.
4. Risk of obsolescence of machinery.
5. Need to maintain machine in operating condition.
6. Arrangement of finance for compensation payable, if any.

18. Decision Regarding Additional Shifts

A very common decision to be taken by management is in connection with the operation of one or more shifts by a business having only one shift.

It is evident that, when an additional shift is added, the costs are bound to be higher, though the cost increases may or may not be in proportion to increases in output. Economies in expenses can possibly be affected by the purchase of materials in larger quantities and better utilisation of some of the fixed costs. The decision on this would be taken after comparing the additional revenue to be earned from the production resulting from one or more shifts and the incremental costs incurred in deriving that revenue.

19. Product Mix Decision

When a company manufactures more than one item, the optimum combination to produce must be determined. The following procedures are followed when making this decision:

1. Produce the maximum of the item with the highest contribution margin per unit under a particular constraint (e.g., machine hour).
2. If there are any remaining machine hour, produce the maximum that can be sold of the item with the next highest contribution margin per unit, continuing until all machine hours are utilised.